The provisions governing the taxation of profits and gains of business or profession form a critical part of the Income Tax Act. This head of income applies to all revenue receipts arising from a business or professional activity carried out by an assessee. It covers both positive incomes in the form of profits and negative incomes in the form of losses. The principle was well established in the case of CIT v. Harprasad & Co. Pvt. Ltd., where it was held that losses of revenue nature must be considered in computing the taxable income under this head.
While the scope of this head primarily concerns revenue receipts, capital receipts are generally outside its ambit unless they fall under certain specified provisions that deem them taxable. The computation of profits is based on the method of accounting regularly adopted by the assessee, as recognised in Section 145. This ensures that the income computation aligns with the real financial operations of the business.
Section 28 lists the incomes chargeable under this head, including certain categories of deemed profits. Similarly, other provisions such as Sections 41 and 68 to 69D identify deemed incomes in specific scenarios. Deductible expenses and allowances are provided under Sections 30 to 37, while disallowances are covered by Sections 40, 40A, and 43B.
Computation of Taxable Profits
Taxable profits are computed with reference to the assessee’s regular accounting method as recognised by law. The two primary systems of accounting are the cash system and the mercantile system, each with distinct characteristics and implications for tax liability.
Cash System of Accounting
In the cash system, entries are recorded only when cash is actually received or paid. Income becomes taxable only upon receipt, and expenses are deductible only upon payment. This method disregards the date of accrual or liability creation. Courts have clarified that under this method, the timing of receipt or payment governs taxation, as seen in cases like Re B.M. Kamdar and CIT v. E.A.E.T. Sundararaj.
Mercantile System of Accounting
Under the mercantile system, income and expenses are recorded as they accrue, irrespective of actual receipt or payment. Profits are taxed in the year in which they are earned, and expenses are deductible in the year in which the liability arises. A notable feature is that once an amount is taxed on accrual, it cannot be taxed again upon actual receipt, as clarified in Explanation 2 to Section 5. Judicial precedents, such as CIT v. Swadeshi Cotton & Flour Mills, have emphasised the principle that liability accrual determines the timing of deduction.
Practical Computation Process
For assessees following the cash system, the computation generally begins with the preparation of a receipts and payments account. For those following the mercantile system, a profit and loss account is prepared. Adjustments are then made for non-allowable expenses, taxable incomes not recorded in the books, allowable expenses not recorded, and exempt incomes. The result is the taxable business or professional income for the relevant year.
A simplified computation format may be represented as follows:
Particulars | Amount (₹)
Net profit as per P&L account | xxxx
Add: Non-allowable expenses and taxable incomes not recorded | xxx
Less: Allowable expenses not recorded and exempt incomes | xxx
Taxable business/professional profit | xxxx
Meaning of Business under Section 2(13)
The term business encompasses trade, commerce, manufacture, or any adventure in the nature of trade. It implies a systematic and continuous activity carried out with the objective of earning income, although the existence of a profit motive is not essential in every case. Judicial interpretations, including the decision in State of Andhra Pradesh v. H. Abdul Bakshi & Bros., have highlighted that even mutual concerns or cooperative societies may carry on activities classified as business.
Characteristics of Business
A key aspect of business is organised activity, which requires a structured and planned course of action, as explained in Barendra Prosod Ray v. ITD. While trade generally refers to the buying and selling of goods, commerce is understood as trade on a larger or more complex scale, as clarified in Sri Gajalakshmi Ginning Factory Ltd. v. CIT.
The scope of business also extends to services and manufacturing. In CIT v. Oceanic Products Exporting Co., it was held that converting goods into new and distinct products qualifies as manufacturing activity.
Single Transaction as Business
Even a single transaction may amount to a business if it exhibits characteristics of a trade-related venture. The following indicators are often considered in identifying an adventure in the nature of trade:
- Intention to resell goods or assets at a profit
- Connection with the assessee’s regular line of business
- Purchase of goods in quantities larger than personal needs
- Modifications or improvements made before resale
- Conduct of activities in a business-like manner
Meaning of Profession under Section 2(36)
A profession refers to an occupation requiring intellectual skill or specialised manual ability. Examples include the work of doctors, lawyers, chartered accountants, and architects. While all professions are businesses in the broader sense, not every business qualifies as a profession. The distinction largely lies in the reliance on personal expertise and the relatively smaller role of capital investment in professional income generation.
Judicial interpretations, such as CIT v. PVG Raju, have reinforced that professional income arises primarily from individual skill. The term profession also includes vocation, which refers to an activity that matches one’s aptitudes and skills. For instance, teaching, artistic work, and even religious preaching may be classified as vocations for tax purposes, as observed in K. Ramaswami Gounder v. CIT.
From a legal perspective, the tax treatment of business, profession, and vocation is uniform, and income from any of these activities is chargeable under the same provisions.
Basis of Charge under Section 28
Section 28 outlines the categories of income chargeable under the head profits and gains of business or profession. The primary category includes profits from any business or profession carried on by the assessee at any time during the previous year. Only net profits are taxable, with capital receipts excluded unless expressly provided otherwise.
Revenue receipts can be in the form of cash or kind, as established in British South Africa Co. v. CIT. Voluntary payments received in the course of a business or profession are also taxable if they arise out of the business relationship between the payer and the recipient.
Profits from illegal businesses are subject to taxation, and losses from such businesses are generally deductible, as held in CIT v. Piara Singh. Ownership of the business is not a precondition for taxability; the person entitled to carry on the business is liable to tax on its profits, as explained in CIT v. City Mills Distributors (P.) Ltd.
It is not necessary for a business to be carried on throughout the entire year; it is sufficient if it is carried on for any part of the year, as clarified in CIT v. Express Newspapers. Receipts from discontinued businesses are taxable in certain cases, particularly where the cash system of accounting is followed, as provided in Section 176(3A) and 176(4).
Pre-commencement receipts are generally not considered business income. In CIT v. State Trading Corporation, it was held that amounts received before the actual commencement of business activities cannot be taxed under this head. However, customer deposits that were initially capital in nature can become taxable if they subsequently become the assessee’s own money, as demonstrated in the case of CIT v. T.V. Sundaram Iyengar & Sons Ltd.
Income from Property Used for Business under Section 22
If a building or property is used for the purposes of a business or profession, the annual value of that property is not taxable under the head income from house property. Instead, it forms part of the business income. This provision ensures that the same income is not taxed twice under different heads.
Principles of Computation under Section 29
Section 29 provides that profits and gains of business or profession are to be computed in accordance with the provisions of Sections 30 to 43D. However, the scope of allowable expenses extends to all those that are incidental to the business, even if not specifically listed.
In G.G. Dandekar Machine Works Ltd. v. CIT, it was held that genuine business expenses could be allowed as deductions even if there is no explicit provision for them, provided they are incurred wholly and exclusively for business purposes.
Deductibility of Business Losses
Business losses are generally deductible if they meet the following conditions:
- They are not of capital nature, as clarified in Mandani Development Corporation (P.) Ltd. v. CIT
- They are incidental to the trade, as in CIT v. Textool Co. Ltd.
- There is no specific provision disallowing the loss, as held in Badridas Daga v. CIT
Losses directly connected with the conduct of business, including those arising from natural calamities, theft, or fraud by employees, may be deductible if they meet the criteria of being incidental to the trade.
Deductions and Allowances in Computing Profits
When computing profits under the head of business or profession, certain expenditures are specifically allowed as deductions. These ensure that only the net income after legitimate business expenses is subjected to tax. Sections 30 to 37 outline these allowances, while certain sections like 40, 40A, and 43B set limitations.
Expenses Relating to Buildings, Plant, and Machinery
Section 30 permits deductions for rent, rates, taxes, repairs, and insurance in respect of premises used for business. If the premises are partly used for personal purposes, only the portion attributable to the business is allowable. Section 31 covers repairs and insurance of machinery, plant, and furniture used for the business. This includes routine repairs but excludes capital improvements.
Depreciation on Tangible and Intangible Assets
Section 32 allows depreciation on assets like buildings, machinery, plant, furniture, and certain intangible assets including patents, copyrights, and trademarks. Depreciation is calculated on the written down value at prescribed rates. For newly acquired assets used for less than 180 days in a year, only 50 percent of the normal rate is allowed. The aim is to recognize the reduction in value due to wear and tear and technological obsolescence.
Scientific Research Expenditure
Section 35 encourages investment in research related to the business. Expenditure on in-house research or payments to approved institutions is deductible. Capital expenditure on scientific research, excluding land, is also eligible, provided it is incurred before commencement of business and related to the business carried on.
Amortization of Certain Preliminary and Other Expenses
Sections 35D, 35DD, and 35DDA permit amortization of specific expenses over a number of years. Preliminary expenses like legal charges, feasibility studies, and project reports can be spread over five years. Expenditure on amalgamation or demerger under Section 35DD is allowed equally over five years. Section 35DDA deals with voluntary retirement payments, which are spread over five years to avoid a heavy one-time deduction.
Expenditure on Specified Businesses
Section 35AD grants 100 percent deduction for capital expenditure on specified infrastructure and other businesses, such as cold chain facilities, warehousing for agricultural produce, and laying of cross-country pipelines. However, expenditure on land, goodwill, and financial instruments is excluded. This provision aims to promote sectors crucial to economic growth.
Disallowance of Certain Expenses
While some expenses are allowed, others are specifically disallowed to prevent misuse and ensure that only genuine business costs are deducted.
Payments to Relatives and Associated Persons
Section 40A(2) restricts deductions for payments to related persons if they are found excessive or unreasonable compared to market value. The assessing officer can disallow the portion deemed excessive. The definition of related persons includes relatives, partners, and directors, as well as their relatives.
Cash Payments Beyond Prescribed Limits
Section 40A(3) disallows deductions for expenses exceeding a specified limit (currently ₹10,000) made otherwise than by account payee cheque, draft, or electronic clearing. Exceptions are provided for payments where banking facilities are not available or under certain circumstances specified in the rules.
Disallowance under Section 43B
Certain expenses are allowable only on actual payment, regardless of the accounting method. These include tax, duty, cess, contributions to employee welfare funds, bonuses, and interest on loans from public financial institutions. Even if accrued in the books, they are deductible only when paid.
Disallowance of Unpaid Liabilities to Employees
Section 40(a)(ia) deals with disallowance of amounts payable to residents on which tax is deductible at source but has not been deducted or deposited within prescribed time limits. For example, payments to contractors, rent, or professional fees without TDS compliance can be disallowed.
Deemed Profits and Gains
In certain cases, incomes are deemed to be business profits even if they do not arise directly from normal operations.
Recovery of Deductions
Section 41(1) provides that if an allowance or deduction has been claimed in earlier years and later the liability is remitted or ceased, the amount is taxable as business income. For example, if a creditor waives part of a debt for which deduction was claimed, the benefit is taxable.
Sale of Depreciable Assets
Under Section 41(2), if a depreciable asset is sold for more than its written down value but less than its original cost, the excess is treated as a balancing charge and taxed as business income, limited to the depreciation allowed earlier.
Unexplained Credits, Investments, and Expenditure
Sections 68 to 69D cover unexplained cash credits, investments, and expenditure. If such amounts are not satisfactorily explained, they are deemed to be income and taxed accordingly. For instance, unexplained loans or share application money credited in books without supporting evidence can be taxed.
Special Provisions for Certain Businesses
The Act contains special provisions for specific types of businesses, recognizing their unique nature and the need for simplified taxation.
Presumptive Taxation for Small Businesses
Section 44AD offers a presumptive taxation scheme for eligible businesses with turnover up to a specified limit. Income is presumed at a fixed percentage of turnover, and no further deduction for business expenses is allowed. This simplifies compliance for small businesses.
Presumptive Taxation for Transporters
Section 44AE applies to persons engaged in the business of plying, hiring, or leasing goods carriages. Income is presumed based on the number and type of vehicles owned, and no further deductions are allowed.
Special Provisions for Professionals
Section 44ADA provides a presumptive scheme for specified professionals such as doctors, lawyers, and accountants, allowing them to declare a fixed percentage of gross receipts as income without maintaining detailed books.
Treatment of Losses in Business
Losses incurred in the course of business or profession can be set off and carried forward, subject to certain conditions.
Set-off of Business Losses
A business loss can be set off against income from any other business or profession and, if not fully absorbed, against income under other heads except salary. This ensures that genuine commercial losses reduce the tax burden in the year they occur.
Carry Forward of Losses
If losses cannot be set off in the current year, they can be carried forward for up to eight years to be adjusted against future business profits. However, such carry forward is allowed only if the return is filed within the prescribed due date.
Losses from Speculation Business
Speculation losses can only be set off against speculation income and carried forward for four years. The restrictive treatment reflects the speculative and high-risk nature of such activities.
Losses from Specified Businesses
Losses from businesses under Section 35AD can only be set off against income from similar specified businesses. This ensures that incentives for these sectors are not diluted by cross-adjustment with other incomes.
Income from Discontinued Business
The law also addresses situations where business operations have ceased.
Taxability of Post-discontinuance Receipts
Section 176(3A) provides that any sum received after discontinuance, which would have been taxable as business income had the business continued, is still taxable in the year of receipt. This ensures that outstanding amounts such as recoveries from debtors remain within the tax net.
Deductions for Post-discontinuance Payments
Similarly, certain expenses incurred after discontinuance can be deducted if they relate to the business, such as payments for outstanding liabilities. This prevents double taxation and recognizes the continuing financial impact of the business.
Income from Illegal Business
Profits from unlawful activities are also taxable. The principle is that tax law does not condone illegal acts but ensures that income from such activities is not exempt. Deductions for expenses incurred in earning such income are generally allowed if they are not prohibited by law. For example, in cases involving smuggling, losses due to confiscation of goods may be allowed if they are incidental to the business.
Conversion of Capital Assets into Stock-in-trade
When a capital asset is converted into stock-in-trade, the fair market value on the date of conversion is treated as the sale consideration for capital gains purposes, and the difference between the eventual sale price and the fair market value is treated as business income. This ensures proper bifurcation between capital gains and business profits.
Transfer of Business Assets
Section 28(via) covers situations where a business asset is transferred on dissolution or reconstitution of a firm, AOP, or BOI. The fair market value is deemed to be the full value of consideration, and profits arising are taxed as business income. This prevents avoidance through undervaluation.
Treatment of Speculative Transactions
Speculative transactions are distinct from regular business transactions. A speculative transaction is one in which a contract for the purchase or sale of any commodity, including stocks and shares, is settled otherwise than by the actual delivery or transfer of the commodity or scrips. The essence of speculation is that the transaction is settled without actual physical delivery, with the parties agreeing to pay the difference in price.
The profits or losses from speculative transactions are taxed separately from normal business income. The law also imposes restrictions on the set-off of speculative losses, allowing them to be set off only against speculative profits. Carry forward of such losses is permitted for a limited number of assessment years, subject to the filing of returns within prescribed timelines.
Treatment of Deemed Profits
Certain receipts are treated as deemed profits even though they are not actual sales or receipts in the traditional sense. Examples include:
- Recovery of bad debts previously allowed as a deduction
- Sale of depreciable assets where the consideration exceeds the written-down value
- Withdrawal from special reserves or provisions previously allowed as deductions
- Value of benefits or perquisites arising from business
These receipts are included in business income in the year they are realized or withdrawn, ensuring that prior deductions or allowances are reversed when no longer justified.
Disallowance of Expenses in Certain Cases
The income computation provisions disallow certain expenditures in specific situations to prevent misuse or curb undesirable practices. Common disallowances include:
- Expenditure incurred in relation to exempt income
- Payments made to relatives or associated entities where such payments exceed the fair market value
- Cash payments exceeding the prescribed threshold
- Expenditure on advertisements in prohibited media
- Expenditure relating to any offence or prohibited activity
The aim is to ensure that only genuine and reasonable expenses directly related to business are allowed as deductions.
Treatment of Scientific Research Expenditure
Scientific research expenditure incurred for the purpose of the business is eligible for deduction, whether capital or revenue in nature. Deduction is allowed for in-house research related to the taxpayer’s business as well as for contributions to approved research associations or universities.
Capital expenditure on scientific research is deductible in the year it is incurred, provided it is related to the business and not incurred for acquiring land. Revenue expenditure, such as salaries to research staff, consumables, and utilities for laboratories, is also deductible in the year of payment.
Amortization of Certain Expenditures
Some specific types of expenses are amortized over multiple years instead of being deducted fully in the year incurred. These include:
- Preliminary expenses incurred before the commencement of business
- Expenditure on voluntary retirement schemes
- Expenditure on amalgamation or demerger
- Capital expenditure on specified business projects
This amortization ensures a fair matching of expenses with the income generated over the relevant period.
Computation of Income for Special Businesses
Certain businesses have special rules for computing profits and gains. These special provisions apply to industries like shipping, exploration of mineral oils, civil construction, or turnkey power projects. In such cases, income is computed on a presumptive basis, either as a percentage of gross receipts or based on tonnage capacity, rather than on actual books of account.
Presumptive taxation simplifies compliance for businesses engaged in specified sectors, but opting for it often comes with restrictions on claiming normal deductions.
Income from Export Business
Export businesses enjoy special deductions and incentives to promote foreign trade. These include deductions for profits derived from export of goods, services, or software, provided certain conditions are met. The deduction is often computed as a proportion of export turnover to total turnover.
However, the eligibility is subject to conditions such as realization of export proceeds in convertible foreign exchange within a specified period and compliance with regulatory guidelines.
Income from Units in Special Economic Zones
Businesses operating in notified Special Economic Zones can claim deductions of a percentage of their profits for a prescribed number of years. The deduction is linked to the export profits of the undertaking and is available only if the unit begins operations within specified timelines.
Such units must maintain separate books of account, file returns within due dates, and comply with other conditions to avail the benefit.
Treatment of Insurance Compensation
When an asset used in business is destroyed, lost, or damaged, and compensation is received from an insurance company, such compensation is taxable. If the asset is a depreciable asset, the compensation is adjusted against the block of assets to determine the written-down value.
If it exceeds the block value, the surplus is treated as short-term capital gain. For stock-in-trade, insurance compensation is treated as business income since it replaces the revenue that would have been earned from the sale of such goods.
Deduction for Employment Generation
Businesses can claim deductions for creating new employment, provided certain thresholds of additional employees and employment duration are met. The deduction is usually a percentage of the wages paid to new employees, subject to documentation and compliance requirements. This provision encourages businesses to expand their workforce and contribute to economic growth.
Maintenance of Books and Audit Requirements
Every business or profession above certain turnover or gross receipt limits must maintain prescribed books of account. These include cash books, ledgers, journals (if applicable), and supporting vouchers.
In addition, if turnover exceeds specified limits, a tax audit by a chartered accountant is mandatory. The audit report must be filed in the prescribed format within the due date to avoid penalties.
Income from Composite Activities
Many businesses undertake activities that span multiple heads of income, such as manufacturing and trading, or service provision alongside product sales. In such cases, apportionment of common expenses is necessary to determine the correct taxable profit from each segment.
Special care is needed to segregate income and expenses for each activity to ensure accurate computation and compliance.
Foreign Business Operations
For businesses with operations abroad, income is computed in accordance with domestic law, but relief may be available for taxes paid in foreign countries under double taxation avoidance agreements.
Exchange rate fluctuations can impact the computation of such income. Gains or losses arising from the conversion of foreign currency are generally recognized on an accrual basis, depending on the nature of the transaction.
Depreciation on Intangible Assets
In addition to tangible assets like machinery and buildings, depreciation is also allowed on intangible assets such as goodwill, trademarks, patents, and licenses. The rate of depreciation for such assets is generally uniform, and the asset must be used for the purposes of business to qualify.
Disputes often arise regarding the eligibility of certain intangible assets for depreciation, and judicial precedents play a significant role in resolving such matters.
Valuation of Stock
Stock valuation is a critical aspect of determining business profits. The general principle is to value stock at the lower of cost or net realizable value. Cost can be determined using methods such as FIFO (First In First Out), weighted average, or specific identification, depending on the nature of the goods.
Valuation must be consistent year to year unless a change is justified and disclosed. Incorrect valuation can lead to underreporting or overreporting of profits.
Transfer of Business Assets
When business assets are transferred, whether by sale, exchange, or conversion to personal use, the consideration or market value is brought to tax. For depreciable assets, the block of assets concept applies, and any surplus over the written-down value is treated as short-term capital gain.
For non-depreciable assets, gains are computed under the capital gains provisions, though certain transfers may be exempt if they form part of a corporate restructuring.
Advances and Deposits
Advances or deposits received from customers are generally not taxable until they are adjusted against sales or services rendered. However, if such advances are forfeited due to cancellation of the contract, they become taxable as business income in the year of forfeiture.
Similarly, security deposits from suppliers or contractors are not taxable unless appropriated against dues.
Recovery of Unallowed Deductions
If an expense was earlier disallowed for non-compliance with conditions but is subsequently allowed due to rectification or fulfillment of conditions, it may be deductible in the year of compliance.
Conversely, if an earlier deduction is found to have been wrongly claimed, the amount can be added back to the income in the year of detection.
Judicial Interpretations
The scope of profits and gains of business or profession is constantly refined through judicial interpretations. Courts have clarified issues such as whether compensation for breach of contract is revenue or capital receipt, or whether certain subsidies are taxable.
Businesses must stay updated with landmark rulings to ensure their tax positions are compliant and defensible.
Conclusion
The e-way bill system under GST has emerged as a crucial mechanism for ensuring transparency, efficiency, and compliance in the movement of goods across India. By mandating the generation of an electronically verifiable document for consignments above a specified value, the system has minimized opportunities for tax evasion, improved monitoring of inter-state and intra-state transactions, and streamlined logistics processes. Its integration with GST returns, real-time verification features, and user-friendly online interface have further enhanced operational convenience for businesses of all sizes.
However, successful implementation requires consistent awareness among taxpayers, adequate training for transporters, and seamless functioning of the portal to avoid operational bottlenecks. The government’s periodic updates and relaxations, along with technological enhancements, have addressed several challenges, yet continued stakeholder engagement remains key.
In the long term, the e-way bill framework is expected to contribute significantly to the formalization of the economy, reduction of transit times, and improvement in revenue collection. It stands as a vital tool in the evolving GST ecosystem, balancing regulatory requirements with the needs of trade and commerce.