Overview of Start-up Expenses: Preliminary & Preoperative Expenses

Introduction

Preliminary expenses are of the nature of fictitious assets.  These are the expenses of the company incurred before the incorporation of the company. 

Preoperative expenses are those expenses incurred by a company before commencement of commercial operations; or before starting to earn income. These are distinct from preliminary expenses or formation expenses. Preoperative expenses are of capital nature, are to be capitalised with cost of fixed assets in relations to which they have incurred, whereas pre operative expenses are to be charged against profits, the year in which business has commenced.

Under Schedule III

The Schedule III does not deal with any accounting treatment for the preliminary expenses such as share issue expenses, ancillary borrowing costs and discount or premium relating to borrowings, the same continues to be governed by the respective Accounting Standards/practices. Further, the Schedule III is clear that additional line items can be added on the face or in the notes. Keeping this in view, entity can disclose the unamortized portion of such expenses as “Unamortized expenses”, under the head “other current/ non-current assets”, depending on whether the amount will be amortized in the next 12 months or thereafter.

Under Accounting Standard - Start up Preliminary Expenses

(Discussed with respect to existing Accounting Standard however Ind AS is applicable to some companies)

Generally Accepted Accounting Principle

Expenditure directly attributable to the acquisition & incurred in bringing to their present location and condition form part of Cost of Assets / Capitalized (which ultimately inflow future economic benefit) whereas  any received adjusted in the cost of respective Assets or form part of Promoters Contribution or recognized in Statement of P & L  as the case may be.

Under AS 10

Paragraph 9.2 of AS 10,Administration and other general overhead expenses are usually excluded from the cost of fixed assets because they do not relate to a specific fixed asset. However, in some circumstances,  such expenses as are specifically attributable to  construction of a project or to the acquisition  of a fixed asset or bringing it to its working  condition, may be included as part of the cost of the  construction project or as a part of the cost of the  fixed asset.

Expenses incurred on formation of an entity cannot be said to be attributable to bringing an asset/project into existence and, therefore, cannot also be included as part of cost of fixed assets.

Under AS 16

As per AS 16, stipulates that the interest on loans and borrowing costs to be capitalised to the respective asset, if it relates to a specific asset. In case of general interest or administration costs on general loans, it should be apportioned in the appropriate ratio.

Under AS 26

As per Para 56 of AS 26.

In some cases, expenditure is incurred to provide future economic benefits to an enterprise but no intangible asset or other asset is acquired or created that can be recognised. In these cases, the expenditure is recognised as an expense when it is incurred. For example, expenditure on research is always recognised as an expense when it is incurred. Examples of other expenditure that is recognised as an expense when it is incurred include:

a) Expenditure on start-up activities (start-up costs), unless this expenditure is included in the  cost of an item of fixed asset under AS 10.Start- up costs may consist 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);

b) Expenditure on training activities;

c) Expenditure on advertising and promotional activities; and

d) Expenditure on relocating or re-organising part  or all of an enterprise.

Share issue expenses, discount on shares, ancillary costs-discount/premium on securities borrowing, Incidental costs for arranging borrowings, Expenditure on exploration, mining etc., Contracts between insurers and policy holders, being special nature items are excluded from the scope of AS 26 Intangible Assets (Para 5).

Consequent to the issue of AS 26, the preliminary expenditure is written off totally in the year of incorporation of the company and does not appear in the balance-sheet any more. Expensing out through the profit and loss (P&L) account is understandable if the entity is an existing entity and is going in for expansion.

As per Accounting Standard on Financial Instrument

IndAS 32 and IndAS 109 deals with Discount/premium on securities & Incidental costs for arranging borrowings which are taken at cost at initial recognition and are recognised on a straight line basis at subsequent recognition.

As per Guidance Note

As per Guidance Note on Accounting for Oil and Gas Producing Activities, There are two alternative methods for accounting for acquisition, exploration and development costs, viz.,

1. Successful Efforts Method (SEM)
2. Full Cost Method (FCM)

Treatment under income Tax

Preliminary expenses will be dealt with as in Section 35D; Pre-operative, which can be allocated to fixed assets, will be capitalised with fixed assets created and  benefit of depreciation can claim.

Where an Indian Company or non- corporate resident assessee incurs any expenses at the time of commencement of business or on extension of existing undertaking or setting up of new unit, then deduction is allowed in respect of such preliminary expenditure.

Amount of Deduction 

1/5th of the qualifying amount over 5 years is to be allowed as deduction starting from the year in which business has started or extension has been completed.

For this purpose the qualifying amount is –

I. For Indian Company

Least of the following

1. Amount actually incurred or
2. 5% of cost of project or 5% of capital employed (whichever is higher)

II. For non- corporate resident assessee

Least of the following

1. 5% of cost of project or
2. Amount actually incurred

Qualifying Expenses 

The qualifying expenses in respect of which deduction will be allowed are-

For any assessee:

Expenses incurred in respect of –

a) Preparation of feasibility report

b) Preparation of project report

c) Conducting market surveys and other survey required for business

d) Legal expenses for drafting agreement between the assessee and other person involved in setting up of business

e) Engineering services related to business of the assessee

Also, provided that all the above mentioned work is done in connection with the assessee himself or by any other concern which is being approved for this work by the Board .

For any company:

Expenses incurred in respect of –

a) Printing of Memorandum and Articles of Association of the company

b) Registration fees of the company

c) Legal expense required for drafting of Memorandum and Articles of Association of the company

d) 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

e) Any other expenses as may be prescribed.

Explanations:-

I. Cost of project -The actual cost of the fixed assets, being land, buildings, leaseholds, plant, machinery, furniture, fittings and railway sidings (including expenses incurred 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 or the last day of the previous year in which the extension of the undertaking is completed , or the new unit commences its operation (as the case may be).

II. Capital Employed – 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 or the last day of the previous year in which the extension of the undertaking is completed , or the new unit commences its operation (as the case may be).

III. Long term borrowings – Any moneys borrowed by the company from the Government or the Industrial Finance Corporation of India(IFCI) or the Industrial Credit and Investment Corporation of India(ICICI) or any other financial institution which is eligible for deduction u/s 36(1)(vii) or any Banking institution or,

Any moneys borrowed or debt incurred by it in a foreign country in respect of the purchase outside India of capital plant and machinery, where the terms under which such moneys are borrowed or the debt is incurred provide for the repayment thereof during a period of not less than seven years.

Also, as per the Foreign Exchange Management Regulations (The Amendment Regulations, 2016) permits wholly owned subsidiary set up in India by a non-resident entity, operating in a sector where 100 per cent foreign investment is allowed in the automatic route and there are no FDI linked conditionalities, to issue equity shares or preference shares or convertible debentures or warrants to the said non-resident entity against pre-incorporation/ preoperative expenses incurred by the said non-resident entity up to a limit of five per cent of its capital or USD 500,000 whichever is less.

Important Case Laws:

1. In the case of “ACIT Vs Khoday India Ltd (ITAT Bangalore)”. It was held that if the expenses are of revenue nature, then the same are to be allowed and section 35D will not be applicable. Therefore, the AO will examine the details and in case any of the expenditure is in capital nature, then the same will not be allowed.
    
2. In the case of “M/s International Computers Vs CIT (Bombay High Court)”, the assessee claimed depreciation on the capitalized expenditure on issue of shares which cannot fall within the purview of Section 32 because the legislature, specifically provide for amortization of the preliminary expenditure (under Sec 35D) which includes expenditure incurred for issuance of shares by the assessee in connection with the issue of shares.
   
   Hence the claim of the assessee for depreciation on such expenditure being capitalized could not be allowed taking into consideration the provisions of Section 32 of the Act and taking into consideration the specific provision for amortization as provided under Section 35D.

Disclaimer: Views expressed are strictly personal. The content of this document are solely for information purpose.  It does not constitute professional advice or recommendation.  The Author does not accept any liability for any loss or damage of any kind arising out of information in this article and for any actions taken in reliance thereon.