Profits and Gains of Business or Profession

Profit and gains of business as specified in section 28 of Income tax Act are taxable.

The term ‘business’ includes trade, commerce or manufacture or adventure or concern in nature of trade, commerce or manufacture [section 2(13) of Income Tax Act]

 ‘Professional Income’ is income from exercise of any profession or vocation which calls for an intellectual or manual skill. It covers doctor, lawyers, accountants, consulting engineers, artists, musicians, singers etc.

Profits of business or gains from profession are calculated after allowing all legitimate business expenditure. Some important deductions admissible in computing income from business or profession are as follows  [sections 30 to 36  of Income Tax Act] —

* Rent, rates, taxes, repairs and insurance for business or professional premises [section 30 of Income Tax Act]

* Current repairs and insurance of machinery, plant and furniture [section 31 of Income Tax Act]

* Depreciation on building, machinery, plant or furniture [section 32 of Income Tax Act] (discussed below)

* Revenue expenditure on scientific research [section 35(1) of Income Tax Act]

* Capital expenditure on scientific research related to business (except land) [section 35(2) of Income Tax Act]

* Preliminary expenses in relation to formation of a company or in connection with extension of an undertaking or setting up of a new industrial unit can be amortised in 5 equal installments over 5 years. The preliminary expenditure is permitted only upto 5% of cost of project [section 35D]

* Insurance expenses  [section 36(1)(i) of Income Tax Act]

* Insurance premium on health of employees  [section 36(1)(ib) of Income Tax Act]

* Bonus or commission to employees [section 36(1)(ii) of Income Tax Act]

* Interest on borrowed capital [section 36(1)(iii) of Income Tax Act]

* Contributions towards approved provident fund, superannuation fund and gratuity fund [section 36(1)(iv) and 36(1)(v) of Income Tax Act]

* Bad debts in respect of income considered in previous years can be written off and allowable as deduction [section 36(1)(viii) of Income Tax Act]

* Banking cash transaction tax [section 36(1)(xiii) of Income Tax Act]

* Advertisement expenditure is fully allowed as deduction. However, expenditure incurred on advertisement in any souvenir, brochure, pamphlet etc. of a political party is not allowed as a deduction [section 37(2B) of Income Tax Act]

* Expenditure in maintenance of guest house is permissible as deduction [section 36(1)(i) of Income Tax Act]

* Any other expenditure which is not of capital nature or personal expenses of the assessee is allowed if it is expended wholly and exclusively for the purposes of business or profession. However, it should not have been for purpose which is an offence or is prohibited by any law [section 37 of Income Tax Act]

5-1 Depreciation - Depreciation means diminution in value of an asset on account of wear and tear and obsolescence.

In any business, raw material is used fully and immediately, while plant and machinery is used slowly over a period of time. After the estimated life of machinery, its value becomes Nil. Hence, it is fair that cost of machinery is charged over the period of its estimated useful life. This is the basic principle of depreciation on capital goods. Since land does not depreciate, no depreciation is allowed on land.

Under Income Tax, depreciation is calculated on the basis of ‘block of assets’. ‘Block of assets’ means a group of assets falling within a class of assets, in respect of which the same % of depreciation rate has been prescribed. e.g. all machinery having rate of depreciation as 25% will form one block of asset, machinery having 40% rate of depreciation will form another ‘block of asset’ and so on.

Depreciation is allowed on actual cost of the asset. Interest paid on borrowed funds and capitalised as pre-commencement expenses before the asset is commissioned is added to cost of the asset and depreciation claimed on such expenditure. Thus, pre-production expenditure can be included in cost of the machinery and depreciation can be charged on such ‘actual cost’. In Chellapalli Sugar v. CIT AIR 1975 SC 97 = 98 ITR 167 (SC), it as held that it includes all expenditure necessary to bring such asset into existence. [Thus, it will include installation charges]. It was held that interest on loans upto date of commencement of business forms part of 'actual cost' of plant for purpose of depreciation.

Depreciation is calculated on Written Down Value (WDV) method. If the asset is put to use for purpose of business for less than 180 days, only 50% of normal depreciation is permissible. In other words, full depreciation for the year is permissible only if asset is commissioned before 30th September of that year.

If depreciation cannot be fully claimed in a particular year for want of profits, the un-absorbed depreciation can be carried forward for any number of succeeding assessment years. [section 32(2)].

The depreciation rates in respect of some important assets are as follows :

* Residential building – 5%. Others (including hotels and boarding houses) – 10%. Purely temporary structures – 100%.

* Furniture and fittings including electrical fittings – 10%

* Motor cars 15% . Buses, lorries, and taxis used in business of running them on hire – 30%,

* Pollution control equipment and specified energy saving devises - 100%

* General machinery - 15%, aeroplane – 40%,  Ships – 20%

* Computers including software - 60%.

* Books by professionals – 100% for annual subscription and 60% for others - books in library - 100%.

* Intangible assets - know-how, patents, copyrights, trade marks, licenses, franchises or any other right of similar nature - 25%.

In Mysore Minerals v. CIT 1999 AIR SCW 3146 = 1999(5) SCALE 340 = 239 ITR 775 = AIR 1999 SC 3185 = 106 Taxman 166 (SC), it was held that claimant of depreciation need not be owner of asset in legal sense. Person in whom for the time being vests the dominion over the asset and who is entitled to use it in his own right is eligible to claim depreciation. – followed in Dalmia Cement v. CIT 2000 AIR SCW 4198 (SC 3 member bench).

However, if assessee has not acquired dominion over the asset, he will not be entitled to depreciation on that asset. – Tamilnadu Civil Supplies v. CIT (2001) 116 Taxman 369 = 2001 AIR SCW 4777 (SC 3 member bench).

Depreciation compulsory – As per Explanation 5 to section 32(1)(ii), inserted w.e.f. 11.5.2001, depreciation is compulsory in computing total income even if assessee had not claimed the same. This amendment applies to AY 2002-03 onwards. [In CIT v. Mahendra Mills (2000) 2 SCALE 384 = AIR 2000 SC 1960 = 243 ITR 56 = (2000) 109 Taxman 225 (SC), it was held that assessee has option to claim or not to claim depreciation. The depreciation cannot be thrust upon him. Now, this judgement is ineffective from AY 2002-03]

Depreciation in case of imported machinery obtained on loan in foreign currency – If machinery is imported on loan repayable in foreign currency, the amount payable in rupees will go on changing due to fluctuations in foreign exchange rates, as the installments and interest are spread over a period. In such case, the value of machinery should be increased on basis of entire loan outstanding and not merely installments of loans that fell due during the accounting period. – CIT v. Arvind Mills (1992) 193 ITR 255 = 60 Taxman 192 (SC) – quoted and followed in CIT v. Madras Fertilizers (2002) 124 Taxman 581 (Mad HC DB).

5-2 Expenditure not allowed as deduction - Following expenditures are not allowed as deduction for purpose of income tax.

Deduction of taxes, interest etc. Only on actual payment basis - Tax, duty, cess, fees payable under any law, Employer’s contribution to provident fund or ESIC, bonus to employees, commission to employees, interest on any loan or borrowing from financial institutions, banks, SFC, leave encashment  are eligible as deduction only if they are paid on ‘due dates’ on which these were payable. Even if these are not paid on due dates but are paid before filing of return, these are allowed as deduction, if proof of payment is filed along with the return. However, in case of employer’s contribution to provident fund, superannuation fund or gratuity fund, the same is allowed as deduction only if it was paid before due date of payment [section 43B of Income Tax Act]

Expenditure in excess of Rs 20,000 in cash fully disallowed - If expenditure is incurred in business or profession by payment of cash over Rs 20,000 in a day, entire expenditure is disallowed [Earlier, 20% of such expenditure was  disallowed upto AY 2007-08]. All cash transactions in a day to a party should not exceed Rs 20,000. [Till 31-3-2008, each transaction  was considered for the limit of Rs 20,000. Now, total transactions in a day will be considered [section  40A(3) of Income Tax Act]

 Payment over Rs 20,000 should be made by cheque or demand draft.

This restriction is not applicable in case of payments to # RBI, other banks and financial institutions, LIC # Government payments, payment by book adjustment, railway freight * Payment for agricultural produce, poultry, fish etc. to the cultivator, grower or producer (i.e. payments to middlemen are not excluded from this provision) [rule 6DD]

Similarly, a person can accept loans or deposits of Rs 20,000 or more only by account payee bank draft or cheque.

Interest on delayed payment to small industries  - Interest on delayed payment made to Small Scale Industries is not allowable as  deduction.

Expenditure for any purpose which is an offence in law - Section 37(1) of Income Tax Act states that any expenditure incurred for any purpose which is an offence or which is prohibited by law shall not be allowed as deduction.

5-3 Different accounting for balance sheet and income tax purposes - Method of depreciation, valuation of stock etc. is different under Companies Act and Income Tax Act. Hence, one method of accounting for income tax and other for Companies Act is permitted. The practice has been specifically approved in United Commercial Bank v. CIT 1999 AIR SCW 4050 = AIR 2000 SC 94 = 106 Taxman 601 (SC).

Accounting profits and assessable profits are conceptually different. – CIT v. Bipinchandra Maganlal (1961) 41 ITR 290 (SC).

Other important provisions in respect of business income

6 Some important provisions in relation to income from business or profession are as follows -

Maintenance of books of account -  In respect of professional in legal, medical, engineering, architecture, accountancy or technical consultancy must maintain books, if their gross receipts are less that Rs 1.50 lakhs, they have to maintain such books of account as may enable Income Tax Officer to compute their taxable Income. If their gross receipts exceed Rs 1.50 lakhs, they have to maintain books of account as specified in rule 6F i.e. cash book, journal, ledger, copies of bills exceeding Rs 25 issued by him, original bills in respect of expenditure  and payment vouchers etc. Person carrying on medical profession has to maintain additional books as prescribed. [Section 44AA and rule 6F]

Persons carrying on business or professionals other than those mentioned above have to maintain books of accounts if annual income exceeds Rs 1,20,000 or gross receipts or turnover exceed Rs. ten lakhs in case of business also have to maintain books of account.

Accounts on mercantile or cash basis - Accounts should be maintained either on mercantile basis or cash basis. Hybrid i.e. mixed system is not permitted. [In cash system, income or expenditure is considered only when it is actually received / paid. In mercantile system, income/expenditure is considered on accrual and payable basis. Actual receipt or payment may occur in subsequent financial year and may not happen in that particular year.]

Income tax audit report - If gross receipts or turnover of business exceeds Rs 40 lakhs per annum, the accounts have to be compulsorily audited. In case of professional income, accounts have to be audited if gross receipts exceed Rs ten lakhs. This audit report should be submitted along with income tax return, before 30th September. [section 44AB].