Treatment of pre-incorporation expenses (whether dead loss or capitalisation with fixed assets)

Section 3 of the Income tax Act, 1961 define the first previous year being the period beginning with the date of setting up of the business or profession. Setting up is broadly narrated as the date on which the assessee is ready to commence business. Further in the context of a company assessee section 35D provide for allowance of certain expenses incurred before actual commencement of business. Sub-section (2) of section 35 D list out such categories of expenses as under:

“ (2) The expenditure referred to in sub-section (1) shall be the expenditure specified in any one or more of

the following clauses, namely:–

(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:
Provided that the work in connection with the preparation of the feasibility report or the project report or the conducting of market survey or of any other survey or the engineering services referred to in this clause is carried out by the assessee himself or by a concern which is for the time being approved in this behalf by the Board;

(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, 1956 (1 of 1956);
(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.”

In the context of allowance of preliminary expenses the Madras High Court in Commissioner of Income-tax v. Ennar Steel and Alloy (P) Ltd. (2003) 261ITR347 held that the preliminary expenses in respect of which benefit can be claimed under section 35D have been spelt out in that section. The power reserved to include other items of expenditure has not been exercised by the authority who had been conferred with the power. The Courts cannot proceed to exercise that power and include within section 35D items which have not been included therein by Parliament. The deductions allowable under the Act have necessarily to be allowed in accordance with the provisions of the Act as it exists. The Act must be applied as one finds it and it was not open to the Courts to allow amortisation for expenditure for which the Act does not make provision for amortisation.

Further in regard to the first category of expenses viz. Feasibility, project, market survey or engineering expenses it is provided therein that each of such activity must be carried out by the assessee himself or by any other concern approved in this regard by the Board. Thus in a situation the company is not so incorporated and promoters are to incur any such expenses these are necessarily to be pre approved by the Board for their allowance at a later date in the hands of the new entity. In other words it is desirable to have a pre approval from the board for the purpose of getting an allowance of deduction for Feasibility, project, market survey or engineering expenses where these were to be incurred by any other concern. Further in the second category there is a provision for allowance of legal costs in relation to drafting of agreement etc. necessitated for the purpose of the setting up of business of the assessee. In the third and final category there is also a provision for allowance of company incorporation expenses. Thus sub-section (2) alongside sub-section (3) in plain words limits as well as restricts allowance for deduction of post incorporation expenses and in case of company assessee even incorporation expenses. Thus ordinarily speaking there is no provision for allowance of any pre-incorporation expenses under the Act unless these are pre approved viz a viz only those expenses that are finding entry in sub-section (2) list.

The Madras High Court in Cairn Energy (India) Ltd. v. Joint Commissioner of Income-tax (2008)297ITR59 upheld the order of the assessing authority who disallowed the claim of Rs. 2,73,93,866 relatable to pre-incorporation expenses incurred by the holding company. In this case the assessing authority took the view that no deduction had been provided for either in section 35D or in any other provisions of the Act on the claim of pre-effective cost.

As a safeguard in order to seek benefit of deduction of pre-incorporation expenses it is advisable to get an approval of the Board which would serve as some kind of advance ruling in the allowance of deduction at assessment stage. In the worst case scenario where no approval is obtained a petition u/s 119 (2) (b) can be moved to the Board to seek allowance of pre-incorporation expenses. However it must be ensured that the kind of expenditure incurred must be one falling in one of the categories mentioned in sub-section (2) of section 35D. Any other expenditure must be claimed either u/s 37 or as part of plant and machinery capitalisation depending on the nature of each expenditure.