Depreciation is a key concept under the Income Tax Act of India that allows taxpayers to reduce taxable income by accounting for the gradual wear and tear of assets over time. However, certain situations arise where the depreciation allowable in a financial year exceeds the income available for deduction, leading to what's termed as unabsorbed depreciation. This unutilized portion can be carried forward and set off in future years under specific provisions in the Income Tax Act. The concept of unabsorbed depreciation is beneficial for businesses, especially during times of lower profits or losses, as it helps reduce future tax liabilities.
What is Depreciation?
Depreciation refers to the decline in the value of tangible assets, such as machinery, buildings, or vehicles, due to usage and the passage of time. Under Section 32 of the Indian Income Tax Act, depreciation is allowed as a deduction for assets used in the business, thereby reducing taxable income. Depreciation is calculated based on prescribed rates provided in the Income Tax Rules and can be claimed as per either the Written Down Value (WDV) method or the Straight-Line Method (SLM).
However, in some cases, a business may not have sufficient taxable income in a given year to absorb the full amount of depreciation. In such cases, the unabsorbed depreciation can be carried forward and utilized in subsequent years.
Provisions of Unabsorbed Depreciation under the Income Tax Act
1. Section 32(2) – Unabsorbed Depreciation Carry Forward
The concept of unabsorbed depreciation is governed by Section 32(2) of the Income Tax Act. According to this section, if the current year's depreciation is more than the income available for deduction, the excess depreciation can be carried forward to subsequent assessment years. This carry-forward is allowed until it is fully adjusted against taxable income.
Some key highlights include:
• Unabsorbed depreciation can be carried forward indefinitely, i.e., there is no time limit or restriction on the number of years for carry-forward.
• It can be set off against any head of income (except income from salary).
• Unabsorbed depreciation is given priority over business losses when it comes to set-off.
2. Conditions for Carrying Forward Depreciation
For carrying forward unabsorbed depreciation, the following conditions must be met:
• Ownership of Asset: The taxpayer must be the owner of the depreciable asset during the year for which depreciation is claimed.
• Use of Asset: The asset should be used for the purposes of the business or profession during the financial year for which depreciation is claimed.
• Filing of Return: The taxpayer must file the income tax return within the due date prescribed under Section 139(1) of the Income Tax Act. Failure to file a timely return may result in the loss of the ability to carry forward unabsorbed depreciation.
3. Applicability to Different Types of Taxpayers
• Individual and HUFs: Both individual taxpayers and Hindu Undivided Families (HUFs) who carry on business or profession are entitled to claim and carry forward unabsorbed depreciation.
• Partnership Firms and LLPs: Partnership firms and Limited Liability Partnerships (LLPs) can also carry forward unabsorbed depreciation if they meet the necessary conditions.
• Companies: Companies are significant beneficiaries of the unabsorbed depreciation provision, especially in cases where there are large capital expenditures, and profits are insufficient to absorb depreciation fully.
4. Priority of Set-off: Business Loss vs. Unabsorbed Depreciation
When a taxpayer has both unabsorbed depreciation and business losses to set off against income, a specific priority is followed:
• Unabsorbed depreciation can be set off against any head of income (excluding salary) in subsequent years, while business losses can only be set off against income from business and profession.
• Therefore, unabsorbed depreciation is given precedence over business losses for set-off purposes.
Set-Off of Unabsorbed Depreciation
1. Set-Off against Business Income
In the year when the taxpayer has both unabsorbed depreciation and business income, the taxpayer can directly set off the unabsorbed depreciation against such business income.
2. Set-Off against Other Heads of Income
One of the major benefits of unabsorbed depreciation is its flexibility in being set off against income from other heads, except salary. For example:
• Set-Off against Income from House Property: If a taxpayer has income from house property and unabsorbed depreciation from the business or profession, they can use the unabsorbed depreciation to reduce the taxable house property income.
• Set-Off against Capital Gains: Capital gains from the sale of assets can also be reduced by utilizing unabsorbed depreciation.
This flexibility provides significant relief to businesses, especially those that experience cyclical downturns in profitability.
Indefinite Carry Forward of Unabsorbed Depreciation
One of the most notable aspects of unabsorbed depreciation is the fact that it can be carried forward indefinitely until it is fully absorbed. This contrasts with other types of losses, such as business losses, which can only be carried forward for a maximum of eight assessment years.
This indefinite carry forward allows taxpayers to adjust their depreciation against future profits, reducing their taxable income in future years.
Restrictions and Limitations
While unabsorbed depreciation provides substantial tax relief, certain limitations apply:
1. No Set-Off against Salary Income: Unabsorbed depreciation cannot be set off against income from salary. Taxpayers need to have income from other sources like business, capital gains, or house property for set-off.
2. No Carry Forward without Filing Return on Time: As mentioned earlier, if a taxpayer fails to file their income tax return by the due date, they may lose the right to carry forward unabsorbed depreciation.
3. Change in Ownership or Business Structure: In cases where there is a change in the ownership structure of a business (e.g., amalgamation, demerger, or succession), certain rules apply to the carry-forward of unabsorbed depreciation, which we'll discuss in the next section.
Special Cases: Amalgamation and Demerger
When companies undergo restructuring, such as amalgamation or demerger, special provisions apply to the carry-forward and set-off of unabsorbed depreciation.
1. Amalgamation (Section 72A)
In the case of amalgamation, the unabsorbed depreciation of the amalgamating company (the transferor company) is allowed to be carried forward by the amalgamated company (the transferee company). However, this is subject to certain conditions laid down in Section 72A of the Income Tax Act:
• Both companies should be engaged in industries such as manufacturing, shipbuilding, software, etc.
• The amalgamated company should continue the business of the amalgamating company for at least five years.
• The amalgamated company should hold at least 75% of the book value of the fixed assets of the amalgamating company for a minimum of five years.
2. Demerger (Section 72A)
In the case of demerger, the unabsorbed depreciation of the demerged company can be carried forward by the resulting company. However, the same conditions as mentioned above apply. Additionally, the unabsorbed depreciation will be apportioned in the ratio of the assets transferred to the resulting company.
3. Succession of Business
If there is a succession of business (e.g., in the case of family succession), the unabsorbed depreciation can be carried forward by the successor entity. However, the depreciation carry forward can be availed only by the successor carrying on the same business. The successor should fulfill all conditions regarding the continuation of business.
Judicial Precedents on Unabsorbed Depreciation
Several landmark judicial pronouncements have clarified various aspects of unabsorbed depreciation. Some of the key rulings are:
1. CIT v. Jaipuria China Clay Mines (1966): The Supreme Court held that unabsorbed depreciation can be set off against any income (other than salary), and it should be given priority over business losses.
2. CIT v. Virmani Industries Pvt. Ltd. (1995): This case reiterated that unabsorbed depreciation is carried forward indefinitely and can be set off against any head of income.
3. Brakes India Ltd. v. CIT (2000): This case discussed how unabsorbed depreciation should be carried forward in cases of amalgamation.
These rulings have helped clarify and solidify the position of unabsorbed depreciation within the Income Tax framework, ensuring uniform application of the law.
Tax Planning with Unabsorbed Depreciation
Taxpayers can use the provisions of unabsorbed depreciation as part of their tax planning strategy to minimize tax liabilities. For instance:
• Capital Expenditure in Loss Years: Businesses anticipating a year of low profits or losses can opt for capital expenditures that will generate higher depreciation. This depreciation, if unabsorbed, can be carried forward and used in future profitable years, reducing future tax liabilities.
• Claiming Additional Depreciation: Under Section 32(1)(iia), additional depreciation is available for new plant and machinery, which can lead to unabsorbed depreciation in cases of large capital investments.
By utilizing these strategies, businesses can create an efficient tax structure that reduces tax burdens and enhances profitability in future years.
In summation, the provision for unabsorbed depreciation under the Indian Income Tax Act is a beneficial tool for taxpayers, particularly businesses. By allowing the indefinite carry forward and flexible set-off against various heads of income, it provides businesses with a cushion during times of low profitability, ensuring that capital-intensive investments don’t result in undue tax burdens. While the law provides significant flexibility, understanding the nuances, including priority rules, conditions, and restrictions, is crucial for effective tax planning. By adhering to the legal provisions and filing timely returns, taxpayers can fully utilize the benefits of unabsorbed depreciation to optimize their tax liabilities across assessment years.
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