ADAF-F1 (Business Taxation)

Punjab College University Campus, Faisalabad. 1

CAPITAL AND REVENUE

Q # 1. WHY IS THE DISTINCTION BETWEEN CAPITAL AND REVENUE

IMPORTANT FROM INCOME TAX VIEWPOINT? BRIEFLY EXPLAIN TESTS
FOR DIFFRENTIATING CAPITAL AND REVENUE EXPENDITURES.

NECESSITY OF DIFFERENTIATION
Expenditures incurred by a taxpayer may be of two types:
a) Capital expenditures
b) Revenue expenditures
It is necessary to differentiate between capital and revenue receipts because income tax is
levied on revenue receipts only and not on capital receipts. On the other hand, capability
to differentiate between capital and revenue expenditure is must because, while
ascertaining the profits of a business only the revenue expenditures are deducted from the
revenue receipts. The deduction of capital expenditure is not allowed.

TESTS TO DIFFERENTIATE BETWEEN

CAPITAL AND REVENUE EXPENDITURES

The following tests may be applied to determine whether a certain item of expenditure is
capital expenditure or revenue expenditure:

1. PURCHASE OF ASSET
The amount spent on the purchase of fixed asset is capital expenditure where as the
amount spent on the purchase of floating asset is revenue expenditure.

Fixed asset
Fixed asset means an asset purchased for the long-term use in the business. Such an asset
is not for the purpose of re-sale in the normal course of business.

Floating asset
Floating asset means an asset purchased for re-sale purpose in the same condition or after
some manufacturing process.

Illustration:
Suppose a factory purchases the machinery and raw material. Machinery is fixed asset
because it is purchased for long-term use in the business. So any expenditure incurred on

Mr. Rashid Pervez

ADAF-F1 (Business Taxation)
Punjab College University Campus, Faisalabad. 2

fixed asset is called capital expenditure. Raw material is floating asset because it is used
in the manufacturing process. So any expenditure incurred on it is revenue expenditure.

2. PERIOD OF BENEFIT
An expenditure which gives continuous benefit to the business i.e. more than one
accounting period, it represents capital expenditure but if it will provide benefit to the
business for less than one accounting period, it represents revenue expenditure.

Illustration:
Expenditures incurred by an organization on advertisement to introduce a new product
represent capital expenditure but the expenditures incurred by an organization on normal
day-to-day advertisement represents revenue expenditure.

3. INITIATION OF BUSINESS
All the expenditures incurred at the time of initiation of business are called capital
expenditures. For example: cost of acquisition of land, cost of construction of building,
cost of issuing shares and debentures, purchase of machinery or other related equipments
and expenditures incurred to introduce a new product or to start a new business etc.

Illustration:
Legal fee paid to legal advisor for drafting a partnership deed of a partnership firm
represents capital expenditures because the amount is spent for initiation of business
while any salary paid by partnership firm to legal advisor during the course of business
represents revenue expenditures.

4. EXTENTION OF BUSINESS
Any expenditure incurred for the extension of business represents capital expenditure.
For example: Installation of further machinery, construction of an additional room in
building, cost on issuance of additional capital etc.

Illustration:
Directors of Sitara Textile Mills Limited decided during the annual general meeting of
the company to raise equity shares capital of a company. Company incurred Rs.50,000 on
issuance of such capital regarding newspaper advertisement, bank commission etc. Such
expenditures represent capital expenditures.

5. INCREASE IN EARNING CAPACITY OF BUSINESS

If any expenditure raises the earning capacity of business, it will be called capital
expenditure. On the other hand if any expenditure maintains the earning capacity of
business, it will be called revenue expenditure.

Illustration:
Sitara Textile Mills Limited spent Rs.10,000 on the replacement of worn out part of
machinery represents revenue expenditure. On the other hand if it spent Rs.50,000 on a

Mr. Rashid Pervez

ADAF-F1 (Business Taxation)
Punjab College University Campus, Faisalabad. 3

new part or device in the machinery which results in increase the earning capacity of
business represents capital expenditure.

EXAMPLES OF CAPITAL EXPENDITURES

1) Cost incurred on purchase of fixed tangible or intangible assets for business like
land, building, machinery, patents, trademarks, copyrights, designs, etc.
2) Cost of issuing shares and debentures.
3) Cost incurred on overhauling of second hand machinery purchased.
4) Cost incurred on formation of partnership like partnership deed etc.
5) Cost incurred on formation of company like MOA, AOA, etc.
6) Cost of affixing the signboard at the business place.
7) Legal expenses incurred in raising the loan.
8) Royalties paid for acquiring a copyright.

EXAMPLES OF REVENUE EXPENDITURES

1) All expenses which are incurred during the process of manufacturing like cost of
raw material consumed, labour charges, factory overhead charges etc.
2) Interest on loan borrowed for business.
3) Cost of white washing the building.
4) Freight expenses on purchase of stock in trade.
5) Advertising charges normally incurred.
6) Expenses on overhauling the machinery.
7) Wages paid for manufacturing of goods.

Mr. Rashid Pervez