Profits and Gains of Business or Profession — Practice

Question 1

A firm's net profit as per its profit and loss account is ₹18,00,000. It has debited ₹1,20,000 as income-tax paid, ₹40,000 as donation to a political party, and depreciation of ₹3,00,000 as per books. Tax depreciation computed under the Act is ₹3,80,000. It has not credited ₹25,000 of interest income on a fixed deposit, which is taxable under Other Sources. Compute business income.

Accepted Answer

Start from net profit as per the profit and loss account, 18,00,000, and adjust systematically. Income-tax of 1,20,000 debited in the books is not a deductible business expense under the Act, being a tax on income rather than an expense of earning it, so it is added back: plus 1,20,000. The donation of 40,000 to a political party, while it may separately qualify for a deduction under a specific provision when computing total income, is not an expense laid out wholly and exclusively for the purposes of the business and is added back here: plus 40,000. Book depreciation of 3,00,000 is added back in full, since depreciation for tax purposes is computed independently on the block system rather than taken from the books: plus 3,00,000. Tax depreciation of 3,80,000, correctly computed under section 32, is then deducted: minus 3,80,000. The interest income of 25,000 was never credited in the books at all and is taxable, but under the head Other Sources rather than Business or Profession, so it must not be added into business income; since it was never credited it requires no adjustment here, and is simply computed and added separately under its own head when total income is assembled. Business income is therefore 18,00,000 plus 1,20,000 plus 40,000 plus 3,00,000 minus 3,80,000, that is 22,00,000.

Question 2

A block of plant and machinery (rate 15%) has opening WDV of ₹40,00,000. During the year, machinery costing ₹12,00,000 is purchased and put to use on 10 August (more than 180 days before year end), and machinery costing ₹6,00,000 is purchased and put to use on 20 January (less than 180 days before year end). No asset is sold. Compute depreciation for the year.

Accepted Answer

Depreciation is computed on the closing WDV of the block, but the half-rate rule requires the addition used for less than 180 days to be identified and depreciated separately at half the normal rate for this year. Opening WDV is 40,00,000. The addition put to use on 10 August has been in use for more than 180 days by the year end (31 March), so it qualifies for the full rate; the addition put to use on 20 January has been in use for less than 180 days, so only 50% of the normal rate applies to it this year. Depreciation on the opening WDV plus the full-rate addition: 15% on 40,00,000 plus 12,00,000, that is 15% on 52,00,000, giving 7,80,000. Depreciation on the short-period addition: 50% of 15%, that is 7.5%, on 6,00,000, giving 45,000. Total depreciation for the year is 7,80,000 plus 45,000, that is 8,25,000. Closing WDV of the block carries forward at 40,00,000 plus 12,00,000 plus 6,00,000 minus 8,25,000, that is 49,75,000, and in the following year the full 15% rate applies to the entire closing WDV including the previously short-period addition, since the 180-day restriction applies only in the year of acquisition.

Question 3

A block of furniture (rate 10%) has opening WDV of ₹8,00,000. All furniture in the block is sold during the year for ₹9,50,000, and no further furniture is acquired. Compute the tax treatment, and separately state the position if the sale proceeds had been ₹6,50,000 instead.

Accepted Answer

Where all the assets in a block are sold and the block ceases to exist during the year, no depreciation is allowed for that year on that block. Where the sale proceeds exceed the opening WDV, as here, 9,50,000 exceeding 8,00,000, the excess is treated as a short-term capital gain: the excess is 9,50,000 less 8,00,000, that is 1,50,000, which is a short-term capital gain under section 50, taxed as such rather than adjusted through depreciation. No further asset remains in the block, so it simply closes at nil. If instead the sale proceeds had been 6,50,000, less than the opening WDV of 8,00,000, and no assets remain in the block, the shortfall of 8,00,000 less 6,50,000, that is 1,50,000, is allowed as a terminal deduction, generally treated as a short-term capital loss under the same section 50 mechanism that governs blocks of depreciable assets, since the block has ceased to exist with unrecovered cost remaining in it. In neither variant is ordinary depreciation computed for the year, because depreciation under section 32 requires the block to continue in existence with at least one asset remaining at the year end; a block reduced to nil assets is closed out through the capital gains mechanism rather than through the depreciation schedule.

Question 4

A company pays ₹8,00,000 as professional fees to a resident consultant without deducting TDS, and separately pays ₹5,00,000 as royalty to a non-resident without deducting TDS. Compute the disallowance under section 40(a) for both payments, and state the position if the company deducts and pays the TDS on the resident payment in the following year.

Accepted Answer

The two payments attract sharply different disallowance rates because of the payee's residential status, and this distinction is the point most frequently tested in this provision. On the resident consultant's professional fees of 8,00,000, where tax deductible at source has not been deducted at all, section 40(a) disallows 30% of the expenditure for a payment to a resident: 30% of 8,00,000, that is 2,40,000, is disallowed, and the remaining 70%, that is 5,60,000, continues to be an allowable deduction despite the TDS default. On the non-resident royalty payment of 5,00,000, where tax deductible was similarly not deducted, the disallowance for a payment to a non-resident is of the entire amount: 100% of 5,00,000, that is the full 5,00,000, is disallowed, leaving nothing deductible for that payment at all. If the company deducts and pays the TDS on the resident payment in the following year, the disallowed 2,40,000 becomes allowable as a deduction in that later year, the year in which the tax is actually deducted and paid, rather than being permanently lost; the same reversal mechanism would apply to the non-resident payment's 5,00,000 if the default were similarly cured in a later year, restoring the full deduction then rather than in the year of original expenditure.

Question 5

A trader pays ₹12,000 in cash to a single supplier for goods on one day, and separately pays a transport operator ₹32,000 in cash on one day for hiring a goods carriage. Advise on the disallowance under section 40A(3) for each, and state the general threshold and the special threshold that applies.

Accepted Answer

Section 40A(3) disallows 100% of expenditure where a payment or the aggregate of payments made to a person in a day, otherwise than by account payee cheque, account payee bank draft or electronic clearing system, exceeds the prescribed threshold. The general threshold is 10,000; a higher threshold of 35,000 applies specifically to payment made to a transport operator for plying, hiring or leasing goods carriages, recognising that the transport sector commonly involves larger cash settlements as a matter of trade practice. On the supplier payment of 12,000 in cash, this exceeds the general threshold of 10,000, so the entire 12,000, not merely the excess over 10,000, is disallowed; the provision operates on an all-or-nothing basis once the threshold is crossed, not as a cap allowing the first 10,000 and disallowing only the balance. On the transport operator payment of 32,000 in cash, this is below the special threshold of 35,000 applicable to transport operators, so no disallowance arises under section 40A(3) at all, and the full 32,000 remains deductible provided it otherwise satisfies the general conditions for deductibility. The contrast illustrates why identifying whether a payee is a transport operator for this specific purpose is worth checking carefully before applying the general 10,000 figure.

Question 6

A company follows the mercantile system of accounting. It has an outstanding employer's PF contribution of ₹2,00,000 for March, accrued but unpaid at year end, and outstanding GST liability of ₹3,50,000, similarly accrued but unpaid at year end. The return filing due date is 31 October. State the deductibility of each in the year of accrual under two scenarios: payment made on 15 October, and payment made on 15 December.

Accepted Answer

Both items fall within section 43B's list of statutory liabilities deductible only on actual payment notwithstanding the mercantile system: employer's contribution to a provident or similar welfare fund, and tax, duty, cess or fee under any law, which covers the GST liability. Under the first scenario, payment on 15 October, which is before the return filing due date of 31 October, the proviso to section 43B applies to both items: where payment is made on or before the due date of filing the return of income under section 139(1), the deduction is allowed for the year in which the liability was incurred, notwithstanding that actual payment occurred after the financial year end. So both the 2,00,000 employer's PF contribution and the 3,50,000 GST liability are deductible in the year of accrual, since both were paid by 15 October, before the 31 October due date. Under the second scenario, payment on 15 December, after the return filing due date, the GST liability of 3,50,000 loses the proviso relief and is not deductible in the year of accrual at all; it becomes deductible only in the year of actual payment, that is the following year. The employer's PF contribution, however, is governed by the general section 43B rule in the same way as any other item on its list, so the same conclusion applies to it as well on these facts: paid after 31 October, it too is deferred to the year of actual payment. The important distinction to note, though not decisive on these facts, is that the employer's own contribution is governed by section 43B and gets the proviso relief up to the return due date, whereas the employee's contribution deducted from wages by the employer is governed by a separate and stricter provision requiring payment by the due date under the relevant welfare legislation itself, with no extension to the return filing date.

Question 7

Mr. Rao, a resident individual running a retail business, has turnover of ₹1,60,00,000 for the year, of which ₹1,50,00,000 was received through banking channels and the remainder in cash. He opts for presumptive taxation under section 44AD. Compute his presumptive business income, and state whether he may separately claim depreciation.

Accepted Answer

Cash receipts are 1,60,00,000 less 1,50,00,000, that is 10,00,000, which as a proportion of total turnover is 10,00,000 over 1,60,00,000, that is 6.25%, exceeding the 5% threshold that would otherwise permit the enhanced 3 crore turnover limit; but since Mr. Rao's turnover of 1,60,00,000 does not exceed even the base 2 crore threshold, he remains an eligible assessee under section 44AD regardless of the cash proportion. His presumptive income is computed at differentiated rates depending on how each rupee of turnover was received: the portion received through banking channels or other prescribed digital modes, 1,50,00,000, is presumed at the lower rate of 6%, giving 9,00,000; the balance received in cash, 10,00,000, is presumed at the ordinary rate of 8%, giving 80,000. Total presumptive business income is 9,00,000 plus 80,000, that is 9,80,000. Mr. Rao may not separately claim depreciation or any other business expense against this figure: the entire point of the presumptive scheme is that the declared percentage is deemed to already account for all business expenses including depreciation, and no further deduction is available once income is returned under section 44AD, whatever the assessee's actual books might otherwise have shown.

Question 8

Mr. Singh has declared income under section 44AD for the past three years. In the current year his actual profit is only 5% of turnover, and his total income for the year exceeds the basic exemption limit. Advise on his obligations for this year.

Accepted Answer

Mr. Singh must maintain regular books of account and get them audited under section 44AB for this year, because he has declared profit below the presumptive rate prescribed under section 44AD while his total income exceeds the basic exemption limit, which is precisely the exit trigger the provision is built around. Section 44AD ordinarily relieves an eligible assessee of the need to maintain detailed books and to undergo an audit purely on the ground of turnover, on the footing that profit is presumed at a fixed percentage regardless of actual results. But where the assessee chooses to declare actual profit below that presumed percentage, rather than accepting the presumptive figure, the relief from books and audit is withdrawn if his total income for the year, computed without regard to the presumption, exceeds the basic exemption limit; the rationale is that the Act allows presumptive taxation as a simplification for a taxpayer content to be taxed on the presumed figure, but withdraws that simplification the moment the taxpayer instead wants to be assessed on a lower actual figure, at which point the ordinary safeguards of maintained books and an independent audit become necessary to verify the lower figure claimed. Mr. Singh must therefore maintain books under section 44AA and have them audited under section 44AB by the prescribed due date, in addition to declaring the actual 5% figure rather than the presumed 8%.

Question 9

Two assessees each sell shares at a profit during the year. Assessee A is a trader who bought and sold the same shares repeatedly within short holding periods as part of frequent, high-volume dealing, treating them as stock-in-trade in his books. Assessee B bought shares as a long-term investment and held them for several years before selling. Explain how the profit is classified in each case and the factors relevant to the distinction.

Accepted Answer

Assessee A's profit is business income, taxable under Profits and Gains of Business or Profession, because the shares were held as stock-in-trade rather than as an investment: they were dealt in repeatedly, in volume, with short holding periods, and treated in the books as trading stock rather than as a capital asset, all of which are hallmarks of a trading activity rather than an investment. Assessee B's profit is capital gains, taxable under the head Capital Gains, because the shares were held as an investment with the intention of holding for appreciation over the long term rather than for resale as part of a trading business, and the extended holding period and the absence of frequent dealing both point away from a trading character. The classification is a question of fact rather than one determined by the type of asset alone, since the same category of asset, shares, land, or securities, can generate either business income or capital gains depending entirely on the assessee's intention and pattern of dealing with it. The factors examined include the frequency and volume of transactions, the holding period, whether the assessee has a stated business of dealing in such assets, how the asset is treated and disclosed in the assessee's own books of account, the source of funds used for acquisition, whether borrowed funds were used, and the assessee's conduct generally, no single factor being conclusive on its own but the overall pattern determining the answer.

Question 10

A manufacturing company purchases new plant and machinery for ₹50,00,000 and puts it to use on 15 June (more than 180 days in use during the year), and further new plant and machinery for ₹20,00,000 put to use on 5 February (less than 180 days). Compute the total depreciation, including additional depreciation, for the year, assuming the normal rate for this block is 15%.

Accepted Answer

Two layers of depreciation apply to new plant and machinery used in manufacturing: normal depreciation under section 32 on the block, and additional depreciation under the same section for new plant and machinery acquired and installed by a manufacturer, over and above the normal depreciation. On the June addition, used for more than 180 days, normal depreciation is the full 15% on 50,00,000, that is 7,50,000, and additional depreciation is the full 20% of actual cost since it has been used for more than 180 days, that is 20% of 50,00,000, giving 10,00,000. On the February addition, used for less than 180 days, normal depreciation is restricted to half the rate, that is 7.5% on 20,00,000, giving 1,50,000, and additional depreciation is similarly restricted to half, that is 10% of actual cost rather than 20%, giving 10% of 20,00,000, that is 2,00,000; the remaining 10% of additional depreciation not allowed this year because of the short period, that is a further 2,00,000, is allowed in the immediately succeeding year, a relief unique to additional depreciation and not available for ordinary normal depreciation restricted by the half-rate rule. Total depreciation for the current year is normal depreciation of 7,50,000 plus 1,50,000, that is 9,00,000, plus additional depreciation of 10,00,000 plus 2,00,000, that is 12,00,000, giving an aggregate of 21,00,000 for the year, with a further 2,00,000 of additional depreciation to follow in the succeeding year.

Question 11

State the test under section 37(1) for a general business deduction, and explain why expenditure incurred on an activity that is itself illegal cannot be deducted even if it was genuinely incurred for business purposes.

Accepted Answer

Section 37(1) is the residual, catch-all deduction provision covering any expenditure not falling within the specific deductions in sections 30 to 36, provided the expenditure is not capital in nature, is not a personal expense of the assessee, and is laid out or expended wholly and exclusively for the purposes of the business or profession. The phrase wholly and exclusively is the operative test and is deliberately stricter than a test of mere reasonableness or partial business connection: the expenditure must be incurred entirely for business purposes, and where it serves a mixed business and personal purpose, only a business-attributable portion, if separable, is deductible rather than the whole. Beyond this general test, the Act contains an explicit exclusion aimed specifically at unlawful expenditure: expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law is deemed not to have been incurred for the purpose of business or profession, and no deduction or allowance is made in respect of such expenditure. This exclusion exists as a deliberate policy choice independent of whether the expenditure would otherwise satisfy the wholly-and-exclusively test: a bribe paid to secure a business contract, or a payment made in connection with a prohibited activity, might well be genuinely, even demonstrably, incurred for the purposes of the business in a purely commercial sense, but the law refuses to let the tax system subsidise such expenditure by allowing it as a deduction, on the view that permitting the deduction would make the state complicit in reducing the effective cost of unlawful conduct.

Question 12

A company incurs ₹8,00,000 of preliminary expenses in connection with its formation. State how this is deducted under section 35D, and the general cap that applies to companies.

Accepted Answer

Preliminary expenses eligible under section 35D are not deducted in full in the year incurred, but are amortised, that is deducted in five equal annual instalments commencing from the year the business commences, or in the case of an extension, from the year the extension is completed or the new unit commences production. On 8,00,000 of eligible preliminary expenditure, the annual instalment would be 8,00,000 divided by 5, that is 1,60,000, deductible in each of five successive years, provided the expenditure itself and the annual instalment both fall within the statutory cap. For a company, the deduction is further capped at a specified percentage of the cost of the project, or, at the assessee's option, of the capital employed in the business, whichever the assessee elects, so that even where actual preliminary expenditure incurred exceeds this cap, only the amount within the permitted percentage is eligible for the amortised deduction, with expenditure beyond the cap not being deductible under this provision at all. This staged amortisation, rather than an immediate full deduction, exists because preliminary expenses such as incorporation costs and share issue expenses in some sense benefit the business over its ongoing life rather than being consumed entirely in the year of formation, so spreading the deduction across five years better matches the expense to the periods it can be said to benefit.

Question 13

Explain the distinction between the obligation to maintain books of account under section 44AA and the obligation to have accounts audited under section 44AB, and why an assessee might be required to maintain books without being required to have them audited.

Accepted Answer

The two obligations are related but distinct, addressing different questions. Section 44AA governs whether an assessee must maintain books of account at all, and to what standard: specified professions, such as legal, medical, engineering, architectural, accountancy and certain others, must maintain prescribed books where gross receipts exceed a threshold in any of the three immediately preceding years, while other businesses and professions must maintain books adequate to enable the Assessing Officer to compute total income correctly, where income or turnover exceeds prescribed limits considerably lower than the audit thresholds. Section 44AB governs a separate and generally higher-threshold question, whether those books, once maintained, must additionally be audited by a chartered accountant, broadly triggered where turnover of a business exceeds a prescribed threshold, or gross receipts of a profession exceed a prescribed threshold, or where an eligible assessee under a presumptive scheme declares profit below the presumptive rate while total income exceeds the basic exemption limit. Because the section 44AA thresholds for maintaining books are generally lower than the section 44AB thresholds for audit, an assessee can readily fall into a position of being required to maintain proper books of account without yet being required to have them audited, simply by having turnover or receipts above the lower maintenance threshold but below the higher audit threshold; the two obligations therefore operate as successive gates, with maintenance of books as the lower bar and audit as the higher one layered on top of it for larger or specifically triggered cases.

Question 14

A company pays ₹15,00,000 to a firm in which its managing director holds a substantial interest, for consultancy services, when the fair market value of comparable services is ₹9,00,000. Advise on the tax treatment, and explain the purpose of section 40A(2).

Accepted Answer

Section 40A(2) empowers the Assessing Officer, where an assessee incurs expenditure for goods, services or facilities and the payment is made to a specified related person, including a person having a substantial interest in the business or a firm in which a director has a substantial interest, to disallow the excess of the expenditure over what is reasonable having regard to the fair market value of the goods, services or facilities, where the Assessing Officer is of the opinion that the expenditure is excessive or unreasonable. On these facts, the payment of 15,00,000 for consultancy services genuinely worth 9,00,000 at fair market value, made to a firm in which the company's own managing director holds a substantial interest, falls squarely within the provision's scope: the payee is a related person by virtue of the director's substantial interest in the firm, and the amount paid substantially exceeds fair value for comparable services. The excess over reasonable value, that is 15,00,000 less 9,00,000, giving 6,00,000, is liable to be disallowed as a deduction, leaving only 9,00,000 as an allowable business expense. The purpose of section 40A(2) is to prevent related-party transactions from being used to extract value from a company or business at inflated prices dressed up as ordinary business expenditure, effectively shifting profit to a connected person while claiming a full deduction for what is, in substance, only partly a genuine business cost and partly a disguised distribution or benefit to the related party.

Question 15

A bank earns interest on loans it has advanced to customers, and separately earns rental income from a surplus office floor it lets out because the space is temporarily unused. Classify each receipt, explaining the distinction that governs.

Accepted Answer

The interest income is taxable as business income, while the rental income is taxable under Income from House Property, and the distinction turns on whether the receipt genuinely forms part of the assessee's actual business operations or is merely incidental to holding an asset outside that operation. Interest earned by a banking business on loans it advances is not an incidental investment return; lending money at interest is the very substance of what a bank does, so interest income of this kind is business income, taxable under Profits and Gains of Business or Profession, computed as part of the bank's ordinary trading results rather than separately under Other Sources, which is the head that would apply to interest earned by a non-banking assessee on, say, a fixed deposit unconnected to any business. The rental income from the surplus office floor is different in character: letting out property is not the bank's business, and the letting arises only because a portion of premises held for banking operations happens to be temporarily surplus to those operations; this is an incidental exploitation of a business asset rather than an activity forming part of the business itself, and rental income of this kind, where letting out property is not the assessee's business, is taxed under the head Income from House Property rather than as business income, computed under that head's own rules of Gross Annual Value and section 24 deductions rather than as an item within the bank's trading profit and loss.

Practice — Profits and Gains of Business or Profession

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