Section 35(1)(iv) IT Act | Capital Expenditure on R&D Deductible Only After Business Commencement : ITAT Pune

The Income Tax Appellate Tribunal (ITAT) Pune has delivered a critical ruling on the allowability of capital expenditure on scientific research under Section 35(1)(iv) of the Income Tax Act, 1961. The judgment clarifies that such expenditure is deductible only in the year the business commences, not during preparatory phases. This decision has significant implications for biopharmaceutical and research-intensive industries where R&D spans multiple years before commercial production.

Background & Facts

The Dispute

The respondent, Epygen Biotech Pvt. Ltd., a biopharmaceutical company engaged in research and manufacturing of therapeutic proteins, claimed a deduction of ₹3,72,88,916 under Section 35(1)(iv) of the Income Tax Act for capital expenditure on scientific research. The company declared a loss of ₹5,25,98,291 in its return for Assessment Year (AY) 2018-19. The case was selected for scrutiny on two issues: business loss and the deduction claimed for scientific research.

Procedural History

The timeline of proceedings is as follows:

• 28.11.2018: Assessee filed return declaring loss.
• 06.04.2021: Assessing Officer (AO) disallowed the claim under Section 35(1)(iv), observing that the business had not commenced during AY 2018-19. The AO relied on Saurashtra Cement & Chemical Industries Ltd. but distinguished it on facts.
• 10.10.2024: Commissioner of Income Tax (Appeals) [CIT(A)] allowed the assessee’s claim, holding that research activities constituted commencement of business.
• 23.02.2026: Revenue appealed to ITAT Pune.

Relief Sought

The Revenue sought to:

• Vacate the CIT(A)’s order for alleged perversity in failing to conduct necessary inquiries.
• Restore the AO’s order disallowing the deduction.

The Legal Issue

The central question was whether capital expenditure on scientific research under Section 35(1)(iv) of the Income Tax Act is allowable in a year where the assessee’s business has not yet commenced, particularly when such expenditure was incurred in the three years preceding the alleged commencement year.

Arguments Presented

For the Revenue

The Revenue contended that:

• The assessee had not commenced business activities, as evidenced by the absence of sales, purchases, or stock during AY 2018-19.
• Explanation 1 to Section 35(2) permits deduction only for capital expenditure incurred within three years immediately preceding the commencement of business. Since the business had not commenced, the claim was inadmissible.
• The CIT(A) erred in relying on Saurashtra Cement & Chemical Industries Ltd., as the facts were distinguishable.

For the Assessee

The assessee argued that:

• Research and development activities, including land identification, factory construction, and incurring R&D expenses, constituted commencement of business.
• The company had generated income from the sale of product dossiers, recorded as "Other Income."
• The Department of Scientific and Industrial Research (DSIR) had recognized the company as a scientific research entity, validating its claim.
• The judgment in Saurashtra Cement & Chemical Industries Ltd. supported the view that business commences when the first necessary activity (e.g., research) begins.

The Court's Analysis

The ITAT Pune conducted a detailed examination of Section 35(1)(iv) and Explanation 1 to Section 35(2) of the Income Tax Act. Key observations include:

1. Statutory Framework:

   • Section 35(1)(iv) allows deduction for capital expenditure on scientific research related to the business.
   • Explanation 1 to Section 35(2) deems capital expenditure incurred within three years preceding business commencement as incurred in the year of commencement.
   • The Tribunal emphasized that the provision is designed to promote R&D but requires actual commencement of business for the deduction to be allowable.

2. Commencement of Business: The Tribunal held that commencement of business is not defined under the Act but must be interpreted contextually. For biopharmaceutical companies, research activities alone do not constitute commencement unless the product is ready for manufacturing and commercial exploitation.

   "Once the object of research and development gives the result and the assessee starts manufacturing such product, then it has to be construed that for the purpose of claiming deduction u/s. 35(1)(iv) read with Explanation 1 to section 35(2) of the Act, business has commenced."

3. Application to Facts:

   • The assessee had not manufactured any product during AY 2018-19, nor had it generated revenue from operations.
   • The Tribunal noted that the assessee’s plant and machinery were ready for use, but manufacturing had not commenced.
   • The DSIR certificate merely recognized the assessee’s in-house R&D but did not establish business commencement.
   • The Tribunal distinguished Saurashtra Cement & Chemical Industries Ltd., where limestone extraction (a preparatory activity) was held to constitute business commencement. In contrast, the assessee’s research had not yet yielded a marketable product.

4. Precedential Distinction: The Tribunal observed that the assessee’s reliance on judgments dealing with depreciation was misplaced, as Section 35(1)(iv) is a special provision for capital expenditure on scientific research, not a general depreciation allowance.

The Verdict

The ITAT Pune allowed the Revenue’s appeal, holding that:

• The assessee had not commenced business during AY 2018-19, as required under Explanation 1 to Section 35(2).
• The deduction under Section 35(1)(iv) was therefore inadmissible.
• The disallowance of ₹3,72,88,916 by the AO was restored, and the business loss was assessed at ₹1,53,09,375.

What This Means For Similar Cases

Commencement of Business Is a Prerequisite for R&D Deductions

Practitioners must note that capital expenditure on scientific research under Section 35(1)(iv) is allowable only in the year the business commences. Mere preparatory activities, such as research or setting up infrastructure, do not suffice. Key takeaways:

• Documentary Evidence of Commencement: Assessees must provide evidence of business commencement, such as:
  • Sales invoices or revenue from operations.
  • Purchase of raw materials or stock records.
  • Manufacturing or production records.
• Timing of Expenditure: Only capital expenditure incurred within three years preceding business commencement is deductible. Expenditure beyond this period is not allowable.

DSIR Recognition Alone Is Insufficient

• A DSIR certificate recognizing in-house R&D does not automatically establish business commencement.
• Assessees must demonstrate that research activities have culminated in a marketable product or commercial activity.

Distinguishing Precedents

• Courts may distinguish judgments like Saurashtra Cement & Chemical Industries Ltd. where preparatory activities (e.g., limestone extraction) were held to constitute business commencement.
• For biopharmaceutical companies, research must yield a product ready for manufacturing to qualify as business commencement.

Practical Implications for Tax Planning

• Deferral of Claims: Assessees should defer claims under Section 35(1)(iv) until the year of actual business commencement.
• Alternative Deductions: Consider claiming depreciation under Section 32 for capital assets used in R&D, where applicable.
• Audit and Compliance: Ensure robust documentation to prove business commencement, including:
  • Board resolutions.
  • Production records.
  • Sales or service agreements.