Depreciation under Income Tax Act

What is Depreciation?

Depreciation is the process of allocating the cost of an asset over its useful life. It reflects the reduction in the value of assets due to usage, wear and tear, or obsolescence. For tax purposes, the Income Tax Act permits depreciation claims on assets used in the production of income, helping taxpayers reduce their taxable income. Depreciation is a non-cash Depreciation under the Income Tax Act, meaning it does not affect cash flow directly but reduces taxable profits.
 

Depreciation Under the Income Tax Act

Section 32 of the Income Tax Act, 1961 provides the framework for claiming depreciation. The Act allows depreciation on both tangible assets (such as buildings, machinery, and furniture) and intangible assets (like patents, trademarks, and copyrights). For depreciation claims, the asset must be used for business or professional purposes. Personal use assets are not eligible for depreciation claims, though partial claims can be made if the asset is used partly for business.

Depreciation Rates and Block of Assets

Under the Income Tax Act, assets are grouped into a block of assets based on their nature and depreciation rate. This grouping simplifies the process, as a uniform rate of depreciation is applied to all assets within the block. Depreciation is calculated on the Written Down Value (WDV) of the asset or block of assets.

The Income Tax Act prescribes different depreciation rates for various asset types. The following table outlines the rates for common assets:
 

These rates are fixed under the Income Tax Act and help determine the amount of depreciation taxpayers can claim based on the asset’s nature and purpose.
 

Conditions for Claiming Depreciation

To claim depreciation under the Income Tax Act, the following conditions must be met:

Ownership: The taxpayer must own the asset, either fully or partially. In cases of co-ownership, depreciation can be claimed on the taxpayer's share of the asset.

Business or Professional Use: The asset must be used for business or professional purposes. Depreciation cannot be claimed on assets used for personal purposes, but if an asset is used for both business and personal purposes, depreciation can be claimed for the business portion.

Exclusion of Certain Assets: Depreciation cannot be claimed on land and goodwill. Land typically does not lose value over time, and goodwill, while intangible, does not undergo wear and tear.

Asset Usage in the Year: Depreciation is only allowed for assets that have been used in the financial year. If an asset is sold or discarded in the same year, no depreciation can be claimed.

Methods of Calculating Depreciation

The Income Tax Act provides two main methods for calculating depreciation: the Written Down Value (WDV) method and the Straight Line Method (SLM). Each method is suitable for different types of assets.

1. Written Down Value (WDV) Method

The WDV method is the most commonly used method under the Income Tax Act. Depreciation is calculated on the reduced value of the asset at the start of each year.

How It Works: The depreciation for the year is calculated on the asset’s value at the beginning of the year. Each subsequent year, the depreciation is calculated on the reduced value, leading to a declining depreciation amount over time.

Example: If a machine costs ₹1,00,000 and the depreciation rate is 10%, the depreciation for the first year would be ₹10,000. In the second year, depreciation is calculated on the reduced value of ₹90,000, resulting in ₹9,000 depreciation.

2. Straight Line Method (SLM)

The SLM method calculates depreciation as a fixed percentage of the asset’s original cost over its useful life. This method is commonly used for assets that have a consistent useful life.

How It Works: Depreciation is evenly spread over the asset’s useful life, meaning the same amount is deducted each year.

Example: If an asset costs ₹1,00,000 and has a useful life of 10 years, the depreciation under SLM will be ₹10,000 annually.

How to Claim Depreciation

To claim depreciation, follow these steps:

• Classify Assets: Group assets into blocks based on depreciation rates.
• Calculate WDV: Determine the Written Down Value (WDV) of the asset at the start of the financial year.
• Apply Depreciation Rates: Apply the appropriate depreciation rate for each asset block.
• Record in Accounts: Ensure depreciation is reflected in the profit and loss account.
• File Tax Returns: Claim depreciation when filing income tax returns for the financial year.

Benefits of Depreciation for Businesses

Depreciation offers several benefits for businesses, including:

Tax Reduction: Depreciation reduces taxable income, leading to lower tax liabilities.

Improved Cash Flow: As depreciation is a non-cash expense, it improves cash flow without affecting actual cash reserves.

Encourages Investment: Tax relief through depreciation encourages businesses to invest in new assets, which can boost productivity and growth.

Simplified Tax Compliance: Depreciating assets as a block simplifies tax calculations and reduces errors.
 

Conclusion

Depreciation under the Income Tax Act, 1961 is a powerful tool for businesses and individuals to reduce their taxable income and enhance financial planning. By understanding the different depreciation methods, eligibility conditions, and tax benefits, taxpayers can strategically manage their assets and optimise their tax position. With mandatory depreciation, businesses can consistently benefit from tax deductions, supporting long-term growth and investment.