Limitation With Depreciation As Tax Shield.
Depreciation, although a non-cash item of cost, is deductible expenditure in determining the taxable income. Depreciation provisions are prescribed by the companies act for accounting purposes and by the income tax act for taxation purpose.
The purpose of provisions of depreciation contained in the Companies Act is the computation of managerial remuneration, dividend payment and disclosure in financial statements. Since the Companies Act regulates companies in India, they should provide depreciation in books of accounts in accordance with schedule XIV of the Act, which prescribes the rate of depreciation for various types of depreciable assets on written down value (WDV) basis as well as strait line basis. It also permits companies to charge depreciation on any other basis provided it has the effect of writing off 95% of the original cost of the asset on the expiry of the specified period and has the approval of the government. In actual practice, however, companies follow the provisions of the Income Tax Act with the basic objectives of its tax-deductibility.
The provisions of Income Tax Act relating to depreciation are containing in section 32. the section envisages three important conditions for following depreciation, namely
i. The asset is owned by the assessee,
ii. The asset is used by the assessee for the purpose of business and
iii. The asset is in the form of buildings, furniture, machinery, and plants including ships, vehicles, books scientific apparatus, surgical equipments and so on.
The amount of annual depreciation on an asset is determined by
- The actual cost of asset and
- Its classification in relevant block of assets.
The actual cost means the cost of acquisition of the asset and the expenses incidental thereto which are necessary to put the asset in the usable state, for instance, freight and carriage inwards, installation charges and expenses incurred to facilitate the use of the asset like expenses on the training of operator or on essential construction work.
Depreciation is charged, with the view to simplify the computation, not on a block of asset. A block of assets defined as a group of asset falling within a class of assets and in respect of which the same rate of depreciation is prescribed. Thus, assets, which fall within the same class of assets and in respect of which qualify for depreciation at 25 %, will form one block and depreciation is computed with reference to the actual cost of the block. Similarly, asset depreciation at 50 %, and the fourth block comprises assets subjects to 100 percent write-off.
Depreciation is computed at block-wise rate on the basis of written down value (WDV) method only. Presently, the block- wise rate for plant and machinery are at 25%, 40% and 100%. The depreciation allowance on office buildings and furniture and fittings is 10%. Where the actual cost of plant and machinery dose not exceed Rs.5, 000, the entire cost is allowed to be written off in the first year of its use. If an asset acquired during a year has been used for a period of less than 180 days during the year, depreciation on such assets is allowed only at 505 of the computed depreciating according to the relevant rate.
Apart form the simplification of the computation of the amount of depreciation, the significant implication of categorizing assets in to blocks is that if an asset falling in a block is sold out, there is no capital gain or terminal depreciation or balancing charge. The scale proceed of the asset are reduced from the WDV of the block. Capital gain/loss can arise in these situations:
i. When the sale proceeds exceeds the WDV of the whole block.
ii. When the entire block is sold out
iii. In case of 100 percent depreciable assets.
Te terminal losses is not allowed in the relevant assessment year but is spread over a number of years to be allowed by way of depreciation.
In case of insufficiency/ absence of profit, unabsorbed depreciation can be set off against income under any head against business income as in case of unabsorbed loss. Effective 1996-97, it can be carried forward for a maximum period of eight years. However, it cannot be assigned/transferred/claimed by the transfer of business.