Depreciation – Multifarious views and Court Judgements

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The common school of thought is that, the term ‘Depreciation’ is associated with the wear and tear of an object which has a useful life extending beyond the normal operating cycle or accounting year whichever is longer. But there are two different interpretations possible under the popular laws namely the Income tax act, 1961 and the Companies Act, 1956. The definition for Depreciation as found in IAS-16 (Property, Plant and Equipment) is “the systematic allocation of the depreciable amount of an asset over its expected useful life” (It may be noted that as per Central Government notified AS-6, Depreciation is the measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. We have to see if the same definition as in IAS-16 will be adopted). IAS-16 clearly is silent whether depreciation will arise only on wear and tear of an asset. In fact the advocacy is to systematically allocate the cost of the asset over the useful life thereby covering amortisation of intangible assets.

It is a known fact that Depreciation is a necessary measure to fulfil the ‘matching’ concept i.e. price incurred for deriving revenue is to be matched with the revenue. In the context of IAS-16 the definition clearly reflects the necessity to match the revenue with a systematic allocation, whereas AS-6 requires measurement of the wear and tear as depreciation. This paves the way for doubts regarding measurement during idle seasons where there would not be usage and no wear and tear. But the bottom-line is IAS-16 would neither object the measurement of depreciation during idle periods by virtue of its definition or lesser allowance in periods of overutilization. Having said this, allocation should have been decided after considering normal idle periods on account of seasonal factors. Thus the new definition sounds more like an application methodology (IAS-16) rather than a conceptual explanation (AS-6).

We all are aware of the Straight line method and WDV method of depreciation. The WDV method bears an explainable logic. The popular rationale is that in the first year of usage, repairs are bound to be lesser whereas the usage will be quite heavy to charge depreciation on the higher side. As years pass by and with more wear and tear, expenditure on current repairs will be heavier, but the capacity and usage reduces such that only a very low depreciation is warranted. The Bottom-line is to even out the charge during the asset accounting cycle. In every life cycle there is a phase of increasing performance, saturation and decreasing performance. Perhaps during the phases of increasing and decreasing performance, the usage of WDV method holds logic. Similarly during a phase of stagnation (saturation) usage of SLM method is explainable. There is encouragement to use any method reflecting the consumption pattern for production. The question arises is it practically possible to keep changing the depreciation method (which as per the current IGAAP is a change in accounting policy and requires retrospective adjustment). It is an affirmative answer to this query in the ensuing days under the prospective IAS-16 where a change in method of depreciation is regarded as change in accounting estimate and only prospective adjustment is required. To this extent the management is hassle free.

Under Production unit method, allocation is based on expected production units from the asset during its expected useful life. This method is more scientific compared to the above two methods for the simple reason of exactly matching the revenue generation. The Sales amount of the finished goods will directly correlate with the yearly charge of allowance. In fact the correctness of the percentage of depreciation can be cross verified with the asset turnover ratio which is nothing but Sales .

Fixed Assets

Depreciation is not defined explicitly in Income tax act, but the usage of the words ‘put to use’seems to be evidential of the condition of actual usage to claim the allowance. Under the Companies Act, the depreciable amount is ascertained rather than the yearly allocation. Sec.205 requires that while computing distributable profits, depreciation has to be provided for depreciable assetssuch that 95% of the original cost is written off to P&L. We may remember one of the other views of depreciation that it is the amount set aside for funding future replacement cost of the asset. If Company law had adopted that view then depreciation could have been formatted as a ‘Below the Line’ item which is not the case. Perhaps lawmakers had a different way of viewing depreciation.

The following is a snapshot of some thought provoking Court decisions that happened in the aged past on depreciation.

· Depreciation’ allowance is a concession granted by the State in the computation of income based on very many factors relevant to a wholesome fiscal administration - Parthas Trust v.CIT [1988] 169 ITR 334 (Ker.)(FB). This is quite an intriguing interpretation. The deep rooted understanding that Depreciation is a matter of right to the assessee is completely shaken.

· The following is a set of contradictory interpretations by the MP High court. During 1990 inCIT v. R.J. Trivedi & Sons [1990] 53 Taxman 485/183 ITR 420 (MP) the HC pronounced that Depreciation represents the diminution in the value of an asset when applied to the purpose of making profit or gain. But earlier in 1989 the same HC ruled in CIT v. Raipur Pallottine Society [1989] 80 CTR (MP) 127 that a Charitable Trust is entitled to deduction of depreciation. We all appreciate the fact that a charitable trust is not a profiteering organization. This contradictory judgment had come within a year! In fact the charitable institutions do claim depreciation as well as Property income exemptions. Actually the IT department did start disallowing most of the claim of depreciation by charitable trusts. But then as per the newly amended definition, the term charitable purpose is said to be tainted if the income applied is generated from a trade or commerce conducted using the property. If there is no exemption for this income from property held under charitable trust, then very obviously the claim of depreciation has to be sustained.

· This is a very significant Supreme court decision in CESC Ltd. v. CIT [1998] 233 ITR 50 (SC) that a company may keep its accounts in foreign currency but depreciation will have to be calculated in Indian currency at the point of time of acquisition of the asset. This judgment could be significant in the context of the ‘Functional currency’ system to be prescribed under the Indian equivalent AS of IAS-21-The effect of changes in Foreign Exchange rates. A functional currency is defined as the currency of the primary operating environment in which the entity operates. To determine which is a functional currency there are primary and secondary tests to be conducted. Thus if the Indian currency is not the functional currency for a company in India as per the definition and the tests, then separate depreciation computations may be required for IT purpose.

· Supreme Court brought out the real essence of the IT act in depreciation allowance by means of a single judgment. The expression ‘used for the purposes of the business’ means used for the purposes of the business during the accounting year. In order to attract the operation of clauses (v), (vi) and (vii) of section 10(2) of the 1922 Act the machinery and plant must be such as were used, in whatever sense that word is taken, at least for a part of the accounting year. If the machinery and plant have not at all been used at any time during the accounting year, no allowance can be claimed under clause (vii) in respect of them and the second proviso also does not come into operation - Liquidators of Pursa Ltd. v.CIT [1954] 25 ITR 265 (SC). Thus usage is a precondition for claim of depreciation, though many High courts have differed on this in their judgment.

· In Sitalpur Sugar Works Ltd. v. CIT [1963] 49 ITR 160 case the Supreme Court held that no depreciation was admissible on capital expenditure incurred on shifting factory from one site to another because no tangible asset was acquired by the expenditure and no improvement was made to any capital asset in the sense that there was an increase in the value thereof. In fact applying the grounds of interpretation in the above judgement we may as well conclude that the dismantling cost of a machinery when moved to a new location is not allowable either. As per the prospective IAS-16 (Indian AS), one of the elements of capitalisation of Plant & Machinery cost is Present value of agreed dismantling cost obligation arising in future. Hence to this extent there is going to be a tax basis difference at inception which is not reversible in future. Also separate register maintenances will be required.

· The following is a very old interesting decision by Punjab High court. In CIT v. Sarveshwar Nath Nigam [1963] 48 ITR 853 case the Court held that to claim depreciation it is not necessary that the factory should be worked by the assessee himself, and it is enough if the factory is worked on by a licensee or a hirer. This may be weird since the principle laid down in the matching concept gets extinguished if allowance claim is by a person who has not used the asset to generate revenue.