SET OFF OF UNABSORBED DEPRECIATION WHILE DETERMINING BOOK PROFIT u/s 40(B)

 ISSUE FOR CONSIDERATION

Section 40(b) limits the deduction, in the hands of a partnership firm, in respect of an expenditure on specified kinds of payments to partners. Amongst several limitations provided in respect of deduction to be claimed by the partnership firm, clause (5) of section 40(b) limits the deduction for remuneration to the working partners to the specified percentage of the ‘book profit’ of the firm.

The term ‘book profit’ is defined exhaustively by Explanation 3 to section 40(b) which reads as under:

‘Explanation 3 – For the purpose of this clause, “book profit” means the net profit, as shown in the profit and loss account for the relevant previous year, computed in the manner laid down in Chapter IV-D as increased by the aggregate amount of the remuneration paid or payable to all the partners of the firm if such amount has been deduced while computing the net profit.’

‘Book profit’, as per Explanation 3, means the net profit as per the profit and loss account of the relevant year, computed in the manner laid down in Chapter IV-D. The net profit in question is the one that is shown in the profit and loss account which is computed in the manner laid down in Chapter IV-D. This requirement to compute the net profit in the manner laid down in Chapter IV-D has been the subject matter of debate. Section 32, which is part of Chapter IV-D, provides for the depreciation allowance in computing the income of the year and, inter alia, sub-section (2) provides for the manner in which the unabsorbed depreciation of the earlier years is to be adjusted against the income of the year. The interesting issue which has arisen with respect to the computation of ‘book profit’ for the purpose of section 40(b) is whether the net profit for the year should also be reduced by the unabsorbed depreciation of earlier years and whether the amount of remuneration to the partners eligible for deduction should be computed with respect to such reduced amount.

The Jaipur bench of the Tribunal has held that in computing the ‘book profit’ and the amount eligible for deduction on account of the remuneration to partners, unabsorbed depreciation of the earlier years should be deducted from the net profit for the year as provided in section 32(2). As against this, the Pune bench of the Tribunal has taken a contrary view and has allowed the assessee firm’s claim of the remuneration paid to its partners which was computed on the basis of ‘book profit’ without reducing it by the unabsorbed depreciation of the earlier years.

THE VIKAS OIL MILLS CASE

The issue first came up for consideration of the Jaipur bench of the Tribunal in the case of Vikas Oil Mills vs. ITO (2005) 95 TTJ 1126.

In that case, for the assessment year 2001-02 the A.O. disallowed the remuneration amounting to Rs. 1,79,005 paid to the working partners on the ground that the assessee firm had not reduced the unabsorbed brought-forward depreciation of earlier years from the profit of the year under consideration while claiming deduction for the remuneration payable to the partners. Since the resultant figure after reducing the unabsorbed depreciation of earlier years from the profit of the assessee firm was a negative figure, the A.O. disallowed the remuneration paid to the partners. The CIT(A) confirmed this order.

The assessee argued before the Tribunal that the unabsorbed depreciation was allowed to be deducted only because of a fiction contained in section 32(2) and that otherwise the deduction was subject to the provisions of section 72(2). Hence, unabsorbed depreciation should not be considered for computation of net profit in Chapter IV-D. On the other hand, the Departmental representative supported the orders of the lower authorities by submitting that unabsorbed depreciation of earlier years was part of the current year’s depreciation as per section 32(2) which fell in Chapter IV-D and, therefore, for computation of book profit unabsorbed depreciation was to be necessarily taken into account.

The Tribunal concurred with the view of the lower authorities and held that the remuneration paid to the working partners was to be reduced from the book profit as per the provisions of section 40(b)(v). The definition of book profit was provided in Explanation 3 as per which it was required to be computed in the manner laid down in Chapter IV-D. Therefore, the Tribunal held that the unabsorbed depreciation of earlier years had to be reduced as provided in section 32(2) while determining the book profit for the purpose of determining the amount of deductible remuneration. However, the Tribunal agreed with the alternative plea of the assessee for allowing the minimum amount of remuneration which was allowable even in case of a loss.

RAJMAL LAKHICHAND CASE

The issue thereafter came up for consideration before the Pune bench of the Tribunal in the case of Rajmal Lakhichand vs. JCIT (2018) 92 taxmann.com 94.

In this case, for the assessment year 2010-11 the A.O. disallowed the remuneration to working partners amounting to Rs. 17,50,000 on the ground that the unabsorbed depreciation of earlier years was not reduced in computing the book profit which was contrary to the provisions of section 40(b). Upon further appeal, the CIT(A) deleted this disallowance by holding that the remuneration to partners was to be worked out on the basis of the current year’s book profit and therefore the remuneration was to be deducted first before allowing the set-off of brought-forward losses. He held that the computation of book profit was as per section 40(b) while the set-off of brought-forward losses was to be granted in terms of section 72. Therefore, while arriving at the business income, the deduction of section 40(b) was to be given first and then, if at all there remained positive income, the brought-forward losses were to be set off.

Before the Tribunal, the Income-tax Department assailed the findings of the CIT(A) on the ground that the unabsorbed brought-forward depreciation became a part of the current year’s depreciation as per the provisions of section 32(2) and that as per Chapter IV-D, the book profit was determined only after deduction of depreciation including unabsorbed depreciation. Since, in the assessee’s case, there was a loss after deduction of unabsorbed brought-forward depreciation to the tune of Rs. 10,84,75,430 remuneration to the extent of only Rs. 1,50,000 should have been allowed. Reliance was placed on the decision in Vikas Oil Mills (Supra).

As against that, the assessee submitted that the remuneration paid to the partners was to be based on the current year’s book profit derived before deducting the unabsorbed depreciation and that the set-off of unabsorbed losses and depreciation was governed by section 72. The unabsorbed business losses were to be set off first and then the unabsorbed depreciation was to be considered.

The Tribunal upheld the order of the CIT(A) deleting the disallowance of remuneration paid to the working partner by the assessee-firm. In addition to accepting the contention of the assessee, the Tribunal also relied upon the decision of the Ahmedabad bench of the Tribunal in the case of Yogeshwar Developers vs. ITO [IT Appeal No. 1173/AHD/2014 for assessment year 2005-06 decided on 13^th April, 2017]. The decision of the Jaipur bench in the case of Vikas Oil Mills (Supra) cited before the Tribunal by the Income-tax Department was not followed by the bench.

OBSERVATIONS

Sub-section (2) of section 32 provides that where full effect cannot be given to the depreciation allowance for any previous year, then the depreciation remaining to be absorbed shall be added to the amount of the depreciation allowance for the following previous year and deemed to be part of the depreciation allowance for that year. It further provides that if there is no such depreciation allowance for the succeeding previous year, then that unabsorbed depreciation of the preceding previous year itself shall be deemed to be the depreciation allowance for that year. However, such a treatment of unabsorbed depreciation u/s 32(2) is subject to the provisions of sub-section (2) of section 72 and sub-section (3) of section 73 under which first brought-forward business loss needs to be set off and then unabsorbed depreciation. Therefore, in a situation where the assessee has brought-forward business loss as well as unabsorbed depreciation, the combined reading of sections 32 and 72 or 73 required that the brought-forward business loss shall be set off first against the income of the previous year and then against the unabsorbed depreciation.

As per Explanation-3 to section 40(b), all the deductions as provided in Chapter IV-D including depreciation allowance provided in section 32 have to be taken into consideration while determining the book profit. Since the provision of section 32(2) treats the unabsorbed depreciation of earlier years at par with the depreciation allowance of the current year, except where there is a brought-forward business loss, the issue as to whether the unabsorbed depreciation should also be deducted from the book profit requires deeper analysis.

Though the literal interpretation of all the provisions concerned may appear to support the view that the amount of depreciation allowance, whether of the current year or the one which is of the earlier years and has remained unabsorbed, should be reduced from the net profit for the purpose of arriving at the book profit, one needs to also consider the legislative history as well as the intent of the provisions of section 32(2) before accepting the literal interpretation. The present provision of section 32(2) as it stands today was brought in force by the Finance Act, 2001 by substituting the old provision with effect from assessment year 2002-03. The old provision of section 32(2), prior to its substitution by the Finance Act, 2001, was effective for the assessment years 1997-98 to 2001-02 and it read as under:

(2) Where in the assessment of the assessee full effect cannot be given to any allowance under clause (ii) of sub-section (1) in any previous year owing to there being no profits or gains chargeable for that previous year or owing to the profits or gains being less than the allowance, then, the allowance or the part of allowance to which effect has not been given (hereinafter referred to as unabsorbed depreciation allowance), as the case may be,

(i) shall be set off against the profits and gains, if any, of any business or profession carried on by him and assessable for that assessment year;

(ii) if the unabsorbed depreciation allowance cannot be wholly set off under clause (i), the amount not so set off shall be set off from the income under any other head, if any, assessable for that assessment year;

if the unabsorbed depreciation allowance cannot be wholly set off under clause (i) and clause (ii), the amount of allowance not so set off shall be carried forward to the following assessment year and,

(a) it shall be set off against the profits and gains, if any, of any business or profession carried on by him and assessable for that assessment year;

(b) if the unabsorbed depreciation allowance cannot be wholly so set off, the amount of unabsorbed depreciation allowance not so set off shall be carried forward to the following assessment year not being more than eight assessment years immediately succeeding the assessment year for which the aforesaid allowance was first computed.

It is significant to note that for the assessment years up to 2001-02, the unabsorbed depreciation did not become part of the current year’s depreciation and was not to be reduced from the net profit for the purposes of section 40(b) of the Act; in short, it was not to be reduced from the book profit. It can be noticed that the manner in which the unabsorbed depreciation is treated under the old provision differed greatly from the manner in which it is treated under the present provision. One of the glaring differences is that before the amendment it was not being treated as part of the depreciation allowance for the current year. Instead, it was required to be set off against the profits and gains of business or profession separately. Sub-clause (a) of clause (iii) of the old provision made this expressly clear by providing that unabsorbed depreciation allowance was to be set off against the profits and gains of any business or profession assessable for the subsequent assessment year as such and not as a part of the depreciation allowance of that year. Further, the amount against which the unabsorbed depreciation allowance was required to be set off was the profits and gains of any business or profession carried on by the assessee and assessable for that assessment year. The assessable profits and gains of any business or profession for the purpose was necessarily the profits determined after claiming all the permissible deductions, including remuneration to the partners, subject to the limitations provided in section 40(b). Any other interpretation or connotation was not possible; a contrary interpretation would have needed an express provision to that effect which was not the case.

As a result, the requirement under the then Explanation-3 to section 40(b) to compute the book profit in the manner laid down in Chapter IV-D was to exclude the set-off of unabsorbed depreciation. Any interpretation otherwise would have led to an unworkable situation whereunder the amount of unabsorbed depreciation which could have been set off would then be dependent upon the amount of the deductible remuneration, and the amount of the deductible remuneration would in turn be dependent upon the amount of unabsorbed depreciation that could be set off.

Having analysed the position under the old provision of section 32(2), let us consider the objective of its substitution by the Finance Act, 2001 with effect from 1^st April, 2002. The Memorandum explaining the provisions of the Finance Bill, 2001, which is reproduced below, explains the legislative intent behind the amendment.

Modification of provisions relating to allowance of depreciation

Under the existing provision of sub-section (2) of section 32 of the Income-tax Act, carry forward and set off of unabsorbed depreciation is allowed for 8 assessment years.

With a view to enable the assessee to conserve sufficient funds to replace capital assets, specially in an era where obsolescence takes place so often, the Bill proposes to dispense with the restriction of 8 years for carry forward and set off of unabsorbed depreciation.

It can be observed that the limited purpose of substituting the provision of sub-section (2) of section 32 was to relax the limitation of eight years over the carry forward of unabsorbed depreciation. It is worth noting that in order to achieve this objective, the old provision as it existed prior to its amendment by the Finance (No. 2) Act, 1996, was being restored. Therefore, effectively, the present provision of sub-section (2) of section 32 is the same as the provision as it existed prior to its amendment by the Finance (No. 2) Act, 1996. It was only for the period starting from the assessment year 1997-98 to 2002-03 that the provision was different.

In the context of the old provision prevailing up to assessment year 1996-97, the Supreme Court in the case of CIT vs. Mother India Refrigeration Industries (P) Ltd. (1985) 155 ITR 711 has held as follows:

‘It is true that proviso (b) to section 10(2)(vi) creates a legal fiction and under that fiction unabsorbed depreciation either with or without current year’s depreciation is deemed to be the current year’s depreciation but it is well settled that legal fictions are created only for some definite purposes and these must be limited to that purpose and should not be extended beyond that legitimate field. Clearly, the avowed purpose of the legal fiction created by the deeming provision contained in proviso (b) to section 10(2)(vi) is to make the unabsorbed carried forward depreciation partake of the same character as the current depreciation in the following year, so that it is available, unlike unabsorbed carried forward business loss, for being set off against other heads of income of that year. Such being the purpose for which the legal fiction is created, it is difficult to extend the same beyond its legitimate field and will have to be confined to that purpose.’

In view of these observations of the Supreme Court and the legislative intent behind section 32(2), it can be inferred that the only purpose of deeming the unabsorbed depreciation as the depreciation allowance of the current year, post amendment, is limited to ensuring the benefit of its set off, irrespective of the number of years, against any income, irrespective of the head of income under which it falls. In other words the intention has never been to treat it as  part of the depreciation of the year.

Further, in a situation where the assessee has both, i.e., unabsorbed depreciation and business loss brought forward from earlier years, the set off of business loss in terms of sections 72 or 73 needs to be given a preference over set-off of unabsorbed depreciation as per section 72(2). This again confirms that the unabsorbed depreciation is given a separate treatment than the business loss and both are intended to be distinct and separate from each other. The Supreme Court, in the case of CIT vs. Jaipuria China Clay Mines (P) Ltd. 59 ITR 555, had held that the reason for such order of allowance is as under:

‘The unabsorbed depreciation allowance is carried forward under proviso (b) to section 10(2)(vi) of the 1922 Act and the method of carrying it forward is to add it to the amount of the allowance of depreciation in the following year and deeming it to be part of that allowance; the effect of deeming it to be part of that allowance is that it falls in the following year within clause (vi) and has to be deducted as allowance. If the legislature had not enacted proviso (b) to section 24(2) of the 1922 Act, the result would have been that depreciation allowance would have been deducted first out of the profits and gains in preference to any losses which might have been carried forward under section 24 of the 1922 Act, but as the losses can be carried forward only for six years under section 24(2) of the 1922 Act, the assessee would in certain circumstances have in his books losses which he would not be able to set off. It seems that the legislature, in view of this gave a preference to the deduction of losses first.’

The set off of business loss is governed by section 72 which is part of Chapter VI and not Chapter IV-D and, therefore, is not required to be considered while computing the book profit for the purpose of section 40(b). Hence, it would be absurd and contrary to the provisions to set off the unabsorbed depreciation first only for the purpose of arriving at the book profit for the purpose of section 40(b), though unabsorbed depreciation is to be set off only after brought-forward business losses are exhausted in accordance with section 72(2).

Further, if one analyses the definition of book profits as contained in Explanation 3 to section 40(b), it refers to ‘net profit, as shown in the profit and loss account for the relevant previous year…’  Therefore, clearly, the intention is only to consider the profit of the relevant year and not factor in adjustments permissible against such profits relating to earlier years, such as unabsorbed depreciation.