The distinction between preliminary and preoperative expenses often determines not only where they appear in the financial statements but also how and when they are allowed for tax purposes.
With enhanced compliance requirements under Section 35D and mandatory Form 3AF e-filing from FY 2024–25, accurate classification of these expenses has become essential for audit integrity and tax efficiency.
Core Distinction at a Glance
| Particulars | Preliminary Expenses | Preoperative Expenses |
|---|---|---|
| Stage of Incurrence | Before incorporation or before commencement of business | After incorporation but before commencement of commercial operations |
| Nature | Formation or feasibility costs | Setup or trial-run phase costs |
| Accounting Standard Reference | AS 26 / Ind AS 38 (Intangible Assets) | AS 10 / Ind AS 16 (Property, Plant & Equipment) |
| Tax Section | Section 35D | Section 32 |
| Book Treatment | Expensed off or amortized | Capitalized as part of asset cost |
| Tax Treatment | Deduction in 5 equal installments (5% cap rule) | Depreciation on capitalized amount post-commissioning |
| Applicable Forms (FY 2024–25) | Form 3AF (mandatory), Form 3AE (for non-corporates) | No specific form—part of asset schedule |
Classification Decision Framework
Step 1: Was the expense incurred before the business or entity came into existence?
→ Yes: Treat as Preliminary Expense (Sec. 35D)
Step 2: Was it incurred after incorporation but before commercial operations began?
→ Yes: Treat as Preoperative Expense to be capitalized with the related asset.
Step 3: Was it incurred after business commencement?
→ Yes: Treat as a Revenue Expense deductible under Section 37(1).
The timing of incurrence—not merely the type of expense—defines its classification.
Preliminary Expenses — Legal, Accounting, and Tax Perspective
Definition & Scope
Preliminary expenses are incurred before the commencement of business for purposes such as:
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Feasibility studies and project reports
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Market surveys and engineering evaluations
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Legal drafting and contract formation
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Company incorporation costs, MoA/AoA preparation
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Public issue or share listing expenses
Accounting Treatment (AS 26 / Ind AS 38)
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Preliminary expenses are not intangible assets.
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Ideally, written off in the year of incorporation.
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If amortized, the unamortized balance is shown under Other Non-Current Assets.
Income Tax Treatment — Section 35D
Under Section 35D, specified preliminary expenses are allowed as a deduction over 5 years, starting from the year of commencement of business or production.
(a) For Non-Corporate Assessees
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Deduction capped at 5% of the project cost.
Example: Project cost ₹50 lakh → Max. eligible = ₹2.5 lakh.
(b) For Indian Companies
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Deduction capped at 5% of the higher of:
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Project cost, or
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Capital employed (paid-up share capital + reserves + long-term borrowings).
Example: Project cost ₹50 lakh, capital employed ₹60 lakh → Max. eligible = ₹3 lakh.
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Allowed Deduction:
→ Lower of actual expenses or statutory cap, amortized equally over 5 years (1/5th per year).
Compliance Framework for FY 2024–25
| Particular | Requirement |
|---|---|
| Form 3AF | Mandatory e-filing (digitally signed or via EVC) one month before ITR due date |
| Authority | Principal Director General of Income Tax (Systems) |
| Details Required | Full expenditure breakup, vendor/TDS details, and project particulars |
| Form 3AE (CA Certificate) | Required for non-corporates to certify claim accuracy |
| Consultant Approval | Finance Act, 2023 removed the CBDT-approved consultant requirement—self or external professional permitted |
Practical Note:
Omission or delayed filing of Form 3AF renders the claim invalid, even if expenses qualify substantively.
Preoperative Expenses — Financial and Tax Treatment
Definition & Nature
Preoperative expenses are incurred after incorporation but before the start of commercial operations. These relate to the setup or construction phase of a project.
Typical Examples:
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Trial run and testing costs
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Employee salaries during setup
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Interest during construction period
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Rent, utilities, and administrative costs prior to operations
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Equipment installation and training expenditure
Accounting Treatment (AS 10 / Ind AS 16)
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Directly attributable preoperative expenses are capitalized to the cost of the asset.
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Indirect expenses allocable to multiple assets should be apportioned on a rational basis.
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Capitalization ceases when the asset is ready for its intended use, even if not operational.
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Depreciation begins once the asset is put to use.
Income Tax Treatment
| Aspect | Treatment |
|---|---|
| Eligibility u/s 35D | Not applicable |
| Capitalization | Mandatory addition to cost of the fixed asset |
| Deduction Mechanism | Depreciation u/s 32 from year of “put to use” |
| Cap or Ceiling | None — full capitalization permitted |
| Judicial Support | ACIT v. Food Specialties Ltd (ITAT) — Preoperative expenses of revenue nature are capitalized proportionately when not directly identifiable with specific assets. |
Key Developments for FY 2024–25 (AY 2025–26)
| Update | Impact |
|---|---|
| Mandatory Form 3AF e-filing | Now required for every Section 35D claim; non-filing invalidates deduction |
| Form 3AE (CA certification) | Still applicable for non-corporate entities |
| Consultant approval abolished | Self or any external professional may prepare the claim |
| Proposed Income Tax Bill, 2025 | Section 35D to be renumbered as Section 44 — no change in substance |
Documentation Blueprint
| Category | Essential Records |
|---|---|
| Preliminary Expenses | - Original invoices & proof of payment - Vendor & TDS details - Form 3AF acknowledgment - CA Certificate (Form 3AE) - Proof of commencement date |
| Preoperative Expenses | - Asset-wise expense linkage - Commissioning/trial-run certificates - Capitalization schedule approved by auditors - Depreciation workings with date of “put to use” |
Strategic Tax Planning for FY 2024–25
Timing Optimization: Expenses incurred after incorporation may yield better outcomes if capitalized (no 5% limit) rather than claimed as preliminary.
Entity Structuring: Companies often benefit from a higher cap owing to inclusion of “capital employed.”
Synchronize Compliance: Align Form 3AF preparation with the ITR filing calendar to avoid deadline breaches.
Cross-functional Coordination: Ensure the accounting team’s capitalization schedule matches the tax computation schedule.
Audit Preparedness: Maintain real-time documentation to withstand scrutiny under tax and statutory audit.
Common Pitfalls and Corrective Practices
| Frequent Error | Correct Approach |
|---|---|
| Claiming depreciation on preliminary expenses | Not permissible — only 35D amortization allowed |
| Treating preoperative expenses under Section 35D | Must be capitalized under Section 32 |
| Late or missing Form 3AF filing | Disqualifies deduction entirely |
| Using incorrect 5% base | Verify definition of “project cost” or “capital employed” |
| Not linking preoperative expenses to assets | Maintain allocation sheet with audit evidence |
Key Takeaways for FY 2024–25
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Preliminary expenses: Governed by Section 35D, restricted by a 5% cap, amortized over 5 years, and require Form 3AF e-filing.
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Preoperative expenses: Treated as capital expenditure, added to the cost of assets, and eligible for depreciation u/s 32.
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Accurate classification ensures not only correct tax computation but also alignment between financial reporting and tax audit disclosures.
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Enhanced compliance from FY 2024–25 (AY 2025–26) demands robust documentation, precise timing, and inter-departmental coordination.
Conclusion
The distinction between preliminary and preoperative expenses goes far beyond terminology — it determines when deductions are allowed, how assets are valued, and whether compliance withstands audit scrutiny.
For FY 2024–25, with the mandatory e-filing of Form 3AF, strengthened documentation norms, and the proposed renumbering of Section 35D, businesses must combine accounting rigor with procedural discipline.
A correctly classified expense today safeguards both financial transparency and tax efficiency tomorrow — ensuring smooth transition from project stage to profitable operations in AY 2025–26.
