201 ITR 770 (AP)
HIGH COURT OF ANDHRA PRADESH
SYED SHAH MOHAMMED QUADRI AND P. VENKATARAMA REDDI, JJ.
CR NO. 180 OF 1985.
OCTOBER 30, 1992
Syed Shah Mohammed Quadri J. ‑ The Income-tax Appellate Tribunal, Hyderabad, referred the following questions of law to the High Court for its opinion under section 256(1) of the Income-tax Act :
“1. Whether, on the facts and in the circumstances of the case, the assessee could be held to have commenced its business and, therefore, or otherwise, is entitled to the deduction of the administrative expenses and exploration and mining expenses from out of its interest income ?
2. Whether, on the facts and in the circumstances of the case, the Tribunal was justified in directing the Income-tax Officer to consider, to the extent admissible, the claim of the assessee for setting off of interest received on short-term deposits against unadjusted expenditure for the assessment years 1976-77, 1977-78, 1978-79 and 1979-80 ?”
Under the United Nations Development Programme, the assessee-company was incorporated for establishment of a sponge iron plant. It is a Government company and is a subsidiary of the Andhra Pradesh Industrial Development Corporation (APIDC), another State undertaking. The share capital is contributed by the State Government as well as the Central Government. Out of its share capital, the assessee made short-term deposits of Rs. 53,74,000 with banks and received interest as noted hereunder.
Rs. 1,37,030 for the assessment year 1976-77.
Rs. 1,80,930 for the assessment year 1977-78.
Rs. 1,83,670 for the assessment year 1978-79.
Rs. 2,80,240 for the assessment year 1979-80.
This was treated as income from “other sources” and the assessee was taxed. It claimed that it had already commenced its business and, therefore, the expenditure incurred in those assessment years and allocated under the head “Exploration and general administration” may be allowed as deductions from out of that income. The Income-tax Officer found that the business of the assessee did not commence at any time in the accounting years relevant to the said assessment years and he assessed the interest income to tax. Against the assessments, four appeals were filed before the Commissioner of Income-tax (Appeals). In the appeals, an alternative plea was taken that the interest would go to reduce the capital cost and should not be taxed as income from “other sources”. The Commissioner agreed with the Income-tax Officer that the business did not commence and rejected the alternative contention also and thus dismissed the appeals. The assessee then carried the matter in appeal to the Income-tax Appellate Tribunal. The Tribunal noted that the primary object of the assessee-company was to set up a sponge iron plant to produce 30,000 tonnes per annum and that it was for this purpose that a survey of raw materials was conducted at various places and a testing laboratory for different types of iron ore at Bayyaram, Bellary, Hospet and Bailadilla and other places was set up. The claim of the assessee that it started industrial consultancy even at the inception was not accepted on the ground that such a consultancy was developed only at a later stage and that there was no consultancy practically during the four assessment years in question. Having noticed that the assessee was engaged in the construction of the proposed factory for manufacture of sponge iron and that there was search for raw material and that erection of the plant was not completed and the closing stock did not indicate the existence of any raw material and that it contained only building materials, stores and tools in connection with construction work and that the plant and machinery were shown as under installation or transit and the expenditure in relation to the construction was shown as amount " awaiting allocation ", and the structural work for the factory was given on contract and even the plant for preparation of raw materials was only ordered, the Tribunal came to the conclusion that the business was not started and, on that basis, the assessee's claim for determination of loss on account of administrative expenses and charges for exploration and mining was not accepted. The Tribunal, however, took the view that the interest earned during this period should go to reduce the capital cost inasmuch as the interest was on short-term deposits pending utilisation of available funds on erection, construction, etc. The allocation of expenses under the head " Exploration, general administration and capital items " was found to be prima facie justifiable under the relevant principles of accountancy. The Tribunal further held that there was no basis to conclude that that allocation was other than bona fide. The Tribunal directed that the assessee's claim for capitalisation be considered by the Income-tax Officer in the light of the decisions of the Special Bench in Nagarjuna Steels Ltd. v. ITO  3 ITD 796 ; 1 SOT 355 (Hyd) and Arasan Aluminium Industries (P) Ltd. v. First ITO  1 ITD 10 ; 1 SOT 45 (Mad). On an application under section 256(1) of the Income-tax Act, the aforesaid questions of law are referred to this court.
Mr. Ratnakar, learned counsel for the assessee, contended that the assessee's business included various activities including search of iron ore, testing and consultancy and was not confined to establishment of plant and production of sponge iron as would be evident from the articles of association and having regard to the activities of the assessee in the light of the objects clause, the business had already commenced and so the expenses in question are allowable deductions. He further contended that the interest income should be treated as business income and accordingly the deductions in question might be allowed. Mr. S. R. Ashok, learned standing counsel for the Revenue, contended that there has been no commencement of the business and, on the basis of the material on record, all the authorities including the Tribunal held that the business did not commence during the relevant period which is a finding of fact recorded by the Tribunal and therefore, the assessee cannot be allowed to contend that the business had commenced.
At the outset, we may observe that the contention of Mr. Ratnakar that the interest income may be treated as business income and on that basis allowability of deductions in question may be considered was not urged before the Departmental authorities or the Tribunal and the same does not arise out of the order of the Tribunal. However, the first question of law referred to us is so broad-based as to take this aspect in its sweep.
Now, we shall consider the first question. It is in two parts. The first part has two limbs. The first limb of the first part relates to commencement of the business and the second limb "or otherwise" takes in its fold other contentions on which the claim for deduction may be based. The second part relates to deduction of expenses. The first limb of the first part is whether, on the facts and in the circumstances of the case, the assessee could be held to have commenced its business. When a business has commenced is a question of fact. But what activities would amount to commencement of business is a mixed question of fact and law and will have to be decided on the facts of each case.
Before we proceed to deal with the factual aspect, it will be useful to refer to the cases cited at the Bar.
CIT v. Saurashtra Cement and Chemical Industries Ltd.  91 ITR 170 (Guj). In that case, the assessee-company was formed in 1956 for the manufacture and sale of cement. As part of its business, the assessee obtained a mining lease for quarrying limestone and started the mining operations in 1958. The company claimed that the expenditure incurred by way of salary, travelling expenses, dead rent, electricity charges, etc., in connection with the installation of plant and machinery and for extracting limestone as also depreciation and development rebate for the machinery installed for that purpose be allowed as deduction in computing the income for the assessment years 1960-61 and 1961-62. The Income-tax Officer allowed expenditure relating to extraction of limestone as revenue expenditure and depreciation allowance and development rebate on the installed machinery, but rejected the claim in regard to the expenditure incurred in connection with the installation of plant and machinery as being capital expenditure. On appeal, the Appellate Assistant Commissioner disallowed the expenditure relating to extraction of limestone and depreciation allowance and development rebate, added these items back and enhanced the assessment. The assessee went up in appeal to the Tribunal. It was pointed out by the Tribunal that the business of the assessee might be classified into three stages : the first stage was procurement of raw material, the second was manufacture of cement and the third was sale of manufactured cement. On a reference to the High Court, Chief Justice Bhagwati ( as he then was ), speaking for the Division Bench of the Gujarat High Court, approved the approach of the Tribunal and observed that the activities which constituted the business of the assessee were divisible into three categories : the first category consisted of the activity of extraction of limestones by quarrying the leased area of land, which was necessary for acquiring raw material to be utilised in the manufacture of cement, the second activity comprised the activity of manufacture of cement by user of plant and machinery set up for that purpose and the third activity consisted of selling manufactured cement and that these three activities combined together constituted the business of the assessee. The first activity came first in point of time and laid the foundation for the second activity and the second activity, when completed, laid the foundation for the third activity. It was held that the assessee commenced its business when it started the first activity of extraction of limestone in 1958 and, therefore, it was carrying on the business during the relevant years of account and as such the expenditure incurred by the assessee in carrying on the activity of extraction of limestone as also depreciation allowance and development rebate in respect of machinery employed in extracting limestone, were deductible in computing the trading profits of the assessee for the assessment years 1960-61 and 1961-62. The test laid down in this case is that the business would commence when the activity which is the first in point of time and which must necessarily precede the other activities is started, as business connotes a continuous course of activity and all the activities which go to make up the business need not be started simultaneously in order that the business may commence.
Sarabhai Management Corporation Ltd. v. CIT  102 ITR 25 (Guj). In that case, a private limited company was doing the business of acquiring immovable property to give on licence or lease basis with amenities of storage, watch and ward, canteens, refreshment rooms, etc. It acquired a bungalow in March, 1964, after attending to its repairs necessary for reconverting it into residential accommodation and rendering it more serviceable for the licensees or lessees. It incurred certain expenditure between October, 1964, and March 31, 1965. Part of the building was given on lease on May 1, 1965. On the ground that the company was ready to commence its business only from May 1, 1965, the said expenditure was disallowed by the assessing authority, the appellate authority as well as the Income-tax Appellate Tribunal. On a reference, a Division Bench of the Gujarat High Court applied the test laid down in Saurashtra Cement and Chemical Industries Ltd.'s case  91 ITR 170 (Guj) and held that the business activities of the company fell into three categories : first to acquire, either by purchase or by any other manner, immovable property, so as to offer it on lease or licence ; the second category of the business was to put the building accommodation and lands and gardens in proper shape, so that ultimately the property could be given on lease and licence and the third category was to actually give the accommodation on lease or on licence basis, so that the amount spent by the company was held to be allowable expenditure as it was incurred after the business was commenced. It was also held that there was a distinction between setting up of business and commencement of business and that the expenditure incurred in the interval between the setting up of the business and the commencement of the business would be a permissible deduction. This judgment was affirmed by the Supreme Court in CIT v. Sarabhai Management Corporation Ltd.  192 ITR 151. The Supreme Court held that, even if the acquisition of the property for being let out could be said to be only a preparatory stage, the subsequent activities constituted activities in the course of the carrying on of the respondent's business. It was observed that it was not correct to treat the respondent as having commenced business only when the lessee or licensee occupied the premises or started paying rent.
In Prem Conductors Pvt. Ltd. v. CIT  108 ITR 654 (Guj), the assessee-company was incorporated in November, 1963. The object of the company was to manufacture aluminium and copper conductors. For the assessment year 1965-66, the company showed a loss of about Rs. 47,000 which loss was made up of expenses like salaries, postage, rates and taxes, printing, etc. For the assessment year 1966-67, the assessee claimed a loss of Rs. 58,000. The company actually started production in June, 1965. The said expenditure which related to the period prior to the date of commencement of production, i.e., June, 1965, was disallowed by the Department as well as by the Tribunal. On reference, Divan, Chief Justice ( as he then was ), speaking for the Division Bench of the Gujarat High Court, observed that one business activity might precede another and that what was required to be seen was as to whether one of the essential activities for the carrying on of the business of the assessee-company as a whole was or was not commenced. It was held that the company had commenced its business by securing orders first and going into production later on and as the business activity of securing the business had practically started since the very date of the incorporation of the company, the business activity also started from the date of its incorporation and not from the date when the production of aluminium conductors commenced. The said amounts were treated as business losses.
CIT v. Omer Khayyam Wineries (P) Ltd.  120 ITR 859 (AP). In that case, a winery was being set up by the assessee-company. It appointed a French national for rendering necessary help in setting up a modern plant for manufacture of wines. The terms of the agreement with the French national provided that he would supervise erection of the plant and help in processing and blending of wines. The assessee spent a sum of about Rs. 20,000 up to April 3, 1968, and Rs. 77,000 odd subsequent to that date. The said amounts spent on the French national were treated as of capital nature by the Assessing Officer. The Appellate Tribunal, however, held the expenditure to be revenue in nature. On reference, a Division Bench of our High Court held that the expenditure incurred up to April 3, 1968, could not but be said to be capital in nature as, until then, there was no business transaction, but the expenditure incurred after that date could only be revenue in nature.
In Western India Vegetable Products Ltd. v. CIT  26 ITR 151 (Bom), the question before the Bombay High Court was as to when a business could be said to have been set up within the meaning of the expression under section 2(11) of the Indian Income-tax Act, 1922. The Bombay High Court pointed out that there was a clear distinction between a person commencing a business and a person setting up a business. The relevant question which would fall for consideration under section 2(11) of the Act was the setting up of the business and not the commencement of the business and it was only when a business was established and was ready to commence business then it could be said that the business was set up, but before it was ready to commence business it could not be said to have been set up.
CIT v. Sarabhai Sons Pvt. Ltd.  90 ITR 318 (Guj). In that case, the assessee started a new business for manufacture of scientific instruments and communication equipment. In January, 1966, an order for machinery was placed and the same was received in February, 1966. An order was also placed for raw materials and land was obtained on lease. In July, 1966, the machinery was installed and production was commenced. The assessee claimed deduction of certain amounts spent in connection with the new business till March 31, 1966, in the assessment year 1966-67. A Division Bench of the Gujarat High Court has held that, for the purpose of section 3(1)(d) of the Income-tax Act, 1961, what is required to be considered is the 'setting up' of the business ; when a business is established and it was ready to be started, it could be said to be set up. Obtaining land on lease and placing orders for machinery and raw materials were held to be mere operations for the setting up of the business and that the business could be said to be set up only in July, 1966, when the machinery had been installed and the factory was ready to commence production. Therefore, the revenue expenditure incurred before that date would not be a permissible deduction in the computation of the income for the assessment year 1966-67.
In CIT v. Industrial Solvents and Chemicals Pvt. Ltd.  119 ITR 608 (Bom), the assessee-company was incorporated on August 1, 1959, and the construction of the building and erection of the plant and machinery for manufacture of industrial solvents was completed by the end of December, 1960, or January, 1961. In the accounting year 1961-62, the raw material was first charged on February 5, 1961, and thereafter 42 times on different occasions. But, the finished products were not in a marketable condition. Consequently, there were no sales in the said accounting year. The assessee claimed to deduct the expenses incurred in the said year as revenue loss. The Income-tax Officer disallowed the expenses. On appeal, the Appellate Assistant Commissioner found that the business was set up in February, 1961, when trial runs had commenced. On further appeal, the Tribunal found that in spite of the fact that the trial run proved unsuccessful and did not result in marketable finished products, the assessee could be said to have commenced its business in February, 1961, and it was entitled to the allowance of expenses incurred for business purposes. On a reference, the Bombay High Court observed that the findings of fact recorded by the Tribunal showed that between August 19, 1961, and September 11, 1961, finished products were obtained by the assessee though they were sub-standard and, therefore, the business was deemed to have been set up by August 19, 1961, and not in February, 1961. Therefore, the loss would have to be calculated from August 19, 1961.
In K. Sampath Kumar v. CIT  158 ITR 25 (Mad), the assessee started a business ; for that purpose, he purchased machinery out of borrowed amounts. The machinery was installed in the assessment year 1979-80. His claim to deduct the interest paid on the borrowed capital as revenue expenditure was rejected by the Income-tax Officer. The Tribunal took the view that any interest paid before the commencement of the production on the amounts borrowed for purchasing and installing the plant and machinery would form part of the actual cost to the assessee and, therefore, the assessee was not entitled to claim interest as revenue expenditure. On the rejection of his application under section 256(1) of the Income-tax Act to refer certain questions of law, the assessee filed an application under section 256(2) of the Income-tax Act to refer, inter alia, the following question of law to the High Court for opinion ( at page 27 ) :
“Whether the Appellate Tribunal was justified in upholding the disallowance of interest of Rs. 35,526 as capital in nature ?”
The Madras High Court held that the assessee could be taken to have started the business only when his plant and machinery went into production and, in that case, during the assessment year in question, all that was done was to purchase and erect the machinery and that nothing else had taken place and so the business could not be said to have commenced and, consequently, the interest paid could not be allowed as expenditure. The application to refer the said question was rejected.
From the above discussion, the following propositions emerge :
(i) Whether a business has been commenced or not is a question of fact. However, what activities constitute commencement of business is a mixed question of law and fact and it has to be decided on the facts of each case.
(ii) There is a distinction between setting up of business and commencement of business. A business is said to be set up when it is ready to commence.
(iii) Where the business consists of continuous course of activities, for commencement of business, all the activities which go to make up the business need not be started simultaneously. As soon as an activity which is the essential activity in the course of carrying on the business is started, the business must be said to have commenced.
Now, we shall refer to the findings of fact recorded by the Tribunal to determine the first question.
The assessee-company was incorporated on March 18, 1975. The certificate for commencement of the business was issued on March 31, 1975. From a perusal of the memorandum and articles of association of the assessee-company, it is clear that the main objects are not only to produce, manufacture, purchase, refine, import, export, sell and deal in naturally occurring ores and agglomerated iron ores, pre-reduced forms of iron such as sponge iron, all forms and/or by-products thereof, etc., but also to search for, get, work, make merchantable, sell and deal in naturally occurring iron ore, minerals and substances, etc. Having regard to the findings of the Tribunal mentioned above, it is evident that the works relating to the construction of plant and installation of machinery for establishing the factory for sponge iron, were in progress during the relevant years and the machinery was awaited and that the work had not commenced. What is, however, debated is that, as the search for iron ore has commenced and as that is also one of the main objects of the company, the expenditure incurred for that purpose must be allowed as a deduction. Alternatively, it is submitted that the business of the company fell into three stages : The first stage relates to exploration of iron ore which are suitable for production of sponge iron for non-coking coal, in the second stage falls the actual mining operations and the third stage is said to be production of sponge iron. As the first activity commenced in the period relevant to the assessment years 1975-76 and 1976-77, the business has commenced and the expenditure is deductible.
We shall take up the alternative submission first. Though it is possible, having regard to the nature of the business in question, to divide a business into different stages, we do not think that the business of manufacture of sponge iron can properly be divided into three stages comprising (i) exploration of iron ore suitable for production of sponge iron, (ii) mining of iron ore ; and (iii) production of sponge iron, as contended by Mr. Ratnakar. It appears to us that the activity comprising exploration of iron ore suitable for production of sponge iron is too remote to be in proximity to the business of production of sponge iron to form the first stage of that business. Perhaps the same cannot be said of the suggested second stage of mining operations of iron ore. We, therefore, reject this contention.
Regarding the first submission, it may be observed that from the order of assessment passed by the Income-tax Officer it is clear that the exploration activity to find suitable iron ore for sponge iron was conducted by the Andhra Pradesh Industrial Development Corporation long before the incorporation of the assessee-company and it was only after ascertaining the suitability of the iron ore for production of sponge iron that the Andhra Pradesh Industrial Development Corporation proposed incorporation of the assessee-company. Therefore, as a fact, it cannot be contended that the business activity of exploration of raw material by the assessee-company had commenced. In our view, mere inclusion of a business in the main objects clause in the memorandum of association is not enough to conclude that the business has commenced to lay claim for deduction of expenses ; the business pursuant to the objects clause should have been started to justify the claim. In the instant case, evidence of starting the exploration for raw material is lacking. The initial test of raw material stores found at Bayyaram was done in the Metallurgical Lab and other laboratories and, for the purposes of exploration, the services of the Mineral Development Corporation, A. P. Mining Corporation National Mineral Development Corporation, were also commissioned in the years 1976 to 1979. These activities cannot be treated as doing search for iron ore material by the assessee-company. They can only be treated as preliminary activities for purposes of establishing and setting up the business of production of sponge iron. For these reasons, the submission fails.
We accordingly answer the first limb of the first question by saying that the business of the assessee had not commenced during the period in question.
Another aspect of the first question remains to be considered. Mr. Y. Ratnakar submits that the interest income has to be treated as business income for purposes of determining the loss and allowing the deduction of the amounts in question. As observed above, this contention was not urged before the Departmental authorities or the Tribunal. But the sweep of the first question " or otherwise " is broad enough to entertain this contention. In support of this contention, he relied on the judgment of the Supreme Court in CIT v. Cocanada Radhaswami Bank Ltd.  57 ITR 306. In that case, the assessee-bank which was carrying on banking business held securities as part of the trading assets of its business. It earned certain interest on these securities and suffered some amount of loss in the assessment years in question. The Income-tax Officer refused to set off the loss against the income computed under the head " interest on securities ". The Supreme Court held that the assessee was entitled to set off the loss brought forward against the entire income including the interest on securities in the succeeding years, as the income from securities formed part of the assessee's trading assets and its income included income from interest on securities. It was observed that the scheme of the Income-tax Act is that income-tax is one tax and that section 6 of the Indian Income-tax Act, 1922, classifies the taxable income under different heads for the purpose of computation of the net income of the assessee. For the purpose of computation of the income, interest on securities is separately classified, but income by way of interest on securities does not cease to be part of the income from business if the securities are part of the trading assets. It is thus clear that when the securities formed part of the trading assets, the interest that accrued on them was treated as income. Therefore, the carried forward loss was allowed to be set off against the income from securities in the succeeding years. In the instant case, it cannot be said that the capital was part of the trading assets of the assessee.
In Snam Proghetti S. P. A. v. Addl. CIT  132 ITR 70 (Delhi) an Italian company was carrying on business as engineers and contractors in the field of petroleum and petrochemical plants. It had large liquid funds which were placed in short-term deposits with banks and income was earned thereon. The question before the Delhi High Court was whether the loss suffered in the business which was brought forward from the earlier assessment year can be set off against the interest income of the assessee in the subsequent year. It was held by the Division Bench of the Delhi High Court that the assessee had not come from Italy to make bank deposits in India but had come to carry on business and the income earned by it by depositing spare funds in banks and earning interest thereon would also be business income and, for the purpose of set off, it could not be treated as separate from business income. Therefore, the brought-forward loss from the earlier assessment year was allowed to be set off against the interest income of the assessee for the subsequent year. It may be noted that, in that case, the assessee was carrying on business and, therefore, the part of the income from interest was treated as business income. In the instant case, we have held above that the business had not commenced and it cannot be said that, in the course of the business, the assessee was earning interest on deposits. Therefore, we are of the view that the interest income cannot be treated as business income.
For the aforesaid reasons, on the first question, we hold that the assessee is not entitled to the deduction of the administrative expenses and exploration and mining expenses from out of its interest income. Accordingly, the first question is answered in the negative, i.e., in favour of the Revenue and against the assessee.
The second question is whether the assessee can claim to set off interest received on short-term deposits against the unadjusted expenditure for the four assessment years in question.
The assessee allocated the expenses as against three items, viz., exploration, general administration and capital. The claim of the assessee was that the short-term capital amount was invested on short-term deposits, pending utilisation of available funds on erection, construction, etc., and the interest earned on such deposits should go to reduce the capital cost. The Tribunal accepted the claim of the assessee in principle, following the two Special Bench decisions in Nagarjuna Steels Ltd.  3 ITD 796 ;  Taxman 17 (Hyd) and Arasan Aluminium Industries (P) Ltd.  1 ITD 10 ; 1 SOT 45 (Mad). The Tribunal observed that the Income-tax Officer was not justified in dismissing the assessee's claim in general terms and that it cannot be said that the entire interest income is to be treated as income from other sources without any deduction. The Tribunal ultimately held as follows :
“It is difficult to imagine that none of the administrative expenses have any nexus with the earning of interest income as had been assumed by the authorities. It is under these circumstances that we are remitting the assessee's claim back to the Income-tax Officer for a fresh consideration de novo in accordance with law.”
Though we approve of the observation made by the Tribunal that the administrative expenses having a nexus with the earning of interest income would qualify for deduction, the direction given by the Tribunal in general terms to consider the question of deductibility in the light of the Special Bench decision in Arasan Aluminium Industries' case  1 ITD 10 (Mad), is not correct, having regard to the Division Bench decision of this court in CIT v. Derco Cooling Coils Ltd.  198 ITR 375 to which one of us (P. Venkatarama Reddy J.) was a party. In that case the Division Bench held that unless there is a nexus or correlation between the item of receipt and expenditure, it is not permissible to set off an item of receipt against an item of expenditure unrelated to the former or incurred in a different connection. The Division Bench held that an item of receipt which is prima facie income cannot be transposed into capital account unless the set off is in respect of a related item of expenditure. Thus, the principle enunciated in the judgment of the Special Bench in Arasan Aluminium Industries' case  1 ITD 10 (Mad), cannot be applied without the qualifications which were pointed out by the Division Bench of this court in the abovementioned case. Subject to this qualification, we do not see any illegality in the direction given to the Income-tax Officer to consider the claim of the assessee for set off of interest received on short-term deposits against unadjusted expenditure to reduce the capital cost to the extent admissible.
The question is, therefore, answered in the affirmative and in favour of the assessee but subject to the clarification given above.
In the result, the referred case is answered accordingly.