The Income Tax Appellate Tribunal (ITAT), Ahmedabad Bench, has held that expenses incurred during the period between the setting up of a business and the actual commencement of commercial operations can, in principle, qualify for deduction under the Income Tax Act, drawing a clear distinction between the point at which a business is “set up” and the point at which it actually “commences” operations.

The Bench of Dr. B.R.R. Kumar (Vice-President) and Rahul Chaudhary (Judicial Member) has observed that expenses incurred during the intervening period between the setting up of the business and the commencement of business are permissible deductions under the Income Tax Act, while the question of when a particular business has been set up is essentially one of fact. 

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The central controversy before the Tribunal concerned the allowability of pre-operative expenditure exceeding Rs. 2 crore, accumulated over earlier financial years and claimed as a deduction when the assessee’s real-estate business entered the stage of commercial operations. The assessee challenged, among other things, the finding that the expenditure constituted prior-period expenses and contended that the expenses were revenue in nature and allowable under Section 37(1) of the Income Tax Act, 1961. 

The assessee was a partnership firm constituted on December 14, 2011 and engaged in the business of real-estate development. During assessment proceedings, the Assessing Officer noticed that an amount of Rs. 2,07,39,569 had been debited to the Profit and Loss Account under the head “Pre-operative Expenditure.”

The amount represented accumulated administrative, selling, financial and other miscellaneous expenditure incurred during financial years 2011-12, 2012-13 and 2013-14, corresponding to Assessment Years 2012-13, 2013-14 and 2014-15. The firm’s business involved developing agricultural land contributed by its partners as capital into residential plots. 

A crucial feature of the dispute was the requirement to obtain statutory permissions before the developed plots could legally be transferred to customers. The final permission for conversion of the land to Non-Agricultural (NA) residential use was granted by the Collector, Anand, on January 4, 2014. The assessee maintained that commercial operations, in the form of entering into agreements for sale with customers, commenced thereafter and therefore the accumulated expenditure was claimed as a deduction in the year under consideration. 

The Assessing Officer rejected the claim primarily on the ground that the assessee followed the mercantile system of accounting.

According to the AO, under the mercantile system, expenditure must be accounted for in the year in which the corresponding liability accrues or crystallises. Since computation of taxable income under the Income Tax Act is linked to a particular previous year, the expenditure claimed as a deduction must pertain to that relevant year. 

The AO consequently concluded that the liability relating to the expenditure had already accrued and crystallised during earlier previous years. The amount of Rs. 2,07,39,569 was therefore characterised as prior-period expenditure, disallowed and added to the assessee’s income. 

The CIT(A) subsequently dismissed the assessee’s appeal and substantially endorsed the AO’s reasoning.

The appellate authority observed that administrative and selling expenses were period costs that could not simply be deferred. It considered the principle that a liability is deductible in the year in which it crystallises to be fundamental to the mercantile system of accounting. Since the disputed liabilities had crystallised in earlier years, the CIT(A) found the AO justified in refusing their deduction in the year under appeal. 

The CIT(A) also rejected the assessee’s reliance on decisions dealing with deferred revenue expenditure. According to the appellate authority, those decisions did not establish a general rule permitting an assessee to postpone ordinary day-to-day revenue expenditure and claim it in a later year of its choice. 

The CIT(A) observed that the assessee had not demonstrated the amount of corresponding project income offered to tax during the relevant year. It noted that merely stating that agreements with customers had begun was insufficient without information regarding the revenue actually recognised in the books. 

The CIT(A) separately examined the borrowing-cost component of the pre-operative expenditure, including interest on unsecured loans and vehicle loans.

It held that deduction of interest on borrowed capital under Section 36(1)(iii) required the assessee to establish a direct and clear nexus between the borrowed funds and their use for business purposes.

According to the CIT(A), the assessee had failed to produce sufficient evidence such as loan agreements, bank statements or fund-flow statements demonstrating that the borrowed funds were actually deployed in the real-estate project rather than diverted for non-business purposes. It therefore held that the borrowing-cost claim could fail independently on this ground. 

Ultimately, the CIT(A) upheld disallowance of Rs. 2,04,85,862 towards pre-operative expenditure and Rs. 2,53,707 towards other non-allowable expenses. 

Before the ITAT, the assessee contended that the expenditure could not properly be characterised as prior-period expenditure because the amounts had been recorded in their respective years and carried forward as “Pre-operative Expenses.”

The argument was that commercial operations commenced only after receipt of NA permission on January 4, 2014. The accumulated expenditure was said to be revenue expenditure incurred wholly and exclusively for business purposes and therefore deductible under Section 37(1). The assessee also relied on Ind AS 16 to support its accounting treatment. 

The Revenue, on the other hand, maintained that under the mercantile system a liability accrues and crystallises when the expenditure is incurred, rather than at a later point selected by the taxpayer for claiming the deduction. 

The Tribunal’s decision turned significantly on the distinction between a business being “set up” and its actual “commencement”.

The ITAT observed that there is a well-established distinction between a business having been set up—meaning that it is established and ready to commence—and the actual commencement of trading or operational activities.

Applying that principle to the real-estate development business before it, the Tribunal found that the business could be regarded as having been set up in 2011, when the firm was formed and the land was acquired.

Its commercial operations, however, commenced after the NA permission was granted in January 2014, from which point the assessee entered into agreements for sale. 

This distinction proved decisive to the legal character of the expenses.

The Tribunal rejected the proposition that the treatment of the expenditure as prior-period expenditure was merely the result of a choice exercised by the assessee.

After examining both the component activities and the overall nature of the business, the ITAT categorically held that “the expenses claimed by the assessee are deductible in principle.”

The Bench further held that the expenditure was incurred wholly and exclusively for the purposes of the business and had been carried forward as pre-operative expenditure because commercial operations commenced only after receipt of the NA permission on January 4, 2014.

The Tribunal held that Section 37(1) of the Income Tax Act was applicable to the expenditure. 

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