Depreciation under the Income Tax Act: A Comprehensive Guide

Understanding Depreciation in the Income Tax Act

Definition and Purpose of Depreciation

Depreciation allows businesses to account for the gradual wear and tear of assets. The Income Tax Act provides specific guidelines for calculating and claiming depreciation, making it one of the important income tax concepts. 

Depreciation, as defined under the Income Tax Act, refers to the deduction allowed to account for the reduction in the value of an asset due to wear and tear, obsolescence, or usage. It spreads the cost of an asset over its useful life, reducing taxable income in the process.

Tax Implications of Depreciation:

• Reduces taxable income by allowing deductions for asset wear and tear.
• Encourages businesses to invest in assets by offsetting purchase costs over time.
• Impacts overall tax liability, making it a crucial component in tax planning under income tax concepts.

Depreciation vs. Amortization

Depreciation (Income Tax Act) and amortization serve similar purposes but differ in scope and calculation methods.

Aspect	Depreciation (Income Tax Act)	Amortization
Definition	Spreads the cost of tangible assets over their useful life (e.g., machinery, vehicles).	Allocates the cost of intangible assets over time (e.g., patents, trademarks).
Formula	(Cost – Salvage Value) / Useful Life	Cost / Useful Life
Applicability	Tangible assets only	Intangible assets only
Residual Value	The estimated value of a tangible asset at the end of its useful life is considered in calculations.	Not applicable, as intangible assets typically have no salvage value.
Calculation Method	Straight-Line or Accelerated methods	Typically Straight-Line
Purpose	Manages tangible asset costs	Spreads cost of intangible assets over time.

Asset Classification for Depreciation

Tangible vs. Intangible Assets

• Tangible Assets: Physical assets like buildings, machinery, furniture, and appliances that depreciate due to wear, usage, and environmental exposure.
• Intangible Assets: Non-physical assets such as patents, trademarks, and licenses that depreciate due to limited legal life or market relevance. Only those acquired on or after April 1, 1998, are eligible for depreciation.

Different Categories of Assets and Their Classification

As per Income Tax basics, assets are grouped into Blocks of Assets for depreciation purposes. A Block of Assets refers to a group of assets of a similar nature and depreciation rate. Individual assets within a block lose their separate identity. Depreciation is calculated based on the written down value (WDV) of the entire block rather than on individual assets.

Asset blocks are classified based on:

• Nature: The physical or non-physical form and type of the asset.
• Lifespan: The useful life or duration over which they provide economic benefits.
• Usage/Application: Assets used in similar types of operations or business functions. 

Examples of each asset category:

Classification Criterion	Asset Type	Examples
Nature of the Asset	Machinery	Industrial equipment
	Buildings	Offices, factories, warehouses
	Patents	Legal rights for inventions
	Furniture	Desks, chairs, office fixtures
Lifespan of the Asset	Short lifespan	Computers (3–5 years)
	Medium lifespan	Vehicles, office equipment (5–8 years)
	Long lifespan	Buildings, industrial machinery (20+ years)
	Limited legal life	Trademarks, copyrights (10–20 years)
Usage / Application	Production	Manufacturing machinery
	Administrative	Office furniture
	Commercial	Retail outlets
	Legal Protection	Patents, trademarks, copyrights

Depreciation Rates and Methods

Prescribed Rates of Depreciation under the Income Tax Act

The Income Tax Act prescribes specific depreciation rates for various asset categories under Schedule XIV. These rates vary based on the nature and usage of the asset.

Schedule XIV of the Income Tax Act: 

Simplified depreciation rate table for commonly used assets:

Asset Class	Asset Type	Depreciation Rate
Building	Residential buildings (excluding hotels/boarding houses)	5%
	Hotels and boarding houses	10%
	Temporary wooden structures	40%
Furniture	Furniture and fittings (including electrical fittings)	10%
Plant & Machinery	General machinery, motor cars (non-commercial use)	15%
	Motor vehicles for hire or bought between 23 Aug 2019 and 1 Apr 2020	30% – 45%
	Computers and computer software	40%
	Books (annual publications or lending libraries)	60% – 100%
Intangible Assets	Franchises, trademarks, licenses, patents, copyrights, know-how, etc.	25%

 

Changes in Depreciation Rates Over Time: 

Depreciation rates have been revised periodically to reflect changes in industry needs, technology, and government policy.

• Accelerated Depreciation: Introduced temporarily for motor vehicles acquired between specific dates (e.g., 23 Aug 2019 to 1 Apr 2020) to boost investment.
• Higher Depreciation Rates: Certain assets, like pollution control equipment, renewable energy devices, and medical equipment, are eligible for rates as high as 40%.
• Technological Advancements: Computers and software have higher depreciation (40%) due to shorter useful life and rapid obsolescence.

Different Methods of Depreciation Calculation

Straight-Line Method (SLM):

The Straight-Line Method (SLM) allocates depreciation evenly across the useful life of an asset. It is simple, predictable, and is used when the asset generates equal value each year. The formula for computation is:

Depreciation per year = (Original Cost – Residual Value) / Useful Life

Where, 

• Original Cost: Price paid to acquire the asset
• Residual Value: Expected value at the end of useful life
• Useful Life: Operational tenure of the asset in years

This method is suitable for assets like buildings or furniture, where the asset’s benefit is consistent over time

Written Down Value (WDV) Method:

The WDV Method calculates depreciation on the asset’s book value at the beginning of each year. This results in higher depreciation in earlier years and lower depreciation in later years. The formula used for calculation is:

Depreciation Rate = {1 – (S/C)^(1/N)} × 100

Where:

• S = Residual Value
• C = Original Cost
• N = Useful life (in years)

This method is widely used under Indian Income Tax rules, especially for machinery or technological equipment where the asset’s utility declines quickly in the initial years. WDV is more prevalent under the Income Tax Act, making it relevant for share market advisory and other business operations where accelerated depreciation can offer earlier tax benefits.

Comparison of Methods:

Criteria	Straight-Line Method	Written Down Value Method
Depreciation Amount	Same every year	Higher in early years, lower in later years
Asset Value Reduction	Linear – decreases evenly	Exponential – faster reduction initially, tapering off over time
Ease of Calculation	Simple and predictable	Slightly complex due to reducing the balance
Usage	Financial reporting, steady-use assets like buildings	Tax reporting, especially for technology, machinery, share market advisory, and similar services
Examples	Buildings, office furniture	Vehicles, electronics, IT equipment, plant & machinery

Claiming Depreciation: Conditions and Procedures

Eligibility Criteria for Claiming Depreciation

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

Ownership of the Asset: 

• The assessee must be the asset’s owner, either fully or partially.
• Ownership may be legal or beneficial in nature.
• Even if the legal title of the asset is held by another party, the assessee can still claim depreciation if they have constructed the asset or paid for it and use it for business or professional purposes.
• In the case of a finance lease, as governed by Accounting Standard AS-19, the lessee is considered the owner for the purpose of claiming depreciation, provided the asset is capitalised in their books..

Use of the Asset for Business or Profession: 

The asset must be used for the purpose of business or profession to be eligible. Full-year usage is not necessary; even partial or seasonal use qualifies. If used partly for non-business purposes, depreciation must be apportioned proportionally as per Section 38 of the Income Tax Act.

Documentation Requirements for Depreciation Claims

• Proof of ownership (purchase invoice, lease deed, loan agreement)
• Date of acquisition and use
• Asset classification and depreciation rate applied
• Fixed asset register or accounting records
• Usage evidence for business (e.g., logbooks for vehicles).

Impact of Lease vs. Ownership on Depreciation Claims

• Owned Assets: Eligible for depreciation. The asset must appear on the balance sheet.
• Finance Lease: Lessee may claim depreciation if the asset is capitalised (as per AS-19).
• Operating Lease or Hire Agreements: Lessee cannot claim depreciation; the lessor retains ownership and claims it.
• Constructed Assets on Leased Land: If the assessee builds a structure, even on someone else’s land, depreciation on the structure can be claimed.

Depreciation is only allowed on capital assets, not land or goodwill. Also, depreciation under the Income Tax Act takes precedence over the Companies Act for tax purposes.

Depreciation on Assets Sold During the Year

If an asset is sold, discarded, demolished, or destroyed in the same year it is acquired, no depreciation is allowed. Depreciation is only applicable for assets that are used during the year. This rule prevents immediate write-offs and ensures assets are actually utilized before claiming deductions.

Depreciation in Case of Co-Ownership

When an asset is co-owned, each co-owner can claim depreciation in proportion to their share of ownership, provided the asset is used in their respective businesses. Ownership and business use must both be established. This allows equitable tax benefits among co-owners of jointly held property or equipment.

Special Considerations for Depreciation

Depreciation under the Companies Act, 1956

• Depreciation was calculated based on asset cost and residual value.
• The method allowed higher initial deductions, impacting taxable income.

Depreciation under the Companies Act, 2013

• Focuses on useful life and residual value rather than specific rates.
• Aligns with the WDV method, reducing discrepancies in tax calculations.

Treatment of Losses on Sale of Depreciated Assets

• Losses on depreciated asset sales can be adjusted against other business income.
• If the asset was part of a block, the remaining block value is adjusted for the sale proceeds.

Impact of Inflation on Depreciation

• Inflation can impact asset values, affecting depreciation calculations.
• The Income Tax Act does not allow revaluation of assets based on inflation.

Conclusion

Understanding depreciation under the Income Tax Act is vital for effective tax planning and compliance. Accurate calculation and timely claims can significantly reduce taxable income, impacting overall tax liability. Whether you own a business or work as a share market advisory consultant, comprehending the nuances of depreciation can enhance financial planning and optimize tax outcomes. For those new to taxation, understanding what is income tax and how depreciation interacts with it is essential for making informed financial decisions.

FAQs on Depreciation under the Income Tax Act

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