This article is written by Sohum Dua, pursuing a Certificate Course in Advanced Corporate Taxation from LawSikho.

Introduction

The Income Tax Act, 1961 (hereinafter, Act), places the income earned from business and profession under the head of “Profits and Gains from Business and Profession”. The income categorised under this head includes the profits earned from said business or profession, along with the compensations and incentives directly connected to the business of professional activity.

However, running a business or being a professional also calls for incurring certain expenditure, such as rent for an office, repairs and maintenance of machinery, expenditure on research and development, and so on. Such expenses of business and profession are deducted from the profits earned in order to arrive at the taxable income. This is done so that only the true income earned from a business of profession is taxed, without taxing the expenditures involved in running said business or profession.

Types of business expenses

Business expenses are those which are incurred in running the day to day business of profession.^[1] Such business expenses can take the nature of capital expenditure or revenue expenditure.

• Capital Expenditure: Capital expenditures are those expenditures which have an effect on the long-term assets or liabilities, or when the benefit of such an expenditure is utilised over a period of more than one year. Examples of such expenditure include the purchase of machinery for a factory, or purchasing an office space by a law firm.^[2]
• Revenue Expenditure: Revenue Expenditures are those expenditures which a business or a professional incurs in the day to day running of the business. These expenditures do not have a material effect on the long-term assets or liabilities of a firm. Examples of such expenditures include the expense of purchasing raw materials, payment of salary, and so on. These expenditures may also be referred to as operating expenditures, however, this term has a narrower scope and includes only those expenses which are directly connected to the main business or professional activity.^[3]

Deductions under the Income Tax Act

Section 29 of the Act states that the profits and gains from business and profession must be calculated according to sections 30 to 43D of the Act. The admissible deductions are laid down under sections 30 to 37 of the Act. The general rule that governs whether an expense is admissible as a deduction or not is that it should be connected to the business or professional activity in lieu of which such deduction is claimed. The deductions admissible under the Act are as follows:

• Section 30 – Rent, rates, insurance, repairs, etc. for building: These expenses are allowed as deductions only to the extent that they are used for business or professional purposes. For example, if a person rents a 2-storey building, and uses one floor to carry out his business and one floor for residential purposes, then only the rent for the one floor being used to carry on the business will be allowable as a deduction.
• Section 31 – Insurance/Repairs of Plant, Machinery and/ or furniture: The main thing to be kept in mind, apart from the fact that the expenditure must be directly related to the business activity, is that such an expenditure must not be of a capital nature. This is because capital expenditures may be construed as being utilized to enhance operations to increase income, rather than enable the day to day running of operations. For example, if a machine is broken, but instead of just being repaired, a few parts are upgraded that will increase production capacity, then a deduction will be allowed only to the extent necessary for repairs. The costs of upgrade will not be allowed as a deduction.
• Section 32 – Depreciation: When an asset is purchased, it usually has a life of more than one year, during which its benefit is derived by a business or profession. Keeping this in mind, the entire cost of such an asset is not recognized all at once, but is spread out over the years during which such asset is put to use. This method of recognizing the cost of an asset over a number of years is called depreciation. This is allowed as a deductible expense under section 32 of the Act and is mandatory to be claimed. Section 32 also prescribes certain conditions which have to be fulfilled in order to claim depreciation as a deduction, along with the applicable methods of calculating such depreciation.
• Section 33 – Specific Deductions: Section 33 of the Act provides for certain deductions that are only available to entities which carry on certain business specified in the Act. These businesses include those of tea, coffee, rubber, manufacturing of iron and steel, fertilisers, cement, petroleum, and so on.
• Section 35 – Deductibility of Expenditure on Scientific Research: In order to encourage scientific research, certain incentives are provided to businesses by allowing a deduction of 100-150% of the expenses incurred in such scientific research. The kinds of research for which such deduction may be allowed are notified by the Government under the various sub-sections of section 35.
• Section 35ABB – Expenditure on Obtaining Telecom Licence/Spectrum: To be amortised over the number of years for which the licence is obtained.
• Section 35AD – Deduction for Investment in Specified Businesses: 100% deduction is allowed for investment in certain businesses, like warehousing, hotels, hospitals, slum redevelopment, and so on.
• Expenditure on Development Programmes: Deduction is allowed for certain expenditure incurred in rural, skill and agricultural development programmes under sections 35CCA-CCD.
• Section 35D – Amortisation of Preliminary Expenses – Preliminary expenses incurred in setting up of a new company or extension of an existing company are allowed to be amortised over a period of 5 years.
• Section 35DDA – Expenditure on Voluntary Retirement Scheme: Payments towards VRS are allowed over a period of 5 years.

Deductions under Section 36

Section 36 provides a list of certain business expenses, which are allowed as deductions from income earned under the head of PGBP (Profits and Gains from Business and Profession).

This section covers the following allows deductions for the following businesses:

• Insurance premium paid on stock, cattle, employee healthcare, and payments towards keyman insurance policies.
• Bonus and commission paid to employees.
• Interest paid on debt capital.
• Employer’s contribution to recognised provident/superannuation funds, pension funds and gratuity funds.
• Animals, when not used as stock, can be deducted as expenses when they die to reach the end of their useful life, by subtracting the sale price of the animal from the cost of buying it.
• Bad debts, which are written off, can be claimed as expenses, only if they are incidental to the business. No deduction is allowed on a provision created for writing off bad debts.

Apart from the above, the section also provides for other expenses, such as the payment of Securities/Cash Transaction Tax, Expenses to promote family planning, buying sugarcane, etc. to be deducted from income.

Deductions allowed to start-ups

The Government has provided various tax incentives to start-ups in order to encourage entrepreneurship and build a stronger economy in India. It must however, be kept in mind that these incentives can be availed only if the start-up fulfils the criteria laid down by the Department for Promotion of Industry and Internal Trade (DPIIT).

Deductions allowed under the Income Tax Act

• Exemption from Angel Tax

Section 56(2)(viib) of the Act provides that the income from shares issued at a premium by a start-up to a Venture Capital Fund/Company shall not be treated as “income from other sources’, as is done for any other enterprise.

• Beneficial Deduction of Profits

Section 80-IAC of the Act allows an exemption of 100% profits to an eligible start-up for any 3 consecutive years out of the first 7 years from its date of incorporation.

• Exemption to Shareholders

Section 54B of the Act exempts shareholders who invest in an eligible start-up from long term capital gains arising out of transfer of residential property.

Computation of business income on an estimated basis

Sections 44AD, 44ADA and 44AE of the Act are special provisions, enabling businesspeople and professionals to compute business income on an estimated basis.

Section 44AD is applicable to a resident individual, HUF or partnership firm, whose annual turnover does not exceed INR 2 crores. In this case, business income is taken as 8% of the annual turnover. The section also provides for certain businesses and professions which cannot avail such benefits. No further deduction is allowed in case this scheme is opted for.

Section 44ADA is applicable to professionals, as specified u/s 44AA(1), whose gross receipts do not exceed INR 50 lakhs. The professional income, in such a case, is taken as 50% of the gross receipts.  No further deduction is allowed in case this scheme is opted for.

Section 44AE specifies the computation of business income for those engaged in the business of plying leasing or hiring trucks. Profits and gains for a heavy goods vehicle are taken as INR 1000 per vehicle, while they are INR 7500 for other vehicles. No further deduction is allowed in case this scheme is opted for.

Conclusion

Adam Smith laid down the 4 canons of taxation, which every country aims to follow. Of these canons, the ones that stand out most in the context of computing PGBP are those of Equity and Economy.

The canon of Equity states that a person must pay tax only according to his abilities and not more. The canon of Economy states that the Government must endeavour to keep as little out of the pockets of the people as possible.^[4] 

The provisions for computing PGBP fulfil these canons, as taxing businesses solely on the basis of their income is incorrect. 2 businesses may have the same turnover, but may have hugely different profiles of business expenditure. Thus, it is important to take into account the various expenses incurred in carrying out the businesses and deducting those for the purpose of taxation.

In this manner, equitable taxation is ensured.

References

• Income Tax Act, 1961
• Kanga & Palkhivala, The Law and Practice of Income Tax (11^th, 2020)
• https://www.irs.gov/businesses/small-businesses-self-employed/deducting-business-expenses
• https://corporatefinanceinstitute.com/resources/knowledge/accounting/expenditure/
• https://fee.org/articles/on-the-canons-of-taxation-and-the-taxation-of-cannon/

[1] https://www.irs.gov/businesses/small-businesses-self-employed/deducting-business-expenses

[2] https://corporatefinanceinstitute.com/resources/knowledge/accounting/expenditure/

[3] Ibid

[4] https://fee.org/articles/on-the-canons-of-taxation-and-the-taxation-of-cannon/

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