Accounting and tax treatment of expenses prior to incorporation

This article is a contribution from the accounting firm Milestone. If you would like to share quality content for startups in the form of a contribution, please contact the Venture Square editorial team at editor@venturesquare.net.

If you decide to operate a business as a corporation, you'll need to go through the administrative procedures of incorporation and business registration, which will incur various costs. These costs may be borne by the individual who will become the corporation's representative, or, if a subsidiary is established, by the parent company. In this column, we'll examine the accounting for startup costs incurred prior to incorporation, the input tax deduction under the Value Added Tax Act, and the attribution of profits and losses under the Corporate Tax Act.

1. Accounting

Paragraph 69 of K-IFRS No. 1038 Intangible Assets stipulates that start-up costs, such as legal and administrative expenses incurred in establishing a legal entity, should be recognized as expenses when incurred.

Even in the case of general corporate accounting standards, Chapter 11, Intangible Asset Practice Guidelines 11.17, requires that start-up costs, such as legal costs incurred in establishing a legal entity, and opening costs incurred when opening a new facility or business, be recognized as expenses in the period in which they are incurred.

2. Value Added Tax Act Purchase Tax Credit

From the perspective of the Value-Added Tax Act, expenses incurred prior to incorporation are, more accurately, expenses prior to business registration. Article 39, Paragraph 1 of the Value-Added Tax Act lists expenditures for which documentation is insufficient or not directly related to business as non-deductible input tax. This scope also includes input tax incurred prior to business registration application (Item 8).

However, this excludes cases where business registration is applied for within 20 days of the end of the taxable period to which the supply period falls. Ultimately, under the Value Added Tax Act, a deduction is possible if business registration is applied for within 20 days of the end of the taxable period, provided the corporation's representative provides appropriate documentation and the business is directly related to the corporation's business.

3. Attribution of profits and losses before the establishment of a corporation under the Corporate Tax Act

(1) Definition of costs prior to incorporation

Article 4, Paragraph 2 of the Enforcement Decree of the Corporate Tax Act stipulates, "If profits or losses accrued prior to the commencement of the first fiscal year are effectively attributed to the corporation, and there is no risk of tax evasion, such profits or losses may be included in the corporation's first fiscal year's profits or losses, provided the initial fiscal year does not exceed one year." This provision is understood to recognize expenses that are effectively expenses of the same entity but cannot be attributed due to the incorporation registration not being completed.

Referring to the interpretation of relevant laws and regulations, the definition of start-up costs, which are expenses incurred before the establishment of a corporation and can be deducted as expenses, is as follows.

– Start-up costs: Costs to be borne by the company as stated in the articles of incorporation pursuant to Article 290, Paragraph 4 of the Commercial Act, taxes paid for establishment registration, registration fees, and costs paid to obtain business licenses or permits during the opening preparation period.

In the past, there was a provision to reflect this as an intangible asset and process it as a depreciation expense, but now it has all been revised to process it as an expense in the same way as accounting.

(2) Costs that require inclusion in the articles of incorporation

Among the startup costs explained above, in the case of the establishment costs to be borne by the company as specified in the articles of incorporation pursuant to Article 290, Paragraph 4 of the Commercial Act, if interpreted conversely, the establishment costs and promoters' compensation paid without being specified in the articles of incorporation are not considered startup costs and therefore cannot be recorded as a corporation's deductible expense.

Let's look at some examples.

– When a parent company pays service fees, etc. for the subsidiary’s new business before establishing a separate subsidiary for a new business and requests payment in accordance with the shareholders’ agreement.

– When a parent company pays office rent, interior construction costs, labor costs, etc. before registering the establishment of a subsidiary and records them as advance payments and receives a refund after the date of registration of the establishment of the subsidiary.

Even assuming that in both cases there is no concern about tax evasion and that the date of incorporation does not exceed one year from the date of expenditure in question, it can be interpreted that if the articles of incorporation do not specifically state the details of the altered incorporation pursuant to Article 290, Paragraph 4 of the Commercial Act, they cannot be included as deductible expenses in the corporation's first fiscal year.

(3) Conclusion

Taxes, fees, and other expenses incurred for the purpose of registering a company are deductible under the Corporate Tax Act even if they are not included in the articles of incorporation. However, various other expenses, even if they are related to the business and have proper documentation, are not all attributed to the company's profits and losses, so it is safe to seek advice from a tax expert in advance.

---

• See more related columns