ADAF-F1 (Business Taxation)

Punjab College University Campus, Faisalabad. 1

CAPITAL AND REVENUE

Q # 2. WHY IS THE DISTINCTION BETWEEN CAPITAL AND REVENUE

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

NECESSITY OF DIFFERENTIATION
Receipts are of two types:
a) Capital receipts
b) Revenue receipts
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 RECEIPTS
The following tests may be applied to determine whether a certain item of receipt is
capital receipt or revenue receipt:

1. RECEIPTS FROM SALE OF ASSET

Any amount received on sale of fixed asset is a capital receipt where as any amount
received on sale of floating or circulating asset is a revenue receipt.

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:
Amount realized by sale of machinery is a capital receipt and amount realized by sale of
stock in trade is a revenue receipt.

Mr. Rashid Pervez

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

2. RECEIPTS IN THE HAND OF RECIPIENT

In order to determine whether a receipt is capital or revenue in nature, it is judged in the
hand of its recipient. In other words, the source from where the payment is made has no
concern with it.

Illustration:
A fee paid to legal advisor for drafting a memorandum of association is a capital
expenditure but it is treated as revenue receipt in the hand of legal advisor.

3. LUMPSUM RECEIPT
In order to determine whether a receipt is capital or revenue in nature, the fact that it is
lump sum receipt is not relevant. It may confuse your judgment because a lump sum
receipt may be a revenue receipt and in certain cases an amount received in installments
may be a capital receipt.

Illustration:
Beacon House School System sold its goodwill to Mr. Rashid for opening a branch at
Faisalabad for Rs.50,00,000. The amount will be paid in equal installments of Rs.500,000
annually. For Beacon House School System it is a capital receipt because it has
completely surrendered his right. It has no concern with lump sum payment or
installment payment.

4. SUBSTITUTION OF SOURCE OF INCOME

An amount received in substitution of a source of income is a capital receipt but on the
other hand an amount received in substitution of income alone is a revenue receipt. For
example, compensation for loss of employment is a capital receipt and compensation for
temporary disablement is a revenue receipt.

Illustration:
A person received Rs.400,000 as a commutation of pension, it is a capital receipt because
it represents substitution of source of income, it means monthly receipt of pension has
been eliminated till death. On the other hand if due to certain reasons, a person is unable
to receive pension for the last six months and ultimately received it as a lump sum
amount for last six months, it is a substitution of income and source of income is still
present, so it is treated as revenue receipt.

5. SURRENDER OF RIGHTS
If a person receives any amount against complete surrendering of his right of ownership
for example copyright, trademark, patents etc is called capital receipt. On the other hand
if a person received any amount against surrendering of his right of ownership for short
period is called revenue receipt.

Mr. Rashid Pervez

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

Illustration:
If Mr. Rashid completely sells his copyrights as a writer of book to White-rose Publishers
then any amount received by Mr. Rashid is a capital receipt. On the other hand, if Mr.
Rashid sells his right to White-rose Publishers on Rs.30,000 per annum for a period of
five years. Such receipt represents revenue receipt.

6. PURPOSE OF TRANSACTION
The motive behind the transaction is of most importance. It means it is decided on the
basis of the motive of the person receiving the amount whether it is capital receipt or
revenue receipt.

Illustration:
A person purchases a building for his own residence. After some time, he feels need of
money and he sells his building. The amount received by him is a capital receipt.

On the other hand if a person purchases the building for the purpose of reselling it at
profit, the amount realized on sale will be a revenue receipt.

EXAMPLES OF CAPITAL RECIEPTS

1) Premium on issue of shares.

2) Amount received from sale of intangible assets like patents, trademark etc.
3) Amount received from sale of tangible assets like land, building etc.
4) Amount received from sale of house purchased for residential purpose.
5) Amount received from sale of Defense Saving Certificates.

EXAMPLES OF REVENUE RECIEPTS

1) Profit on sale of house by a property dealer.

2) Royalty received from the user of a right.
3) Interest received on debentures.
4) Legal fee received by lawyer for drafting MOA or AOA of a company.
5) Amount received on account of bad debts previously written off.

Mr. Rashid Pervez