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7.1 CASE STUDY ON ISSUE OF DISALLOWANCE OF EXPENDITURE INCURRED PRIOR TO COMMENCEMENT OF BUSINESS/COMMER-CIAL PRODUCTIONThe
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.
On receipt
of
the
notice/requisitions/show
cause
notice
concerning
the
issue of
disallowance
of
expenditure
incurred
prior
to
commencement
of
business/commercial production
the
assessees
and
the
tax
practitioners
should
keep
in
mind
the
undermentioned
well
settled
and
established principles
of
Law:
(A) Pre-Commencement
Business
Expenditure:
(i)
The
expenditure
incurred
prior
to
the
incorporation
of
an
enterprise
is to
be
considered
as
a pre-incorporation
capital
expenditure.
(ii)
The
expenditure
incurred
prior
to
the
‘setting-up
of
business’
is
to
be considered
as
a pre-operative
capital
expenditure.
(iii)
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 fulfils
the
mandated
conditions under
section
37(1)
of
the
Act.
The Real-time
scrutiny
notice/requisition/show
cause
notice
under
section
143(2)/142(1) of
the
Act,
concerning
the
issue
of
expenditure
incurred
Practical Case Study on ‘E-Assessment’ under section 143 : Disallowance of Pre-Commencement Business ExpenditureC H A P T E R
7
127
CASE STUDY
ON
ISSUE
OF
DISALLOWANCE
OF
EXPENDITURE
Para 7.1
prior
to
commencement
of
business/commercial
production,
is
being reproduced
below
for
ready
reference
of
the
worthy
readers.
Para 7.1
DISALLOWANCE OF
PRE-COMMENCEMENT
OF
BE
128
129
CASE STUDY
ON
ISSUE
OF
DISALLOWANCE
OF
EXPENDITURE
Para 7.1
The assessee
is
required
to
file
his
‘e-responses/submissions’
to
such
notic-
es and
requisitions
under
section
143(2)/142(1)
of
the
Act
and
attach
the
relevant supporting
records
and
documents
as
attachments
exactly
in
the
same manner
as
has
already
been
discussed
in
detail
in
paragraph
no.
3.4.1
of Chapter
No.
3 on
‘Practical
Guide
to
e-Assessments’.
Para 7.1
DISALLOWANCE OF
PRE-COMMENCEMENT
OF
BE
130
131
CASE STUDY
ON
ISSUE
OF
DISALLOWANCE
OF
EXPENDITURE
Para 7.1
The Specimen of an ideal ‘e-response’ to the Scrutiny Notice/Requisition/Questionnaire/Show Cause Notice under section 142(1)/143(2) of the Act, on the issue of disallowance of expenditure incurred prior to commence-ment of business/commercial production is reproduced below for the ready reference of the worthy readers.
ABC AND COMPANY
CHARTERED ACCOUNTANTS
Tax Chambers, New Delhi - 1100XX, Tel.: 011-12345678, Fax: 011-87654321
E-mail: [email protected]
September 24, 2019
The ACIT (e-Verification) Prescribed Income Tax Authority, New Delhi
In the Matter of: M/s ABC Pvt. Ltd. (hereinafter referred to as ‘the assessee company’)
PAN: AAACA1234H; Address: XYZ Nagar, New Delhi, India
Para 7.1
DISALLOWANCE OF
PRE-COMMENCEMENT
OF
BE
132
Subject: Submission w.r.t. Notice under section 143(2) for A.Y. 2018-19.
Dear Sir,
This is
in
reference
to
the
captioned
Notice
under
section
143(2)
of
the
Act,
dated 22-9-2019
for
the
AY
2018-19,
and
the
subsequent
requisitions
and
the show
cause
notice
wherein
the
assessee
company
has
been
required
to
furnish its
reply
in
substantiation
and
corroboration
of
its
claim
of
allow-
ability of
expenditure
incurred
by
it prior
to
commencement
of
business/
commercial production.
In this
regard
it is
respectfully
submitted
that
during
the
FY
2017-18
cor-
responding to
the
AY
2018-19,
presently
under
consideration,
the
assessee
has incurred
total
operative
business
expenditure
of
Rs.
1.5
crores
after
the setting
up
of
its
business
and
before
commencement
of
commercial
production.
The apprehension
of
the
ld.
assessing
authority
concerning
the
capitalization
of the
said
expenditure
seems
to
stemming
from
a fundamental
fallacy
that all
the
expenditure
including
the
operating
revenue
expenditure
be-
ing incurred
by
the
assessee
prior
to
the
commencement
of
commercial
production is
required
to
be
capitalized.
However, in
raising
such
fundamentally
fallacious
apprehension,
it needs
to
be appreciated
by
the
ld.
assessing
authority
that
in
the
Income-tax
Act,
it is
only
the
expenditure
which
has
been
incurred
prior
to
the
incorporation
and prior
to
the
“setting-up
of
business”
by
the
assessee,
which
is
required
to be
capitalized.
The
expenditure
incurred
after
the
“setting-up
of
business”
but prior
to
commencement
of
business/commercial
production
is
also
an allowable
expenditure.
The expression
“setting-up
of
business”
is
not
synonymous
with
the
expres-
sion “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.
The operating
expenditure
incurred
after
the
“setting-up
of
business”
but
prior to
the
commencement
of
business/commercial
production
is
fully
allowable business
expenditure
if it fulfils
the
mandated
conditions
under
section 37(1)
of
the
Act.
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
incor-
porated and
set-up.
133
CASE STUDY
ON
ISSUE
OF
DISALLOWANCE
OF
EXPENDITURE
Para 7.1
For ready
reference
the
text
of
section
3 and
its
proviso
is
being
reproduced
as under:
“Previous year”
defined.
“3. 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. West-
ern 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
be-
gins 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 busi-
ness 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”.
So,
the
correct
and
lawful
legal
position
concerning
the
allowability
of expenditure
incurred
in
case
of
a newly
incorporated
business
enterprise
or a ‘start-up’
is:
(i) The expenditure incurred prior to the incorporation of an enterprise is to be considered as a pre-incorporation capital expenditure.
(ii) The expenditure incurred prior to the ‘setting-up of business’ is to be considered as a pre-operative capital expenditure.
(iii) The expenditure incurred after the ‘setting-up of business’ is to be considered as a tax-deductible revenue expenditure, even if it has
Para 7.1
DISALLOWANCE OF
PRE-COMMENCEMENT
OF
BE
134
been incurred before the commencement of actual business or commencement of commercial production, if it fulfils the mandated conditions under section 37(1) of the Act.
Over a period
of
time,
different
High
Courts
and
even
the
Hon’ble
Supreme
Court have
adjudicated
the
issue
of
allowability
or
otherwise
of
expendi-
ture 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.
Reliance
in
this
regard
is
placed
upon
the
undermentioned
numerous judgments
of
the
Hon’ble
Supreme
Court
and
the
Hon’ble
High
Courts:
(i) CIT v. Sarabhai Management Corporation Ltd. [1991] 192 ITR 151 (SC);
(ii) CIT v. Hughes Escorts Communications (P.) Ltd. [2007] 165 Taxman 318 (Delhi);
(iii) CIT v. Whirlpool of India Ltd. [2009] 185 Taxman 387 (Delhi);
(iv) CIT v. L.G. Electronic (India) Ltd. [2005] 149 Taxman 166 (Delhi);
(v) CIT v. ESPN Software India (P.) Ltd. [2009] 184 Taxman 452 (Delhi);
(vi) CIT v. Aspentech India (P.) Ltd. [2010] 187 Taxman 25 (Delhi);
(vii) CIT v. E. Funds International India [2007] 162 Taxman 1 (Delhi);
(viii) CIT v. Dhoomketu Builders & Development (P.) Ltd. [2013] 34 taxmann.com 18/216 Taxman 76 (Delhi);
(ix) CIT v. Samsung India Electronics Ltd. [2013] 37 taxmann.com 239/218 Taxman 466 (Delhi) (Mag.);
(x) CIT v. Franco Tosi Ingegneria [2000] 241 ITR 268 (Mad.);
(xi) CIT v. Western India Seafood (P.) Ltd. [1993] 69 Taxman 246 (Guj.);
(xii) CIT v. Saurashtra Cement & Chemical Industries Ltd. [1973] 91 ITR 170 (Guj.);
(xiii) DCIT v. Jatra Ruchi Cosmetics (India) (P.) Ltd. ITA No. 5877/Del/2015, dated 20-2-2019 (Delhi ITAT);
135
CASE STUDY
ON
ISSUE
OF
DISALLOWANCE
OF
EXPENDITURE
Para 7.1
Application of the aforesaid judgments on the assessee company in evi-dencing that it has duly and fully set-up its business in the FY 2017-18 presently under consideration:
The assessee-company
has
been
incorporated
under
the
“Make
in
India”
initiative
of
the
Central
Government
and
is
engaged
in
the
business
of manufacturing
and
supply
of
traction/induction
motors,
alternators,
wind
generators and
propulsion
system
to
Indian
Railways.
The
fact
of
set-up
of
its business
by
the
assessee-company
during
the
FY
2017-18
in
testimony
to the
abovementioned
binding
legal
precedents
is
duly
evidenced
by
the
undermentioned activities
being
taken
by
it during
the
FY
2017-18:
(i)
Incorporation
under
the
Companies
Act;
(ii)
Opening
of
Current
Bank
A/cs
with
‘name
of
bank’;
(iii)
Induction
of
Share
Capital
Funds
for
the
Business
Purposes;
(iv)
Acquisition
of
Land;
(v)
Acquisition
of
Factory
Building
vide
Sale
Deed;
(vi)
Purchase
of
Plant
&
Machinery
for
Manufacturing
Set-up;
(vii)
Installation
and
Commissioning
of
Plant
&
Machinery;
(viii)
Obtainment
of
Statutory
Approvals
for
Supply
of
Alternators
and
Induction
Motors
to
Indian
Railways
from
Research
Designs
& Standards
Organisations
(RSDO),
Government
of
India,
Ministry
of
Railways;
(ix)
Payment
of
Engineering
&
Design
Services;
(x)
Recruitment
of
Skilled
&
Unskilled
Staff
and
their
enrolment
with
EPFO &
ESIC
Authorities;
(xi)
Payment
&
Disbursal
of
Staff
Salaries
and
Remunerations.
Therefore, from
the
above
undisputed
factual
propositions,
it is
duly
evident
and crystal
clear,
that
during
the
FY
2017-18,
presently
under
consideration,
the
assessee-company
has
undertaken
the
entire
gamut
of
activities
to constitute
the
“setting
up
of
business”
as
per
the
criteria
and
tests
laid
out
by the
Hon’ble
Delhi
High
Court
in
its
numerous
binding
judgments
and
in fact
the
assessee-company
has
undertaken
the
entire
lot
of
activities
in
the FY
2017-18,
as
above,
out
of
which
even
undertaking
one
of
the
said
activities qualifies
for
constituting
setting
up
of
business
as
per
the
binding
legal precedents.
Thus, in
view
of
the
aforesaid
undisputed
facts
and
well
settled
and
estab-
lished binding
legal
precedents,
the
operating
expenditure
being
incurred
by the
assessee
company
during
the
FY
2017-18,
after
the
setting
up
of
its
business but
prior
to
commencement
of
commercial
production
is
fully
eligible to
be
claimed
as
tax
deductible
revenue
expenditure
and
in
fact
Para 7.1
DISALLOWANCE OF
PRE-COMMENCEMENT
OF
BE
136
has been
lawfully
and
rightly
claimed
by
the
assessee-company
in
its
ITR
during the
FY
2017-18,
presently
under
consideration,
and
there
can
be
no
question of
capitalisation
of
such
operating
expenses.
Alternatively, Justification for Capitalisation of Interest Income earned on Temporary Fixed Deposits made out of Share Capital Funds infused for Business Purposes of the Assessee Company and the Income from Scrap Plant & Machinery, Inextricably Linked with the Business Operations of the Assessee Company:
As has
been
duly
substantiated
above, that
the
assessee
company
has
followed
the uniform
and
consistent
policy
of
treating
its
operating
expenses
other
than pre-operative
expenses
as
well
as
interest
income
of
Rs
1,80,00,000/-
earned by
it on
temporary
fixed
deposits
with
scheduled
banks
made
out
of the
share
capital
contributions
inducted
and
infused
by
the
promoters
solely
and
exclusively
for
the
business
purposes,
and
the
income
from sale
of
scrap
plant
&
machinery
of
Rs.
8,60,000/-
also
forming
an
integral
part of
the
business
operations,
as
revenue
in
nature
and
that
is
why
it has
suo-motu offered
its
said
interest
income
and
income
from
sale
of
scrap
plant &
machinery
for
taxation
purpose
in
its
ITR
and
has
claimed
the
operating expenditure
excluding
the
pre-operative
expenses
incurred
by
it after
the
setting
up
of
its
business,
as
tax
deductible
revenue
expenditure.
Without prejudice
to
above,
if still,
a pre-conceived
view
is
being
taken
by
the ld.
Assessing
Authority
regarding
the
disallowance/capitalisation
of
the operating
expenses
on
account
of
considering
the
same
as
expenditure
incurred prior
to
the
commencement
of
commercial
production
by
the
assessee-company, then
on
the
same
reasoning,
footing
and
ground,
the
interest income
of
Rs.
1,80,00,000/-
being
earned
by
the
assessee-company
on temporary
fixed
deposits
made
by
it out
of
its
share
capital
contributions
infused by
the
promoters
solely
and
exclusively
for
the
business
purposes
of acquisition
of
land,
construction
of
factory
building
and
setting
up
of
the manufacturing
plant
&
machinery
and
other
required
infrastructure
for undertaking
its
business
projects
of
manufacturing
and
supply
of
trac-
tion motors,
alternators,
wind
generators
and
propulsion
system
to
Indian
Railways and
the
income
from
sale
of
scrap
plant
and
machinery
of
Rs.
8,60,000/- being
inextricably
linked
with
the
business
operations
of
the
assessee company,
must
also
be
considered
and
treated
as
capital
receipts
and accordingly
must
be
reduced
from
the
proposed
capitalisation
of
the
remaining operating
expenses.
During the
FY
2017-18,
presently
under
consideration,
the
assessee
compa-
ny has
earned
an
interest
income
of
Rs.
1,80,00,000/-
on
temporary
fixed
deposits with
scheduled
banks
made
out
of
the
share
capital
contributions
inducted and
infused
by
the
promoters
solely
and
exclusively
for
the
busi-
ness purpose
of
acquisition
of
land
and
construction
of
factory
building
and
137
CASE STUDY
ON
ISSUE
OF
DISALLOWANCE
OF
EXPENDITURE
Para 7.1
setting up
of
the
manufacturing
plant
&
machinery
inextricably
linked
to
its business
projects
of
manufacturing
and
supply
of
traction
motors,
alter-
nators, wind
generators
and
propulsion
system
to
Indian
Railways
under
the “Make
in
India”
initiative
of
the
Central
Government.
The
purpose
of
making the
fixed
deposits
was
to
make
efficient
use
of
the
project
capital
and to
thereby
reduce
the
cost
of
the
project
to
the
extent
possible.
By
no
means did
they
represent
funds
taken
away
from
the
project
as
surplus
funds to
create
an
independent
source
of
income.
The
funds
so
deployed
in fixed
deposits
continued
to
remain
inextricably
linked
with
the
business
projects of
Indian
Railways
of
the
assessee
company
and
as
such
the
said
interest income
and
the
income
from
sale
of
scrap,
ought
to
be
capitalized
and reduced
from
the
proposed
capitalisation
of
operating
expenses.
The well
settled
and
well-established
legal
position
concerning
the
tax
treat-
ment of
Pre-Commencement
Business
Interest
&
Other
Income
is
as
under:
(i)
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’.
(ii)
Interest
and
other
similar
income
earned
by
way
of
temporary
in-
vestment of
share
capital
or
borrowed
funds,
which
are
otherwise
inextricably linked
to
the
setting
up
of
the
business
plant
or
infra-
structure 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.
In this
regard,
reliance
is
being
placed
by
us
on
the
numerous
binding
judgments of
the
Hon’ble
Supreme
Court
and
the
jurisdictional
Hon’ble
Delhi High
Court
&
jurisdictional
Hon’ble
Delhi
ITAT,
in
the
undermen-
tioned cases
of:
(i) CIT v. Bokaro Steel Ltd. [1999] 102 Taxman 94 (SC);
(ii) CIT v. Karnal Co-operative Sugar Mills Ltd. [2001] 118 Taxman 489 (SC);
(iii) CIT v. Karnataka Power Corporation [2000] 112 Taxman 629 (SC);
(iv) Bongaigaon Refinery and Petrochemicals Ltd. v. CIT [2001] 119 Taxman 488 (SC);
(v) Indian Oil Panipat Power Consortium Ltd. v. ITO [2009] 181 Taxman 249 (Delhi);
(vi) CIT v. Jaypee Dsc Ventures Ltd. [2012] 17 taxmann.com 257/204 Taxman 169 (Delhi);
Para 7.1
DISALLOWANCE OF
PRE-COMMENCEMENT
OF
BE
138
(vii) Principal CIT v. Facor Power Ltd. [2016] 66 taxmann.com 178/237 Taxman 613 (Delhi);
(viii) Indian Synthetic Rubber Pvt. Ltd. v. ITO in ITA No. 4827/Del/2017, dated 7-2-2018 (Delhi ITAT);
(ix) ITO v. KSK Wind Energy Halagali Benchi Pvt. Ltd. in ITA No. 1098/Hyd/2017, dated 30-11-2017 (Hyderabad ITAT).
Therefore,
in
view
of
the
above
stated
factual
propositions
and
legal precedents,
the
assessee
company
has
rightly
and
lawfully
claimed
the
operative business
expenditure
incurred
by
it after
the
setting
up
of
its
business though
before
commencement
of
its
commercial
production,
as
tax deductible
revenue
expenditure.
Thanking You.
Yours Sincerely
For ABC & Company
Chartered Accountants
--sd--
(Authorised Counsel of the Assessee Company)
Passing of the Final Assessment Order by NeAC
The NeAC
forwards
the
‘e-Responses’
of
the
assessee
to
the
Show
Cause
Notice to
the
Regional
Assessment
Unit
which
in
turn
after
taking
due
cognizance of
all
the
e-responses
of
the
assessee
passes
the
revised
assess-
ment order.
If the assessee so requires, the NeAC may provide the assessee
with the opportunity of personal hearing via video telephony. The
regional
assessment unit
after
taking
cognizance
of
the
inputs
from
such
personal
hearing as
provided
to
it by
NeAC,
again
passes
the
final
assessment order,
which is
uploaded
by
NeAC
in
the
registered
‘e-Filing’
account
of
the
asses-
see, within
the
time
barring
limitation
period
of
completion
of
assessments
under section
143(3)
of
the
Act,
which
can
be
seen
and
downloaded
by
the
assessee from
the
main
window
under
the
tab
‘e-proceedings’.
The NeAC
also
transfers
the
final
assessment
order
and
all
the
assessment
records to
the
file
of
jurisdictional
AO
for
imposition
of
penalty
if any
and
recovery of
outstanding
income
tax
demand,
if any.
