Amortization of Certain Preliminary Expenses

Introduction

Preliminary expenses are allowed as deduction in 5 equal installments starting from the tax year in which business is commenced or the new undertaking or unit starts its operation. This deduction is available only to an Indian company or a resident non-corporate assessee.

1. About

1.1. Who can claim this deduction?

An Indian company or any resident person can claim deduction under this provision in respect of preliminary expenses. Such expenditure may be incurred before commencement of the business or after commencement of the business in connection with extension of an undertaking or in connection with setting up a new unit.

1.2. What is preliminary expense?

Preliminary expenses are those expenses which are incurred before incorporation and commencement of business. In general, any legal charges paid before incorporation of company, amount paid for stamp duty, professional and consulting charges for incorporation of a company, expense in connection with marketing survey, project report, etc. are called preliminary expenses.

However, for the purpose of deduction under this provision of Income-tax Act, following expenses shall be treated as preliminary expenses.

1.2-1. In case of any assessee

(a) Preparation of feasibility report

(b) Preparation of project report

(c) Conducting a market survey or any other survey necessary for the business of the assessee

(d) Engineering services relating to business of assessee

(e) Legal charges for drafting any agreement between the assessee and any other person for any purpose relating to setting up or for conduct of business of assessee.

The assessee shall be required to furnish a statement in Form No. 5 for each tax year containing the particulars of expenditure specified in points (a) to (d) to the Director General of Income-tax (Systems). This statement shall be furnished 1 month prior to the due date for furnishing the return of income under Section 263(1).

1.2-2. In case of company assessee

In addition to the aforesaid expenses, a company assessee may also claim deduction under this provision for the following expenditure:

(a) Legal charges for drafting the Memorandum of Association and Articles of Association of the company

(b) Printing of the memorandum and articles of association

(c) Registration fees of the company payable under the Companies Act, 2013. The fees paid for increasing the share capital is not deemed as fees for registration of the company. Hence, it is not deductible under this provision

(d) Expenses in connection with issue of shares for public subscription or issue of debentures. Such expenses include underwriting commission, brokerage, drafting charges, stamp duty

1.3. How much deduction is allowed?

The deduction for preliminary expenditure shall be calculated in following two-steps:

Step 1: Calculate the qualifying amount which shall be lower of actual preliminary expenditure incurred on aforementioned items or 5% of the cost of project, in case of non-corporate assessee. However, in case of Indian company, the qualifying amount shall be lower of actual preliminary expenditure incurred on aforementioned items or 5% of cost of project (or 5% of capital employed, at the option of the assessee).

Step 2: One-fifth of the qualifying amount calculated in Step 1 shall be allowed as deduction in five successive years beginning from the year in which business commences or extension of the undertaking is completed or the new unit commences production or operation, as the case may be.

If any expenditure, covered under this provision, is also deductible under any other provisions of the Act, the deduction may be claimed by the assessee under either of the provisions.

1.4. Deduction in case of business restructuring

If, before expiry of 5 years, undertaking of an Indian Company is transferred in a scheme of amalgamation or demerger to another Indian company, no deduction is allowed to the transferor (i.e., amalgamating or demerged co.) for the tax year in which amalgamation or demerger takes place. In that situation, the transferee (amalgamated or resulting co.) is entitled to claim the deduction for the unexpired period of 5 years provided it is an Indian company beginning with the tax year in which amalgamation or demerger takes place.

In case of amalgamation or demerger of co-op. banks, the amount of deduction so determined shall be apportioned between the transferor (amalgamating or demerged co-op. bank) and transferee (amalgamated or resulting co-op. bank) in the ratio of number of days for which the assets are used by them during the tax year in which ownership changes. In subsequent years, the transferee shall be entitled to claim the deduction for the unexpired period.

1.5. Meaning of certain terms

1.5-1. Cost of Project

It means the actual cost of fixed assets, which are shown in the books of the assessee as on the last day of the tax year in which the business of the assessee commences. If deduction is to be claimed for the preliminary expenditure incurred in connection with the extension of an existing undertaking or in connection with setting up of a new unit, the cost of project shall mean the actual cost of fixed assets, as are shown in the books of the assessee as on the last day of the tax year in which the extension of undertaking is completed or the new unit commences production or operation, as the case may be. However only such fixed assets shall be considered which have been acquired or developed in connection with the extension of the undertaking or the setting up of the new unit, as the case may be.

For the purpose of computing cost of project, the fixed assets include land buildings, leaseholds, plant, machinery, furniture, fittings, railway sidings and expenditure on development of lands and buildings.

1.5-2. Capital Employed

‘Capital employed’ is the aggregate of issued share capital, debentures and long-term borrowing which has been obtained or issued in connection with commencement of business or extension of undertaking or setting up of new unit of assessee. Share premium collected by an assessee-company on its subscribed share capital shall not be included in ‘capital employed’

It shall be calculated as on the last day of the tax year in which the company commences business. However, if deduction is to be claimed for the preliminary expenditure incurred in connection with the extension of an existing undertaking or in connection with setting up of a new unit, the capital employed shall be calculated as on the last day of the tax year in which extension of undertaking is completed or the new unit commences production or operation, as the case may be.

1.5-3. Long-term Borrowings

‘Long-term Borrowings’ shall mean any money borrowed by the company from the following sources:

(a) From Government

(b) From IFCI or ICICI or any other financial institution eligible to claim deduction under Section 32(e) or any banking institution

(c) From foreign country for purchase of plant and machinery outside India, where the term of borrowing is not less than 7 years.

Borrowings taken from the resident lenders, even if short-term, shall be included in the definition of long-term borrowings

1.6. Other Conditions to be fulfilled

The deduction shall be admissible to the assessee, other than a company or a co-operative society, only if its books of account for the year or years in which the expenditure is incurred have been audited by a Chartered Accountant, and the assessee furnishes such report of audit in Form 6, along with his return of income for the first year in which the deduction under section 44 or 51 is claimed. Report of audit shall be furnished before one month prior to the due date of furnishing return of income under section 263(1) for the first year in which the deduction under this section is claimed.

References

CIT v. Hindustan Insecticides Ltd. 250 HR 338 (Del.)

CIT v. Mahindra Ugine & Steel Co. Ltd. 250 ITR 84 (Bom.)

CIT v. Neha Proteins Ltd. [2008] 171 Taxman 455 (Raj.)

Berger Paints India Ltd. v. CIT [2017] 79 taxmann.com 450 (SC)

CIT v. Core Healthcare Ltd. [2009] 308 ITR 263

This article is general information and not tax advice. Provisions change. Confirm your position with a qualified professional before acting.