Unit 3: Carry Forward and Set-off of Losses - Subjective Questions

Set-off of loss means adjusting a loss from one source or head of income against taxable income from another source or head during the same assessment year.

Carry forward of loss means carrying an unabsorbed loss to subsequent assessment years when it cannot be fully set off in the year in which it is incurred.

Distinction:

• Time of adjustment: Set-off ordinarily takes place in the current year, whereas carry forward permits adjustment in a future year.
• Order: Intra-head and inter-head set-off are considered before a loss is carried forward.
• Return requirement: Most losses can be carried forward only if the loss return is filed within the time prescribed under Section 139(1), subject to statutory exceptions.
• Time limit: Different carried-forward losses have different periods of eligibility. For example, normal business loss can generally be carried forward for eight assessment years.
• Permitted adjustment: A carried-forward loss can be adjusted only against the income specified for that category of loss.

Thus, set-off provides immediate relief, while carry forward preserves eligible unabsorbed losses for future adjustment.

Under Section 70, a company may generally set off a loss from one source against income from another source falling under the same head of income during the same assessment year. This is called intra-head set-off.

Examples:

• Loss from one non-speculative business may be set off against profit from another non-speculative business.
• Loss from one house property may be adjusted against income from another house property.
• Short-term capital loss may be adjusted against short-term or long-term capital gains.
• Long-term capital loss may be adjusted only against long-term capital gains.

Important restrictions:

• Speculation business loss is governed by Section 73 and cannot be set off against normal business profit.
• Loss from a specified business under Section 35AD is subject to Section 73A.
• Capital loss cannot be adjusted against income under another head.
• Loss from owning and maintaining racehorses is subject to separate rules.
• Loss from an exempt source cannot ordinarily be adjusted against taxable income.

Intra-head set-off is therefore available only after applying the specific restrictions attached to each type of loss.

Inter-head set-off means adjustment of a loss under one head of income against taxable income under another head during the same assessment year.

Under Section 71, the following principles are relevant to a company:

• A normal business loss may generally be set off against income under another head, except income chargeable under the head Salaries. Since a company does not ordinarily earn salary income, this restriction is usually of limited practical relevance to companies.
• A loss under the head Income from house property may be adjusted against income under other heads, subject to the statutory limit applicable for the relevant assessment year. Any balance may be carried forward under Section 71B.
• A capital loss cannot be set off against business income, house-property income, or income from other sources.
• A speculation loss cannot be set off against income from a non-speculation business or another head.
• A loss from a specified business under Section 35AD cannot be set off against normal business income or income under another head.
• Loss from owning and maintaining racehorses can be set off only against income from the same activity.
• Losses that are not permitted to be set off against income taxable under Sections 115BB, 115BBE, or other special provisions remain subject to those restrictions.

Only the amount remaining after permissible intra-head and inter-head adjustments is considered for carry forward.

Section 72 governs the carry forward and set-off of a non-speculative business loss that could not be fully adjusted in the year in which it arose.

Main provisions:

• The loss may be carried forward for a maximum of eight assessment years immediately following the assessment year for which the loss was first computed.
• It may be set off only against profits and gains of a business or profession carried on by the company in the relevant subsequent year.
• The business in which the loss originally arose need not necessarily continue, unless a specific provision imposes a contrary condition.
• A timely return of loss under Section 139(3), read with Section 139(1), is generally required for carrying forward the loss.
• The loss must be determined in pursuance of a return filed in accordance with the Act.
• Current-year depreciation is deducted before setting off brought-forward business loss.
• Brought-forward business loss is generally set off before unabsorbed depreciation.

The usual order is:

1. Current-year depreciation and current-year business adjustments.
2. Brought-forward normal business loss.
3. Unabsorbed depreciation under Section 32(2).

These provisions prevent business losses from being adjusted against unrelated categories of future income.

Brought-forward business loss and unabsorbed depreciation differ in several important respects:

Order of adjustment:

1. Current-year depreciation.
2. Brought-forward business loss.
3. Unabsorbed depreciation.

The distinction is important because unabsorbed depreciation receives more liberal treatment in relation to the period of carry forward and compliance with the due date for filing a return.

A speculation loss is governed by Section 73 and is subject to stricter set-off rules than a normal business loss.

Set-off and carry-forward rules:

• A speculation loss can be set off only against profits from another speculation business.
• The unabsorbed loss may generally be carried forward for four assessment years immediately following the assessment year in which it arose.
• In each subsequent year, it can be adjusted only against speculation profits.
• A timely return of loss is generally necessary for carry forward.

Explanation to Section 73:

Where a company carries on the business of purchasing and selling shares of other companies, that activity may be deemed to be a speculation business to the extent provided by the Explanation, even when actual delivery of shares takes place.

The deeming rule does not apply to specified excluded companies, including, subject to the statutory conditions:

• A company whose gross total income mainly consists of income chargeable under specified non-business heads.
• A company whose principal business is trading in shares.
• A company whose principal business is banking or granting loans and advances.

Transactions in eligible derivatives or eligible commodity derivatives that are excluded from the definition of speculative transaction under Section 43(5) are not treated as speculative merely because they are derivative transactions.

The exact application depends on the company's principal business, composition of gross total income, and the nature of its transactions.

The principal differences are as follows:

Illustration: If a company has normal business profit of and speculation loss of , the speculation loss cannot be adjusted against the normal business profit. The normal business profit remains , while the eligible speculation loss is carried forward for adjustment against future speculation profit.

Section 73A applies to a loss arising from a specified business for which deduction is available under Section 35AD.

Key provisions:

• A loss from a specified business can be set off only against profits and gains of any specified business.
• It cannot be adjusted against profit from a normal business or income under another head.
• If it cannot be fully set off in the current year, the balance may be carried forward to subsequent assessment years.
• The Act does not prescribe an eight-year or four-year ceiling for such loss; it can generally be carried forward indefinitely, subject to the applicable statutory conditions.
• In a subsequent year, the carried-forward loss continues to be adjustable only against profit from a specified business.
• The set-off may generally be made against profit from any eligible specified business and is not necessarily confined to the particular specified business that generated the loss.
• Compliance with the return-filing and determination requirements applicable to losses must be considered.

The ring-fencing of this loss ensures that the substantial investment-linked deduction available under Section 35AD does not reduce ordinary business income or income under unrelated heads.

Capital losses are governed by Section 74 and are classified as short-term capital loss and long-term capital loss.

Short-term capital loss:

• It may be set off against both short-term capital gains and long-term capital gains.

Long-term capital loss:

• It may be set off only against long-term capital gains.
• It cannot be adjusted against short-term capital gains.

Common rules:

• Capital loss cannot be set off against business income, house-property income, or income from other sources.
• An unabsorbed capital loss may be carried forward for eight assessment years immediately following the assessment year in which it was incurred.
• A timely return of loss under Section 139(3), read with Section 139(1), is generally necessary.
• In subsequent years, the loss retains its character as short-term or long-term capital loss.
• Loss from the transfer of an asset whose income is exempt cannot ordinarily be used to reduce taxable capital gains.

Thus, the nature of the capital loss determines the category of gains against which it may be adjusted.

Step 1: Set off the long-term capital loss

Long-term capital loss can be adjusted only against long-term capital gain:

Step 2: Set off the short-term capital loss

Short-term capital loss can be adjusted against both short-term and long-term capital gains. It may first be adjusted against the short-term capital gain:

The remaining short-term capital loss of is then adjusted against the remaining long-term capital gain of :

Result:

• Taxable short-term capital gain: Nil
• Taxable long-term capital gain: Nil
• Short-term capital loss carried forward:
• Long-term capital loss carried forward: Nil

The carried-forward short-term capital loss may be adjusted against eligible short-term or long-term capital gains within the prescribed eight-assessment-year period.

A company owning house property may incur a loss under the head Income from house property, commonly because the deduction for interest on borrowed capital exceeds the property's net annual value.

Treatment of the loss:

• Loss from one house property may be set off against income from another house property under Section 70.
• Current-year house-property loss may be set off against income under other heads under Section 71, subject to the statutory annual limit applicable under the Act.
• The portion that cannot be set off may be carried forward under Section 71B.
• A carried-forward house-property loss can be set off only against income from house property.
• It may be carried forward for eight assessment years immediately following the assessment year in which the loss was incurred.
• Unlike business loss and capital loss, carry forward of house-property loss is generally not denied merely because the return was filed after the due date under Section 139(1), although filing and determination under a valid return remain necessary.

The restriction on future set-off ensures that a brought-forward house-property loss does not reduce the company's business income or capital gains.

A return of loss is a return furnished under Section 139(3) by a taxpayer that has incurred a loss and wishes to carry it forward under the relevant provisions of the Income-tax Act.

Importance for a company:

• The return should generally be filed within the due date prescribed under Section 139(1).
• Under Section 80, specified losses cannot ordinarily be carried forward unless they have been determined in pursuance of a return filed in accordance with Section 139(3).
• This condition is particularly relevant to normal business loss, speculation loss, specified-business loss, capital loss, and loss from owning and maintaining racehorses.
• Filing the return enables the tax authority to determine and record the amount and character of the loss.
• Merely having losses in the books of account does not automatically entitle the company to carry them forward for income-tax purposes.

Important exceptions:

• Unabsorbed depreciation under Section 32(2) is generally not subject to the timely loss-return condition.
• House-property loss under Section 71B may generally be carried forward even where the return was not filed by the due date, subject to a valid return and determination under the Act.

Therefore, timely filing is a significant tax-compliance requirement in corporate loss planning.

Section 79 restricts the carry forward of losses of a company in which the public are not substantially interested when there is a substantial change in its shareholding.

General rule:

A loss incurred in a previous year cannot ordinarily be carried forward and set off in a subsequent year unless, on the last day of the year in which set-off is claimed, shares carrying at least 51% of the voting power are beneficially held by the same persons who beneficially held shares carrying at least 51% of the voting power on the last day of the year in which the loss was incurred.

Purpose:

• It discourages the acquisition of loss-making companies merely to use their accumulated tax losses.
• The test focuses on beneficial ownership and voting power, not merely the number or face value of shares.

Scope:

• The restriction generally applies to carried-forward losses and not to current-year losses.
• It does not ordinarily restrict the carry forward of unabsorbed depreciation, since unabsorbed depreciation is governed by Section 32(2) rather than being treated as a loss for this purpose.
• The section contains specific relaxations and exceptions for eligible start-ups and certain genuine restructurings or changes in shareholding.

The company's ownership history must therefore be reviewed before relying on accumulated tax losses.

Although Section 79 generally requires continuity of at least 51% of voting power, the Act provides exceptions for specified situations in which a change in shareholding is not treated as abusive loss trafficking.

Major relaxations include, subject to statutory conditions:

• Eligible start-ups: A qualifying eligible start-up may carry forward losses if all shareholders who held shares in the loss year continue to hold those shares in the year of set-off and the loss is incurred during the prescribed period from incorporation. The special start-up rule operates subject to the conditions and time period specified in the Act.
• Death of a shareholder: A change in voting power caused by the death of a shareholder is disregarded in the specified circumstances.
• Gift to a relative: A change resulting from a gift of shares by a shareholder to a relative may qualify for relief.
• Foreign corporate restructuring: Changes in an Indian company's shareholding caused by an amalgamation or demerger of its foreign holding company may be protected when the prescribed continuity conditions are satisfied.
• Resolution or insolvency cases: Specified changes arising under an approved resolution plan or insolvency framework may receive relief, subject to compliance with the applicable conditions.
• Tribunal-approved restructuring: Certain changes pursuant to approved restructuring arrangements may also be covered by statutory exceptions.

Each exception is conditional. A company must examine beneficial ownership, voting rights, the cause of the change, approvals obtained, and the wording applicable to the relevant assessment year.

Section 72A permits the accumulated business loss and unabsorbed depreciation of an amalgamating company to be treated, subject to conditions, as the loss or depreciation of the amalgamated company.

Objective:

The provision facilitates genuine reconstruction or revival by allowing tax attributes to continue after a qualifying amalgamation.

Important conditions may include:

• The amalgamation must fall within the eligible categories and satisfy the statutory definition of amalgamation.
• The amalgamating company must have carried on the relevant business for the prescribed minimum period.
• It must have held the prescribed proportion of the book value of its fixed assets for the required period before amalgamation.
• The amalgamated company must hold the prescribed proportion of the acquired fixed assets for the prescribed period.
• The amalgamated company must continue the business of the amalgamating company for the prescribed period.
• It must satisfy prescribed conditions intended to ensure revival of the business and must furnish the required reports or certificates.

Effect:

• Eligible accumulated business loss becomes the loss of the amalgamated company for the previous year in which the amalgamation takes effect.
• Eligible unabsorbed depreciation similarly becomes the depreciation allowance of the amalgamated company.
• The benefit does not automatically extend to every category of loss; only losses covered by the provision qualify.

If post-amalgamation conditions are violated, the tax benefit previously obtained may be withdrawn and treated as income under the applicable clawback provision.

In a qualifying demerger, Section 72A provides for the transfer or allocation of accumulated business loss and unabsorbed depreciation between the demerged company and the resulting company.

Rules of allocation:

• If the accumulated loss or unabsorbed depreciation is directly relatable to the undertaking transferred, it is carried forward by the resulting company.
• If it is not directly relatable to a particular undertaking, it is apportioned between the demerged company and the resulting company in the ratio of assets retained and assets transferred.

The proportional allocation may be represented as:

Conditions and effect:

• The arrangement must satisfy the statutory definition and conditions of a demerger.
• The resulting company is treated as having the allocated loss or depreciation for the relevant previous year.
• The remaining portion continues with the demerged company.
• The period for which an accumulated business loss can be carried forward remains subject to the applicable provisions; a demerger does not necessarily grant a fresh eight-year period in every case.
• Unabsorbed depreciation continues to be governed by Section 32(2).

This method aligns the tax attributes with the undertaking and assets to which they economically relate.

Losses generally belong to the taxpayer that incurred them and cannot be transferred to another person merely because the business is transferred. Carry forward by a successor is permitted only when a specific provision authorises it.

Relevant principles:

• In a qualifying amalgamation or demerger, Section 72A may transfer eligible accumulated business loss and unabsorbed depreciation.
• Section 72A also covers certain qualifying reorganisations, such as specified conversions or successions, subject to detailed conditions.
• The transaction must satisfy the definitions and conditions prescribed for the relevant form of reorganisation.
• There must ordinarily be continuity of business, assets, ownership, or profit-sharing interests to the extent required by the applicable provision.
• Eligible business loss and unabsorbed depreciation may be treated as belonging to the successor for tax purposes.
• Capital losses, speculation losses, and other special-category losses do not automatically pass to the successor unless the statute expressly permits their transfer.
• If the conditions are subsequently violated, the tax benefit may be withdrawn and the amount previously set off may become taxable.

Therefore, the legal form and statutory qualification of the reorganisation must be verified before losses are included in the successor company's tax computation.

The generally accepted order of adjustment is:

1. Current-year depreciation under Section 32(1).
2. Brought-forward normal business loss under Section 72.
3. Unabsorbed depreciation under Section 32(2).

Reason for the order:

• Current-year depreciation is an allowance in computing the current year's business income and must therefore be deducted first.
• Brought-forward business loss is ordinarily available for only eight assessment years. It should be used before unabsorbed depreciation so that it does not expire.
• Unabsorbed depreciation can generally be carried forward indefinitely and consequently comes after brought-forward business loss.

Illustration: Suppose a company has business profit before depreciation of , current depreciation of , brought-forward business loss of , and unabsorbed depreciation of .

After setting off brought-forward business loss:

Unabsorbed depreciation of is then set off. The remaining of unabsorbed depreciation is carried forward.

1. Compute normal business income after current depreciation

2. Set off brought-forward normal business loss

3. Set off unabsorbed depreciation

4. Adjust speculation loss

The speculation loss can be adjusted only against speculation profit:

The speculation loss cannot be adjusted against the normal business income of .

Final result:

• Taxable normal business income:
• Taxable speculation income: Nil
• Brought-forward normal business loss remaining: Nil
• Unabsorbed depreciation remaining: Nil
• Speculation loss carried forward: , subject to the four-assessment-year limit and return-filing conditions.

Certain incomes are taxed under special provisions that restrict or prohibit the adjustment of losses and allowances.

Section 115BBE:

• It applies to specified income referred to in Sections 68, 69, 69A, 69B, 69C, and 69D, such as unexplained cash credits, unexplained investments, unexplained money, and certain unexplained expenditure.
• No deduction in respect of expenditure or allowance is permitted in computing such income, subject to the wording applicable to the relevant year.
• No set-off of any loss is allowed against income taxable under Section 115BBE.

Effect on a company:

• A normal business loss cannot reduce income assessed as unexplained cash credit under Section 68.
• A speculation loss, capital loss, house-property loss, or unabsorbed depreciation cannot be used to reduce such specially taxed income where the statutory prohibition applies.
• The company must compute specially taxed income separately from income eligible for ordinary set-off.
• Other special-rate provisions may also contain restrictions or require separate categorisation of income and losses.

Accordingly, corporate tax planning must distinguish between ordinary taxable income and income covered by provisions that expressly override normal set-off rules.