Understanding Carry Forward of Losses:

Introduction  :

It is an inherent feature of a tax system that collects tax on profits but does not provide full relief for losses (i.e. does not pay out an equivalent ‘negative tax’ on negative profits) that provision needs to be made to allow unrelieved losses to be carried over and offset against past and future profits if manifest inequity is to be avoided. A rational system of taxation has
to take due cognizance of losses suffered by a taxpayer. That’s why there are specific provisions for intra-head and inter-head set off and also for carry forward of certain specific items of losses for set off in subsequent years. The operating carry forward of loss is an Income Tax provision for the off-setting of a prior year loss against current profits. The importance of the loss carry forward provision to an assessee is that it preserves valuable cash which otherwise would have to be paid out in taxes. Such funds are retained in the business and can be used for working capital and/or expansion of fixed or other non-current assets.

The process of carry forward of loss is applied only when a loss cannot be set off. For the set off to take place, there has to be inter-source adjustment under the same head of income. If that’s not possible, then it has to go through the inter-head adjustment in the same assessment year. And in case the loss fails to filter through this process, then loss is allowed to carry forward for the subsequent assessment years as per the provisions of the Income Tax Act.

The amount of profit determines what portion of the carry forward will be applied to reduce taxes. The actual tax benefit, when cash is conserved, is in the year of realization, not in the year of the loss. Before any loss is allowed to be carried forward, two conditions have to be satisfied:

1.    Firstly, the return of loss must be submitted on or before the due date and

2.    Secondly such loss has been determined by the Assessing Officer.

The Assessing Officer has to notify the assessee by an order in writing the amount of the loss as computed by him which the assessee is entitled to carry forward. The losses which are eligible to be carried forward must be set off against the income/ profit of the immediately succeeding year and if there is any balance still to be set off, it should be set off in the immediately next succeeding year or years within the time allowed. Where the  losses incurred are not set off against the income/ profits of the immediately succeeding year/ years, as the case may be, they cannot be set off at a later date4. Where the loss return is filed but the acceptance of the loss is not notified, such loss does not get lost for income tax purposes.

The unabsorbed losses must enter the assessment of every ‘following year’ for ascertaining whether they could be set off against the profits and gains of any business, profession or vocation. It is only when it is found in each year that they could not be so absorbed then they are allowed to be carried forward to the next following year and so on. If the loss arising in the previous year was under a head not chargeable to tax, it could not be allowed to be carried forward and absorbed against income in a subsequent year from a taxable source. In such cases, the assessee is not required to show the same in the return.

Nor is the ITO under any obligation to compute or assess it, much less for the purpose of ‘carry forward’ Indian taxation law does not provide for all loses to be carried forward. Only the following losses enjoy this right to carry forward their right under our taxation law:

1. Loss under the head “Income from house property”- Section 71B.

2. Loss under the head “Profits and gains of business or profession”, i.e., loss from

speculative or non-speculative business- Sections 72 and 73.

3. Loss under the head “Capital gains, i.e., short term or long term capital loss- Section

74.

4. Loss from the activity of owning and maintaining race horses- Section 74A.

Carry forward of Business Loss

Loss from a business can be adjusted against income from any other head of income in the same assessment year. However, when the loss is to be carried forward to the subsequent year, it can be adjusted only against business income. Loss can be carried forward and set off only against the business income but not necessarily the same business in which the loss has been incurred. Business profits would also include profits derived from a business activity but assessable under a head other than “Profits and gains of business or profession”. (In some cases income from a business activity is taxable under other heads of income). Business income may be from the same business in which the loss was incurred, or may be any other business. It is impossible to formulate any infallible general rule or test applicable to all cases for determining whether two businesses are separate or whether they constitute one and the same business: the determination of that question depends upon the facts and circumstances of each case. One test which has been frequently invoked in order to determine whether two or more businesses are separate businesses or constitute the same

An interconnection, an interlacing, interdependence between and a unity embracing, the

businesses. The interdependence may be financial; the unity may be unity of management and control. But this principle will not apply where income is derived by the exploitation of a commercial asset. In the case of latter type of income, there is only a difference in the manner of exploitation, that is to say, instead of the user of the asset by the assessee himself, there is a leasing out of the asset. The income derived from such leasing is to be considered to be of the same nature, i.e., business income. Unabsorbed depreciation and losses incurred when the asset was exploited by the assessee himself can be carried forward and set off against the income derived from leasing out the commercial asset. It is the profits of the assessee who incurred the loss against whom the loss can be carried forward and set off subject to following exceptions:

· Accumulated business loss of a demerged company.

· Accumulated business loss of a proprietary concern or a firm when its business is

taken over by a company by satisfying conditions of section 47(xiii)/(xiv).

· Loss of business acquired by inheritance.

Carry forward of depreciation which is not absorbed during the current year, unabsorbed capital expenditure on scientific research and family planning expenditure is governed by section 32(2) and not by section 72.

In some cases income from a business activity may be taxed under other heads also. For example, dividend income is though assessable under the head “other sources”, it may well be treated as business income for purposes of set off of past business losses against such income, if the relevant shares were held as stock in trade and not as investment. However, with effect from the assessment year 2004-05, the dividend income is exempt and hence, there is no question of set off.

Business income is broken up under different heads only for the purpose of computation of total income. By this break up, business income does not cease to be the income of the business. The different heads of income are only the classification prescribed by the Income tax Act for computation of income.

The carried forward loss can be set off against interest earned by placing the excess business funds in short-term deposits with a bank though interest may be chargeable under the head other sources. Usually, the losses can be set off only by the assessee who has incurred loss. But there is an exception to it; where a business carried on by one person, is acquired by another person through inheritance. A loss can be carried forward by the legal heir for the balance number of years for which the assessee could have carried forward the loss. But the unabsorbed depreciation cannot be carried forward by the legal heir as inheritance is not covered under section 32(2)18.

As per section 72(2), the business loss should be set off before setting off unabsorbed

depreciation, etc. Such carried forward business loss will be set off against business head only after the current year’s depreciation, current capital expenditure on scientific research and expenditure on family planning have been claimed. Therefore, the order of set off will be as under:

1. Current year depreciation- section 32(1);

2. Current year capital expenditure on scientific research and current year expenditure

on family planning to the extent allowed;

3. Brought forward business or profession losses- Section 72(1);

4. Unabsorbed depreciation-section 32(2);

5. Unabsorbed capital expenditure on scientific research- section 35(4);

6. Unabsorbed expenditure on family planning- section 36(1)(ix).

According to the proviso to section 72(1), if there is any loss of a business which is

discontinued in the circumstances specified in section 33B19 and it is re-established,

reconstructed or revived by the assessee at any time before the expiry of a period of three years from the end of the previous year in which it was discontinued, then the loss of the previous year in which such business is discontinued including the brought forward loss:

1. Shall be allowed to be set off against the profit and gains, if any, of that business or

any other business carried on by him and assessable for that assessment year; and

2. If the loss cannot be wholly so set off, the amount of balance loss be carried to the

following assessment year and so on for seven assessment years immediately

succeeding provided such reestablished business is continued to be carried by the

assessee.

Continuity of the business is not necessary for the loss to be carried forward by the assessee during the year in which brought forward loss is sought to be set off but it cannot be carried forward for more than eight assessment years. However, there could be situation where a business loss can be carried forward for more than eight assessment years. As per section 41(5), where the business or profession referred to in this section is no longer in existence and there is income chargeable to tax under sub-section (1), sub section (3), sub section (4) or sub section (4A) in respect of that business or profession, any loss, not being a loss sustained in speculation business, which arose in that business or profession during the previous year in which it ceased to exist and which could not be set off against any other income of that previous year shall, so far as may be, be set off against the income chargeable to tax under the sub sections aforesaid.

Since the scope for deducting a business loss is wider, and operates against the totality of the income, section 72(3) limits its operation for only eight assessment years. It is in this context that section 72(2) gives priority to the business loss over the carried forward depreciation Section 33B refers to cases where the business of any industrial undertaking carried on in India is discontinued in any previous year by reason of extensive damage to, or destruction of, any building, machinery, plant or furniture owned by the assessee and used for the purposes of such business as a direct result of flood, typhoon, hurricane, cyclone, earthquake or other convulsion of nature; or riot or civil disturbance; or accidental fire or explosion; or action by an enemy or action taken in combating an enemy. Allowance. Whenever there is a business loss as well as depreciation allowance to be carried forward, effect shall first be given to the business loss as provided under section 72(1).

Carry forward and set off of loss and depreciation- When permissible in the hands of amalgamated and demerged company.

If we see the Budget Speech of the Finance Minister, the Notes on Clauses of the Finance (No. 2) Bill of 1977 and the Memorandum explaining the provisions of the said Bill, it will appear clear that sickness among industrial undertakings was regarded as a matter of grave national concern in as much as closure of any sizeable manufacturing unit in any industry entails social costs in terms of firstly, loss of production, secondly, unemployment and thirdly, waste of valuable capital. At that time, taking over of sick units by the Government was a more viable solution than closure. Further useful was amalgamation of such units with other active units and hence it was felt that a more wiser strategy would be to facilitate amalgamation of sick industrial units with sound ones by providing incentives and removing impediments in the way of such amalgamation. This was done by providing a deeming fiction, where under an amalgamated company, although a successor in interest, was allowed to carry forward and set off accumulated loss and unabsorbed depreciation of the amalgamating company subject to certain conditions.

During the last decade or so, with the advent of foreign companies into the Indian market, competitiveness has grown and as a result there arose a need for the rationalisation of laws regarding the business reorganisation for the restructuring of the production system and better utilisation of resources. One such need was to make demergers (a relatively new phenomenon to the Indian Economy during the nineties) tax neutral. This was required especially where there was a unit or an undertaking which was beyond the managerial skills  Section 72A of the I.T. Act. Of a company and could be put to better use by another company. Thus as a result, it was important that the advantage of carry forward of unabsorbed losses be also given to demergers and amalgamations with the least amount of procedural formalities.

Thus, it was felt that the procedure which was provided was too cumbersome for traditional amalgamations and inadequate for demergers of undertakings. Hence, the section was changed by the Finance Act, 1999 and S. 2(19AA) and S. 2(19AAA) were added to define a ‘demerger’ and a ‘demerged company’ respectively. Further, a need was felt that the benefit of this section also be extended to hotels and to banks and hence an amendment was made in this section by the Finance Act, 2003 and the benefit was extended to hotels as well as banks. Now this will also extend to the business of operation of aircraft with one or more Public Sector Company or companies engaged in similar business with effect from 1.4.2008 by the Finance Act, 2007.

The section has prescribed a definition of accumulated loss and unabsorbed depreciation which would be the subject matter of set off or carry forward in the hands of the business entity resulting out of the reorganisation. This section does not apply to a merger of cooperative societies. Section 72A is an exception to the rule that the depreciation and business loss can be carried forward by a person who has incurred the loss. Section 72A is applicable in the following cases:

1. Amalgamation of companies.

2. Demerger

3. Conversion of a proprietary concern/firm into company.

4. Amalgamation of a banking company with a banking institution.

Amalgamation : S. 72A(7)(a) provides that accumulated loss refers to the loss under the head “Income from Business and Profession” which the entity present prior to the reorganisation would have been entitled to set-off or carry forward u/s 72 had the reorganisation not taken place.  S. 72A(7)(b) provides that unabsorbed depreciation is the depreciation which would have been allowed to the entity present prior to the reorganisation if the reorganisation would not have taken place.

1. Conditions to be followed: The accumulated loss shall be not allowed to be carried

forward if the following conditions are not complied with

a. Amalgamating company

i. Has been engaged in the business, in which the accumulated loss occurred or depreciation remained unabsorbed, for three or more years.

ii. Has held continuously, as on the date of the amalgamation, at least three-fourths of the book value of fixed assets held by it two years prior to the date of the amalgamation

b. Amalgamated Company

i. Holds continuously for a minimum period of five years from the date of amalgamation at least three-fourths of the book value of the fixed assets of the amalgamating company acquired in the scheme of amalgamation.

ii. Continues the business of the amalgamating company for a minimum period of five years from the date of the amalgamation.

iii. Such other conditions as may be prescribed.

2. Amalgamating company owning an industrial undertaking Where a company owns an industrial undertaking as defined by S. 72A(7)(aa), then the conditions to be complied with by the amalgamating company increase. An Industrial Undertaking is defined as an undertaking engaged in

a. The manufacture or processing of goods

b. The manufacture of computer software

c. The business of generation or distribution of electricity or any other form of power

d. The business of telecommunication services (basic or cellular) including radio paging, domestic satellite service, network of trunking, broadband network and internet services.

e. Mining

f. The construction of ships, aircrafts or rail systems

If a company owning such an undertaking undergoes amalgamation, then Rule 9C of the Income Tax Rules provided that the amalgamated company will have to further comply with the following conditions.

i. A level of production of at least 50 percent of the installed capacity27 shall be obtained before the end of four year from the date of amalgamation and the said minimum level of production shall be maintained till the end of five years from the date of the amalgamation. This requirement may be relaxed by the Central Government, with respect to the time period as well as the level of production, having regard to the genuine efforts and circumstances preventing such efforts made by the amalgamated company, so shown by means of an application.

ii. A certificate verified by an accountant in Form No. 62 along with other documents showing particulars of production, the return of income for the year in which the prescribed level of production is achieved and for subsequent assessment years relevant to the previous years falling within five years from the date of amalgamation.

3. Company owning a ship or a hotel A company owning a ship or a hotel undergoing an amalgamation with another company fulfilling the conditions enlisted by S. 72A(2) would be entitled to claim benefit of this section.

4. Banking Company merging with Specified Bank Where a Banking Company undergoes a merger with a ‘specified bank’31 and complies with the conditions abovementioned, then it can claim benefit of the Section.  This term refers to the capacity of production as on the date of the amalgamation., See explanation (a) to Rule 9C. Explanation (b) to Rule 9C refers to S. 288(2) of the Income Tax Act which refers to the term “accountant” to mean a Chartered Accountant within the meaning of the Chartered Accountants Act, 1949 and also includes any person entitled to be appointed to act as an auditor of companies under S. 226(2) of the Companies Act, 1956

5. Result of compliance with the Section As result of the compliance with the conditions mentioned, the accumulated loss and unabsorbed depreciation of the amalgamating company will be treated as the accumulated loss and the unabsorbed depreciation of the amalgamated company for the previous year in which the amalgamation was effected and other provisions regarding set-off and carry forward shall apply accordingly. Here it must be noted that S. 72(3) of the Act provides that losses cannot be carried forward for more than 8 assessment years immediately succeeding the assessment year for which this loss was first computed. But the wording of S. 72A and the presence of a non-obstante clause gives an impression that the period of eight years for the losses deemed to be of the amalgamated company shall start afresh.

6. Result of Non-compliance Where any of the conditions so specified are not complied with, then the set-off of loss or the unabsorbed depreciation made in any previous year in the hands of the amalgamated company shall be deemed to be the income of the amalgamated company in the year in which such default takes place.

2. Demerger of an Undertaking of the Company

Conditions to be followed during demerger:

· all property of the undertaking gets transferred to the resulting company

· all liabilities relating to the undertaking become the liabilities of the resulting company

· the transfer of the liabilities and the properties above is done at values appearing in the books of the demerged company

· the resulting company must issue shares to the shareholders of the demerged company as a result of the transfer of the undertaking.

· The shareholders holding not less than three-fourths in value of the shares of the demerged company (other than such shareholder who are nominees of the resulting company or it’s subsidiary) become shareholders of the resulting company otherwise than as a result of the acquisition of property or assets of the demerged company by the resulting company

· The undertaking is on a going concern basis

· The demerger is in accordance with the conditions specified by the central government.

i. Where loss and unabsorbed depreciation can be identified with the undertaking(s) transferred In such as case, the loss and unabsorbed depreciation shall be allowed to be carried forward and set-off in the hands of the resulting company.

ii. Where loss or unabsorbed depreciation not identifiable with undertaking transferred In such a case, the loss and unabsorbed depreciation shall be apportioned on the basis of the proportion of the assets of the  undertakings transferred and shall be allowed to be carried forward and set-off in the hands of the resulting company.

3. Succession of a Proprietary Concern by a Company

Where there has been a reorganisation of business in such a manner that a proprietary concern is succeeded by a company, then the losses and unabsorbed depreciation allowance of the concern can be deemed to be loss and depreciation allowance of the successor company for the previous year in which such succession occurs only if such as succession is not a transfer for the purposes of Capital Gains Taxation i.e. it falls under S. 47 (xiv).

The conditions provided under that sections are as follows:

1. The sole proprietor transfers all buildings, plant and machinery and furniture or other intangible assets to the company.

2. All assets and liabilities of the concern relating to the business are transferred to the company.

3. The shareholding of the sole proprietor is not less then 50% of the voting capital and that he retains such shareholding for a period of 5 years from the date of succession.

4. The sole proprietor does not receive any direct or indirect benefit for this transfer other than shares in the successor company.

If the above conditions are not complied with, then the set-off of loss or the unabsorbed

depreciation allowance shall be treated as income in the hands of the successor company for the year in which such conditions are not complied with.

4. Succession of Partnership Firm by a Company

Where there has been a reorganisation of business in such a manner that a partnership firm is succeeded by a company, then the losses and unabsorbed depreciation allowance of the firm can be deemed to be loss and depreciation allowance of the successor company for the previous year in which such succession occurs only if such as succession is not a transfer for the purposes of Capital Gains Taxation i.e. it falls under S. 47 (xiii).

The conditions provided under that sections are as follows:

1. All assets and liabilities of the firm immediately before the succession are transferred to the company.

2. All partners of the firm immediately before the succession become the shareholders of the company in the same proportion in which their capital accounts stood in the books of the firm on the date of the succession.

3. The aggregate of the shareholding of the partners in the company is not less then 50% of the voting capital and that he retains such shareholding for a period of 5 years from the date of succession.

4. The partners do not receive any direct or indirect benefit for this transfer other than shares in the successor company.

If the above conditions are not complied with, then the set-off of loss or the unabsorbed

depreciation allowance shall be treated as income in the hands of the successor company for the year in which such conditions are not complied with.

Carry forward and set off of losses of a banking company against the profit of a banking institution under a scheme of amalgamation

There have been some mergers amongst banks which have come about as a result of implementation of schemes formulate and sanctioned by the Central Government under S. 45(7) of the Banking Regulation Act, 1949. For these purpose, amendments were brought about by Finance Act, 2005 by inserting S. 47(viaa), S. 72AA and also amending s. 49(1)(iii)(e).

Following conditions should be satisfied for section 72AA to be applicable:

1. There is an amalgamation of a banking company with any other banking institution. Banking company for this purpose means a company which transacts the business of banking in India. A manufacturing or trading company which accepts deposits of money from the public merely for the purpose of financing its business shall not be deemed to transact the business of banking. A banking institution for this purpose means any banking company and includes State Bank of India or a scheduled bank.

2. The amalgamation is sanctioned and brought into force by the Central Government under section 45(7) of the Banking Regulation Act, 1949.

3. The provisions of section 2(1B)(i)/(ii)/(iii) may or may not be satisfied.

4. The provisions of section 72A may or may not be satisfied.

If the above conditions are satisfied, the accumulated loss and unabsorbed depreciation of the amalgamating banking company shall be deemed to be the loss or the allowance for depreciation of the banking institution for the previous year in which the scheme for

amalgamation is brought into force.

By the Finance Act, 2007 section 72AB has been inserted after section 72AA which deals with the carry forward and set off of accumulated loss and unabsorbed depreciation allowance in business reorganization of cooperative banks. This section will come into force from 1.4.2008.

Carry forward and set off of Speculation Loss.

Where speculative transactions carried on by an assessee are of such a nature as to constitute a business, the business shall be deemed to be distinct and separate from any other business. Speculative transaction means a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled, otherwise than by the actual delivery or transfer of the commodity or scrips.

Section 73 of the Income Tax Act provides that any loss computed in respect of speculation business carried on by an assessee will not be set off except against the profits and gains, if any, of another speculation business. Further, where any loss, computed in respect of a speculation business for an assessment year is not wholly set off in the above manner in the said year, the excess shall be allowed to be carried forward to the following assessment year and set off against the speculation profits, if any, in that year, and so on. Explanation to section 73 provides that the business of purchase and sale of shares by companies which are not investment or banking companies or companies carrying on business of granting loans or advances will be treated on the same footing as a speculation business. Thus, in the case of aforesaid companies, the losses from share dealings will now be set off only against profits or gains of a speculation business. Where any such loss for an assessment year is not wholly set off against profits from a speculation business, the excess will carried forward to the following assessment year and set against profits, if any, from any speculation business.

The object of section 73 is to curb the device sometimes restored to by business houses controlling groups of companies to manipulate and reduce the taxable income of companies under their control.

The Explanation to section 73 is applicable only when the purchase and sale of shares is settled through delivery as where the delivery is not taken it is otherwise a speculation

business. This explanation applies only to a company but shall not apply to the investment companies and a company whose principal business is of banking or granting of loans/advances. The word ‘any part’ given in the explanation cannot be said to be used in a restrictive sense so as not to include the whole. The explanation is attracted even where the entire business of the company was in share dealing. The explanation does not require that both sale and purchase should take place in the same year. All that the explanation requires is that the business of the company consists of the sale and purchase of shares. Explanation to section 73 has no application in the course of purchase and sale of securities since it applied only to company shares. This rule will be applicable even if there is no avoidance of tax by the assessee.

Loss in a speculation business can be carried forward to the subsequent year and set off only against the profits of a speculation business carried on that year. Such loss can be carried forward for four assessment years41, immediately succeeding the assessment year for which the loss was first computed. Continuity of the speculation business in which the loss was incurred is not necessary for it to be carried forward but the assessee should be the same.

Return of loss should be submitted in time.

Loss in a speculative transaction entered into on behalf of principal, is non-speculative loss of agent. Income from forward transactions entered into on behalf of constituents is not income from speculation business carried on by the assessee. Where a loss arises from illegal speculative business, it cannot be carried forward to the subsequent years for set off against the profits of same speculative business or any other speculative business carried by the assessee44.

The loss in speculation may also include the loss on account of bad debts, irrecoverable profits and interest on borrowings. Loss from derivative trading shall be treated as loss from non-speculative business, if transaction of derivatives is done through NSE or BSE.

Concluding Remarks

The Indian Income Tax law is a highly complicated and confusing document. For the common man the task of understanding the procedure and provisions of law is daunting, to say the least. Not only is the process of tax calculation very difficult, its practical implementation is tedious and cumbersome. However, under the law, the taxpayer is legitimately entitled to plan his taxes in such a manner that his tax liability is minimal. Tax provisions about setting off losses are, indeed, a bit complex. One needs to file income tax returns within the due date for availing the benefit of losses to reduce future tax liability. Adjustment or carry forward of loss is not an inherent right. One requires specific provision in the Act permitting such right. But, once such a right is available, an assessee cannot, by choice, forego it in one year and choose to exercise it in the second year, when he expects a much higher income.

The provisions of the Income Tax have a direct bearing on the citizens of the country. In

fact its not just the citizens but all those who come with in the ambit of the term ‘assessee’ are bound to comply with provisions of the Act. In the case of a non-resident, his foreign  income is not included in his total income which is to be computed subject to the provisions of section 73. If the total income is loss, it has to be carried forward subject to the provisions of section 73(2) and cannot be set off against any income which does not form part of the total income. Otherwise, a non-resident would not get any relief in Indian taxation on account of the loss incurred by him in India.

The assessee is bound to make a clear and unambiguous statement of his income to the concerned income tax official. Thereupon the assessment function, as prescribed under the Act, follows whereupon the determination of the tax liability is computed on the basis of the return filed or on other basis (if the Act so provides and entails the circumstance for such purposes). Thus one finds that the assessment function forms the bulk of the procedural aspect of the Income Tax law. Further, it is important to note that since filing of return is compulsory (Section 139), the provisions are compulsorily to be abided by all the assessee.