This article deals with deduction or allowance under Income Tax Act, 1961 (“ITA”) for Pre-operative Expenses/preliminary Expenses.
1. What are Pre-operative Expenses/preliminary Expenses?
A business may incur many expenditures before it starts. These costs can be called as Start-up costs which consists of preliminary expenses incurred in establishing a legal entity such as legal and secretarial costs, expenditure to open a new facility or business (pre-opening costs) or expenditures for commencing new operations or launching new products or processes (pre-operating costs)
Few examples of such expenses are:
2. Taxability of Preliminary Expenses
Deduction for Preliminary Expense is covered in Section 35D of the ITA.
2.1 Preliminary expenses allowed under section 35D for persons who are resident in India includes expenditure:
(i) before the commencement of his business, or
(ii) after the commencement of his business, in connection with the extension of his undertaking or in connection with his setting up a new unit
2.2 The expenditure that are allowed as per Section 35D are:
As per Section 35D of the ITA, preliminary expenses:
“ a) expenditure in connection with—
(i) preparation of feasibility report;
(ii) preparation of project report;
(iii) conducting market survey or any other survey necessary for the business of the assessee;
(iv) engineering services relating to the business of the assessee:
(b) legal charges for drafting any agreement between the assessee and any other person for any purpose relating to the setting up or conduct of the business of the assessee;
(c) where the assessee is a company, also expenditure—
(i) by way of legal charges for drafting the Memorandum and Articles of Association of the company;
(ii) on printing of the Memorandum and Articles of Association;
(iii) by way of fees for registering the company under the provisions of the Companies Act;
(iv) in connection with the issue, for public subscription, of shares in or debentures of the company, being underwriting commission, brokerage and charges for drafting, typing, printing and advertisement of the prospectus;
(d) such other items of expenditure (not being expenditure eligible for any allowance or deduction under any other provision of this Act) as may be prescribed.”
2.3 The maximum amount of expenditure allowable is 5 %:
(a) of the cost of the project, or
(b) where the assessee is an Indian company, at the option of the company, of the capital employed in the business of the company,
“Cost of the project” means the actual cost of the fixed assets, being land, buildings, leaseholds, plant, machinery, furniture, fittings and railway sidings (including expenditure on development of land and buildings), which are shown in the books of the assessee as on the last day of the previous year in which the business of the assessee commences.
“Capital employed in the business of the company” means the aggregate of the issued share capital, debentures and long-term borrowings as on the last day of the previous year in which the business of the company commences.
2.4 Amount of deduction shall be one-fifth of the expenditure mentioned above per year starting from the year in which the business commences or, as the case may be, the year in which the extension of the undertaking is completed or the new unit commences production or operation.
2.5 For assessee other a company or a co-operative society, other conditions for claiming deduction is that accounts have to be audited by chartered accountant and Form No. 3AE has to be furnished for the first year in which the deduction is claimed.
Let’s discuss with an example:
Ex.1:
ABC Ltd is a new Company incorporated on May 2023. It has incurred the following expenses:
a) expenditure for preparation of feasibility report- ₹ 150,000
(b) expenditure for company incorporation- ₹ 25,000
(c) legal charges for drafting the Memorandum and Articles of Association- ₹ 25,000
Total preliminary expenses- ₹ 200,000
The company commences it business on February 2024. The following details are available as on March 31, 2024:
a) Furniture & Fittings – ₹ 200,000
(c) Plant & Machinery – ₹ 10,00,000
(d) Issued & paid-up capital- ₹ 10,00,000
(e) Long-term borrowings- ₹ 20,00,000
Calculation of preliminary expenses allowable u/s 35D:
| Sl No | Particulars | ₹ |
| 1 | Furniture & Fittings | 200,000 |
| 2 | Land | 500,000 |
| 3 | Plant & Machinery | 10,00,000 |
| Cost of the project | 17,00,000 | |
| 5 % of Cost of the project (A) | 85,000 | |
| 1 | Issued & paid-up capital | 10,00,000 |
| 2 | Long-term borrowings | 20,00,000 |
| Capital employed | 30,00,000 | |
| 5 % of Cost of the project (B) | 150,000 |
Preliminary expenses can be taken as (A) or (B) at the option of the company. Since (B) is more beneficial for the company, preliminary expenses allowable under the ITA can be taken as ₹ 150,000. These can be claimed in 5 years starting from the financial year 2023-2024 to 2027-2028.
Expenses deductible per year is 1/5 th of ₹ 150,000, i.e., ₹ 30,000.
Ex. 2:
Consider in example 1, it is an LLP.
Calculation of preliminary expenses allowable u/s 35D:
| Sl No | Particulars | ₹ |
| 1 | Furniture & Fittings | 200,000 |
| 2 | Land | 500,000 |
| 3 | Plant & Machinery | 10,00,000 |
| Cost of the project | 17,00,000 | |
| 5 % of Cost of the project | 85,000 | |
| 1 | Issued & paid-up capital | 10,00,000 |
| 2 | Long-term borrowings | 20,00,000 |
| Capital employed | 30,00,000 | |
| 5 % of Cost of the project (B) | 150,0000 |
LLP doesn’t have the option has to select (A) or (B). Hence, preliminary expense for deduction under ITA ₹ 85,000. These can be claimed in 5 years starting from the year 2023-2024 to 2027-2028.
Expenses deductible per year is 1/5 th of ₹ 85,000, i.e., ₹ 17,000.
LLP has to have its accounts for the year 2023-2024 audited by a chartered accountant and Form No. 3AE has to be furnished.
3. Taxability of Pre-operative Expenses- Revenue
3.1 Section 13 of the ITA defines “previous year”. Previous year means the financial year immediately preceding the assessment year. The proviso appended to this section further contemplates that in case of a business newly set up in the said financial year the previous year shall be the period beginning with the date of setting up of the business. The expression “set up” has not been defined anywhere in the ITA.
Two terms are relevant for claiming pre-operative expenses under the ITA. One is set-up of business and commencement of business. This is relevant because as per the ITA, expenditure incurred prior to the setting up of a business is not allowed as deduction.
3.2 Capital Expenditure
Pre-operative expenses which form part of Capital assets incurred can be claimed as depreciation as per Section 32 of ITA. As per Section 32(1) of the ITA, depreciation is to be computed on the cost of the assets as defined in section 43 of the ITA. The depreciation is allowed starting the year in which the asset is put to use. The concept of put to use is explained in the article
3.3 Revenue Expenditure
For claiming pre-operative expenses which are revenue in nature, it is important to under the concept of “set-up of business” and “commencement of business”. This is relevant because as per the ITA, expenditure incurred prior to the setting up of a business is not allowed as deduction.
There are many judicial pronouncements which distinguishes the difference between “set-up” of business and “commencement” of business. Few of the above judgements are:
“6. In view of the above, the business of the assessee could be said to have been set up on September 3, 1995, as prior to these necessary agreements had been entered into, key personnel had been recruited and the assessee-company had started working necessary infrastructure like office premises, office equipment, etc. and the assessee company was ready to commence trading operation as on the date of incorporation, viz., August 3, 1995. Accordingly, the Assessing Officer is directed allow the revenue expenditure incurred after the setting up of business which was September 3, 1995, notwithstanding the fact that commercial operations started with effect from October 1, 1995. For the purpose of claiming expenditure incurred thereafter, as revenue expenditure, reliance are placed on the following decisions.”
“ 11. On a reading of the above referred quotations, it is clear that it is only after the business is set up, that the expenses incurred in the business can be claimed as permissible deduction under Section 37 of the Act. For commencement of a business, there must be in place some income generating asset or income earning structure. In several cases, there is a gap or an interval between setting up and commencement. When the business is set up, is a mixed question of law and fact and depends upon the line, nature and character of the business/professional activity. For example, for manufacturing business, purchase of new material or electricity connection may be relevant point to determine setting up but in case of a property dealer, the moment, he puts up a chair and table, or starts talking, his business is set up. The present assessee was engaged and incorporated for carrying on trading activities in different commodities. The word ‘trade’ even though not defined in the Act is used to denote operations of a commercial character by which a trader provides to customer for reward, some kind of goods or services. In other words, when the trader start providing such goods and services, the business is said to have commenced but the same may not hold good for set up of a business, which is a stage before the commencement. 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; registration as an entity and under the local laws etc.’ The said list of activities are not exhaustive and facts of each case need to be considered. Indeed purchase of goods would amount to commencement of business, but before the said act, spade work and efforts to commence have to be undertaken. A trader before actual purchase would possibly interact and negotiate with manufacturers, landlords, conduct due diligence to identify prospective customers, spread awareness etc. These are all integral part and parcel of the business of a trader. The said activities continue even post first sale/purchase. When first steps are taken by a trader, the business is set up, commencement of purchase and then sales is post set up.”
“Since the assessee has acquired the licence on August 15, 1995, and after getting the licence, the assessee was in a position to start the business, so, under these circumstances, we have no hesitation in holding that the assessee has commenced its business on or after August 15, 1995 and we do not find any infirmity with regard to this finding in the order passed by the Tribunal.”
“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(11) 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 a business would obviously not be permissible deductions because those expenses would be incurred at a point of time when the previous years of the business would not have commenced.”
“…A business activity consists of three stages: the first stage relates to the activity necessary for the purpose of acquiring the raw material and establishment of plant and machinery and the second activity comprises the processing and manufacturing by using the raw material and the plants and machinery set up for the purpose and the third category consisted of the marketing thereof. The first in point of time lays the foundation for the second activity and the second activity when completed lays the foundation for the third activity. Therefore, the expenditure incurred for carrying on any of these activities including the first activity is also deductible in computing the profits and gains of the assessee for the relevant year when the activity is undertaken. In Sarabhai Management Corporation Ltd. v. CIT, [1976] 102 ITR 25, the Gujarat High Court took the same view and held that the business commences with the first activity for acquiring by purchase or otherwise, immovable property. There may be an interval between the setting up of the business and the commencement of the business. All expenses incurred during that interval are also permissible for deduction. In CIT v. Sarabhai Management Corporation Ltd., [1991] 192 ITR 151 (SC) the decision of the Gujarat High Court was affirmed and went a step ahead that even the activities at a preparatory stage is also admissible.”
“3. There are four other issues raised in the present appeal. The first issue relates to the date on which the business of the respondent assessee was set up. The Assessing Officer has held that the business of the respondent assessee was set up on 1st June, 2001. The Assessing Officer, therefore, disallowed expenses to the extent of Rs.19,37,773/-, which include salaries, wages, bonus, staff welfare expenses, recruitment and training etc. for the period prior to 1st June, 2001. Similar expenses have been also disallowed on power and fuel, i.e., electricity and water.
4. On the said aspect/question, we find that the tribunal has dealt with the issue in depth and has recorded several factual findings. We would like to reproduce here paragraph 6 of the order passed by the tribunal, which reads as under: ” We have considered the rival contentions and found from the record that the assessee company was duly incorporated on 5.2.2001 under the Companies Act, 1956. It has also applied for approval to FIPB, and FIPB vide approval dated 24.1.2001 allowed for setting up of business in India for various activities. The assessee set up its business from 1st April, 2001 and was ready to commence its business operation. First director was appointed on 5.2.2001 on the date of incorporation and additional directors were appointed on 10.2.2001. It has taken premises on lease w.e.f. 1.4.2001, the physical possession of which was already taken w.e.f. 15.2.2001. It opened its bank account with Dutche Bank in March first week wherein first remittance was received on 9.2.2001. It is quite clear from these activities of the assessee company that it has set up its business and was ready to commence on 1.4.2001. There is no dispute to the well settled legal proposition that at the point of time, the assessee is in a complete state of readiness to undertake its activity, it can be said that it has set up its business, the actual commencement of business may be at a later date. The trading business of the assessee was ready to commence upon set up of requisite infrastructure i.e. acquisition of place of business, commencement of hiring of suitable personnel, identifying clients, opening bank account etc. which enabled the assessee to carry out its object clause. ITAT Delhi Bench in the case of Whirlpool of India Ltd.- 19 SOT 293 observed that there may be interregnum(sic) between setting up of business and date of commercial commencement of business, but under the Income Tax Act, all the expenses incurred after the date of setting up of business are to be allowed as a deduction while computing the income u/s 28. The Hon’ble Bench in this case held that where the assessee company has appointed branch manager and regional manager in 1995, paid salaries including PF contribution etc. beginning from November, 1995, its business can be said to be set up from 1.11.1995 i.e. the date on which the company was in a position to commence its business, and not on 1.2.1996 when its bank account was opened. The instant case before us is at a more sound footing where even a bank account was opened prior to 1.4.2001 and the assessee has claimed the expenditure only after it has set up its business which was ready for commencement. Merely because assessee entered into agreement with DHL on 21.5.2001 which was to be operative from 1.6.2001 date on which assessee took over the running business of DHL, it cannot be said that it has set up its business only on 1.6.2001 and not from 1.4.2001. Accordingly, we do not find any merit in the action of the lower authorities for not allowing the expenditure incurred after 1 st April, 2001. The AO is at a liberty to verify that the expenditure to be allowed should be restricted to revenue expenditure. We direct accordingly.”
“9. The Tribunal has observed that having regard to the business of the assessee, which is the development of real estates, the participation in the tender represents commencement of one activity which would enable the assessee to acquire the land for development. If the assessee is in a position to commence business, that means the business has been set-up. The acts of applying for participation in the tender, the borrowing of monies for interest from the holding company, the deposit of the borrowed monies on the same day with NGEF Ltd. as earnest money were all acts which clearly establish that the business had been set-up. The commencement of real estate business would normally start with the acquisition of land or immoveable property. When an assessee whose business it is to develop real estates, is in a position to perform certain acts towards the acquisition of land, that would clearly show that it is ready to commence business and, as a corollary, that it has already been set-up. The actual acquisition of land is the result of such efforts put in by the assessee; once the land is acquired the assessee may be said to have actually commenced its business which is that of development of real estate. The actual acquisition of the land may be a first step in the commencement of the business, but section 3 of the Act does not speak of commencement of the business, it speaks only of setting-up of the business. When the assessee in the present case was in a position to apply for the tender, borrowed money for interest albeit from its holding company and deposited the same with NGEF Ltd. on the same day, it shows that the assessee‟s business had been set-up and it was ready to commence business. The learned senior standing counsel for the revenue would, however, state that till the land is acquired, the business is not set- up. The difficulty in accepting the argument is that an assessee may not be successful in acquiring land for long period of time though he is ready to commence his business in real estate, and that would result in the expenses incurred by him throughout that period not being computed as a loss under the head “business” on the ground that he is yet to set-up his business. That would be an unacceptable position. The other argument of the learned standing counsel for the revenue that the tax auditors of the assessee have themselves pointed out that the assessee is yet to commence its business is also irrelevant because of the distinction between the commencement of the business and setting-up of the same.”
3.4 From the above case laws, the question as to when the business can be said to have been set up is the question of fact which has to be ascertained on the facts and circumstances of each case and considering the nature and type of the particulars business. A universally applicable test or format cannot be prescribed for all types of businesses. Expenditure incurred prior to the setting up of a business is not allowed as deduction.
4. Conclusions
4.1 Preliminary expenses can be allowed as deduction under Section 35 D as discussed in Para 2.
4.2 Pre-operative expenses which are in the nature of capital expenses can be claimed as Depreciation under Section 32 satisfying conditions therein.
4.3 Pre-operative expenses which are in the nature of revenue expenses incurred prior to the setting up of a business is not allowed as deduction.
4.4 The question as to when the business can be said to have been set up is the question of fact which has to be ascertained on the facts and circumstances of each case and considering the nature and type of the particular businesse. A universally applicable test or format cannot be prescribed for all types of businesses.
4.5 Those pre-operative revenue expenses incurred after setting up of business can be claimed as deduction, subject to satisfaction of other conditions.
Disclaimer: The views expressed herein are strictly personal. This document is intended solely for informational purposes and does not constitute professional advice or recommendations. The entire content of this document has been formulated based on relevant provisions and information available at the time of preparation. Although diligent efforts have been made to furnish authentic information, it is advised to seek a better understanding and obtain professional advice after a thorough examination of the specific situation. The author disclaims any liability for any loss or damage of any kind arising from the information in this article and any actions taken in reliance thereon.