2.2 Query
Tax treatment of loss on destruction of machinery in fire.
1.A Ltd.’ is a closely held company having its accounting year end on 31st March every year.
2.There occurred a fire in the machinery of ‘A Ltd’ on 14.10.1989 and as a result of the fire, a part of the machinery of the company was gutted. The written down value of the machinery gutted as at the beginning of accounting year was Rs. 15.00 lacs [Cost being Rs. 30.00lacs at the time of installation].
3.The said machinery was insured on replacement value basis. The replacement cost of the machinery gutted is Rs. 70.00 lacs.
4.The company received Rs.70.00 lacs from the insurance company and the whole amount was invested in plant and machinery.
5. The querist has referred the following issues for the opinion of Expert Advisory Committee:
(a) Whether the company is liable to pay any income tax on the income of Rs. 55.00 lacs received through the above transaction. What will be the liability of the company for capital gains and under section 115J of the Income-tax Act, 1961?
(b) What will be the accounting treatment of the above transaction to minimise the tax?
Opinion March 29, 1990 1.The Committee notes subsection (6) of Section 43 of the Income-tax Act, 1961, which states, inter alia: -
“43 (6) “Written down value” means –
(a) …….
(b) …….
(c) in the case of any block of assets,-
(i) in respect of any previous year relevant to the assessment year commencing on the 1st day of April, 1988, the aggregate of the written down values of all the assets falling within that block of assets at the beginning of the previous year and adjusted,-
(A) by the increase by the actual cost of any asset falling within that block, acquired during the previous year;
and
(B) by the reduction of the moneys payable in respect of any asset falling within that block, which is sold or discarded or demolished or destroyed during that previous year together with the amount of scrap value, if any, so, however, that the amount of such reduction does not exceed the written down value as so increased; and
(ii) in respect of any previous year relevant to the assessment year commencing on or after the 1st day of April, 1989, the written down value of that block of assets in the immediately preceding previous year as reduced by the depreciation actually allowed in respect of that block of assets in relation to the said preceding previous year and as further adjusted by the increase or the reduction referred to in item (i)………”.
2.The Committee presumes that since the new machinery purchased is for replacing to old machinery which is gutted in fire, the new machinery purchased and the old machinery gutted in fire will fall in the same block of ‘Machinery and Plant’. Accordingly, the written down value of the block of ‘Machinery and Plant’ should be calculated, for income-tax purposes, as under:
Block-Machinery & Plant
Written down value as on 1.4.1989 ‘X’ + 15.00 lacs (Where ‘X’ is the written down value of machineries other than the machinery gutted in fire)
Add: Machinery acquired during the year 70.00 lacs (Machinery purchased out of insurance claim)
Less: Moneys payable in respect of machinery 70.00 lacs Destroyed during the year (Insurance claim) _______________ Written down value for the purpose of calculating Depreciation for the previous year 1989-90. ‘X’ + 15.00 lacs
_______________
3.In the view of the Committee, the company should calculate depreciation, for income-tax purposes, on the written down value of the block of machinery and plant at the beginning of the year increased by the cost of new machinery purchased and reduced by the moneys received from insurance company. Since the money received from insurance company is equal to the cost of new machinery, there will be no change in depreciation on account of the destruction of machinery and purchase of new machinery.
4.The Committee is also of the view that Rs. 70.00 lacs received by the company from insurance company is a compensation for extinguishment of the machinery and represents the money received in lieu of that machinery and hence amounts to “transfer” under section 2(47) of the Income-tax Act.**
5. The Committee notes section 50 of the Income-tax Act, 1961, which is reproduced below, is relevant at this stage: -
“Special provision for computation of capital gains in case of depreciable assets
50. Notwithstanding anything contained in clause (42A) of section 2, where the capital asset is an asset forming part of a block of assets in respect of which depreciation has been allowed under this Act or under the Indian Income-tax Act, 1922 (11 of 1922), the provisions of sections 48 and 49 shall be subject to the following modifications: -
(1) where the full value of the consideration received or accruing as a result of the transfer of the asset together with the full value of such consideration received or accruing as a result of the transfer of any other capital asset falling within the block of assets during the previous year, exceeds the aggregate of the following amounts, namely:-
(i) expenditure incurred wholly and exclusively in connection with such transfer or transfers;
(ii) the written down value of the block of assets at the beginning of the previous year; and
(iii) the actual cost of any asset falling within the block of assets acquired during the previous year,
such excess shall be deemed to be the capital gains arising from the transfer of short-term capital assets:
(2) where any block of assets ceases to exist as such, for the reason that all the assets in that block are transferred during the previous year, the cost of the acquisition of the block of assets shall be the written down value of the block of assets at the beginning of the previous year, as increased by the actual cost of any asset falling within that block of assets, acquired by the assessee during the previous year and the income received or accruing as a result of such transfer or transfers shall be deemed to be the capital gains arising from the transfer of short-term capital assets.”
6.The Committee is of the view that no capital gains under section 50 of Income-tax Act, 1961 will arise in the instant case.
7. The Committee refrains from giving an opinion on the accounting treatment which will minimise the tax as it falls beyond the scope of functions of the Committee in view of Rule 2 of the Advisory Service Rules. However, the Committee is of the view that the correct accounting treatment would be to recognise the excess of the insurance claim over the book value of the machinery gutted in fire in the profit and loss account. The excess received being an extra-ordinary item, should be disclosed separately in the profit and loss account in a manner that its relative significance and effect on the current operating results of the year can be perceived (para 10 of AS 5 on ‘Prior Period and Extra Ordinary Items and Changes in Accounting Policies’ issued by the Institute of Chartered Accountants of India). 8.The Committee is also of the view that the excess of insurance claim over the book value of the machinery gutted in fire will form part of the book profit under section 115J of the Income-tax Act.
9.The Committee is accordingly of the following opinion in respect of the issues raised by the querist in para 5 of the query:
(a) (i) The company is not liable to pay capital gains tax on the excess of the insurance claim received over the written down value of the machinery gutted in fire. The depreciation under Income-tax Act shall be calculated as suggested in para graphs 2 and 3 above.
(ii) The excess of the insurance claim received over the book value of the machinery gutted in fire will form part of book profit under section 115J of the Income-tax Act.
(b) The Committee refrains from suggesting an accounting treatment which minimizes tax as it falls beyond the scope of functions of the Committee. However, the correct accounting treatment in respect of the above transaction should be as suggested in para 7 above.
_________________________ ** CIT v. J.K. Cotton Spng. & Wvg. Mills Co. Ltd. (1987) 164 ITR 18 (All.) CIT v. Vania Silk Mills P. Ltd., (1977) 107 ITR 300 (Guj.) Mary Bong & Kyel Tea Estates Ltd. v. CIT (1981) 129 ITR 661 (Cal.) Dissenting view in ‘C’ Leo Maclodo v. CIT (1988) 172 ITR 744 (Mad.)
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