AO rejects books of accounts and applies flat net profit rate. Can taxpayer claim depreciation separately or is it embedded in that flat rate?
When an Assessing Officer (AO) rejects a taxpayer’s books of account under Sec 145(3) and resorts to applying a flat net profit (NP) rate on gross turnover, a deceptively simple question arises, “does the taxpayer still get to claim depreciation under Sec 32 separately? Or is it swallowed by that estimated rate?”
The answer is not a clean yes or no. It depends on the nature of the expense, the wording of the assessment order, and the jurisdictional High Court.
THE GENERAL RULE: ORDINARY EXPENSES ARE GONE
Once books are rejected and income is estimated using a flat percentage of turnover, routine business expenses like freight, salary, rent, fuel, repairs are not separately deductible. They are presumed to be embedded in the estimated NP rate. This is well-settled and largely uncontested.
The landmark Punjab & Haryana High Court decision in CIT vs. Gian Chand Labour Contractors (2007) firmly established this “package deal” principle: the estimated rate substitutes the entire Sec 29 computation, absorbing all ordinary PGBP deductions.
SO WHY DEPRECIATION IS DIFFERENT?
Depreciation under Sec 32 is not a cash outflow. It is a statutory allowance for wear and tear of capital assets, it affects the Written Down Value (WDV) of assets for future years, regardless of what happens in any one year’s income computation. Treating it as merely another line item in the P&L misses this point entirely.
CBDT Circular No. 29D (XIX-14) of 1965 explicitly instructed officers: “If it is considered that the net profit should be estimated, it should be estimated subject to the allowance for depreciation, and the depreciation allowance should be deducted therefrom.” But the condition is that the taxpayer must have furnished all the prescribed particulars and details of the assets in the return. If the assessee has maintained a clean, independent fixed-asset register and provided the necessary details, the CBDT’s own instruction requires the AO to treat the Net Profit rate as a pre-depreciation figure and deduct depreciation separately.
THE JUDICIAL DIVIDE
Courts have not spoken in one voice on this. Both sides carry significant High Court authority.
1. Pro-Taxpayer Cases
2. CIT vs. Jain Construction Co. (2000) Rajasthan HC held that Net Profit rate is a gross estimate. The calculated depreciation must be deducted separately if asset particulars are furnished.
3. CIT vs. Chopra Bros. India (P) Ltd. (1993) Punjab & Haryana HC reprimanded authorities for ignoring CBDT Circular 29D and confirmed the separate depreciation even in best judgment assessments.
4. Pro-Revenue Cases: Indwell Constructions vs. CIT (1998) Andhra Pradesh HC held that Estimated rate is a complete substitution of the Sec 29 computation and all deductions including depreciation are absorbed.
SECTION 44AD LOGIC
Parliament eventually ended this litigation for small businesses through presumptive taxation under Sec 44AD. Sec 44AD(2) explicitly state that the 8% (or 6%) presumptive income is deemed to be after allowing depreciation. The WDV is automatically reduced every year, and no separate deduction is permitted.
But the point to be noted here is that Sec 44AD is a voluntary scheme for compliant small taxpayers. A best judgment assessment under Sec 144 after book rejection is a forced penal action, it is not governed by the deeming provisions of Sec 44AD. Revenue authorities may argue the analogy, but the absence of any equivalent statutory deeming provision in Sec 144/145 remains the assessee’s strongest defence.
WHAT DETERMINES THE OUTCOME TODAY?
The real controversy is no longer whether depreciation is legally allowable in principle because it almost always is. The live question is: does the particular estimated rate represent profit before depreciation, or final net profit after depreciation? Everything turns on four factors:
1. The exact wording of the assessment order. If the AO says “net profit estimated at 10%, subject to depreciation,” it is deductible. If the order says “taxable income assessed at 10%,” the argument is weaker.
2. The jurisdictional High Court precedent. There is still a genuine split.
3. Whether the assessee has furnished a complete, reliable fixed-asset register because without this, even the CBDT Circular offers no protection.
PRACTITIONER’S BOTTOM LINE
Ordinary business expenses are dead once books are rejected, they are absorbed in the Net Profit rate without exception. Depreciation is the principal survivor, protected by the statutory character of Sec 32, CBDT Circular No. 29D of 1965, and a strong line of High Court authority but only if the assessee has maintained a clean asset register and the assessment order does not expressly declare the rate to be a final, all-inclusive net profit figure.
Author Bio
