Reset fee deduction denied as capital expenditure during construction period under section 36(1)(iii) proviso

The ITAT Chennai upheld the Revenue's disallowance of reset fee deduction, ruling it must be capitalized as part of asset cost during construction period under section 36(1)(iii) proviso. For section 80HHC computation, independent incomes like testing fees were excluded from export profits, while scrap sales were treated as raw material cost reduction. Interest on delayed payments was remitted for fresh determination. The tribunal denied deduction for abandoned revamping costs as capital expenditure, noting write-off occurred post-assessment year. Depreciation on unused gas sweetening plant was denied due to complete non-user, distinguishing it from passive user cases. Several matters were remitted to CIT(A) for fresh adjudication.

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1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered by the Tribunal include:

(a) Whether the 'reset fee' paid by the assessee to Oil Industries Development Board (OIDB) in restructuring its loan qualifies as deductible interest under sections 36(1)(iii) and 43B of the Income Tax Act, or whether it must be capitalized as part of the cost of the capital asset under the proviso to section 36(1)(iii) effective from AY 2004-05.

(b) The correct computation of 'profits of the business' under Explanation (baa) to section 80HHC, specifically whether certain receipts such as brokerage, commission, interest, rent, testing fees, and sale of scrap should be excluded from total turnover or profits for export profit computation.

(c) The classification and tax treatment of interest on delayed payments and interest on loans/advances received by the assessee-whether such income constitutes business income or income from other sources, and the consequent impact on exclusion under Explanation (baa) to section 80HHC.

(d) The maintainability and allowability of deduction claimed by the assessee for the write-off of revamping costs of an existing visbreaker unit which was abandoned midway-whether such expenditure is revenue in nature or a capital loss.

(e) The allowability of depreciation on a gas sweetening plant which was installed but not used during the relevant assessment year-whether the plant was 'used' or 'ready to use' within the meaning of section 32(1), and if depreciation is admissible despite non-operation due to non-availability of raw material.

2. ISSUE-WISE DETAILED ANALYSIS

(a) Deductibility of Reset Fee as Interest or Capitalization

The assessee had paid a 'reset fee' of Rs. 13.48 crore to OIDB to restructure existing high-cost loans by reducing interest rates. The Revenue treated this fee as interest under section 2(28A), which defines interest to include any service fee or charge in respect of borrowed money, making it deductible under section 36(1)(iii) subject to capitalization proviso effective from AY 2004-05.

The Tribunal noted that the reset fee was a one-time payment in lieu of recurring higher interest cost and thus fell within the definition of interest. Reliance was placed on the decision in CIT v. Gujarat Guardian Ltd. where prepayment charges were held to be interest and deductible under section 43B only upon payment.

However, the proviso to section 36(1)(iii), introduced by the Finance Act 2003 effective 01.04.2004, mandates capitalization of interest paid on capital borrowed for acquisition or construction of an asset during the period before the asset is first put to use. Since the loan was for financing refinery expansion, the reset fee (interest) had to be capitalized as part of the project cost.

The Tribunal rejected the assessee's claim for deduction in the year of payment and upheld the Revenue's view that the reset fee should be capitalized. It further noted that capitalization does not depend on accounting treatment but on the statutory provision, supported by the Supreme Court's ruling in Dy. CIT v. Core Health Care Ltd. The Revenue's approach of granting depreciation on the capitalized interest was also affirmed.

(b) Computation of Profits under Explanation (baa) to Section 80HHC

Explanation (baa) excludes from business profits certain independent receipts such as brokerage, commission, interest, rent, and similar receipts when computing export profits under section 80HHC. The assessee challenged the exclusion of receipts like sale of scrap and testing fees from total turnover and profits.

The Tribunal relied on its own earlier decision for AY 2003-04 and Supreme Court precedents explaining the rationale for excluding independent incomes from export profit computation. It distinguished the sale of scrap from other independent incomes, holding that scrap sales represent a reduction in raw material cost and should not be excluded from profits nor included in total turnover for export profit calculation. However, sale of power was held to be part of total turnover.

Receipts such as testing fees and other similar incomes were upheld as independent and thus excluded. The Tribunal clarified that the exclusion under Explanation (baa) applies only to net income after deducting related expenses, following the Supreme Court's decision in ACG Associated Capsules Pvt. Ltd.

(c) Classification of Interest on Delayed Payments and Interest on Loans/Advances

The assessee contended that interest on delayed payments and interest on loans/advances should be treated as business income or, alternatively, only the net interest income should be excluded under Explanation (baa). The Revenue classified such interest as income from other sources under section 56.

The Tribunal noted conflicting precedents: the Revenue relied on South India Shipping Corporation Ltd. and Tuticorin Alkali Chemicals & Fertilizers Ltd. which held that income classification depends on the manner of derivation; the assessee relied on Bokaro Steel Ltd. and Karnal Co-operative Sugar Mills Ltd. which treated interest incidental to acquisition of assets as capital receipts reducing asset cost.

The Tribunal found the assessee's alternate claim misconceived because Explanation (baa) applies only to business income, and the Revenue's classification as income from other sources precludes that. It also explained that if interest income is assessable under other sources, only net interest income (interest income less related interest expense deductible under section 57(iii)) could be excluded under Explanation (baa).

Given lack of details, the Tribunal remitted the matter to the CIT(A) for fresh adjudication on merits after hearing both parties.

(d) Deductibility of Write-off of Abandoned Visbreaker Unit Revamping Costs

The assessee wrote off Rs. 2.31 crore of revamping costs incurred on an existing visbreaker unit, which was abandoned midway due to a decision to build a new unit instead. The Revenue contended the expenditure was capital in nature and not deductible as revenue expenditure.

The Tribunal examined the facts: the revamp project was dropped in 1997-98, costs were provided for in books over several years, and the write-off was sanctioned in 2004. It held that the write-off could not be claimed as a deduction in the current year since the costs were identified as dead costs and had been provided for earlier, and each assessment year is separate under the Act.

Substantively, the Tribunal held the expenditure was capital in nature as it related to the creation of a capital asset, even though the project was aborted. The character of expenditure as capital does not change because it is infructuous. The Tribunal relied on settled Supreme Court precedents including A.V. Thomas & Co. Ltd., Swadeshi Cotton Mills Co. Ltd., and Hasimara Industries Ltd. It distinguished the assessee's reliance on decisions relating to capital allowances under section 35AB, which are not applicable here.

The Tribunal allowed the Revenue's appeal on this ground.

(e) Allowability of Depreciation on Gas Sweetening Plant Not Used During Relevant Year

The assessee claimed depreciation on a gas sweetening plant which was installed but not used during the relevant year due to non-availability of raw material (sour gas). The AO disallowed depreciation; the CIT(A) allowed it relying on the Tribunal's earlier order for AY 1998-99 where the plant was held to be 'ready to use' and thus eligible for depreciation.

The Tribunal critically examined the earlier order and relevant law under section 32(1), which allows depreciation only on assets 'used for the purposes of business or profession'. It noted the Supreme Court's ruling in Liquidators of Pursa Limited that the asset must be actually used at least for part of the year, though 'used' can include passive use (e.g., standby machines).

The Tribunal found no evidence that the plant was kept in a 'ready to use' state during the relevant year, and that the absence of raw material supply was not a temporary suspension but a prolonged non-availability, making the plant incapable of being used. It distinguished cases where passive user was accepted (e.g., temporary idleness due to repairs or labour unrest) from the present case of complete non-use from installation onwards.

It further elaborated that 'ready to use' is a notional user and cannot substitute for actual or passive user. The Tribunal emphasized that an asset cannot form part of the block of assets for depreciation unless it is used. It cited authoritative decisions including Dineshkumar Gulabchand Agrawal v. CIT, G. Shoes Exports, and Maps Tours & Travels, underscoring that actual or passive user is necessary for depreciation.

Given the absence of material and procedural infirmities in the CIT(A)'s order, the Tribunal remitted the matter back to the CIT(A) for a fresh decision on merits after allowing both parties an opportunity to produce evidence and be heard. It clarified that the CIT(A) must independently examine the facts and law, including verification of the 'ready to use' claim.

3. SIGNIFICANT HOLDINGS

"The reset fee is again only in the nature of interest, defined u/s. 2(28A) to include any service fee or charge in respect of moneys borrowed or debt incurred. The same stands paid during the relevant financial year, so that the condition of s. 43B stands satisfied. Further, in view of the proviso to s. 36(1)(iii), effective AY 2004-05, the same would stand to be a part of the cost of the capital asset/s toward acquiring which the borrowing stands applied; the interest being incurred during the construction period."

"The sale of scrap shall be regarded as a reduction in the cost of raw-material and, further, the sale shall not stand to be included in the amount of 'total turnover' of the business."

"The words 'used for the purposes of business or profession' in section 32(1) require actual use, which includes passive user, but excludes mere readiness to use. An asset not put to use at any time during the year cannot be considered as 'used' so as to qualify for depreciation."

"An expenditure incurred for a capital asset, even if infructuous or abortive, retains its capital character and cannot be allowed as a revenue deduction under section 37(1)."

"Where interest income is assessable as income from other sources, only the net interest income (interest income less interest expense deductible under section 57(iii)) can be excluded under Explanation (baa) to section 80HHC."

"The Tribunal as an appellate authority is under a bounden duty to correct errors in assessment proceedings, issuing appropriate directions, and must determine all questions arising out of the subject matter of appeal in light of evidence and justice of the case."

"The principle of res judicata has no application in proceedings under the Income Tax Act; hence, prior orders do not bind the Assessing Officer or appellate authorities in subsequent years."

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