Setting up and Commencement of Business Under Previous Year

Setting Up and Commencement of Business Under Previous Year: An Income Tax Perspective (Indian Law)

Understanding the nuances of setting up and commencing a business within the framework of the ‘previous year’ is crucial for accurate income tax reporting and compliance in India. The ‘previous year’ plays a significant role in determining the income taxable in a particular assessment year. This article delves into the legal implications and practical considerations of business setup and commencement under the Indian Income Tax Act, 1961.

Defining the ‘Previous Year’ and its Significance

The Income Tax Act, 1961 defines the ‘previous year’ in Section 3. Essentially, it is the financial year immediately preceding the assessment year. The income earned during the previous year is assessed and taxed in the subsequent assessment year.

Section 3 states:

"For the purposes of this Act, “previous year” means the financial year immediately preceding the assessment year:…."

For example, for the Assessment Year 2024-25, the previous year is the financial year 2023-24 (April 1, 2023 to March 31, 2024).

The significance of the previous year lies in the fact that all income earned (or deemed to be earned) during this period is liable to income tax in the corresponding assessment year. Therefore, accurately determining when a business is ‘set up’ and when it ‘commences’ operations within a previous year is essential for proper income tax planning and reporting.

Setting Up a Business: Legal Requirements

"Setting up" a business refers to the initial preparatory steps taken before actual business operations begin. This includes:

Registration and Licenses: Obtaining necessary registrations under various laws like the Companies Act, Partnership Act, Goods and Services Tax (GST) Act, Shops and Establishments Act, and other relevant licenses and permits required for the specific industry.
Infrastructure Setup: Acquiring or leasing premises, purchasing equipment, and setting up the necessary infrastructure for business operations.
Financial Arrangements: Securing funding through loans, investments, or personal savings, and opening bank accounts in the name of the business.
Legal Documentation: Preparing and executing agreements, contracts, and other legal documents relevant to the business.

Legal Implications related to Setting up:

Companies Act, 2013: If the business is a company, it must be incorporated under the Companies Act, 2013. The date of incorporation is a crucial milestone in the "setting up" phase.
Partnership Act, 1932: If the business is a partnership firm, a partnership deed must be executed.
GST Act, 2017: Businesses exceeding the prescribed turnover threshold are required to register under the GST Act.
Other Laws: Depending on the nature of the business, compliance with other industry-specific laws and regulations is necessary.

The expenses incurred during the "setting up" phase are generally considered capital expenditure. While these expenses are not directly deductible as business expenses, they may be eligible for depreciation allowance under Section 32 of the Income Tax Act, depending on the nature of the asset acquired. Preliminary expenses, like registration fees, might be allowed as deduction subject to certain limits.

Commencement of Business: Determining the Start Date

"Commencement of Business" signifies the point when the business starts its actual operations, i.e., when it starts producing goods, providing services, or engaging in trading activities. This is a crucial date for income tax purposes because it determines the point from which income and expenses are recognized for tax computation.

Factors Determining the Commencement Date:

Start of Production: If the business involves manufacturing, the date when production begins.
Rendering of Services: If the business is service-oriented, the date when services are first provided to customers.
Trading Activities: If the business involves buying and selling goods, the date when the first transaction takes place.
Availability of Goods/Services: The date from which the business is ready to offer its goods or services, even if actual sales haven't occurred.
Intention to Carry On Business: Demonstrating a genuine intention to carry on business, even if profits are not immediately generated.

Key Considerations for Determining Commencement:

Evidences: Maintaining records of invoices, receipts, contracts, and other documents that can prove the date of commencement.
Bank Statements: Bank statements showing the first transactions related to business operations.
Registration Dates: While registration is part of setting up, the effective date from which registration is valid can be relevant.
Employee Hiring: The date of hiring employees who are directly involved in the business operations.

Impact of Commencement Date on Income Tax

The date of commencement has a significant impact on various aspects of income tax computation:

Deductibility of Expenses: Expenses incurred after the commencement date are generally deductible as business expenses under Section 37(1) of the Income Tax Act, provided they are wholly and exclusively incurred for the purpose of the business. Expenses incurred before the commencement date, relating to setting up the business, are generally treated as capital expenditure, as mentioned earlier.

Section 37(1) states:

"Any expenditure (not being capital expenditure or personal expenses of the assessee) laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head "Profits and gains of business or profession"."
Recognition of Income: Income earned after the commencement date is taxable under the head "Profits and Gains of Business or Profession." Income earned before the commencement date may be taxable under other heads, such as "Income from Other Sources," if it is not related to business operations.
Depreciation: Depreciation on assets used in the business can be claimed from the date the asset is put to use, which is often linked to the commencement date.
Carry Forward of Losses: If the business incurs losses in the initial years, these losses can be carried forward and set off against future profits, subject to certain conditions specified in Section 72 of the Income Tax Act. The carry-forward period is generally eight assessment years.

Section 72 states:

"(1) Where for any assessment year, the net result of the computation under the head "Profits and gains of business or profession" is a loss to the assessee, not being a loss sustained in a speculation business, and such loss cannot be wholly set off under section 71, so much of the loss as is not so set off or the whole of the losses if the assessee has no income under any other head, shall, subject to the other provisions of this Chapter, be carried forward to the following assessment year, and—…"
Tax Audit: Businesses exceeding the prescribed turnover threshold (as specified under Section 44AB of the Income Tax Act) are required to get their accounts audited by a chartered accountant. The commencement date affects the turnover calculation for determining whether a tax audit is required.

Section 44AB states:

"Every person carrying on business shall, if his total sales, turnover or gross receipts, as the case may be, in business exceed or exceeds one crore rupees in any previous year; or…"

Scenarios and Examples

To illustrate the practical application of these principles, consider the following scenarios:

Scenario 1: Manufacturing Business

A company, "ABC Manufacturing Pvt. Ltd.," was incorporated on July 1, 2023. It obtained all necessary licenses and permits by August 15, 2023. The company purchased machinery and equipment in September 2023 and completed the installation by October 15, 2023. However, actual production began on November 1, 2023.

In this case, the commencement date for ABC Manufacturing Pvt. Ltd. is November 1, 2023. Expenses incurred before this date, related to setting up the factory and purchasing equipment, are generally treated as capital expenditure and may be eligible for depreciation. Expenses incurred after November 1, 2023, such as raw material costs, salaries, and electricity bills, are deductible as business expenses. The income earned from the sale of manufactured goods from November 1, 2023, onwards is taxable under the head "Profits and Gains of Business or Profession."

Scenario 2: Service-Oriented Business

A software consultancy, "XYZ Solutions," was established as a partnership firm on April 15, 2023. The firm acquired office space and hired employees in May 2023. However, the firm received its first project and started providing services to its client on June 1, 2023.

In this scenario, the commencement date for XYZ Solutions is June 1, 2023. Expenses incurred before this date, such as rent and salaries, related to setting up the office, will likely be treated as preliminary expenses. Expenses incurred after June 1, 2023, are deductible as business expenses. The income earned from providing software consultancy services from June 1, 2023, onwards is taxable under the head "Profits and Gains of Business or Profession."

Scenario 3: Trading Business

A retail store, "PQR Traders," obtained a shop license on July 10, 2023. The store stocked its shelves with merchandise by August 1, 2023. However, the store officially opened for business and made its first sale on August 15, 2023.

In this case, the commencement date for PQR Traders is August 15, 2023. While the store was ready to sell goods from August 1st, the actual trading activities commenced only on August 15th. Expenses incurred after this date are deductible as business expenses, and income earned from sales is taxable under the head "Profits and Gains of Business or Profession."

Documentation and Record Keeping

Maintaining proper documentation and records is crucial for substantiating the date of commencement and justifying the deductibility of expenses. This includes:

Registration Certificates: Copies of registration certificates under various laws (Companies Act, GST Act, etc.).
Partnership Deed: A copy of the partnership deed, if applicable.
Invoices and Receipts: Copies of invoices and receipts for purchases, sales, and expenses.
Bank Statements: Bank statements showing transactions related to business operations.
Contracts and Agreements: Copies of contracts and agreements with customers, suppliers, and employees.
Books of Accounts: Properly maintained books of accounts, including cash book, journal, and ledger.

Conclusion

Understanding the concept of "previous year," "setting up," and "commencement of business" is essential for accurate income tax planning and compliance. Businesses need to carefully determine the commencement date based on the specific facts and circumstances of their operations. Proper documentation and record-keeping are crucial for substantiating the date of commencement and justifying the deductibility of expenses. Seeking professional advice from a qualified tax advisor is recommended to ensure compliance with the provisions of the Income Tax Act, 1961 and to optimize tax planning strategies. This will help businesses avoid potential penalties and ensure smooth and compliant operations.