Industrial unit trial production and evidence-based tax deductions prevail over notional disallowances

A newly installed industrial unit was treated as set up and in trial production once contemporaneous records showed commissioning, factory and ESI registrations, licence compliance, and actual production activity, supporting depreciation, additional depreciation, investment allowance and pre-commissioning expenses. The note also addresses rejection of interest disallowance where no borrowed funds were shown to have been diverted to directors or relatives, non-application of section 43B to liabilities paid within time or to carried-forward excise duty, allowance of genuine ex-gratia, service charges and cash payments on the facts, and deduction under section 80M on gross dividend where no actual expenditure was proved.

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Issues: (i) Whether the assessee's new industrial unit had been set up and commenced trial production during the previous year so as to justify depreciation, additional depreciation, investment allowance and deduction of pre-commissioning and trial run expenses; (ii) whether disallowance could be made on the ground that interest-bearing borrowings were diverted for concessional or interest-free advances to directors and relatives; (iii) whether statutory liabilities and excise duty were disallowable under section 43B of the Income-tax Act, 1961; (iv) whether the bonus provision required recomputation across the relevant assessment years; (v) whether ex-gratia payments to employees were allowable business expenditure; (vi) whether service charges paid to Unifab Engineers were genuine and deductible; (vii) whether cash payments were hit by section 40A(3) of the Income-tax Act, 1961; and (viii) whether deduction under section 80M was to be allowed on gross dividend without notional expenditure.

Issue (i): Whether the assessee's new industrial unit had been set up and commenced trial production during the previous year so as to justify depreciation, additional depreciation, investment allowance and deduction of pre-commissioning and trial run expenses.

Analysis: The unit was found to have been installed, commissioned and put to trial production within the accounting year. Contemporaneous material such as accounts, auditor's report, production records, factory registration, ESI registration, factory licence, purchase of diesel and generators, and correspondence with the technical development authorities supported actual trial production. The legal position applied was that once a business is set up and the unit is ready for its intended function, expenses incurred thereafter and asset-use in trial production are allowable even if commercial production starts later.

Conclusion: The issue was decided in favour of the assessee. Depreciation, additional depreciation, investment allowance and trial run expenses were allowable, except the transit shortage item as directed.

Issue (ii): Whether disallowance could be made on the ground that interest-bearing borrowings were diverted for concessional or interest-free advances to directors and relatives.

Analysis: The record showed that the advances were old standing balances and that no borrowed funds raised during the year were shown to have been diverted for non-business purposes. The borrowing was for business purposes and the assessee was not required to charge interest on advances made from its own funds. The notional interest approach adopted by the assessing authority was rejected for want of diversion of borrowed capital.

Conclusion: The issue was decided in favour of the assessee. The interest disallowance was deleted.

Issue (iii): Whether statutory liabilities and excise duty were disallowable under section 43B of the Income-tax Act, 1961.

Analysis: For liabilities such as sales tax and certain fund contributions, the appellate finding accepted that payments made within the statutory time and after the close of the year could not be disallowed if the liability was not claimed in a manner attracting section 43B for the year in question. As to excise duty, the amounts were brought forward from earlier years, predating the statutory provision, so section 43B was held inapplicable.

Conclusion: The issue was decided in favour of the assessee. The disallowances under section 43B were not sustained.

Issue (iv): Whether the bonus provision required recomputation across the relevant assessment years.

Analysis: The bonus working was examined across the three years and was found to be on the right lines, with the assessee accepting verification and modification if needed. The direction was only to recompute in accordance with the correct year-wise allocation and verification of figures.

Conclusion: The issue was decided in favour of the assessee. The recomputation direction was upheld.

Issue (v): Whether ex-gratia payments to employees were allowable business expenditure.

Analysis: The payments were found to be genuine, reasonable and in line with past practice, made to staff members who did not receive bonus and were linked to length of service. Such payments were treated as incurred for commercial expediency and wholly and exclusively for business purposes.

Conclusion: The issue was decided in favour of the assessee. The expenditure was allowed.

Issue (vi): Whether service charges paid to Unifab Engineers were genuine and deductible.

Analysis: The firm receiving the charges was later found to be genuine, and the assessee showed that the work was actually outsourced at a commercially beneficial cost. The payment was supported by comparative cost data and was not shown to be excessive or bogus.

Conclusion: The issue was decided in favour of the assessee. The disallowance was deleted.

Issue (vii): Whether cash payments were hit by section 40A(3) of the Income-tax Act, 1961.

Analysis: The payments were supported by identity of payees, business necessity and contemporaneous vouchers. They were made for practical business reasons, including urgency and insistence by sellers or payees. The exception under the cash-payment rule was applied on the facts.

Conclusion: The issue was decided in favour of the assessee. The cash-payment disallowance was deleted.

Issue (viii): Whether deduction under section 80M was to be allowed on gross dividend without notional expenditure.

Analysis: No material was produced to show actual expenditure incurred for earning the dividend income. The attempt to estimate and deduct a percentage on a notional basis was held unsupported.

Conclusion: The issue was decided in favour of the assessee. Deduction under section 80M was directed on the gross dividend.

Final Conclusion: The Revenue failed on all substantive grounds, and the appellate reliefs granted to the assessee were sustained in full.

Ratio Decidendi: Where an industrial unit is demonstrably set up and put to trial production within the relevant year, expenses incurred and assets used in that trial stage are allowable even before commercial production begins; similarly, business disallowances cannot rest on notional assumptions about diversion of funds or notional expenditure without supporting evidence.

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