Depreciation, according to the Income Tax Act, 1961, is an important concept in that it denotes the decline in value of assets (both tangible and intangible) due to wear and tear, obsolescence, or an elapse of time. It provides a way to allocate cost against income earned over the useful life of an asset, thereby giving the taxpayer an income deduction within which taxation has to further be reduced. Therefore, the same will ensure correct representation of the true income of an assessee by providing deduction against depreciation on business assets used for earning such income.
Section 32 of the Income Tax law, for instance, speaks of income tax applicable to the depreciation of assets such as: buildings, machinery and plants, furniture, and some of the intangible assets such as patents and copyrights. For accounting purposes, one can choose for depreciation either on the basis of the applicable straight line method or the written down value method based on the useful life. However, the Income Tax Act 1961 prescribes written down value as the only method based on which depreciation will be calculated, except for a few power generators who may use the straight line method of depreciation.
The basis of depreciation is a block of assets rather than on each of the individual assets, and this has been prescribed in the Income Tax Rules. The quantum of tax incentive that comes through this route as well as the extent to which capital expenditure is pushed would cumulatively stimulate the economy.
Conditions For Claiming Depreciation Under Income Tax Act 1961
In order to deduct depreciation under Section 32 of the Income Tax Act of 1961, certain conditions are required to be fulfilled. Such conditions provide for depreciation to be deducted only in respect of assets qualifying for the same and which are used for the purpose of any business or profession. The specific conditions are given as below:
- Ownership of the Asset: The assessee must have either the full or part ownership of the asset, whether legal or beneficial. Joint owners of jointly owned assets are eligible to claim depreciation in proportion to their holding. Ownership includes assets purchased under hire purchase or lease, with some limitations.
- Use for Business or Professional Purposes: The asset should be used for business or professional purposes. It must have been used for such purposes in the last year. No depreciation can be claimed on assets which were not put to use in the year. Judicial decisions point towards passive use (i.e., the asset being kept available for business purposes) as sufficient for claiming depreciation.
- Qualifying Assets: Depreciation is only on tangible assets, such as buildings (but not land), machinery, plants, and furniture. Some intangible assets, like patents, trademarks, licenses, franchises, and goodwill (if purchased), qualify for depreciation.
- Classification into a Block of Assets: Assets are grouped into a “Block of Assets” because of their identical characteristics and rates of depreciation. Depreciation is calculated for the whole block and not for separate assets. Depreciation is not allowed if all the assets of the block are sold.
- Use of Assets During the Fiscal Year: The asset should be in use for at least 180 days in the relevant fiscal year to be eligible for full year depreciation. If the asset is used for less than 180 days, the depreciation for the year is limited to 50%. This provision applies only in the year of purchase or addition.
- Requirement to Claim Depreciation: Depreciation should be declared in the income tax return. Under Explanation 5 to Section 32(1), depreciation is regarded as required and is taken into account to be claimed, unless the taxpayer does not explicitly claim it.
- Exclusions from Depreciation Claims: Depreciation is not required on land. Personal items utilised for other than business purposes are also not liable for depreciation.
These factors combined ensure that depreciation is properly claimed, coordinating cost assignment with income production from business property.
Methods of Calculating Depreciation Under The Income Tax Act 1961
Of the various methods and rates of depreciation prescribed in the Income Tax Rules, specific reference must be made to Rule 5 and Appendix I. Accounting standards present multiple methods for depreciation. However, the Income Tax Act accepts two methods with regard to the depreciation, depending on the nature of the business. The Act establishes a systematic and simplified approach to depreciation, predominantly computed on the basis of WDV, for the purpose of uniformity and acceptability, although power plants have some degree of flexibility.
1. WDV is the Primary Method (Default Method)
The method is the most widely utilised under the Income Tax Act, which applies to all taxpayers except power generating companies unless they opt out.
Features:
- Depreciation is assessed on the present value of the asset/block with previous years considered.
- The calculation refers to a block of assets rather than individual items.
- A Block of Assets is a collection of similar assets that earn equal depreciation rates.
Formula:
Depreciation will be an amount equal to WDV of block multiplied by depreciation rate.
Depreciation Amount = WDV of Block x Applicable Rate of Depreciation
Illustration:
For machinery considered to be in the block with a WDV of Rs 10,00,000 and with a depreciation rate of 15%:
Depreciation: Rs 10,00,000×15%=Rs 1,50,000
Half yearly depreciation of 50% is given for all assets acquired and put to use for less than 180 days during the particular year. For the remaining years, full depreciation is allowed on the reduced WDV.
2. Straight Line Method (SLM) – Voluntary or optional for Power Generation Units
Companies engaged in generation or generation and distribution of electricity can opt for the SLM instead of the Written Down Value (WDV) method.
Key Features:
- Depreciation is calculated on the basis of the initial cost of the asset instead of the WDV.
- The depreciation charge is the same every year over the useful life of the asset.
Formula:
Depreciation will be an amount equal to the original cost of the asset multiplied by the rate of depreciation applicable as per rules.
Depreciation = Original Cost × Rate of Depreciation
However, it is to be always noted that –
- Once the SLM is chosen, it has to be used consistently in future years.
- This method allows calculation on an asset-by-asset basis instead of a block basis.
Example:
If a power generation unit buys a plant for ₹10,00,000 at a depreciation rate of 5%, then:
Annual Depreciation = ₹10,00,000 × 5% = ₹50,000 per year.
Note on Additional Depreciation:
- Apart from normal depreciation, an additional depreciation of 20% is allowed under Section 32(1)(iia) in respect of new plant and machinery purchased by industries in the manufacturing or power sectors.
- The additional depreciation can be claimed only in the year of purchase and utilization, subject to certain conditions.
Rates And Amounts Of Depreciation Allowed Under Income Tax Act 1961
Depreciation amounts and rates as provided for under the Income Tax Act of 1961 are regulated by Rule 5 of the Income Tax Rules of 1962, in addition to Appendix I. These rates are generally calculated on the basis of the Written Down Value (WDV), except in the case of electricity-generating units, which can choose the Straight Line Method (SLM). Depreciation is computed on the Block of Assets, with different rates being applicable based on the asset type.
1. Depreciation Rates for Tangible Assets by Category:
A. Buildings:
- Residential buildings (not including hotels and boarding houses) – 5%
- Non-residential buildings (like industrial buildings) – 10%
- Temporary buildings (like wooden sheds) – 40%
B. Furniture and Fittings (including electrical fixtures) – 10%
C. General plant and machinery – 15%
- Motor vehicles (not for hire) – 15%
- Motor buses, lorries, and taxis used in the rental industry – 30%
- Software and computers – 40%
- Energy-saving technologies (e.g., wind energy generators, solar energy equipment) – 40%
- Devices for air pollution control – 40%
Note: Earlier, some assets were allocated depreciation rates of 60% or 80% (e.g., computers at 60% and wind turbines at 80%), but these rates have been redefined and harmonised to 40% in recent revisions.
2. Depreciation Rates for Intangible Assets:
The rate of depreciation for intangible assets like know-how, patents, copyrights, trademarks, licenses, franchises, and goodwill relating to a business or profession is 25%.
3. Additional Depreciation (Section 32(1)(iia)):
This section provides for additional depreciation on certain assets, above the normal rate of depreciation.
Applicability:
- This is for manufacturing and production industries, including power generation.
- It is only for new plants and machinery, not second-hand or office equipment.
Amount:
- The extra depreciation is worked out at 20% of the actual cost of new plant and machinery.
- In case of less than 180 days utilization of the asset, depreciation up to 10% is allowable in the first year, the rest of the 10% can be brought forward in the second year.
4. The Half Year Rule:
In situations when an asset is used for fewer than 180 days in one year of finance, half the allowable depreciation alone may be used that year. Both regular and the supplemental depreciation benefit from this restriction.
Key matters:
- Land does not have a depreciation claim.
- A Block of Assets concept supports monitoring.
- Unabsorbed depreciation can be carried forward without any limit and can be utilised against future earnings.
- Rates of depreciation could vary as per the notifications and Income Tax Rules amendments.
Conclusion
Depreciation as defined in the Income Tax Act of 1961 serves a critical function in establishing the correct measure of taxable income by considering the gradual decrease in the value of business assets. The legislative provision in terms of Section 32, making allowance for depreciation, allows taxpayers to recover the cost of assets used in their profession or business over time. The idea not only signifies the actual net income of an assessee but also serves as a tax incentive, promoting capital investment and development of corporate infrastructure.
The depreciation regime provided under the Act largely applies the Written Down Value (WDV) approach, which has a standardised and simple mechanism through the Block of Assets. The rates fixed by the Income Tax Rules are specific and provide transparency and uniformity in their usage. Moreover, the extra depreciation provisions benefit the manufacturing and power industries by providing higher deductions on new investments.
By permitting depreciation as a tax allowable expense, the Income Tax Act 1961 promotes equitable taxation and economic growth. But in order to avail of these benefits fully, there is a need to comply with the rules and properly classify assets. Thus, depreciation continues to be an important financial and tax planning tool for all companies and professionals conducting business under Indian tax laws.
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