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Unabsorbed Depreciation: Section 32(2) of the Income Tax Act

Updated: May 14


Unabsorbed Depreciation: Section 32(2) of the Income Tax Act

Depreciation is a reduction in the value of assets because of regular usage. It is recorded in the books of accounts as an expense and is reduced from the book value of assets. But what if you can’t use the full extent of depreciation in the year of its occurrence? That's where the concept of unabsorbed depreciation comes into play. 


When organizations experience a downturn and don’t generate enough taxable income to match the depreciation expense for that year, the leftover depreciation is known as unabsorbed depreciation. The unabsorbed depreciation doesn’t just disappear; it gets carried forward to future years when it can be used to offset taxable income when financial circumstances improve.


In this article, we will explore unabsorbed depreciation, its mechanics, the rules that govern it, and strategic ways businesses can manage to take advantage.


 

Table of Content

 

What is Depreciation?

Depreciation in simple terms is a reduction in the value of assets due to its regular usage. It is treated as a business expense and reduced from the cost of the fixed assets. Moreover, under the Income Tax Act as well, depreciation serves as an allowable expense that diminishes the taxable income of a business. The Act provides specific methods and rates for depreciating different types of assets.


What is an Unabsorbed Depreciation?

Unabsorbed depreciation occurs when a business does not generate enough profit to fully utilize the depreciation expense as a deduction in a financial year. This unused portion of depreciation, which cannot be "absorbed" in the profit and loss account due to inadequate profits or losses, can be carried forward to future years to offset against future profits, reducing future taxable income.


Section 32(2) of the Income Tax Act

Section 32(2) of the Income Tax Act deals with unabsorbed depreciation. This provision of the Act allows businesses to indefinitely carry forward and offset unutilized depreciation against the profits of subsequent years. Unlike business losses, which are typically allowed to carry forward for 8 years, unabsorbed depreciation has no such time constraint. This ensures businesses can utilize it until fully absorbed.


Causes of Unabsorbed Depreciation

Unabsorbed depreciation occurs when a business doesn't have sufficient taxable income to utilize the full depreciation deduction available in a financial year. This situation can arise from a variety of operational challenges and strategic decisions. A deeper understanding of the causes can help businesses plan effectively and mitigate the impact of unabsorbed depreciation. Here’s a detailed examination of the primary causes:


  • Low Profits or Operating Losses: Often, insufficient profit due to poor sales, high expenses, or extraordinary losses (such as from natural disasters or unexpected major expenses) can leave insufficient taxable income to offset against depreciation.

  • High Depreciation Rates or Accelerated Depreciation: Certain depreciation methods, like the declining balance method or special accelerated depreciation incentives intended for tax relief, can lead to substantial depreciation expenses in the early years of an asset's life. This often exceeds the taxable income and results in unabsorbed depreciation.

  • Large Capital Expenditures: Significant investments in capital assets can result in high depreciation charges. If the revenue generated by these assets does not increase proportionately, it can lead to unabsorbed depreciation.

  • Seasonal Businesses: Businesses that experience significant fluctuations in earnings, such as those that are seasonal, may not have consistent profits to match depreciation expenses. For instance, a resort purchasing new equipment in the off-season may incur significant depreciation before high-season earnings are realized.

  • Regulatory Changes or Economic Downturns: Shifts in business regulations, tax laws, or economic conditions can unpredictably affect profits. An economic downturn, for example, can reduce revenue across sectors, leading to widespread unabsorbed depreciation due to diminished taxable incomes.

  • Structural Changes in Business Operations: Structural adjustments like mergers or acquisitions can result in unabsorbed depreciation as well. These changes might involve significant asset acquisitions, whose related depreciation might not be fully absorbed due to integration challenges or temporary reduction in profits.

  • Tax Law Limitations: Some jurisdictions impose legal limits on the amount of depreciation that can be claimed annually, regardless of the total calculated depreciation expense. This also results in unabsorbed depreciation.


Calculation of Unabsorbed Depreciation

Consider a company that purchases machinery worth INR 100,000 with an expected life of 10 years, suggesting a straight-line depreciation of 10% per year (INR 10,000 per year). If, in the first year, the company earns a profit (before depreciation) of INR 5,000:


Calculation of Unabsorbed Depreciation

This INR 5,000 of unabsorbed depreciation can be carried forward to the next financial year and offset against that year's profits, in addition to the depreciation for that particular year.


Through this mechanism, unabsorbed depreciation serves as a form of tax relief for businesses, allowing them to smooth out their tax liabilities over periods of variable profitability.


Implications and Significance: Impact on Financial Statements

The unabsorbed depreciation affects the different areas of the financial statements, which includes:


  • Impact on the Balance Sheet: Unabsorbed depreciation increases the carrying amount of fixed assets. It is carried forward as a deferred tax asset, which can offset future profits, thereby affecting asset valuation and equity within the company.

  • Impact on the Profit and Loss Statement: When depreciation is unabsorbed, the profit & loss account displays higher profits due to the lower depreciation expense recorded. However, this scenario reverses in future periods when unabsorbed depreciation is utilized, potentially leading to lower profit margins.

  • Tax Implications: Carrying forward unabsorbed depreciation offers tax relief in future profitable years by reducing taxable income, which impacts the business's tax liabilities in those years.

  • Cash Flow: Although unabsorbed depreciation does not directly impact cash flow, as depreciation is a non-cash expense, the tax savings in future periods can positively influence cash flow by reducing cash outflows towards taxes.


Understanding these impacts is crucial for financial planning and strategy, particularly for businesses with large capital expenditures and fluctuating income streams that can lead to significant amounts of unabsorbed depreciation.


Actual Cost of Assets

Actual cost of assets is the cost incurred to bring the asset in the state of put to use. As per Section 43 of the Income Tax Act, the actual cost is defined as the cost of the assets to the assessee, minus any part of the cost that is met directly or indirectly by any other person or government authority.


Moreover, the circular issued by CBDT (Central Board of Direct Taxes) in 2018, re-defines the manner of determining actual costs of assets. According to the same, the actual costs of assets should exclude the expenses incurred on acquisition of assets in excess of INR 10,000, if paid in any mode other than cheque, bank draft, or electronic clearing system.


However, the actual costs of assets in different instances are:


Actual Cost of Assets

Conditions for Set-Off of Unabsorbed Depreciation

Effectively managing unabsorbed depreciation is essential for businesses to optimize their financial strategies and tax obligations. Here’s an overview of the conditions for setting off unabsorbed depreciation:


Conditions for Set-Off of Unabsorbed Depreciation:


  • Continuity of Business: For unabsorbed depreciation to be set off against future profits, the business must continue its operations in the year the set-off is claimed. If the business is discontinued, unabsorbed depreciation cannot be set off against other income.

  • Ownership of Assets: The assets that generated the unabsorbed depreciation must still be owned by the business and used for business purposes in the years the set-off is sought.

  • No Time Limit: Unlike other business losses, which may have a carry-forward limit, unabsorbed depreciation can be carried forward indefinitely. It can be set off against future profits from any business activity, not just the activity that originally generated the depreciation.


Sequence Followed to Set-Off Unabsorbed Depreciation

The Income Tax Act outlines a specific sequence for utilizing unabsorbed depreciation against taxable income in subsequent years. Here's the prescribed order for setting off unabsorbed depreciation:


  • Set-Off Against Current Year Income: Initially, unabsorbed depreciation should be applied against the profits of the current year. It's important to note that this must be set off before considering any other business or non-business losses. This prioritization helps effectively reduce taxable income.

  • Carry Forward to Future Years: If there remains unabsorbed depreciation after setting it off against the current year's profits, it can be carried forward indefinitely. This feature is unique to unabsorbed depreciation, distinguishing it from other types of losses which may be subject to time limits for carrying forward.

  • No Restriction on the Source of Income for Set-Off: Unabsorbed depreciation can be set off against any income in subsequent years, except income categorized as "Income from Salaries." This flexibility allows businesses to utilize unabsorbed depreciation across various revenue streams, aiding in the management of tax liabilities over time.


How to Carry Forward Unabsorbed Depreciation in case of Belated Returns?

The ability to carry forward unabsorbed depreciation is particularly beneficial, especially when dealing with belated tax returns. Here's how it works:


  • Filing Belated Returns: Taxpayers are permitted to file belated returns under Section 139(4) of the Income Tax Act. The opportunity to carry forward unabsorbed depreciation is not affected even if the return is filed late, which contrasts with other business losses where timely filing is essential for the carry forward option.

  • Documentation and Calculation: Maintaining accurate and detailed records of asset acquisition, depreciation calculations, and profit and loss accounts is critical. These documents are necessary to substantiate the carry forward of unabsorbed depreciation during tax assessments and audits.

  • Reporting in Tax Returns: It is important to clearly report the amount of unabsorbed depreciation being carried forward when filing the tax return, including f returns. This ensures that the records are consistent and secures the entitlement to set off in future years.


FAQ

Q1. Explain unabsorbed depreciation.

Unabsorbed depreciation is the excess depreciation which is more than the total income for that particular financial year. In other words, the unabsorbed depreciation prevents the full utilization of depreciation for tax deduction purposes in a particular financial year.


Q2. Can unabsorbed depreciation be carried forward to subsequent years?

Yes. Unabsorbed depreciation can be carried forward to future years indefinitely. It can be set off against the future taxable income.


Q3. What is the time limit for claiming unabsorbed depreciation?

The unabsorbed depreciation can be carried forward indefinitely. There is no time limit for carry forward of the unabsorbed depreciation.


Q4. Can unabsorbed depreciation be set-off against any income type?

The unabsorbed depreciation can be set-off against the profits and gains from any type of business or profession. However, it cannot be set-off against the salary income.


Q5. How does filing of belated returns affect the carry forward of unabsorbed depreciation?

The unabsorbed depreciation can be carried forward even if the return is filed belatedly. Thus, unlike other losses, there is no restriction on carry forward of unabsorbed depreciation even if the return is filed belatedly.


Q6. What are the implications of unabsorbed depreciation on the financial statements of the company?

The unabsorbed depreciation affects the financial statements of the company by reducing the taxable income of future periods. Therefore, it affects the deferred tax calculations and the tax liability of the company.


Q7. What documents are required for claiming unabsorbed depreciation? 

For claiming the unabsorbed depreciation there is no requirement of any document. However, financial records should be maintained such as: record of assets purchase, depreciation schedules, and other statements to support the calculation and carry forward of unabsorbed depreciation.


Q8. What is the impact of unabsorbed depreciation on tax planning?

Strategic utilization of unabsorbed depreciation will allow businesses to minimize the taxable income when they make profits in the future years. This supports consistent financial performance and effective tax management.


Q9. In what order should unabsorbed depreciation be set-off?

Unabsorbed depreciation must be set-off first from the profits of the business or profession of the current year. After which the depreciation of the current year or other business losses can be considered.








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