Requirement regarding declaration of dividend out of profits arrived at only after providing depreciation ‑ Certain queries answered - Companies Law - No. (10)‑CL‑VI/ 61,

Circular : No. (10) ‑ CL ‑ VI/ 61, dated 27 ‑ 9 ‑ 1961. Subject:- Requirement regarding declaration of dividend out of profits arrived at only after providing depreciation ‑ Certain queries answered Section 205 has been amended by the Companies (Amendment) Act, 1960 requiring companies to provide for minimum depreciation in their profit and loss accounts, in accordance with the norms suggested in that section, before declaring dividend. The views of the Department in regard to the difficulties experienced by company managements in complying with this section have been made known to the chambers of commerce, professional bodies, etc. However, it would appear that some company managements continue to experience difficulties in this regard and the Department s views in regard to the queries raised by them are set out below for information : Query 1: Whether it would be necessary to provide depreciation after the commencement of the Companies (Amendment) Act, 1960 in respect of the entire amount of the original cost as mentioned in sub‑sections (2)(b) and (2)(c) of the above section ? Answer : Any depreciation already provided for in the books, that is the profit and loss account of the financial years prior to the commencement of the Companies (Amendment) Act, 1960, should be taken into account and only the written down value, after deduction of depreciation actually provided in the books in the earlier years, need be depreciated in accordance with section 205(2)(b)/(c). The reference to original cost is only for the purpose of determining the specified period in accordance with section 205(5)(a) and the quantum of annual instalment of depreciation under the straight line method under section 205(2)(b) [or any other method adopted under section 205(2)(c)]. Query 2 : Whether it would be necessary to provide depreciation in respect of immovable property which has been acquired as an investment for the purpose of earning supplementary income and not for the use of the company ? Answer : Since immovable properties, unless they are acquired for resale, represent fixed assets, it would be obligatory to provide for depreciation on such immovable properties in accordance with the provisions of section 205, read with section 350, which contemplates that depreciation should be provided at the rates specified for the asset comprised in the immovable property in question by the Income‑tax Act and the rules framed thereunder. Rates for different classes of buildings and other immovable properties have been prescribed under the Income‑tax Rules and the rates prescribed in these rules have to be adopted for the purpose of providing for depreciation under section 205(2) irrespective of the section of the Income‑tax Act under which income arising from these assets becomes assessable to income‑tax. Query 3 : Whether any company which had adopted the widely used straight line method of providing depreciation in the past is required to change it in view of the provisions of the amended section 205, provided of course that 95 per cent of the original cost of the asset is written off by way of depreciation before the expiry of the specified period ? Answer : Section 205(2)(b) seeks to authorise the use of straight line method of depreciation and no company following this method is obliged to change this, provided the provisions of that section are complied with. The reference in this section to original cost is only for the purpose of determining the quantum of annual instalment of depreciation under the straight line method and the specified period in accordance with section 205(5)(a). Query 4 : Under section 205, it is required that arrears of depreciation should be provided for before any dividend is declared. This may create an anomaly in relation to the provisions of the Income‑tax Act ? Answer : It is expected that depreciation would be provided every year as it is a charge on the revenue of the company and should not be allowed to fall in arrears. Query 5 : Whether it would be open to a company to charge depreciation on straight line method in respect of major fixed assets like plant and machinery, building, etc., while adopting the reducing balance method for fixed assets of a lesser value like motor vehicles, equipment, furniture, fittings, etc. ? Answer : It is permissible to adopt different methods for different types of assets provided the same basis is consistently adopted from year to year in accordance with the provisions of section 205(2). Query 6 : If extra and multiple shift allowance is not claimed by a company for the purpose of income‑tax assessment, whether it would be necessary to take into account such allowances in calculating the specified period? Answer : The real criterion would be whether the assets concerned are used for more than one shift and, if so, the shift allowance will have to be taken into consideration for the purposes of section 205(5)(a) and section 350 and it would be immaterial whether such allowances are claimed by the company for the purpose of its tax assessment. Query 7 : If any asset has already been reduced to 5 per cent or below its original cost, whether any further depreciation would require to be provided in accordance with section 205 before declaring dividend, provided the asset is still in commission. If the written down value is lightly over 5 per cent of the original cost, whether depreciation can be provided under section 205 only to the extent it will bring it down to 5 per cent of its original cost ? Answer : If the straight line method is adopted in accordance with section 205(2)(b), depreciation has to be provided till such time the written down value of the asset is reduced to 5 per cent of its original cost. For the purpose of that section, it would not be statutorily necessary to provide for depreciation in respect of the balance amount of 5 per cent till such time when the asset is sold, discarded, demolished or destroyed. Query 8 : The calculation of depreciation in accordance with section 205(2)(b) would be a strenuous task. Whether it would be adequate if the method is confined to the major assets like plant, machinery, building, etc. ? Answer : It should not be difficult to determine the specified period as prescribed in section 205(5)(a). It is, however, open to a company to choose any of the methods mentioned, namely, the reducing balance method under section 205(2)(b) in respect of any of these fixed assets, subject to the stipulation that once a method is adopted, it must be consistently used in subsequent years. Query 9 : Whether it would be necessary to provide for depreciation in the books of account in respect of assets which are not in use for the whole or part of any financial year ? Answer : Since according to accepted accounting principle, depreciation also arises out of efflux of time, it would be necessary for the purposes of section 205 to provide for depreciation even in respect of assets which are not in use during any financial year, if it proposes to declare to pay dividend for that year. Query 10 : The amendment of section 205 requiring the provision of minimum quantum of depreciation before declaration of dividend would make it difficult for new undertakings to declare dividends even after a number of years after commencing production, as the new company will necessarily take a long time to clear the backlog of arrears of depreciation before it could declare dividend. Answer : From the cases examined in this Department, it would appear that these misgivings have arisen mainly due to the fact that the alternative method of providing for depreciation according to the straight line method under section 205(2)(b) has not been appreciated properly in many cases. The advantage of the straight‑line method is that it evens out the so‑called burden of depreciation on a company and thereby enables it to bear it more easily than what the reducing balance method would ordinarily permit. It is for the managements of the companies, under such expert guidance as they may need to decide for themselves which of these two methods of charging depreciation or any other method, duly approved by the Central Government would serve the basic objects of the provisions of section 205. There is no reason why, if the company s profitability is not below the average obtaining in that particular business or industry, it should not be able to declare adequate dividends after a reasonable period after the commencement of production.