What Is Depreciation in the Income Tax Act?

Depreciation, as outlined in Section 32 of the Income Tax Act, 1961, refers to the reduction in the value of an asset over time due to regular usage, wear and tear, or obsolescence. This concept allows taxpayers to account for the diminishing worth of their assets in financial statements and claim deductions for tax purposes. While depreciation is primarily an accounting measure, it has significant implications for tax calculations, enabling individuals and businesses to reduce their taxable income. The Income Tax Act permits depreciation claims on both tangible and intangible assets.

Block of Assets

Depreciation is calculated on a “block of assets,” a grouping of similar assets with the same depreciation rate. This simplifies the calculation process and allows depreciation to be claimed for groups rather than individual items.

Types of Assets in a Block

• Tangible assets: Buildings, machinery, and furniture.
• Intangible assets: Know-how, patents, trademarks, and copyrights.

Once grouped, these assets lose individual identity, and depreciation is applied to the entire block based on the Written Down Value (WDV) method.

Rates of Depreciation

The rates of depreciation are prescribed by the Income Tax Act and vary based on asset type and use. Below is a comprehensive table outlining these rates:

Claiming Depreciation Under the Income Tax Act

• Ownership: To claim depreciation, the taxpayer must hold ownership of the asset, either fully or partially. Ownership acts as a prerequisite for depreciation claims, as it establishes the taxpayer’s right to benefit from the asset. Even in cases of co-ownership, taxpayers can claim depreciation on their share of the asset, ensuring fairness in tax deductions.
• Usage for business or profession: The asset must be used for business or professional purposes to qualify for depreciation. This ensures that the benefit is only available for assets contributing to generating income. Interestingly, even if the asset is used for only part of the financial year, depreciation can still be claimed proportionately for that period.
• Exclusion of sold assets: Depreciation cannot be claimed for assets that have been sold, discarded, or destroyed within the same financial year. This rule ensures that depreciation benefits are tied to assets actively contributing to income generation during the year.
• Specific asset types: Certain asset categories are excluded from depreciation claims. For example, depreciation cannot be claimed on land and goodwill. Land is excluded because it typically does not depreciate in value over time, unlike machinery or buildings. Similarly, goodwill, though an intangible asset, does not experience wear and tear and is therefore not eligible for this tax benefit.

What Are the Requirements for Claiming Depreciation?

• Goodwill and land cannot be depreciated under the Income Tax Act.
• Depreciation became mandatory from the fiscal year 2002-03 and must be allowed or presumed as a deduction, even if not explicitly claimed in the profit and loss account. The taxpayer can carry forward the Written Down Value (WDV) after applying the depreciation amount.
• If the presumptive taxation scheme is chosen, depreciation is considered part of the deemed profits.
• Depreciation rates under the Companies Act of 1956 differ from those in the Income Tax Act, so only the rates prescribed by the Income Tax Act apply for tax purposes, regardless of what is recorded in the company’s books.
• To claim depreciation, the taxpayer must fully or partially own the asset.
• Assets must be used for business or professional purposes. If used for personal reasons, depreciation will only be allowed for the period the asset is used for business. Section 38 of the Act allows the Income Tax Officer to determine the proportionate share of depreciation.
• Co-owners can claim depreciation on the portion of the asset they own, based on their respective share.

Calculation Methods for Depreciation

The Income Tax Act provides two primary methods for calculating depreciation, each serving different types of assets. These methods ensure that taxpayers can account for the reduction in asset value over time while lowering their taxable income. Here’s a detailed explanation of both methods:

Written Down Value (WDV) Method

The Written Down Value (WDV) method is the most commonly used method under the Income Tax Act for calculating depreciation. In this approach, depreciation is determined using the asset’s reduced value at the start of the year.

• How it works: Each year, depreciation is applied to the asset’s opening balance (i.e., its written down value at the start of the year). This reduces the value of the asset, and the depreciation for the following year is calculated on this reduced amount. The process continues until the asset’s value is completely written off or it is sold.
• Example: If the cost of a machinery asset is ₹100,000 and the depreciation rate is 10%, then in the first year, ₹10,000 will be deducted from the asset’s value. In the second year, depreciation will be calculated on the new value, ₹90,000, resulting in a depreciation of ₹9,000. This method leads to a decreasing amount of depreciation each year.
• Application: The WDV method is applicable to most assets under the Income Tax Act, including buildings, machinery, vehicles, and plant equipment.

Straight Line Method (SLM)

The Straight Line Method (SLM) is an alternative calculation method that is primarily used for assets that provide a constant rate of return over their useful life. This method calculates depreciation as a fixed percentage of the asset’s original cost, distributed evenly throughout its useful life.

• How it works:Unlike the WDV method, where depreciation reduces over time, SLM ensures that the same amount of depreciation is deducted every year, based on the asset’s original cost. The asset’s cost is divided by its useful life, and the same depreciation amount is applied each year until the asset is fully depreciated or disposed of.
• Example: If an asset costs ₹100,000 and has a useful life of 10 years, the depreciation calculated each year will be ₹10,000 (₹100,000 ÷ 10). This amount remains constant throughout the asset’s life, regardless of its residual value.
• Application: The SLM method is mainly used for power-generating units, such as generators or turbines, as these assets tend to lose their value steadily over time. It’s also applied to assets where the service potential is consistent throughout their useful life.

How to Claim Depreciation?

Claiming depreciation under the Income Tax Act involves several steps:

• Classify assets: Segregate assets into blocks based on type and depreciation rate.
• Calculate WDV: Determine the Written Down Value of the asset block at the start of the financial year.
• Apply rates: Use the prescribed depreciation rates to calculate the deduction.
• Record in accounts: Ensure the depreciation amount is reflected in the profit and loss account.
• Include in tax returns: Claim the deduction when filing income tax returns.

Advantages of Tax Depreciation

• Reduces taxable income: Depreciation lowers taxable income by allowing businesses to deduct asset depreciation, resulting in reduced tax liabilities and more cash flow for reinvestment.
• Encourages capital investment: Tax depreciation incentivises businesses to invest in new assets, promoting growth, modernisation, and enhanced productivity in various industries.
• Simplifies compliance: Grouping assets into blocks for depreciation makes tax calculations easier and more efficient, reducing administrative complexity and the risk of errors.
• Improves cash flow: As a non-cash expense, depreciation allows businesses to lower their taxable income without affecting actual cash flow, providing flexibility for other investments.
• Provides long-term benefits: Depreciation spreads tax benefits over the asset’s useful life, offering consistent financial relief and stability for businesses over time.

Conclusion

Understanding depreciation under the Income Tax Act is essential for efficient tax planning. By leveraging the provisions of Section 32, taxpayers can optimise their deductions while ensuring compliance with tax laws. Proper classification, calculation, and reporting of depreciation help businesses reduce their tax liability and encourage long-term asset investment. Always refer to the prescribed rates and conditions to make accurate claims and avoid errors.

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