Tax treatment of payments made for expenses, etc. under Taxability of different kinds of income :

The carrying on of a business in India by different categories of taxpayers involves a variety of expenses being incurred by them both in India and outside. The nature and amount of the expenses would, however, depend on the nature of the business, the purpose of incurring the expenditure and the stage at which it is incurred. Of these, a substantial portion of the expenditure is incurred after the business of the taxpayer in India is actually set up. The expenses incurred prior to the setting up of the business do not qualify for any allowance or deduction in computing the taxable profits of the business in India since the previous year of the business cannot be regarded as having commenced until the business is actually set up. Therefore, expenses which are incurred prior to the setting up of business and which are directly related to the acquisition of capital assets including their installation, whichever necessary, have to be capitalised and the assessee would become entitled to claim depreciation allowance and investment allowance in respect thereof from the time the business commences its normal operations by virtue of the commercial production being started. An important guiding factor for deciding in favour of or against the foreign collaboration agreement would be the admissibility or otherwise of the expenses incurred in the form of payments made to the foreign collaborator in computing the business profits of the taxpayer in India.

Wherever the expenditure is disallowable because of the restrictions under section 37(1) read with section 28 of the Income-tax Act, 1961, the Indian taxpayers will have to be extremely careful to examine, before entering into the foreign collaboration agreement whether the scheme of foreign collaboration could be modified suitably to secure that such a disallowance is not attracted. This is because of the fact that the incurring of any expenditure which is disallowable would effectively mean that the Indian taxpayers’ financial position would be substantially weakened by virtue of the agreement under which the disallowable expenditure becomes liable to be incurred. The reason for this is not far to seek. Under the scheme of the Income-tax law in India, any expenditure which is incurred by a taxpayer carrying on business and which is disallowed in computing the taxable profits would result in an addition to the real income of the assessee to the extent of the disallowed expenditure. Consequently, the taxpayer in India will not only be having the commitment of paying the amount of expenditure but also be faced with the problem of having to pay a sizeable amount towards income-tax with interest on the amount of notional income attributable to the disallowed expenditure in his income-tax assessment.

Section 37(1) would be the primary guiding provision for the purpose of determining the admissibility or otherwise of the expenditure incurred by the Indian taxpayer. Under this section, it is obligatory for the assessee to establish, for the purpose of obtaining an allowance in respect of the expenditure incurred by him, that the expenditure is of a revenue nature and has been incurred wholly and exclusively for the purpose of the business or profession carried on during the previous year, the income of which is assessable to tax in India.

The criteria for deciding the nature of the expenditure to ascertain whether it is capital or revenue is not one of universal application and the decision in each case will have to depend on the facts and circumstances of the case. The question whether a particular expenditure is capital or revenue in nature and is accordingly deductible or not for purpose of computing the taxable profits is essentially a mixed question of law and fact.