‘Income’ & ‘Expenditure’ Pertaining to Pre-Commencement Business Period: Whether Capital or Revenue? – An Insight for ‘Start-Ups’!!

 “To be curious is a good thing and to work towards satisfying ones’ curiosity is even better.”- Mayank Mohanka

Introduction:

The critical question concerning the nature and taxability of ‘income’ and ‘expenditure’ pertaining to the ‘pre-commencement business/commercial production’ period, in newly incorporated business enterprises and ‘start-ups’ has always remained a confusing and litigative issue with Revenue Authorities considering the expenses as capital in nature and income as revenue in nature and the assessees wishing to treat the same in exactly the opposite manner.

In this ‘article’ an honest and sincere attempt has been made to eliminate the confusion and uncertainty regarding this conundrum and to facilitate a clear and better understanding of the entire issue by analysing all significant and prominent legal precedents in this regards.

(A) Nature & Tax Implications of ‘Expenditure’ pertaining to ‘pre-commencement business/commercial production’ period:

The Revenue Authorities, as per their natural tendency of augmenting revenue collections, tend to treat the entire expenditure incurred by the business enterprises and ‘start-ups’ during the initial years of their incorporation as pre-operative expenses or expenditure incurred prior to the commencement of business/commercial production, and consider the same as ‘capital’ in nature to be debited to the ‘Capital Work In Progress” a/c, till the time period of commencement of actual business/commercial production and to be proportionately amortised in subsequent years.

No doubt, it is a well settled and established principle of Law that any expenditure incurred prior to the incorporation of a business enterprise is a capital expenditure. It is also not doubtful that for any expenditure to become eligible to be claimed as tax deductible revenue expenditure u/s 37(1) of the Income Tax Act, it is a mandatory pre-requisite that such expenditure should have been incurred solely and exclusively for business purpose and it should be revenue in nature.

So the natural and simplistic belief of the Assessing Authorities concerning the tax treatment of ‘expenditure’ pertaining to the pre-commencement business period, centers around the philosophy that “when the business has not commenced, how can there be any question of claiming any tax deductible business expenditure by the assessee?”

Now, a natural question crops up in every enlightened mind as to what constitutes “commencement of business”? In simple words, when can a business be said to be commenced?

Again the Revenue Authorities have very simplistic answer to this otherwise complicated question and that is in case of manufacturing concerns the business is deemed to be commenced when the commercial production commences and in trading concerns the execution of first trading order embarks the commencement of business.

However, this simplistic approach of Revenue Authorities results in very complicated situations for the business enterprises and ‘start-ups’ wherein the entire expenditure incurred by these enterprises during their initial years of incorporation is being denied to be claimed as lawful business expenditure, on the ground that actual business has not started or commercial production has not commenced.

Is this simplistic approach of the Revenue Authorities, a correct approach and in conformity with the established principles of Law? This is indeed a million dollar question and this ‘write-up’ tries to address this issue.

Interestingly, in the entire framework of the existing Direct Taxation Law, no-where it is stipulated or mandated that for claiming any lawful business expenditure, the commencement of business or the commencement of commercial production is a mandatory pre-requisite or a sine-quo-non. Infact the terminology “commencement of business” itself does not find any place in any of the sections of the Income Tax Act, and as such, the widely prevailing notion and belief of ‘non-allowability of expenditure incurred prior to the commencement of business’, has infact no statutory backing of the Governing Act i.e. The Income Tax Act, 1961.

So, then what is the correct and actual position of Law in this regards? Again, the Governing Law only comes to rescue to address this complicated question.

 “When in confusion and dilemma en-route any journey, begin from the beginning again.”- Mayank Mohanka

So, in our quest to find a plausible answer to the above question, it is desirable and worthwhile to begin from the very beginning of the sections as contained in the Income Tax Act- the trigger point of the incidence of tax for any business enterprise, its first previous year”.

Proviso to section 3 of the Income Tax Act defines the term “previous year” in the context of any business enterprise or ‘Start-Up’ being newly incorporated and set-up.

For ready reference the text of section 3 and its proviso is being reproduced as under:

“Previous year” defined.

  1. For the purposes of this Act, “previous year” means the financial year immediately preceding the assessment year:

Provided that, in the case of a business or profession newly set up, or a source of income newly coming into existence, in the said financial year, the previous year shall be the period beginning with the date of setting up of the business or profession or, as the case may be, the date on which the source of income newly comes into existence and ending with the said financial year.”

So, a plain reading of the above provision clearly shows that for a new business or ‘start-up’, the ‘previous year’ is the period beginning with the date of ‘setting up of the business’.  

As explained by the Hon’ble Bombay High Court in the case of “M/s. Western India Vegetable Products Limited”:

once it is known what the business of an assessee is, the important question that has got to be considered is from which date are the expenses of this business to be considered permissible deductions and for that purpose the section that we have got to look to is Section 2(31) and that section defines the ‘previous year’ and for the purpose of a business the previous year begins from the date of setting up of the business. Therefore it is only after the business is set up that the previous year of that business commences and in that previous year the expenses incurred in the business can be claimed as permissible deductions. Any expenses incurred prior to setting up of a business would obviously not be permissible deductions because those expenses would be incurred at a point of time when the previous year of the business would not have commenced.

Thus, from above, it is duly evident and amply clear that the cut-off point for considering any expenditure as tax deductible revenue expenditure in the case of a newly incorporated business enterprise or a ‘start-up’ is “the setting-up of business” and not the “commencement of business”, as is being widely believed, or rather mis-believed.

The expression “setting-up of business” is not synominous with the expression “commencement of business/commercial production”.

The business is said to be “set-up” when it is “ready to commence business” and actual commencement is not relevant for “setting up of the business”. The setting up of business is usually a stage anterior to commencement of business and there can be a time interval between the two events.

So the correct and lawful legal position concerning the allowability of expenditure in case of a newly incorporated business enterprise or a ‘start-up’ is:

  • The expenditure incurred prior to the incorporation of an enterprise is to be considered as a pre-incorporation capital expenditure.
  • The expenditure incurred prior to 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 a tax-deductible revenue expenditure, even if it has been incurred before the commencement of actual business or commencement of commercial production, if it fulfills the mandated conditions u/s 37(1) of the Act.

So, now after having clarity over the issue of cut-off point for the allowability of any business expenditure in the case of a newly incorporated business enterprise or a ‘start-up’ to be “the setting-up of its business” and not the “commencement of its business”, the next big question that comes to any curious mind is as to:

What constitutes “setting-up of business”?

The Hon’ble Delhi High Court in the case of “Care four WC & C India (P.) Ltd. v. DCIT” [2015] 53 taxmann.com 289 (Delhi), after referring to its numerous previous judgements, have very comprehensively and beautifully analysed and explained the concept of “setting up of business” and have observed that to ‘set-up a business’, the following activities become relevant:

“Preparation of a business plan; establishment of a business premises; research into the likely markets or profitability of the business; acquiring assets for use in the business; obtaining registration as an entity and under the local laws, opening of bank account; recruitment of personnels, obtaining licenses, obtaining orders etc.”

Over a period of time, different High Courts and even the Hon’ble Supreme Court have adjudicated the issue of allowability or otherwise of expenditure incurred by a newly incorporated business enterprise or a ‘start-up’ and in the process of such adjudication have laid down some well settled and established testimonials to the concept of ‘setting-up of business’ and have categorically held that any operating business expenditure incurred by an enterprise after the ‘setting-up of its business’ is fully allowable tax-deductible revenue expenditure, even if it has been incurred prior to the commencement of business or commercial production.

Some of the prominent and significant judgements in this regard and their citations are enumerated below, for the sake of ready reference:

  • CIT w Sarabhai Management Corporation Ltd (1991) 192 ITR 151 (SC);
  • CIT vs. Hughes Escorts Communications Pvt Ltd” (311 ITR 253) (Delhi High Court);
  • CIT vs Whirlpool of India Ltd. 318 ITR 347 (Delhi High Court);
  • CIT vs L.G. Electronics (I) Ltd. 282ITR 545 (Delhi High Court);
  • CIT vs. ESPN Software India (P) Ltd. 301 ITR 368 (Delhi High Court);
  • CIT vs. Aspentech India (F) Ltd.” [2010] 187 Taxman 25 (Delhi High Court);
  • CIT vs. E. Funds International India, [2007] 162 Taxman 1 (Delhi High Court);
  • CIT Vs. Dhoomketu Builders & Development Pvt. Ltd., 216 Taxman 76;
  • CIT Vs. Samsung India Electronics Limited, 356 ITR 354;
  • CIT Vs. Franco Tosi Ingegnaria, 241 ITR 268;
  • CIT Vs. Western India Seafood (P) Ltd., 199 ITR 777;
  • CIT Vs. Saurashtra Cement & Chemicals Industries Ltd., 91 ITR 170;
  • DCIT vs. Jatra Ruchi Cosmetics ITA No 5877/Del/2015 dated 20.2.2019 (Delhi ITAT);

Based on a thorough analysis of the above judgement, a ready referral guide or pointer to the activities constituting the ‘setting-up of business’ of an enterprise is provided below for the sake of brevity and clear understanding.

 Activities evidencing “Setting-up of Business” in a Business Enterprise/Start-Up:

  • Incorporation & Registration under the various Governing Acts like, the Companies Act; the Factories, Shops & Establishment Act; the CGST & IGST Act etc.
  • Opening of Bank A/c ;
  • Induction of Share Capital Funds for the Business Purposes;
  • Acquisition/Leasing of Land;
  • Acquisition/Construction/Renting of Office Building and Premises;
  • Acquiring Assets for use in the business;
  • Installation & Commissioning of Plant & Machinery;
  • Obtainment of Statutory Approvals & Licenses for business purpose;
  • Obtainment of Electricity and Water Connection;
  • Recruitment of Skilled & Unskilled Staff and their enrollment with EPFO & ESIC Authorities;
  • Payment & Disbursal of Staff Salaries and Remunerations.
  • Preparation of a Business Plan;
  • Research into the likely Markets or Profitability of the business;
  • Participating in Tenders for business procurement;
  • Obtaining Business Orders;

Thus, the newly incorporated business enterprises and start-ups having undertaken the above mentioned one or more gamut of activities ought to be considered to have achieved the status of ‘setting-up of business’, as per the criteria and tests laid out by the Hon’ble High Courts, and the operating expenditure incurred by such enterprises after the ‘setting up of their business’ ought to be considered as tax-deductible revenue expenditure, even if it has been incurred before the commencement of business or commercial production, if it meets the stipulated conditions as envisaged u/s 37(1) of the Income Tax Act viz.

  • The expenditure should have been incurred solely and exclusively for the business operations of the assessee.
  • The expenditure should be of revenue in nature.
  • The expenditure should not be of personal nature.
  • The expenditure should not be expressly disallowed under any other section of the Income Tax Act.

(B) Nature & Tax Implications of ‘Income’ pertaining to ‘pre-commencement business/commercial production’ period:

It is not uncommon for the newly incorporated business enterprises and ‘start-ups’ to temporarily park their share capital contributions and/or borrowed funds in Bank Fixed Deposits or other similar investment avenues to earn interest or other similar income prior to the commencement of business/ commercial production, in order to augment and optimize their project resources or to minimize their project costs.

As the Revenue Authorities tend to consider the ‘expenditure’ incurred by  business enterprises or  ‘start-ups’ during the pre-commencement business period as capital in nature, one would be inclined to believe that the Authorities would adopt the consistency in treating such income earned during this period to be also of capital in nature.

However, the Revenue Authorities are not so consistent after all….

Contrary to their consideration of expenditure pertaining to the pre-commencement of business period, as a capital expenditure, the Revenue Authorities, usually treat the interest and any other similar income earned by the enterprises during this period as revenue in nature, and in doing so, the Authorities most often quote the decision of the Hon’ble Supreme Court in the case of “Tuticorin Alkali Chemicals and Fertilisers Ltd vs. CIT’ reported in 227 ITR 172.

A blanket and blind application of the said judgement of the Hon’ble Supreme Court, without going into its nitty-gritties and details and without even understanding the actual ratio emerging out of the said judgement, is being resorted to, in considering each and every income pertaining to the pre-commencement business period, as revenue in nature.

In the said case of ‘Tuticorin Alkali Chemicals’ [1997] 227 ITR 172, it was found by the authorities that the borrowed funds, being surplus and idle, were utilized by the assessee in investing in fixed deposits to earn interest income and, therefore, the Hon’ble Supreme Court have held that the interest earned on surplus borrowed funds would have to be treated as “Income from other sources”.

However, in numerous subsequent judgements of the Hon’ble Supreme Court and the Hon’ble High Courts, in the cases of :

(i) “Bokaro Steel Ltd. [1999] 236 ITR 315 (SC)”; (i)       

(ii) CIT vs Karnal Co-operative Sugar Mills Ltd 243 ITR 2 (SC);

(iii)CIT vs Karnataka Power Corporation 247 ITR 268 (SC);

(iv) Bongaigaon Refinary And Petrochemicals Ltd. v. Commissioner of Income-Tax, [2001] 251 ITR 329 (SC);

(v) Indian Oil Panipat Power Consortium Ltd vs. ITO 315 ITR 255 (Delhi High Court);

(vi) CIT vs Jaypee Dsc Ventures Ltd in ITA No. 357/2010 (Delhi High Court);

(vii) PCIT vs Facor Power Ltd (2016) 66 Taxmann.com (Delhi High Court);

It has been categorically held that if the income is earned whether by way of interest or in any other manner on the funds which are otherwise inextricably linked to setting up of the plant for business purpose, such income is required to be capitalised to be set off against preoperative expenses.

At this juncture, it would be desirable and worthwhile to bring the worthy readers’ kind attention to the categorical observations and findings of the Hon’ble Delhi High Court in the case of “Indian Oil Panipat Power Consortium Ltd vs. ITO 315 ITR 255” wherein the Hon’ble Delhi High Court have held as under:

“5. In our opinion the Tribunal has misconstrued the ratio of the judgment of the Supreme Court in the case of Tuticorin Alkali Chemicals (supra) and that of Bokaro Steel Ltd. (supra). The test which permeates through the judgment of the Supreme Court in Tuticorin Alkali Chemicals (supra) is that if funds have been borrowed for setting up of a plant and if the funds are surplus and then by virtue of that circumstance they are invested in fixed deposits the income earned in the form of interest will be taxable under the head “income from other sources. On the other hand the ratio of the Supreme Court judgment in Bokaro Steel Ltd. (supra) to our mind is that if income is earned, whether by way of interest or in any other manner on funds which are otherwise inextricably linked to the setting up of the plant, such income is required to be capitalized to be set off against pre-operative expenses.

5.2. It is clear upon a perusal of the facts as found by the authorities below that the funds in the form of share capital were infused for a specific purpose of acquiring land and the development of infrastructure. Therefore, the interest earned on funds primarily brought for infusion in the business could not have been classified as income from other sources. Since the income was earned in a period prior to commencement of business it was in the nature of capital receipt and hence was required to be set off against pre-operative expenses.

In the case of Tuticorin Alkali Chemicals [1997] 227 ITR 172 it was found by the authorities that the funds available with the assessee in that case were “surplus” and, therefore, the Supreme Court held that the interest earned on surplus funds would have to be treated as “Income from other sources”. On the other hand in Bokaro Steel Ltd. [1999] 236 ITR 315 (SC) where the assessee had earned interest on advance paid to contractors during pre- commencement period was found to be “inextricably linked” to the setting up of the plant of the assessee and hence was held to be a capital receipt which was permitted to be set off against pre-operative expenses.”

Thus the ratio of the judgment of the Hon’ble Supreme Court in the case of ‘Tuticorin Alkali Chemicals’ (supra) and that of ‘Bokaro Steel Ltd.’ (supra), is often misconstrued by the assessing authorities and even by the tax professionals.

The real test which permeates through the judgment of the Hon’ble Supreme Court in ‘Tuticorin Alkali Chemicals’ (supra) is that if funds have been borrowed for setting up of a plant and if the funds are surplus and then by virtue of that circumstance they are invested in fixed deposits the income earned in the form of interest will be taxable under the head “income from other sources.

On the other hand, the ratio of the Hon’ble Supreme Court judgment in ‘Bokaro Steel Ltd.’ (supra), is that if income is earned, whether by way of interest or in any other manner on funds which are otherwise inextricably linked to the setting up of the plant, such income is required to be capitalized to be set off against pre-operative expenses.

Concluding Remarks:

Even at the cost of repetition, in view of enabling clear understanding and ready reference, it is worthwhile and desirable to summarise the above discussed propositions concerning the nature and tax implications of ‘Expenditure’ and ‘Income’ pertaining to the pre-commencement business/commercial production period, in the case of newly incorporated business enterprises and ‘start-ups’, as under:

(A) Pre-Commencement Business Expenditure:

  • The expenditure incurred prior to the incorporation of an enterprise is to be considered as a pre-incorporation capital expenditure.
  • The expenditure incurred prior to 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 a tax-deductible revenue expenditure, even if it has been incurred before the commencement of actual business or commencement of commercial production, if it fulfills the mandated conditions u/s 37(1) of the Act.

(B) Pre-Commencement Interest & Other Income:

  • Interest and other similar income earned by way of investment of ‘surplus’ and ‘idle’ share capital or borrowed funds in bank fixed deposits or other similar investment avenues, with a specific view of earning such income, is revenue in nature and is taxable under the head ‘income from other sources’.
  • Interest and other similar income earned by way of temporary investment of share capital or borrowed funds, which are otherwise inextricably linked to the setting up of the business plant or infrastructure or such similar business operations, with a specific view to make efficient use of the project capital and to thereby reduce the cost of the project, is capital in nature and is required to be set off against pre-operative expenses.

It is a cardinal principal and trite law that the Assessing Authority is a Quasi-Judicial Authority and as such it is duty bound to assess and collect only legitimate and due taxes from the assessee as per Article 265 of the Constitution of India.

Article 265 of the Constitution of India lays down that no tax shall be levied except by authority of law. Hence only legitimate tax can be recovered and even an omission by an assessee ­does not give authority to the tax collector to recover more than what is due from him under the law.

It is also worthwhile to mention here that CBDT has itself acknowledged the above proposition as stipulated in Article 265 of the Constitution of India, by way of a Circular No: 14 (XL-35) dated April 11, 1955, wherein it has been stated that:

“Officers of the Department must not take advantage of ignorance of an assessee as to his rights. It is one of their duties to assist a taxpayer in every reasonable way, particularly in the matter of claiming and securing reliefs and in this regard the Officers should take the initiative in guiding a taxpayer where proceedings or other particulars before them indicate that some refund or relief is due to him. This attitude would, in the long run, benefit the Department for it would inspire confidence in him that he may be sure of getting a square deal from the Department. Although, therefore, the responsibility for claiming refunds and reliefs rests with assessee on whom it is imposed by law, officers should:

 (a) Draw their attention to any refunds or reliefs to which they appear to be clearly entitled but which they have omitted to claim for some reason or other;

 (b) Freely advise them when approached by them as to their rights and liabilities and as to the procedure to be adopted for claiming refunds and reliefs.”

Therefore, it is desirable on the part of the Assessing Authorities who hold such a responsible and respectable position of a Quasi-Judicial Authority in the Legislature, to take due cognizance and recognition of the above stated well settled and established principles of Law concerning the nature and taxability of ‘income’ and ‘expenditure’ pertaining to the pre-commencement business/commercial production period and to conduct assessments of the newly incorporated business enterprises and the ‘start-ups’ involving the issues concerning such ‘income’ and ‘expenditure’, by adhering to the principles of natural justice, equity and fair-play, in order to ensure and facilitate the much needed boost and fillip to the “Start-Ups” segment, in real and effective manner.

Author Bio

Qualification: CA in Practice
Company: Sushil Jeetpuria & Co.
Location: New Delhi, New Delhi, IN
Member Since: 28 Jan 2018 | Total Posts: 32
Hi there!! I am Mayank Mohanka, FCA, a Tax Practitioner based at New Delhi. Philosophy of Life: There is one thing which is more powerful than your Nav Grahas & that is Your Will Power.. I can be reached at mayankmohanka@gmail.com or at 9999981515. View Full Profile

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