Question: Define and differentiate between capital and revenue expenditure according to business taxation point of view. ‘OR’
Why and how we differentiate between capital and revenue expenditure for tax point of view.
CAPITAL AND REVENUE EXPENDITURES:
Capital and revenue expenditures have different accounting treatment in the books of account. Financial statements cannot present fair view unless capital and revenue expenditure have been properly treated. Any wrong treatment of capital and revenue items will understate or overstate our profit. Income tax is charged on net income. If net income is not correct then we cannot calculate accurate tax.
All the expenditures that will benefit the business over a longer period of time. Increase earning capacity of the business is called capital expenditure.
All the expenditure that will benefit the business for shorter period of time or benefit of which is enjoyed for one accounting period is called revenue expenditures.
WHY TO DIFFERENTIATE BETWEEN CAPITAL AND REVENUE EXPENDITURES
Capital expenditures find place in Balance Sheet while revenue expenditures find place in profit and loss account. Any wrong treatment of these accounts will be violation of accounting principles.
Necessity for taxation
- Revenue expenditure are admissible expense for the purpose of calculating taxable income.
- Capital expenditures are not admissible expense for tax purpose.
- Revenue expenditures are deducted from the income of the year.
- Capital expenditures cannot be deducted from income of the year.
- Any mistake will understate or overstate taxable income and tax payable.
RULES / PRINCIPLE / TESTS FOR DISTINCTION
Differentiate between capital and revenue expenditures is not an easy job. We consider many factors treating any items as capital or revenue. Following are the main points of distinction between Capital and revenue expenditures.
- Nature Of Assets Purchased:
- Fixed asset
- Floating asset
Such assets are purchased for use purpose and not for resale. Expenditure incurred to purchase of fixed asset is called capital expenditure. For example money spent on purchase land, building, plant, machinery, etc. is capital expenditure.
Floating assets are purchased for resale purpose either in same shape or after some manufacturing process i.e. cotton purchased by cotton ginning factory or goods, merchandise and supplies purchased by trading firm.
- Benefit period
- Longer period benefit
- Shorter period benefit
Longer period benefit
If benefit period of the expenditure is more than one accounting period then it will be capital expenditures i.e. heavy advertisement to introduce new product.
Shorter period benefit
When benefit of the expenditures is to the extent one accounting period then it is revenue expenditure i.e. day to day advertisement, utility bill of the month, paid salaries to employees, paid rent for the month
- Earning capacity
- Increase earning capacity
- Maintain earning capacity
Increase earning capacity
If any expenditure increase the earning capacity of the business it will be capital expenditure i.e. shifting of factory from old to new and better site which can increase sale volume.
Maintain earning capacity
All expenditure incurred to maintain working capacity of the business would be treated as revenue expenditure i.e. repairs and maintenance of furniture, cost of white washing.
- Initiation of business
- Preliminary expenses
- Routine business expenses
Expenses incurred at the start of business are called preliminary expenses. Such expenses are treated as capital expenditure i.e. registration cost of firm, cost of issue of share or debenture etc.
Routine business expenses
Routine business expenses are day to day expenditure which incurred in ordinary course of business i.e. utilities bills, rent, repair and maintenance, salaries and wages etc.
- Extension of business
Expenditure incurred to extend the business is capital expenditure. For example expenditures on construction of new building or erection or installation of machinery, cost incurred to purchase new copyrights or patent rights etc. are capital expenditure.
- Nature of payment
Amount paid by the assessee to clear capital liability will be capital payment i.e. mortgage loan paid while payment of outstanding expenses will considered as revenue payment.
Example of Capital Expenditure:
- Cost of freehold land and building and the legal charges incurred for purchasing them.
- Cost of patents, trade mark, copy right, design etc.
- Cost of expenditure.
- Repairs on purchasing of second hand asset put it into working condition.
- Cost of issuing share and debentures.
- Amount paid as compensation for securing cancellation of a contract.
Example of Revenue Expenditure:
- Legal expenditures incurred defending a suit for breach of contracts to supply of goods.
- Expenses on overhauling the old machinery.
- Rent paid for hired machinery.
- Pension paid to employee.
- Exhibition expenses.
- Payment made for use of a right.