Statutory Deductions “Depreciation”: Key Principles and Court Rulings

Depreciation is statutory deduction that allows businesses to set off cost of their tangible & intangible assets over their useful life. Income Tax Act, 1961, offers framework for claiming depreciation, designed in such way that reduce financial burden on businesses by acknowledging wear & tear that assets undergo over time. This approach encourages investment, facilitates upkeep of assets, and ultimately strengthens business sustainability.

The Act specifies various condition under which depreciation can be claimed and provide rules on calculating depreciation for transferred assets, and permits indefinite carry-forward of unabsorbed depreciation, allowing businesses to optimize their tax planning. In this article we get into these provisions, highlighting key sections, judicial interpretations, and practical applications.

Key Sections & Provisions that governs Depreciation : –

1. Section 32 : Deduction of Depreciation

• Section 32(1) is very foundational provision for claiming depreciation on both tangible assets as like buildings, machinery, & furniture and intangible assets such as goodwill, patents, and trademarks. It allows businesses to reduce their taxable income by claiming deduction for depreciation of assets used in course of business or profession.
• Section 32(1)(ii) includes special focus on intangible assets. It Recognize economic value of intellectual properties on which Income Tax Act allows depreciation claims on assets like goodwill, patents, copyrights, trademarks, and licenses under this clause. This provision widen scope of depreciation beyond physical assets, helping businesses capitalize on intangible resources that contribute to profitability.
• Section 32(1)(iia) introduces the concept of additional depreciation, granting an extra 20% depreciation allowance on new Plant & machinery acquired by manufacturing entities. This provision incentivizes capital investment, helping businesses in staying competitive by modernizing Plant & machinery. However, This additional allowance does not apply to certain sectors as like power generation or distribution and note that it is available only for the initial year of asset acquisition.

2. Section 32(2) – Unabsorbed Depreciation

• Under Section 32(2), if depreciation of asset exceeds assessee’s profits for the year, unabsorbed depreciation can be carried forward indefinitely. This is notable advantage However, most business losses can only be carried forward for eight years. This indefinite carry-forward allows assessee to adjust unabsorbed depreciation against future profits, thereby offering consistent tax-saving mechanism over time.
• The unabsorbed depreciation can be set off against other heads of income, ensuring that businesses can benefit from tax relief even in years when their primary business income may not be sufficient to absorb the depreciation fully.

3. Depreciation on Leasehold Improvements

• Explanation 1 to Section 32 clarifies that improvements made to leasehold premises qualify as capital expenditure, allowing depreciation claims even though lessee does not own property. Businesses that invest in enhancing leased property for operational needs such as installation of machinery or modifying interiors can claim depreciation on these improvements as though they were owner. This provision supports businesses in maintaining leased premises without financial penalty, allowing deductions for necessary improvements over the lease term.

4. Section 43(1) – Actual Cost of Asset

• Section 43(1) defines term actual cost, which is fundamental to determining depreciation base of asset. The actual cost typically refers to price paid by assessee in acquisition of asset, inclusive of all necessary expenses for bringing asset in operational condition.
• This section becomes particularly important when assets are transferred from one business to another. It ensures that the total depreciation claimed on such asset over its life does not exceed original cost. For example, if business purchases machine from another assessee, depreciation base is adjusted so that new owner cannot claim more depreciation than what remains of original cost, ensuring for true and fair taxation.

5. Section 50 – Capital Gain on Sale of Depreciable Assets

• Section 50 applies when taxpayer sells asset that has already undergone depreciation. If sale proceeds exceed written-down value (WDV) of such asset at that time, excess is treated as short-term capital gain, even if asset was held for more than two years. This provision simplifies treatment of gains on depreciated assets, ensuring they are taxed at fair rate & eliminating complications in capital gains tax calculation.
• If asset is part of block of assets (i.e., grouped with similar assets for depreciation purposes), any sale proceeds reduce value of that block. When the entire block is sold then only capital gain (if any) is calculated based on the residual written-down value of the block.
  Let’s go through Judicial pronouncement for Depreciation

6. Case on Leasehold Improvements

• In notable case involving improvements on leasehold premises, Income Tax Appellate Tribunal (ITAT) held that expenses incurred for modifying or upgrading leased property were considered capital in nature. These expenses were eligible for depreciation under Explanation 1 to Section 32 which confirm that businesses could claim depreciation on leasehold improvements made for operational requirements.

7. Depreciation on Non-Compete Fees

• In another case ITAT has also allowed depreciation on non-compete fees, classifying them as intangible asset u/s. 32(1)(ii). This judgment expanded scope of an intangible assets by allowing businesses to claim depreciation on non-compete fees payments which is very common expense in mergers and acquisitions.

8. Unabsorbed Depreciation Carry-Forward

• Principle of indefinite carry-forward of unabsorbed depreciation was clarified in landmark case where court ruled that unabsorbed depreciation can be set off against other income, even if the business has ceased its operations, thus reinforcing the favorable treatment of depreciation carry-forward under Section 32(2).

Case laws: 1) Hindon River Mills Ltd. v. Dy. CIT ITA No. 2301/Del/2016

Facts of the Case

In case of Hindon River Mills Ltd. Vs. Deputy Commissioner of Income Tax, Assessee, Hindon River Mills Ltd., sought to set off unabsorbed depreciation against income other than business income specifically income from house property & income from other sources. AO has specifically disallowed claim by stating that unabsorbed depreciation can not be set off against income from other sources. CIT(A) has upheld decision of AO, leading assessee to appeal decision before ITAT.

Submission by the Assessee:

The assessee, Hindon River Mills Ltd., presented following key arguments:

1. Broad Understanding of Section 32(2):

• Assessee has argued that language of amended section 32(2) allows for unabsorbed depreciation to be set off against any other income which is not limited to business income. They also highlighted that phrase “of any business or profession” had removed from this section indicating that set-off was no longer restricted to Income from business or profession.

2. Other Judgement Supporting Broader Set-Off:

• The assessee referenced past cases, particularly M/s. Suresh Industries (P.) Ltd., in which a similar set-off was allowed by the Mumbai Tribunal. They argued that this decision supported their interpretation of Section 32(2) as permitting set-off against any income head.

3. Consistency in Past Assessments:

– Assessee has mentioned that officer of department i.e. CIT(A) and AO has allowed for set off of unabsorbed depreciation against income for other source in A Y 2007-08 and in A Y 2013-14. They have argued that this consistent treatment in past assessments should apply to the current case as well.

Observation by Income Tax Officer:

Assessing Officer (AO) made the following observations:

1. Disallowance of Set-Off: Assessing Officer has denied set-off of unabsorbed depreciation against income from other source by stating Section 32(2) did not permit such set-off and according to officer unabsorbed depreciation can only be limited to set off against profits from business income only and not other income.

2. Understanding of Section 32(2): AO argued that restrictive interpretation of Section 32(2) was appropriate. In view of AO, section still implied that unabsorbed depreciation should be set off only against business income, as was traditionally understood before the amendment.

Observations by the Commissioner of Income Tax: The CIT(A) supported the AO’s decision and made the following observations:

1. Agreement with the AO’s Interpretation: CIT(A) has agreed with disagreement of officer that Section 32(2) does not permit set-off of unabsorbed depreciation against income from other sources and CIT(Appeal) has held that without clear provisions under the Act for allowance of set-off unabsorbed depreciation can only apply to Income from business and not to other sources.

2. There is no such specific provision for Set-Off Against Income from other sources: CIT(Appeal) has concluded that there was no statutory provision which specifically allow to set-off of unabsorbed depreciation against other heads of income, such as income from house property or income from any other sources.

3. Independence of Assessment Years: CIT(A) acknowledged that the set-off had been allowed in prior assessment years but maintained that each assessment year must be evaluated separately. CIT(A) has reasoned that past treatment did not guarantee the same outcome for current year, particularly given their interpretation of the statutory provisions.

Tribunal’s Decision:

Upon review, Income Tax Appellate Tribunal (ITAT) ruled in favor of assessee, providing the following rationale : –

1. Broad Application of Amended Section 32(2) : – ITAT emphasized significance of amendment to Section 32(2), noting that removal of phrase “of any business or profession” suggested legislative intent to allow unabsorbed depreciation to be set off against any income head, not just business income. The Tribunal held that this change widened scope of set-off by supporting the assessee’s interpretation.

2. Other Judicial pronouncement in Support: Tribunal referenced past judicial rulings, including Mumbai Tribunal’s decision in M/s. Suresh Industries (P.) Ltd., which allowed unabsorbed depreciation to be set off against non-business income. ITAT agreed that these precedents strengthened interpretation that unabsorbed depreciation could be applied broadly.

3. Consistency with Prior Assessments: Tribunal also noted that in assessee’s own past assessments, for years 2007-08 and 2013-14, CIT(A) & AO had permitted similar set-offs. ITAT found no reason to depart from this established treatment, underscoring importance of consistency in tax assessments.

4. Direction to AO: Tribunal has directed officer to allow set-off of unabsorbed depreciation against income from “Income from house property” and “Income from other sources.”

Key Takeaways:

1. Set-Off of Unabsorbed Depreciation Against Income from other sources:- Case clarified that unabsorbed depreciation u/s. 32(2) of Income Tax Act can be set off against any head of income, not limited to business income. This interpretation was based on amended language of Section 32(2), which removed the restriction of set-off only against business or professional income.

2. Amendment of Section 32(2) Allows Broader Set-Off: Tribunal observed that, post-amendment, phrase “of any business or profession” was removed from Section 32(2). This change broadened the applicability of unabsorbed depreciation which allows to set off against other income heads, such as “Income from house property” and “Income from other sources.”

3. Consistency in Past Assessments: Tribunal also noted that in prior assessment years, similar set-offs had been allowed to assessee, emphasizing importance of maintaining consistency in tax treatment across years when similar facts and issues are involved.

4. Reference to Judicial Precedents: Tribunal referenced past decisions, including M/s. Suresh Industries (P.) Ltd., where unabsorbed depreciation was permitted to be set off against non-business income, strengthening consistent judicial approach to interpreting Section 32(2).

5. Taxpayer-Friendly Interpretation: Case supports taxpayer-friendly interpretation of depreciation provisions, permitting flexibility in managing unabsorbed depreciation across different income heads, which can be very much beneficial for tax planning.

CIT v. Mahendra Mills 2000 TaxPub(DT) 1304 (SC)

Fact of Case :-

In this case the primary issue turned around entitlement to claim depreciation u/s. 32 of Act. Assessee has opted not to claim depreciation in particular assessment year to benefit from lower tax liability. Officer sought to apply depreciation mandatorily by reducing total income by including depreciation even-though assessee had not claimed it. Case subsequently reach to Supreme Court addressing whether depreciation could be applied compulsorily by officer or if it required specific claim by assessee.

Submission by the Assessee:

Mahendra Mills, the assessee, argued the following:

1. Depreciation is Not Mandatory if Not Claimed: The assessee contended that depreciation under Section 32 is a beneficial provision, meant to reduce taxable income only when claimed. Since , Act does not make it obligatory for depreciation to be claimed, assessee argued that it could choose not to claim it if doing so would be disadvantageous.

2. Right to Choose for Not claiming Depreciation: Assessee has emphasized its right to compute taxable income based on statutory provisions which allows flexibility in claiming deductions or not claiming deductions including depreciation. Assessee has argued that officer did not have an authority to compel claim for depreciation in absence of explicit claim by assessee.

3. Purpose of Depreciation: Assessee has pointed out that main purpose of allowing depreciation was to encourage assessee to account for asset wear & tear. However, if assessee found it more beneficial not to apply depreciation then they should not be penalized by ITO mandatorily including it in computation of income.

Observations by the Income Tax Officer:

The Income Tax Officer (ITO) made the following observations:

1. Mandatory Inclusion of Depreciation: ITO argued that depreciation is automatic deduction allowed u/s. 32 of Act & must be mandatorily applied regardless of whether it is claimed by assessee or not.

2. Main Purpose of Depreciation : – According to the ITO, depreciation aims to reflect a true and fair view of income by accounting for asset wear and tear. The ITO maintained that including depreciation was necessary to accurately compute the taxable income, as the provision is designed to provide a true reflection of the profit earned.

3. Reduction of Assessed Income: ITO has justified in applying mandatory depreciation by arguing that not doing so would artificially fill taxable income as the assessee would not be reflecting wear & tear on assets.

Observation by Commissioner of Income Tax :

Commissioner of Income Tax (Appeals) has analyzed competing arguments & observed following things :

1. Depreciation as Deduction not as Compulsion : –

• The CIT(A) emphasized that while depreciation is deduction allowed under law, it is still deduction that must be claimed to apply. CIT(A) has observed that depreciation is not like certain statutory expenses which does not automatically apply without consent of assessee.

Discretion of assessee :-

• CIT(A) has sided with assessee’s discretion in deciding whether to claim depreciation or not based on plain reading that Section 32 does not specifically mandate compulsory deduction of depreciation in absence of a claim. CIT(A) has noted that tax provisions allow assesse to manage their tax obligations within the legal limits to minimize tax liabilities.

2. Right of assessee to Waive claim of Depreciation :-

• CIT(A) has concluded that if assessee chose not to claim depreciation then there was no statutory compulsion by which ITO make it compulsory in assessment. This decision was based on interpretation that deductions u/s. 32 are optional benefits rather than mandatory deduction.

Decision of Supreme Court : –

The Supreme Court examined the provisions of Section 32 and relevant arguments, ruling in favor of Mahendra Mills with the following observations:

1. Depreciation is Not Compulsory if is not Claimed by assessee : –

• Supreme Court has held that depreciation u/s. 32 of Act is not mandatory. It is the benefit that must be claimed by assessee for it to apply. Court has noted that language of act did not indicate that depreciation would be automatically applied without claim of assessee.

2. Discretion of assessee to Opt-Out for Depreciation : –

• Court has affirmed that assessee has a right to opt out from claiming depreciation if it is advantageous for assessee. In this ruling it is reinforced that assessee is duly permitted to structure its taxable income within legal framework to minimize liabilities arise for payment of tax.

3. Clarification for Purpose of Depreciation : –

• Supreme Court has clarified that main purpose for claiming depreciation is to allow for asset’s reduction in value over time period but it does not oblige assessee for claim it if it result in higher tax liabilities of assessee. Benefit of depreciation u/s. 32 is optional and assessee can choose whether to avail or not .

4. Not Compulsory Reduction of taxable income:

• Supreme Court has held that Income Tax Officer cannot made ti compulsory for reduction of taxable income by applying depreciation if the taxpayer has not claimed it. Thus, the ITO’s mandate to include depreciation without the taxpayer’s claim was deemed unlawful.

Key Takeaways : –

1. Depreciation is not compulsory its optional : –

• Depreciation u/s. 32 of Act is not mandatory. It is just benefit available for assessee but it must be claimed explicitly else it does not apply.

2. Discretion of Assessee : –

• Supreme Court has upheld that assessee has discretion to decide whether or not to claim depreciation. This allow assessee to structure their income to minimize tax liability within legal framework.

3. No Automatic Adjustment by Tax Authorities:

• The ruling clarified that tax authorities cannot apply depreciation automatically to reduce taxable income if the taxpayer has not claimed it. This prevents the Income Tax Officer (ITO) from mandatorily including depreciation in assessments.

4. Flexibility in Tax Planning:

• The judgment provides taxpayers with more flexibility in tax planning, allowing them to opt out of claiming depreciation if it results in a higher tax liability.

5. Interpretation of Tax Benefits as Non-Compulsory:

The case reinforces that certain deductions or benefits, like depreciation, are optional and must be claimed to apply. This ruling has broader implications for other optional tax benefits, emphasizing that they are not compulsory deductions

Devesh Metcast Ltd. v. Joint Commissioner of Income Tax 011 TaxPub(DT) 1997 (Guj-HC)

Facts of the Case : –

In this case main key issue was whether Devesh Metcast Ltd. was entitled to claim depreciation on certain assets that company had acquired but were allegedly not put to use during the relevant financial year. The Joint Commissioner of Income Tax (Jt. CIT) disallowed the depreciation claim, arguing that the assets were not actively used in the business operations. The case escalated to the Gujarat High Court to determine whether depreciation could be allowed based on the company’s claim that the assets were kept ready for use.

Submission by the Assessee:

Devesh Metcast Ltd. argued the following points:

1. Readiness for Use:

The company claimed that the assets were installed and kept ready for use in its operations, and they were an integral part of the company’s infrastructure. The assessee argued that “use” should encompass assets that are kept ready for deployment, even if not actively utilized, a concept known as “passive use.”

2. Eligibility of Depreciation:

• Assessee has contended that as long as assets were made available for business purposes they should be eligible for depreciation u/s. 32 of Act. Company has also relied on past pronouncements that recognizes both active & passive use of assets are eligible for depreciation.

3. Established Judicial Precedents:

• Devesh Metcast Ltd. cited similar cases, emphasizing that courts have previously allowed depreciation for assets held in a ready-for-use state, reinforcing the concept that readiness for use qualifies under the depreciation provisions.

Observations by the Joint Commissioner of Income Tax :

The Jt. CIT presented the following observations in assessing the company’s depreciation claim:

1. Requirement of Active Use:

• The Jt. CIT held that depreciation under Section 32 requires assets to be actively used in business operations. Merely keeping assets in a ready-to-use state without actual utilization did not fulfill the “use” requirement in the Jt. CIT’s view.

2. Rejection of Passive Use Concept:

• The Jt. CIT argued that the Income Tax Act’s provisions are intended to reflect actual business expenses and operational wear and tear. Without evidence of active use, the Jt. CIT considered the depreciation claim unsupported.

3. Verification of Business Usage:

• The Jt. CIT examined whether the assets were factually deployed for business purposes and found insufficient evidence to support the company’s assertion of their deployment in operations during the relevant financial year.

Observations by the Commissioner of Income Tax:

Upon appeal, the CIT(A) reviewed the case and made the following observations:

1. Broad Interpretation of “Use”:

• The CIT(A) acknowledged that several judicial precedents support a broader interpretation of “use” that includes assets kept ready for use, as long as they are integral to the business setup and available for business purposes.

2. Allowance for Passive Use:

• The CIT(A) recognized that, in certain circumstances, passive use—assets kept ready for business even if not actively utilized—can justify depreciation claims. However, the CIT(A) suggested a detailed review of each asset’s usage status.

3. Requirement of Evidence:

• The CIT(A) noted that while the passive use concept may apply, the company should provide adequate evidence showing that the assets were indeed integral to business operations, ready for use, and required as part of the company’s infrastructure.

Gujarat High Court’s Decision:

The Gujarat High Court ruled in favor of Devesh Metcast Ltd., providing the following key points in its judgment:

1. Recognition of Passive Use:

• The High Court upheld the concept of passive use, affirming that assets kept in a ready-for-use state could be eligible for depreciation. The Court emphasized that readiness for use suffices to meet the “used for business” requirement under Section 32, particularly when the assets are maintained as part of the essential business infrastructure.

2. Judicial pronouncement for Eligibility of Depreciation : –

• Court relied on judicial established interpretations which had previously acknowledged that passive use can be sufficient for claiming depreciation. It referenced cases supporting view that depreciation applies to asset must be held for ready to use even though its not an operational.

3. Depreciation Allowance : –

• High Court has directed authorities to allow claim of depreciation to company by concluding that assets were intended to kept ready for business purposes and hence the same meets criteria for depreciation u/s. 32.

4. Clarification on “Use” Requirement:

• The Court clarified that the term “used” in Section 32 should not be narrowly construed to mean only active use. The decision emphasized that if an asset is part of the operational setup, it qualifies for depreciation even if passively used.

Key Takeaways:

1. Broad Interpretation of “Use”:

• Depreciation can be claimed on assets that are kept ready for business use, extending eligibility beyond only actively utilized assets.

2. Support for Passive Use:

• This judgment supports the concept of passive use, allowing taxpayers to claim depreciation for assets that form part of the operational setup, even if not in active use during the relevant financial year.

3. Judicial Precedents Reinforced:

• The decision aligns with past rulings that recognize both active and passive use, providing valuable guidance on the application of Section 32.

4. Clarity for Taxpayers:

• Businesses can leverage this decision to claim depreciation for essential assets that remain in a ready-for-use state, aiding tax planning and compliance with depreciation provisions.

Practical Application of Depreciation Rules

1. Additional Depreciation for Manufacturing Units:

Manufacturing businesses can claim an additional 20% depreciation on new machinery or plant under Section 32(1)(iia). This additional depreciation encourages investment in modernizing production facilities, ensuring these businesses remain competitive. However same benefit is restricted to initial year of asset acquisition & which does not apply to certain sectors as like power generation.

2. Capital Gain on Sale of Depreciable Asset :-

When running business sale depreciable asset Section 50 comes in ti picture which mandates that any gain exceeding written-down value be treated as short term capital gain. This provision simplify the tax treatment for asset sale which ensures clear & fair tax liability calculation for businesses selling depreciable asset.

3. Transference of Assets and Depreciation Limits:

For businesses that acquire assets from other entities, Section 43(1) ensures that the depreciation base does not exceed the original cost of the asset. This rule prevents excessive depreciation claims on transferred assets, thereby aligning the tax treatment with the asset’s true value.

Conclusion

The provisions under Section 32 and related sections in the Income Tax Act provide a comprehensive framework for depreciation, enabling businesses to manage tax liabilities while investing in essential assets. Judicial rulings have further broadened the applicability of these provisions, supporting depreciation claims on a wide array of assets, whether actively or passively used. With indefinite carry-forward options and the ability to offset unabsorbed depreciation against various income heads, these rules offer businesses considerable flexibility in tax planning and asset management. In essence, the tax treatment of depreciation under Indian law encourages investment, supports asset utilization, and ensures fairness in business taxation.