Income Tax Taxation

Tax Implication of ‘Income and Expenditure’ before the Commencement of Business

Income and Expenditure

The most critical stage for a business is the time before its commencement. Prior to the commencement of business the question which troubles the Revenue Authorities the most is related to the Tax implication of Income and Expenditure during that period. Revenue Authorities consider the expenditure as capital in nature and income as revenue in nature whereas on the other hand assesses wish to treat the same in exactly the opposite manner. In this blog, an attempt has been made to remove the confusion and uncertainty regarding this issue and provide a clear and better understanding of this entire problem by analyzing all significant and prominent legal precedents in this regard.

What will be the Tax Implications of ‘Expenditure’ pertaining to Pre-commencement Business?

 Before the commencement of business, there is a large expenditure of funds. All this expenditure which is incurred by business enterprises and start-ups during the initial years of incorporation is considered as pre-operative expenses or expenditure incurred before the commencement of business by the Revenue Authorities. Revenue Authorities consider this expenditure as ‘capital’ in nature to be debited to the “Capital Work In progress” account, till the production of actual business commences and gets proportionately amortized in subsequent years.

This is a well-defined law that any expenditure incurred before the commencement of business is a capital expenditure. Further, it needs to be noted that for any expenditure to be claimed as tax-deductible revenue expenditure under section 37(1) of the Income Tax Act[1], it is required that such expenditure should have incurred exclusively for business purposes, and it should be revenue in nature.

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The natural belief of the Revenue Authorities revolves around the fact that “when the business has not commenced, how can there be any question of claiming any tax-deductible business expenditure by the assessee?”

As per Revenue Authorities, a business is said to be commenced in manufacturing companies,  when the commercial production begins whereas, in the case of trading companies, the execution of the first trading order marks the commencement of business.

However, this simple explanation by Revenue Authorities is not that simple for business enterprises and start-ups. The entire expenditure incurred by these business enterprises and startups during their initial years of incorporation is denied to be claimed as lawful business expenditure until the actual business has not begun or commercial business has not commenced.

Here we need to understand the difference between ‘commencement’ and ‘setting-up’ of business. Both these terms are not synonymous with each other. The business is said to be “set-up’ when it is ready to be commenced however, the commencement of business is in no relation with setting up of business. There can be a gap between setting-up and commencement of business.

So, the tax implications for ‘expenditure’ incurred before the commencement of business can be understood as explained by the Hon’ble Bombay High Court. As per the Court, the cut-off point for considering the expenditure as tax-deductible revenue expenditure is ‘setting-up of business’ and not the ‘commencement of business’. Therefore, to take advantage of allowable tax deduction business owners need to understand the clear difference between ‘setting-up’ and ‘commencement’ of business.

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INCOME TAX ADVISORY

Allowability of Expenditure in case of a Newly Incorporated Business Enterprise or a ‘Start-Up’

  • The expenditure incurred before the incorporation of a business enterprise is to be considered as a pre-incorporation capital expenditure.
  • The expenditure incurred before the ‘setting-up of business’ is to be considered as a pre-operative capital expenditure.
  • The expenditure incurred after the ‘setting up of business’ is to be considered as tax-deductible revenue expenditure, even if it came into use before the commencement of actual business or commencement of commercial production, if it fulfills the conditions u/s 37(1) of the Act.

What Constitutes “Setting-Up of Business”?

As per the criteria and tests laid out by the Hon’ble High Courts following are the activities constituting the ‘setting-up of business’ of an enterprise:

  • Incorporation and Registration of the business as per various Governing Acts like the Companies Act; the CGST and IGST Act etc.
  • Opening a Bank Account
  • Induction of Share Capital Funds needed for the business
  • Acquisition/Leasing of Land
  • Construction and Renting of Office Building and Premises
  • Gathering assets to be used in the business
  • Installing the Plant and the Machinery
  • Obtaining the Approvals and Licenses required for the business
  • Get water and electricity connection
  • Recruiting the Staff
  • Prepare a business plan
  • Research in the market
  • Obtain business orders

Now when all these activities are done, and the business has been set-up by the enterprise as per the guidelines of various Hon’ble High Courts, the expenditure incurred by these enterprises after the ‘setting up’ of their business is considered as tax-deductible revenue expenditure. This expenditure incurred ought to be considered as a tax-deductible expenditure even if it has been incurred before the commencement of business or commercial production.

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Nature and Tax Implications of ‘Income’ pertaining to Pre-Commencement Business

Revenue Authorities consider the expenditure incurred by business enterprises and start-ups before the commencement of business as capital in nature. After this one would be inclined to believe in the thought that the Authorities will consider the income earned in this period to be also of capital in nature.

However, Revenue Authorities are not so consistent after all. Opposite to their consideration of expenditure pertaining to the period before the commencement of business, as a capital expenditure, the Revenue Authorities tend to treat the interest or any other income generated during this period as revenue in nature.

 Although, as per the subsequent judgments of the Hon’ble Supreme Court and the Hon’ble High Courts, if the income is earned whether, by the way of interest or any other funds which were used to set up the plant for business purpose, it should be capitalized and set-off against preoperative expenses.

Conclusion on Tax Implication of Income & Expenditure

The above-discussed propositions related to the tax implications of expenditure and income of the period before the commencement of business or commercial production can be summarized down to the following  points:

Pre-Commencement Business Expenditure:

  • The expenditure incurred before the incorporation of a business enterprise is to be considered as a pre-operative capital expenditure.
  • The expenditure incurred before the ‘setting-up of business’ is to be considered as a pre-operative capital expenditure.
  • The expenditure incurred after the ‘setting up of business’ is to be considered as tax-deductible revenue expenditure, even if it came into use before the commencement of actual business or commencement of commercial production, if it fulfills the conditions u/s 37(1) of the Act.

Pre- Commencement Interest and Other Income:

  • Interest and other similar incomes generated by the investment of ‘surplus’ and ‘idle’ share capital, with a specific view of earning such income, is considered as revenue in nature and is taxable under the head ‘ income from other sources’.
  • Interest and other similar income which is earned through the temporary investment of share capital or borrowed funds, which ultimately is linked to the setting up of business infrastructure, is capital in nature and is required to be set-off against pre-operative expenses.

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