Losses vs depreciation: Companies Bill amendment has corrected a historical distortion

The Companies Act, 1956, contained a bloomer - while past cash losses were to be set off against the current profits so as to be eligible for declaring dividend, no such accounting and financial nicety detained a company when it came to the other species of loss, i.e. past depreciation.

So much so that a company nursing a past cash loss of say Rs 50 crore and past depreciation of Rs 500 crore could declare dividend from the current profit of say Rs 200 crore, provided it set off the cash loss of Rs 50 crore belonging to the past.

A dyed-in-the-wool accountant would not declare dividend in such a scenario because past depreciation still remained to be absorbed. But the Companies Act thought nothing of it. This omission, deliberate or accidental, seeped into the Companies Act, 2013, as well. The Companies (Amendment) Bill 2014 seeks to rectify this historical and historic omission.

The Income tax Act too deserves a share of the blame for this undeserved dichotomous treatment of the two species of losses. It still says while cash loss has to be absorbed within eight years by future profits, unabsorbed depreciation would have a free run, untrammelled by any time limit.

Another indulgence to unabsorbed depreciation shown by the income tax law is while past cash losses can be set off only against future business profits, unabsorbed depreciation can be set off against any income at all i.e. against income from house property, capital gains and income from other sources. One hopes the Finance Minister would rectify this wrong in the budget 2015.

The preferential treatment given to unabsorbed depreciation is clearly skewed in favour of capital intensive companies manufacturing with the help of expensive plant and machineries and gives a short shrift to labour-intensive businesses such as software and IT-enabled service providers such as BPOs which perforce have to employ a large number of employees and invest less in plant and machinery.

The former got indulgence from both the Companies Act and the Income tax Act. Now the former undeserved leg up would stop while the latter would continue until the government intervenes.

Both the laws have been in the wrong. In the example given above, the company would have been guilty of paying dividend out of capital given the fact that it had not yet set off the unabsorbed depreciation of the past against the current profits. This was an unpardonable mistake, the one that would have unwittingly helped many companies pay dividend where none should have paid or lesser amount should have been paid.

The mistake was so grave that it would have had the effect of undermining the creditors who otherwise would have got paid to the extent dividend was paid without complying with the basic tenets of accounting if not of the company law.

The inequity caused by the distorted provision in this regard in the income tax law can be understood with an example. Suppose there are two companies A and B. The first is fully mechanised whereas the second relies more on human resources. Let us say both have past losses. A has unabsorbed depreciation of Rs 500 crore and B cash loss of Rs 500 crore.

In the following year both make a business profit of Rs 100 crore and income from other sources of Rs 500 crore. Company A can set off the entire amount of Rs 500 crore and need to pay tax only on Rs 100 crore whereas B can set off only Rs 100 crore and has to pay tax on Rs 500 crore by way of income from other sources despite its past loss to the tune of Rs 400 crore still remaining to be absorbed.

One hopes Jaitley swings into action on the tax front as well. Cash losses of the past too should get an untrammelled run without any time limit and qualify for set off against future income of all hues.