Profits from Business/Profession and Capital Gains notes — Unit 3

Sections 28 to 44DB deal with the taxation of business and professional income. This is often considered the most intricate head of income because it mirrors commercial accounting but superimposes strict tax rules.

⇒Definitions

• Business (Sec 2(13)): Includes any trade, commerce, or manufacture, or any adventure or concern in the nature of trade, commerce, or manufacture. (It implies a continuous exercise of activity for profit).
• Profession (Sec 2(36)): Includes vocation. It involves occupations requiring intellectual skill or manual skill based on special learning (e.g., Doctors, Lawyers, CAs, Architects).
• Vocation: Activities performed for earning a livelihood which do not require specialized academic qualifications (e.g., a singer, a broker, an astrologer).

The rules for calculating income for Business, Profession, and Vocation are identical under the Act.

Section 28 lists the specific incomes chargeable under the head PGBP. Key inclusions are:

• 1. The profits and gains of any business or profession carried on by the assessee at any time during the previous year.
• 2. Any compensation received for termination or modification of a business contract/agency.
• 3. Income derived by a trade, professional, or similar association from specific services performed for its members.
• 4. Export incentives (like Duty Drawback or profit on sale of import entitlement licenses).
• 5. Value of any perquisite or benefit arising from business or the exercise of a profession (e.g., a client gifting a car to their lawyer).
• 6. Any salary, bonus, commission, or remuneration due to or received by a partner of a firm from the firm.

Before diving into specific deductions, these foundational principles govern PGBP calculations:

• Business carried on by Assessee: The tax is on the person carrying on the business, not necessarily the owner (e.g., a lessee running a leased factory).
• Method of Accounting: Section 145 allows the assessee to choose either the Cash basis or the Mercantile (Accrual) basis. The tax department will compute income based on the method regularly employed by the assessee.
• Legality of Business: The Income Tax Act makes no distinction between a legal business and an illegal one (like smuggling). Profits from illegal businesses are fully taxable.
• Anticipated Losses: Following commercial prudence, anticipated losses are NOT allowed as deductions, while anticipated profits are NOT taxed. (Tax is on real income).
• Capital vs Revenue: Only revenue receipts are taxed here. Capital receipts are not. Similarly, only revenue expenditures are allowed as deductions. Capital expenditure (buying machinery) is not directly deductible, though depreciation is allowed.

To find the true profit, you must subtract expenses from gross receipts. The Act explicitly allows certain deductions.

⇒Specific Deductions

• Section 30 (Rent & Repairs): Rent, taxes, insurance, and current repairs for premises used for business.
• Section 31 (Machinery): Current repairs and insurance of machinery, plant, and furniture used for business.
• Section 32 (Depreciation): Covered in detail on the next page.
• Section 36: Lists specific items like:
• - Insurance premiums paid for stocks/stores.
• - Bonus or commission paid to employees.
• - Interest paid on capital borrowed for business purposes.
• - Employer's contribution to RPF or approved gratuity fund.
• - Bad Debts: Allowed as a deduction if the debt was previously taken into account in computing income and has been written off as irrecoverable in the accounts.

Depreciation is the wear and tear of capital assets over time. Since you cannot deduct the cost of a machine all at once (it's capital expenditure), the law allows you to deduct a percentage of its value every year.

⇒Conditions for Claiming Depreciation

• 1. Asset Type: Must be a Building, Machinery, Plant, or Furniture (Tangible), OR Know-how, Patents, Copyrights, Trademarks, Licenses (Intangible).
• 2. Ownership: The asset must be owned, wholly or partly, by the assessee. (A lessee can claim depreciation on capital structures built by them).
• 3. Usage: The asset must be used for the purposes of the business or profession during the previous year.

⇒The Block of Assets Method

Unlike normal accounting where depreciation is calculated per machine, Income Tax groups assets into 'Blocks'. A block is a group of assets falling within a class (e.g., Machinery) for which the exact same percentage of depreciation is prescribed (e.g., all 15% machinery form one block). Depreciation is calculated on the Written Down Value (WDV) of the entire block.

Sections 30 to 36 list specific expenses. But a business has thousands of different expenses (stationery, marketing, software, travel). Section 37 is the 'Residuary Clause' that acts as a catch-all for legitimate business expenses.

⇒Conditions for Sec 37 Deduction

Any expenditure can be deducted under Sec 37 if it satisfies ALL of these conditions:

• 1. It must not be an expenditure of the nature described in Sections 30 to 36.
• 2. It must NOT be in the nature of Capital expenditure.
• 3. It must NOT be personal expenses of the assessee.
• 4. It must be laid out or expended wholly and exclusively for the purposes of the business or profession.
• 5. It must NOT have been incurred for any purpose which is an offence or prohibited by law (e.g., Protection money paid to mafia, or bribes paid to officials are NOT deductible).

These are expenses that are strictly PROHIBITED from being deducted, even if they are genuine business expenses. The government uses these to force compliance.

• TDS Default (Sec 40(a)(ia)): If you pay an expense (like professional fees, rent, contractor payments) to a resident and fail to deduct TDS (Tax Deducted at Source), 30% of that expense will be disallowed (you can't deduct it).
• Payments to Relatives (Sec 40A(2)): If you pay a salary or buy goods from a relative (spouse, brother, sister) and the Assessing Officer finds the payment is unreasonable or excessive compared to market rates, the excessive portion is disallowed.
• Cash Payments over ₹10,000 (Sec 40A(3)): To curb black money, if you make any business expense payment exceeding ₹10,000 in a single day to a person in CASH (or bearer cheque), the entire expenditure is 100% disallowed.

The 4th head of income taxes the profit you make when you sell an asset. This taxes the 'tree' itself, not the 'fruit'.

⇒Basis of Charge (Section 45)

Any profits or gains arising from the transfer of a capital asset effected in the previous year shall be chargeable to income-tax under the head 'Capital Gains'.

⇒Two Crucial Requirements:

• 1. There must be a Capital Asset.
• 2. There must be a Transfer of that asset.

If either is missing, there is no Capital Gains tax.

The definition is incredibly wide but has specific, highly tested exceptions.

It means: Property of any kind held by an assessee, whether or not connected with his business or profession.

⇒The Exceptions (What is NOT a Capital Asset):

• 1. Stock-in-Trade: Goods you buy to resell in your business. (Selling stock generates Business Income, not Capital Gains).
• 2. Personal Effects: Movable property held for personal use (e.g., clothes, furniture, car). However, Jewellery, Archaeological collections, Drawings, Paintings, and Sculptures are specifically EXCLUDED from 'personal effects'—meaning selling them WILL attract Capital Gains.
• 3. Rural Agricultural Land: Agricultural land in India situated outside the limits of a municipality (having a population > 10,000) and outside specified aerial distances from the town limits.
• 4. Specified Gold Bonds: Certain Gold Deposit Bonds issued by the Government.

The tax rate and calculation drastically change depending on how long you held the asset before selling it.

⇒Short-Term Capital Asset (STCA)

An asset held for 36 months or less immediately preceding the date of its transfer.

⇒Exceptions (Special time limits)

• 12 Months Limit: For listed securities (shares on BSE/NSE), equity-oriented mutual funds, and Zero Coupon Bonds. If held for >12 months, they become Long-Term.
• 24 Months Limit: For unlisted shares and Immovable Property (Land & Building). If you hold a house for >24 months, it becomes Long-Term.

⇒Why does it matter?

• Short-Term Capital Gains (STCG): Taxed at normal slab rates (or 15% for listed equity). No indexation benefit.
• Long-Term Capital Gains (LTCG): Taxed at a flat 20% (or 10% for listed equity). You get the massive benefit of Indexation.

⇒The Basic Formula

Full Value of Consideration (Sale Price)
LESS: Expenses on Transfer (Brokerage, Stamp Duty)
LESS: Cost of Acquisition (Purchase Price)
LESS: Cost of Improvement (Renovations)
= CAPITAL GAINS

⇒The Magic of Indexation (For Long-Term Assets)

Inflation destroys the value of money. If you bought a house in 2005 for ₹10 Lakhs and sold it in 2024 for ₹50 Lakhs, your real profit isn't ₹40 Lakhs, because ₹10 Lakhs in 2005 was worth a lot more.

For Long-Term Capital Assets, the government allows you to inflate your purchase price using the Cost Inflation Index (CII) published every year.

• Indexed Cost of Acquisition = Cost of Acquisition × (CII of year of sale / CII of year of purchase).

This dramatically increases your legal 'Cost', thereby shrinking your taxable Capital Gains, saving you lakhs in taxes.

Capital gains only arise if there is a 'transfer'. The Income Tax Act definition of transfer is much wider than the Transfer of Property Act.

Transfer includes:

• 1. Sale, exchange, or relinquishment of the asset.
• 2. Extinguishment of any rights therein.
• 3. Compulsory Acquisition: If the government forcibly takes your land to build a highway and pays you compensation, it is considered a transfer and you must pay capital gains tax.
• 4. Conversion of a capital asset into stock-in-trade.
• 5. Maturity or redemption of a Zero Coupon Bond.
• 6. Any transaction allowing possession of immovable property in part performance of a contract (Linking to Sec 53A of TPA).

The government wants to encourage reinvestment. If you sell an asset and invest the profit into specific avenues, your capital gains tax is reduced or completely wiped out.

⇒Section 54: Sale of Residential House

If an Individual or HUF sells a Long-Term Residential House and buys/constructs ANOTHER residential house in India, the capital gains are exempt.

• Timeline: Must purchase 1 year before or 2 years after the sale, OR construct within 3 years after the sale.
• Exemption Amount: Capital Gains OR Cost of new house, whichever is lower.

⇒Section 54EC: Investment in Specified Bonds

If you sell ANY Long-Term Immovable Property (Land or Building) and invest the Capital Gains in specified bonds (like NHAI or RECL) within 6 months of the sale, you get an exemption.

• Maximum limit: You can only invest a maximum of ₹50 Lakhs in these bonds in a financial year.
• Lock-in: The bonds must be held for 5 years.

⇒Summary of Master Concepts

• PGBP: Computes business profit. Admissible deductions (Sec 30-37). Block of assets depreciation.
• Inadmissible Expenses: Cash payments >₹10k (Sec 40A(3)) and TDS defaults are disallowed.
• Capital Asset: Excludes stock-in-trade, personal effects (but jewellery IS an asset), and rural agricultural land.
• Holding Period: 36 months generally. 24 months for Real Estate. 12 months for listed shares.
• Indexation: Adjusts purchase price for inflation for Long-Term assets.
• Exemptions: Sec 54 (House for House) and Sec 54EC (Bonds within 6 months).

⇒University Exam Tips for this Unit (Premium Advice)

• Section 37 (General Deduction): Memorize the 5 conditions on Page 6. It's a highly probable theory question ('What are the conditions for residuary deduction under PGBP?').
• Capital Asset Exceptions: Examiners love testing the exceptions. Remember: A car used for personal use is NOT a capital asset (no tax on selling it). Jewellery used for personal use IS a capital asset (taxable on sale).
• Section 54 vs 54EC: Keep the timelines clear. Sec 54 is 1/2/3 years for a house. Sec 54EC is 6 months for NHAI bonds (max 50L).