Are expenses incurred prior to the commencement of the business allowable as deduction?

When anyone starts a business some expenditure is incurred in the form of preparation of Memorandum of Association, feasibility report, project report this is called preliminary expenditure. Section 35D of the Income Tax Act lays down the requirements, the amount of preliminary expenditure, and other conditions to be satisfied to claim the expenditure. Expenditure incurred for the following items can be claimed as a deduction:

Preparation of feasibility report
Preparation of project report
Conducting market survey necessary for business
Engineering services relating to business
Preparation of agreements between the assessee and any other person for setting up and or conduct of business
Drafting and printing of Memorandum of Association (MoA) and Articles of Association (AoA)
Incorporation of a company
Public issue of shares or debentures of the company

The issue 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 assessee’s wishing to treat the same in exactly the opposite manner. Let us refer to the case of GCO Technologies Centre Pvt Ltd vs ITO, which dealt with a similar issue.

Facts of the Case:

Assessee company was engaged in the business of providing software outsourcing services exclusively to its parent company viz. M/s Global Conference Organizers, B.V, Netherland.
During the course of the assessment proceedings, it was observed by the AO that the assessee company had entered into a service agreement with its parent company.
The AO called upon the assessee to explain as to why the expenses made prior to the commencement of its business amounting to Rs.12,26,063 may not be disallowed being in the nature of pre-commencement expenses.
In reply, it was submitted by the assessee that as the infrastructural facilities were set up, business assignments were explored/negotiated and manpower was recruited by 02.05.2009, therefore, its aforesaid claim of expenses incurred during the period 20.04.2009 to 30.07.2009 was in order and allowable as deduction u/s 37(1) of the Act.
However, the A.O not finding favour the aforesaid claim of the assessee disallowed the aforesaid expenses of Rs. 12,26,063 (net of reimbursement), by treating them as pre-commencement expenses within the meaning of Sec. 35D of the Act.

Order of Commissioner of Income Tax (Appeals) [CIT(A)]

Aggrieved, the assessee assailed the assessment order in appeal before the CIT(A).
As regards the disallowance of the pre-commencement expenses of Rs.12,26,063 by the A.O, the CIT(A) principally upheld the same.
However, taking cognizance of the fact that the said expenses would be squarely covered by Sec. 35D of the Act, the CIT(A) directed that 1/10th of the aforesaid expenditure be allowed to the assessee for each 10 successive previous beginning from the year under consideration
The assessee being aggrieved with the order of the CIT(A), appealed before the Income Tax Appellate Tribunal (ITAT)

Observations of ITAT

On a perusal of the records, ITAT found, that the assessee company had during the period May, 2009 to July, 2009 inter alia incurred expenses towards salaries of the employees, electricity expenses (nominal amount), internet expenses, office expenses, office rent, staff welfare expenses and technical consultancy fees etc., which therein proved that the assessee company, an entity belonging to service industry, had set up or in fact established its business which was ready for commencement.
In this regard, it would be relevant to point out, that as the assessee company which was engaged in the business of providing software development services exclusively to its parent company belonged to the service industry, therefore, the incurring of the aforesaid expenditure i.e payment of rent, salary expenses, electricity expenses, etc., therein revealed, that its business during the aforesaid period under consideration was though set up but had yet not commenced.
The period can safely be held to be the interval between setting up of the business and its commencement.
In ITAT’s view, all expenses which were incurred by an assessee during the interregnum period between setting up of its business and commencement of the business, were permissible as a deduction under Sec. 37 of the Act.

Reference by ITAT to an earlier case

ITAT’s view was fortified by the judgment of the High Court of Bombay in the case of CIT Vs. Axis Private Equity Limited.
In its aforesaid order, the High Court relying on its earlier judgment in the case of Western India Vegetables Products Ltd. Vs. CIT (1954), had held, that business is said to have been set up when it is established and ready to commence.
As observed by the High Court, there may be an interval between a business which is set up and a business which is commenced.
However, all expenses incurred during the interregnum period between setting up of business and commencement of business would be permissible deductions.
Observing, that the assessee before them had set up its business, which, however, was disallowed by the A.O on the ground that the assessee had not yet commenced its business, the High Court had upheld the view taken by the Tribunal which had allowed the assessee’s claim for deduction of the expenses incurred during the interregnum period.
In fact, the High Court in its aforesaid order had referred to an order of ITAT in the case of HSBC Securities India Holdings Pvt ltd, wherein the assessee’s claim for business expenditure incurred after setting up of business prior to its commencement was allowed by ITAT.

In the backdrop of the aforesaid facts, it was concluded that the expenses incurred by an assessee after setting up of its business and prior to the commencement of the same would be allowable as deduction for the purpose of computing its taxable income

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