PROFIT AND GAINS FROM

BUSINESS
1.0: HEADS OF INCOME
Section‐14 of Income‐tax Act 1961 provides for the computation of total income of an assessee which is
divided
under five heads of income. Each head of income has its own method of computation. These five heads
are:
1. Income from ‘Salaries’;
2. Income from House Property’;
3. Income from ‘Profits and Gains of Business or Profession’;
4. Income from ‘Capital Gains’; and
5. Income from ‘Other Sources’
Income from all these heads shall be computed separately according to the provisions given in the
Income Tax Act. Income computed under these heads shall be aggregated after adjusting past and present
losses and the total so arrived at is known as ‘Gross Total Income’. Out of Gross Total Income, Income‐
tax Act 1961 allows certain deductions under section 80. After allowing these deductions the figure which
we arrive at is called ‘Total Income’ and on this figure tax liability is computed at the prescribed rates.
Income from one source of Income, which is to be included in a particular head, cannot be included in
any other head. Each head of income has its own deductions. After computing income from various
sources of income within a particular head its own deductions are allowed and thus, we arrive at income
from that head.

1.1: INCOME FROM BUSINESS

This chapter intends to explain one of the most important and complex heads of income in simple
terms beginning from the basic concepts of business, profession, vocation, trade, commerce, manufacture. It
also covers the computation of taxable profit and gains of business and profession, various general and
specific deductions including depreciation allowable and items not allowed as deduction to the extent
contained in Sections 28 to 43B. “Business” simply means any economic activity carried on for
earning profits.
DEFINITION OF BUSINESS SECTION 2(13)
Business is defined in Sec. 2 (13) in an inclusive definition that “Business includes any trade,
commerce,
manufacture or any adventure or concern in the nature of trade, commerce or manufacture”.

Certain terms used in the definition can be understood as follows:

1. Trade: is the activity of activity of buying and selling, or exchanging, goods and/or services an
object of making profit.
2. Commerce: is primarily concerned with two main types of activities: (1) Trade, and (2) Aids to
Trade. Aids to trade are those activities that facilitate buying and selling of goods, this includes
transport, insurance, warehousing, banking and technology etc.
3. Manufacture: is said to have taken place when as a result of certain process(es) applied on a
product, a new and commercially different product comes into existence which is known to the
market as different from the raw material.
4. Adventure: A single isolated transaction outside the assessee’s line of business may constitute
adventure in nature of trade and commerce. The phrase “adventure in the nature of trade,
commerce or manufacture” indicates that business or profession need not be organized, systematic
or regular. Example of adventure is as follows:
If there is a temporary suspension of business with the object of tiding over the crisis condition and during such period the
machinery, there to use in the business, is leased out then the rental income there from is to be identified as ‘Business income'. CIT
vs. Vikram Cotton Mills Ltd 169 ITR 597 (SC) and CEPT vs. Shri Lakshmi Silk Mills Ltd., 20 ITR 451 (SC).
On the other hand, lease of factory after assessee stopped business with no intention of reviving the business will amount to
earning lease rental as 'income from other sources’ Universal Plast Ltd. vs. CIT, 237 ITR 454 (SC).

1.2: ESSENTIAL FEATURES OF A BUSINESS

 1. Regularity of transactions or continuity of activities: In this connection it is not necessary that
there should be a series of transactions in a business and also it should be carried on
permanently. Neither repetition nor continuity of similar transactions is necessary single act may be
treated as the business or profession.
For Example, when a land was purchased developed and subdivided in smaller plots for resale
was held as an adventure in the nature of trade or commerce or manufacture.
2. Business may be legal or illegal, organized or unorganized, regular or occasional, and may or
may not require the personal talents or skill. It will nevertheless be business and attract tax
liability. For instance, judicially, smuggling was held to be a business.

3. Objective of earning profits: Thus, business is any activity carried out with the intention to earn
profit, whether such an activity is continuous or temporary is immaterial.

1.3 SCOPE OF INCOME FROM BUSINESS

What can be considered as Business Income?
Section 28 defines the scope of business income and following income shall be chargeable to income‐tax
under the head “Profits and gains of business or profession.

1. Any income earned from any trade/commerce/manufacture/adventure carried on by assessee at

any time during previous year shall be chargeable under this head of income after deducting
specified expenses.
2. Profit from speculation business should be kept separate from business income and shown
separately. Speculative transactions are defined to be the transactions settled by payment of difference in
price of goods or securities and not by actual delivery.
3. Export incentives: A government providing export incentives often does so in order to keep
domestic products competitive in the global market. Therefore, export incentives such cash
assistance, duty drawback and Duty Entitlement Pass Book Benefit etc. is considered as
income from business.
4. Profits on sale of import license: By virtue of holding the Import Entitlement (Special Import
License or Advance License), an exporter becomes entitled to make imports itself. Alternatively, he
can also sell Import Entitlement in the market and earn a profit therefrom.
5. Income derived by a trade, professional or similar association from specific services performed for
its members.
6. Value of any benefit or perquisites like gifts whether in cash or kind received by business
owners
7. Any sum received or receivable, in cash or in kind, under an agreement, for Non-competition
and Exclusivity.
8. Amount recovered on account of bad debts allowed in the earlier years.

1.4 GUIDELINES FOR COMPUTING INCOME FROM BUSINESS

Business income is the aggregate income from all the sources specified in Sec 28 in respect of a business
carried on by the assessee in the relevant previous year as reduced by the expenses and deductions laid
down in S. 30 to 44D. On a collective reading of the two sections, following characteristics and
conditions are essential:
1. There must be a business, such business or profession must be carried on by the assessee. The
business must be carried out during the previous year.
2. If a business or profession is closed down the expenses cannot be deducted.
3. Expenses will be allowed as a deduction from gross receipts only if they have been incurred in
the relevant previous year.
4. Expenses incurred before setting of the business will not be allowed except where specifically
provided by law.
5. Taxable business profit is computed by deducting expenses incurred for earning the income,
from the gross income or gross receipts or gross sales subject to modifications given in Section
30 to 44D.
1.5 FORMAT FOR COMPUTING INCOME FROM BUSINESS
Why calculate income from business, when net profit is available in profit and loss account?
Even though a business concern prepares profit and loss account to determine the profit or loss made
by the business, such profit or loss cannot be considered for calculating tax on Income from Business
on account of various reasons.
1. The profit & loss account may be prepared in a manner that benefits the business. For instance, most
the business concerns create reserves and needless provisions so as reduce business profit and
thereby decrease the tax liability.

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 2. Some sole proprietors may debit expenses that may not be related to business with an intension
of lowering profits to save tax.
3. A business may also show higher profits by inflating incomes and also recording incomes that
may not be connected with business. This is done to convince banks in order to get loans.
4. At times accounting rules and income tax rules are not compatible, an expense allowed as per
accounting laws may not be allowed as per income act.
Keeping all these factors in mind a reconciliated statement of income should be prepared in order
to determine income from business as per the provision of income tax act. The format of preparing
income from business as per income tax act is as follows:
PARTICULARS AMOUNT
I : Net Profit or Loss as per P&L account XXX
II : ADD → Transactions that reduces profits
1. Inadmissible Expenses: (Not allowed but Debited to Profit and Loss
account)
2. Admissible Incomes: (Allowed but not Credited to Profit and Loss account)
3. Over valuation of opening Stock
4. Under valuation of closing Stock
Total XXX
III: LESS → Transactions that increases profits
1. Admissible Expenses: (Allowed but not Debited to Profit and Loss account)
2. Inadmissible Incomes: (Not allowed but Credited to Profit and Loss
account)
3. Under valuation of opening Stock
4. Over valuation of closing Stock
Total XXX
Taxable Income from Business[I+II-III] XXX

Particulars Description Location Treatment

These are expenses which are
Inadmissible Debit side of It should be added to
1 not
Expenses P & L a/c net profit or loss.
related to business or not
allowed as per the provision
of IT Act.
These are income that are related
Admissible It should be added to
2 to Adjustments
Income net profit or loss.
business or incomes allowed as per
the provision of IT Act.
These all business-related expenses
Admissible It should be deducted net
3 or expenses allowed as per the Adjustments
expenses profit or loss.
provisions of IT Act.
These are Incomes that are not
Inadmissible Credit side It should be deducted from
4 related to business or not
Income of P&L a/c net profit or loss.
allowed as per the provision
of IT Act

1.6 PROVISIONS RELATED TO ADMISSIBLE & INADMISSIBLE INCOMES & EXPENSES

A key challenge while calculating income from business is to classify incomes and expenses that are
connected with business and also incomes and expenses that are not connected to business. For this
purpose, we apply a common assumption i.e. any expense incurred in the course of business operations
(Trade, Commerce, Manufacture or Adventure) is regarded as business expense. In addition to this we
should also remember certain specific expenses that are allowed as per income tax act that may not be
directly connected with business. Same concept also holds good for incomes, income derived by means of
business operations Trade, Commerce, Manufacture or Adventure) is regarded as business income. In
addition to this we should also remember certain specific incomes that are allowed as per income tax act
that may not be directly connected with business. The following provision (Section 30 to 43D) gives us
knowledge about various admissible and inadmissible Income and expenses:
 1. General rules for deducting an expense: Any expense is admissible or allowed provided:
a. The expense should not be in the nature of capital receipt
b. Expense should be related to business and not personal
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 c. Business expenses are allowed only if it is paid, outstanding expenses are not allowed
d. Expenditure relating to a discontinued business is allowed
e. Reserves, provisions and anticipated losses or contingent liabilities are not allowed. However,
if a portion of reserve or provision is utilized. The amount utilized is admissible.

2. Capital expenditure: Expenses incurred in purchasing, extending and renovating an asset is called
capital expenditure. This also includes the cost of the asset. As per the provision of income tax act
capital expenditure is inadmissible. However, depreciation on capital expenditure can be charged as
per section 32.

3. Depreciation: Under Section 32 depreciation on assets is allowed as deduction while computing

income from business or profession. Provided assessee owns the asset and asset must be used
for the business. Further deprecation should be charged as per the rates prescribe under the
act and deprecation is chargeable on Block value of the asset.
Block of asset: As per section 2 (11) the term block of asset means a group of assets falling within
a class of assets. Assets can be categorized as a block if they have same rate of depreciation or If
they are of same nature. For example, Tangible assets, being building, machinery, plant or furniture.
Intangible assets, being know–how, patents, copyright, trade mark, license, franchises or any other
business or commercial of similar nature.
Steps in calculating deprecation as per section 32:
a. Consider total W.D.V. of assets falling in a particular block of assets at the beginning of the
year.
b. Add cost of assets purchased during the previous year.
c. Deduct Sale Price (or Scrap value) of asset sold, discarded, demolished or destroyed during
the year.
d. On the balance amount i.e. a+b-c, calculate depreciation at the given rate. If WDV
becomes negative, no depreciation is allowed. If all assets in the block are sold depreciation
is not allowed even if block has any balance WDV.
e. Note: If a newly asset acquired is used for less than 180 days’ depreciation is restricted to
half
(50%) of normal depreciation.
f. The rates of depreciation are as follows:
 Furniture 10%
 Land & Building 10%
 Motor Cars 15%
 Intangible asset 25%
 Computer including computer software 40%
 Plant & Machinery 15%
Guidelines for charging depreciation while computing income from business:
Situation I Situation II
If deprecation is given in P&L account and no If deprecation is given in P&L account and
information is given about deprecation in deprecation amount as per IT act is also
Adjustment stated in
the adjustment.
TREATMENT
In such case the depreciation given in In such case the depreciation given in P&L
P&L account would consider as per IT act account would be considered as inadmissible
and therefore no treatment is needed. & it should be added to net profit.
Depreciation as per IT act given in the
adjustment should be deducted from
net profit.
4. Preliminary expenses: Preliminary expenses are those expenses which are incurred in business
before incorporation and commencement of business and also include expenses incurred expansion
of existing business. As per section 35D preliminary expenses are allowable as deduction in 5
equal annual installments. Following preliminary expenditure are eligible for deduction:
a. Preparation of project report
b. Market and other survey cost
 c. Share issue expenditure e.g. underwriting commission, brokerage, etc.
d. Registration fee under any Act
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5. Interest on borrowed capital: Interest on loan availed by an assessee for the purpose of
business is allowed as deduction. Further any expense incurred for borrowing (e.g. brokerage paid)
is also allowed. However, interest paid by an assessee to himself on his capital is
inadmissible.

6. Contribution to certain funds for employee welfare: Any sum paid by the assessee as an
employer by way of contribution towards pension scheme, recognized Provident fund or an
approved super annuation fund, approved Gratuity Fund is an admissible expense. Contribution
of employer will be allowed as deduction when such contribution is deposited with competent
authority on or before the due date. Any contribution made towards unapproved gratuity fund,
unrecognized provident fund and staff welfare fund is not allowed. Note- staff welfare
expenses are allowed.

7. Payments to certain persons which are unreasonable or excessive: Any payment is made by
assessee to his relatives is allowed. However, if the opinion of assessing officer such payment is
excessive or unreasonable then to the extent it is unreasonable will be disallowed. In other
words, payment made to relative associated with assessee’s business is admissible provided it
should not be more that the market rate.

8. Deduction of tax paid: All direct taxes are inadmissible (Income tax, Wealth tax, Gift, Property tax
etc.). All indirect taxes (Custom tax, GST, Service tax, VAT etc.,) are allowed provided they are paid
on or before due date. Any penalty or fine paid due to late payment of tax is not allowed. Income
tax appeal expense, municipal tax of business premises and professional tax is allowed.

9. Payments exceeding Rs. 10,000 made by cash: If assessee incurs any business expenditure
exceeding Rs. 10,000 and if such payment is made by cash or bearer cheque it shall be
disallowed to the extent of 100%. To claim deduction, the payment exceeding Rs.10,000 should be
made through a crossed cheque or a draft.

10.Advertisement expenses: Advertisement expense is allowed as it is incurred in normal course

of business. However, if the advertisement expenses are in the nature of capital receipt it is not
allowed, for example purchase of sign boards etc. Further any advertisement expenses incurred due
to advertisement made in the broachers of political parties is not allowed.

11.Bad debts: Deduction is allowed on this account if debts have arisen out of business transaction.
It is the responsibility of the assessee to prove to the satisfaction of income tax officer that such
debts are irrecoverable. If bad debts are recovered in any of the following years, it is considered
as a business income and following treatment is needed:
a. If not written off earlier: To be treated as inadmissible income and therefore deduct from net
profit.
b. If written off earlier: Admissible income and no treatment required.
c. Partly written off earlier: Amount not written off is in admissible and therefore deduct from net
profit.
d. If no information is available in the question on writing off bad debts it will be treated as
inadmissible income and therefore deduct from net profit.

12.Valuation of stock: Valuation of Inventory should be done at cost price or market price, whichever
is lower. This aspect is equally applicable for accounting purposes as well as for tax purposes. The
following treatment should be followed in case of under or valuation of stock while calculating
income from business:
a. Over valuation of opening Stock: This increases the debit side (expenses), thereby reducing
profit. Hence amount of over valuation should be added back to net profit.
b. Under valuation of closing Stock: This decreases the credit side (incomes), thereby reducing
profit. Hence amount of under valuation should be added back to net profit.
c. Under valuation of opening Stock: This decreases the debit side (expenses), thereby
increasing profit. Hence amount of under valuation should be deducted from net profit.
 d. Over valuation of closing Stock: This increases the credit side (incomes), thereby increasing
profit. Hence amount of over valuation should be deducted from net profit.
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 e. Following equation can be used for determining the amount under or over valuation of stock.
I. Amount of over valuation = [Amount of stock × % of over valuation] ÷ [100 + %
of over valuation]
II. Amount of under valuation = [Amount of stock × % of under valuation] ÷ [100 ̶ % of
over valuation]

13.Non-Business Incomes: Non business incomes which are not from business operations (Trade,
Commerce, Manufacture or Adventure) or they are incomes which are not mentioned in Section 28,
non- business incomes are inadmissible. Some of the common non- business (inadmissible)
incomes are discussed below:
a. Income from Investment: If a business invests any money in securities, bank deposits,
savings account or any other avenue of investments and earns returns by way of interest or
dividend etc. such earning from investment is taxable under the head other sources.
b. Profit or Loss from sale investments or fixed assets: Any Profit made from sale of investment
or other fixed assets is taxable under the head income from capital gains. If there is any loss
from sale of investment or fixed asset is chargeable under the head capital gain.
c. Rent from house property is taxable under the head Income from House Property. However,
rent received from employees is a business income.
d. Following exempted incomes are not chargeable to tax under any head:
I. Income from agriculture in India
II. Share of profit from HUF and partnership firm
III. Dividend from Indian company
IV. Money received on maturity of insurance policy

14.General Expenditure for the purpose of business or profession: As Section 37 any other
expenditure not covered by section 30 to 36 which is of revenue nature will be allowed as
deduction provided it is incurred exclusively for the purpose of business or profession.
a. Rent, rates, taxes, repairs & insurance of business premises
b. Embezzlement of cash and loss due theft or fire in normal course of business
c. Expenses on local festival such as Diwali, Muhurt etc.
d. Lawful expenses related to illegal business
e. Insurance premium on employees and assets of business is admissible

15.Specific expenses not deductible: Under section 37 the following expenses are inadmissible
a. Donations and charities
b. Gifts to relatives
c. Fines and penalties for breach of any laws
d. Personal Drawings and salary to owner or claiming rent for own property
e. Any payment in connection with business paid outside India without deducting tax at
source (TDS).

16.Method of accounting and audit: Starting point of computation is the business profits
computed in accordance with method of accounting regularly employed by the assessee. There are
two main methods of accounting—mercantile system and cash system.
a. Mercantile system: Under the mercantile system of accounting, all the income and expenses
are recorded on accrual basis. Actual receipt of incomes or actual payment of expenses during
the year is not necessary. Net profit or loss is computed after considering all income and
expenses, whether or not actually received or paid during the accounting period.
b. Cash system: Under the cash system of accounting, a record is kept of actual receipts and
actual payments of a particular year. Net profit under the cash system will be equal to difference
of incomes received and expenses paid during the accounting year whether such receipts and
payments relate to the previous year or some other year or years.
Actual position: According to section 145 the recording can be under either of the two
systems so it cannot be that there can be both the systems adopted according to the
convenience of the tax payer when it comes to income under the heads ‘Profits and Gains of
business or profession. There was yet
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another accounting system followed by the asssessee before the enactment of
section 145 in the assessment year 1997-98, called the hybrid system.
Is it compulsory to get the books audited?
(i) Every person carrying on business shall get his accounts audited if the
total sales, turnover or gross receipts in business exceed 1 Crore in the
previous year. (ii) Every person carrying on profession shall get his accounts
audited if his gross receipts exceed Rs 15 lakhs in the previous year.