Direct Tax Alert - Expenses incurred prior to obtaining IRDAI license to conduct insurance business allowable as business expenses

Background

Deductibility of revenue expenses prior to obtaining a license from regulatory authorities to carry on the business activities has been a vexed issue. It is often contented by the revenue authorities that the business cannot be set-up/ activities cannot be undertaken, prior to the date of issuance of license by the regulatory authorities and therefore the entire business expenditure incurred prior to the issuance of license, should either be treated as a sunk cost and/or should be capitalised as preoperative expenses depending upon the nature of such expenditure.

In this regard, recently, the Hon’ble Delhi High Court (HC)¹ had an occasion to examine whether the expenditure incurred during the period of set-up and commencement of business would be eligible for deduction as business expenditure under the provisions of Income-tax Act, 1961 [IT Act].

We, at BDO in India, have summarised the ruling of Delhi HC and provided our comments on the impact of this decision.

Facts of the case

• Maruti Insurance Broking Pvt Ltd [a joint venture between Maruti Suzuki India Ltd (MSIL), Sunbeam Auto Pvt Ltd, IFB Automotive Pvt Ltd and Track Component Ltd] [Taxpayer] was incorporated on 24 November 2010 to conduct the business of soliciting and procuring life and/or general insurance business.
• Post incorporation, the taxpayer held its first board of director’s meeting on 29 November 2010, wherein various decisions were taken, which included, approval of the draft application for obtaining broker’s license and submission to the Insurance Regulatory and Development Authority of India (IRDAI) including authorisation to its CEO to sign the relevant documents.
• To facilitate the day-to day operations, it was also decided to open a current account with HDFC bank to facilitate its transactions. Further, an agreement was executed between the taxpayer and MSIL, pursuant to which employees of MSIL were sent on deputation to the taxpayer and were made to undergo a minimum of 100 hours of mandatory training as insurance brokers.
• The aforesaid activities were a pre-requisite to the application preferred by the taxpayer for issuance of a direct-broker license. The application was lodged with the IRDAI on 1 December 2010.
• During the pendency of the application before IRDAI, the taxpayer also executed lease agreements on 1 June 2011 for conducting insurance business from various locations across the country. Finally, a direct broker's license was issued by IRDAI on 2 February 2012.
• The Tax Officer, while framing the assessment order concluded that since the license was issued by IRDAI on 2 February 2012, the taxpayer’s business could not have been set-up prior to that date and resulting therein disallowance of the entire business expenditure incurred till such date and that such expenditure ought to be capitalized as preoperative expenses. Being aggrieved, the taxpayer, preferred an appeal before the First Appellate Authority (Authority) and the Tax Tribunal respectively who sustained the order of the Tax Officer.

HC observations and ruling:

The HC considered the following points and ruled in favour of the taxpayer based on the following observations:

• The submissions made by the taxpayer and Revenue indicate the recognition of difference between:
  • date of setting-up of business and
  • date of commencement.

The expression “setting up of business” merely means that the concerned taxpayer is ready to commence business and that the connotation does not mean that, the business has commenced.

• The fact that the taxpayer took the stand that it had set-up its business when it filed its Return of Income for fiscal year 2010-11 is of utmost importance.
• The taxpayer had made all the steps to start its operations. To recapitulate the taxpayer, after its incorporation opened a bank account, entered into an agreement for deputing employees, gave necessary training to the employees, executed operating lease agreements, and resultantly, set up offices at 29 different locations across the country.
• Further, in the instant case, IRDAI took more than a year to dispose the application for issuance of license. The license was issued only on 2 February 2012 although the taxpayer was ready to commence business if not earlier, since 1 June, 2011 (date of lease agreement).

BDO comments

Claiming of expenses incurred by life/ general insurance companies till the time of obtaining IRDAI license has always been a matter of litigation between the tax authorities and insurance companies. There have been rulings in past² wherein various courts have held that such expenses are typically in the nature of revenue expenses and not capital expenses. With the Hon’ble Delhi HC adjudicating the appeal in favour of the assessee by explicitly considering the difference between “ready to commence business” and the date from which regulators “issues licence to conducts business”, it is expected that the taxpayer will be able to claim such expenditure incurred by him during the said interim period ensuring that it gets the business deduction for such expenditure during its initial set-up.