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Depreciation as Per the Income Tax Act: What Taxpayers Should Know

Depreciation as Per the Income Tax Act: What Taxpayers Should Know

Depreciation is the inevitable deterioration that assets experience over time. It may seem straightforward in ordinary situations, but it is crucial when it comes to company and taxes. It is an allowance provided by the Income Tax Act  for the deterioration of assets utilised in a business or profession from a tax standpoint. It is a non-cash expense that lowers taxable income and saves firms money on taxes in the long run. According to the Income Tax Act, the depreciation rate varies according to the asset's kind. The owner of the asset (whether a business, partnership firm, or individual) may claim the depreciation on it. In this comprehensive guide, we will explain the concept of depreciation as per the Income Tax Act.

 

Table of Contents

 

What is Depreciation as per the Income Tax Act?

According to the Income Tax Act, depreciation is the reduction in an asset's value brought on by use, deterioration, aging, or obsolescence. The Income Tax Act permits businesses to deduct their depreciation costs from their taxable income. Since depreciation is a non-cash expense, there is no cash withdrawal from the organisation. Rather, it symbolises the distribution of an asset's cost throughout its useful life. This allocation lowers the entity's taxable revenue and thus its tax obligation.

It's crucial to remember that depreciation can only be applied to tangible assets like furniture, machines, buildings, and cars. Patents, trademarks, copyrights, and goodwill are a few examples of intangible assets that are not depreciated. When determining their taxable income, entities must compute and claim depreciation on their assets. The tax authorities may impose penalties and interest charges for failure to comply.


Block of Assets

To compute depreciation, one has to know the WDV of an asset block. A group of assets from the same asset class that are gathered together as a block of assets consists of: 

  • Examples of tangible assets are furniture, appliances, plants, and buildings.

  • Knowledge, patents, copyrights, trademarks, licences, franchises, and any other similar business or commercial rights are some instances of intangible assets. 

The asset block is recognised according to its type, life, and comparable application. In addition, the percentage of depreciation within each asset class needs to be considered when classifying assets. A block of the asset will be identified for each of these asset classes that have the same rate of depreciation. Because depreciation is based on a group of assets rather than individual assets, under the Income Tax Act, individual assets lose their individuality.


Factors Affecting Eligibility for Claiming Depreciation Under the Income Tax Act

To be eligible for the depreciation deduction, an assessee needs to fulfil several requirements. The prerequisites are listed below: 


Classifications of Assets: To receive the benefits of depreciation, the asset's owner must be an assessee. Both tangible and intangible assets are possible. A house, factory, machinery, or furniture are examples of tangible assets. Patent rights, copyrights, trademarks, licences, franchises, and similar property acquired on or after April 1, 1998, are examples of intangible properties. When determining depreciation, the income tax agency only accounts for the house's depreciation. It's possible that they didn't account for the cost of the land the building is situated on. The argument that the land does not lose value owing to usage or wear and tear serves as justification for not including the cost of the property in the house. 


Ownership vs. Lease: Only capital assets that an assessee owns are eligible for depreciation claims. The assessee must be the owner of such properties to benefit from the allowance for property depreciation. An assessee doesn't need to be the property owner. An assessee is entitled to a credit for depreciation on dwellings in cases when he builds one but the property is owned by someone else. If the assessee lives in and utilises the house, he is not eligible to request the deduction. An assessee is eligible for depreciation allowances if he constructed a home on the land and took out a mortgage on it. In the case of hire and buy, an assessee is not entitled to a deduction if he leases the equipment for a short period. Nonetheless, in the case of a loan, an assessee is qualified to get the deduction if he purchases the property and becomes the buyer.


Co-ownership: A co-owner of an asset has the option to record depreciation on the asset as well.


Used for Business or Professions: A business or vocation may have used the commodity to be eligible for the depreciation credit. On the other hand, an assessee is not obliged to claim the depreciation credit, for which the asset must be used during the fiscal year. Consequently, the taxpayer is entitled to depreciation deductions even if he only uses the asset for a brief period throughout an accounting year. Consider every seasonal factory to understand this concept.


Depreciation on Sold Assets: An assessee is not permitted to deduct depreciable assets. An object cannot be deducted by the assessee if it is sold, removed, or damaged in the same year that it was purchased.


Conditions to Claim Depreciation

  • The Income Tax Act and the Companies Act of 1956 have different rules on depreciation. Consequently, regardless of the depreciation rates recorded in the books of accounts, the Income Tax Act's prescribed depreciation rates are the only ones that are allowed. 

  • Depreciation must be allowed or assumed to have been approved as a deduction starting with the fiscal year 2002–03, independent of a taxpayer's claim in the profit and loss account. 

  • If the presumptive taxation plan is employed, the deemed profit is considered to have taken depreciation into account. This means that the taxpayer can carry forward the WDV after subtracting the depreciation amount. 

  • The assets must be used in conjunction with the taxpayer's business or occupation, and they must be owned fully or partially by the assessee. 

  • The permissible depreciation will be commensurate with the duration of time the assets are utilised for business purposes, even if they are utilised for non-business purposes. Co-owners may deduct depreciation up to the value of their joint assets, and Section 38 of the Act gives the Income Tax Officer the authority to determine the proportionate share of depreciation. 

  • Land purchase price and goodwill cannot be depreciated.


Depreciation Rates for Common Assets Applicable in FY 2023-24


Depreciation Rates for Common Assets Applicable in FY 2023-24

Written-Down Value (WDV) of Assets

The depreciation amount is determined by applying the prescribed percentage on the asset's WDV, as per the Income Tax Act. The asset's true cost determines its WDV. In order to calculate depreciation, we must understand what "WDV" and "Actual Cost" entail. 

WDV is defined under the Income Tax Act as:

  • The true cost of the assets if they were purchased in the prior year

  • Under the Income Tax Act, if the difference was brought in an earlier year, the difference between the real cost and the depreciation is allowed.


Methods of Calculating Depreciation as per the Income Tax Act

Different assets may have different depreciation schedules and usable lives. For accounting and taxation purposes, it might also vary depending on the asset type and industry. The Straight Line Method and Written Down Value Method are the most often used techniques for depreciation.  The fundamental distinctions between the methods utilised for depreciation calculation under the Companies Act and the Income Tax Act, aside from depreciation rates, are as follows.

Depreciation methods in accordance with the Companies Act of 1956 (Based on Specified Rates) are: 

  • Straight Line Method

  • Written Down Value Method

Conversely, the Companies Act, 2013 lists the following methods based on the useful life of assets:

  • Straight Line Method

  • Written Down Value Method

  • Unit of Production Method

The Income Tax Act, 1961 relies on the following based on specified rates:

  • Written Down Value Method (block wise)

  • Straight Line Method for power generating units


Amount of Depreciation Allowed

  • Except for businesses involved in the production or distribution of electricity, these businesses may choose to claim depreciation using the Straight-Line or WDV methods, provided that option is used before the deadline for filing the return.

  • In the event of a demerger or amalgamation, the combined depreciation allowance will be divided between the resultant business and the merging firm, respectively. The computation of the aggregate depreciation would be done as though the demerger or amalgamation had never happened.

  • In the event of a financing lease transaction, the lessee is required to capitalise the assets in its books in accordance with AS-19, the Accounting Standard on Leases. The allocation will be made according to the number of days the assets were utilised by said companies. In certain situations, the lessee is permitted to take depreciation since he has the ability to execute the owner's rights on his own.


Section 32 of the Income Tax Act

The Income Tax Act of 1961's Section 32 contains the depreciation allowed provision. The Income Tax Rules, 1962, Rule 5 governs this part. If the cost of the tangible or intangible asset used by the assessee drops, the Income Tax Act allows for the deduction. The asset's life cycle cost, not the asset's entire cost, is used by the income-tax department to calculate the depreciation at the time of the deduction. The written line method or the straight-line approach can be used by an assessee to calculate the amount that depreciation has reduced the asset's value. The income tax agency uses the written line approach among other methods of depreciation.


Conclusion 

Depreciation is a method used to account for an asset's gradual value decrease. For a number of reasons, it is essential for income tax and business. It assists you in keeping tabs on the price and lifespan of your assets and balancing the benefit of their use with the income they produce. Moreover, depreciation costs might lessen the taxable income of your company, which in turn lowers your tax liability. This can assist you with investing in new assets and offer a tax incentive.


FAQ

Q1. What is depreciation for tax purposes?

The Income Tax Act of 1961's Section 32 talks about depreciation. Depreciation is the term used to describe how wear and tear reduces an asset's worth.


Q2. What are the rates of depreciation?

The asset class affects the rate of depreciation. For instance, it is 10% for fixtures and furnishings and 5% for residential constructions.


Q3. How do I calculate the depreciation rate?

You can calculate depreciation using methods such as the written-down value method or the straight-line method.


Q4. Who decides depreciation rates?

In India, the depreciation rates are decided by the Ministry of Commerce.


Q5. What is the depreciation rate on computers as per the Income Tax Act? 

The depreciation on computer hardware and software is considerable, at 40%. This means that the assessee may deduct 40% of the cost of computers and software from their taxable business revenue.


Q6. What is the depreciation rate on plant and machinery as per the Income Tax Act? 

A 15% rate of depreciation applies to any type of equipment and plant that is not covered by another block, including cars that are not used for commercial purposes.



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