Interest During Project Setup Phase Not Taxable and Set Off Against Project Cost

 The Delhi High Court held that interest earned on funds temporarily parked in bank deposits during the project setup phase is capital in nature and not taxable as income, where such funds are not surplus / idle funds but are inextricably linked to project. The Court further clarified that such interest is required to be adjusted against (i.e., set off against) project / pre-operative expenditure, thereby reducing the overall cost of project.

Background:

• Taxpayer was incorporated to set up a manufacturing business and had not commenced operations during the years under consideration. It raised loans from its directors to fund project setup expenses such as technical know-how fees, purchase of land, import of raw materials, etc.
• A portion of the funds raised, which was not immediately required, was parked in bank deposits on which interest was earned. This interest was adjusted against pre-operative project expenses. The Revenue treated the interest as taxable income from other sources.

Revenue's Arguments:

• There was no compulsion on taxpayer to deposit money in a bank, therefore, the deposits were surplus funds and the interest earned thereon was taxable as income from other sources.
• Since the business had not commenced during the relevant years, the bank deposit was not directly connected to the project.
• Relied on landmark ruling of Supreme Court in case of Tuticorin Alkali Chemicals & Fertilizers Ltd. (‘Tuticorin’) and contend that the interest earned is taxable under Income from Other Sources on the premise that the funds placed in deposits were surplus funds.

Taxpayer's Arguments:

• Funds deposited in the bank were not surplus or idle. They were specifically earmarked for pending project payments.
• Bank deposit was merely a prudent arrangement and not independent investment to earn income.
• Relied on landmark ruling of Supreme Court in case of Bokaro Steel Ltd. (‘Bokaro’ Steel) where it was held that any amount, which are inextricably linked with set up of plant & machinery, such receipts will reduce the cost of its assets, and such receipts are capital in nature and cannot be taxed as income.
• Argued that the reliance by Revenue on Tuticorin was misplaced as it was dealing with genuinely surplus funds invested independently to earn income, which is factually distinguishable from this case.

High Court Held:

• Perusal of taxpayer's accounts showed that project related expenses were still payable, and the deposited funds were specifically earmarked to meet these pending obligations, therefore, the funds were not surplus.
• Temporary parking of funds in a bank deposit while awaiting their deployment for project purposes is merely incidental and prudent arrangement.
• Accepted the taxpayer’s reliance on the principle laid down in Bokaro Steel, noting that the facts of the present case were analogous. It further distinguished Tuticorin, clarifying that the latter applies only where surplus funds are independently invested to earn income, which was not the case here.
• Since the nexus between the funds and the project obligations was clearly established. Once this nexus exists, interest earned on such funds cannot be taxed as income and be allowed to be set off against pre-operative expenditure.

Key Takeaway:
Where interest is earned on project funds temporarily parked in bank deposits and earmarked for specific pending project obligations, such interest may be regarded as a capital receipt and not taxed as income. The interest is required to be set off against pre-operative / project setup costs, thereby reducing the capital cost of the project. The critical test is the nexus between the funds and the project