Set Off and Carry Forward of Losses

Profit and loss are basic, universal business principles that significantly affect the financial well-being and long-term viability of an organisation. A profit is said to be made when revenue exceeds expenses; a loss is said to be made when expenses exceed revenue. It is these two outcomes that serve as vital gauges on which major decisions concerning pricing, investments, operations, and expansions are made. Basically, every business is made to make profits so that it can survive and grow, expand, modernise, and even pay dividends to the shareholders. Losses recorded over and over again could, however, be a sign of some inefficiencies or poor management or some market situations that need to be dealt with immediately. Many determinants, including the cost of production, market demand, competition, price policy, and economy, determine profit and loss.  Profit and loss statements are evaluated regularly by organisations to make changes as well as determine the trend, calculate the efficiency of the operation, and establish corrective modifications. The appreciation for such accounting data is pivotal to entrepreneurs, managers, and shareholders because it sets the ground upon which they take decisive decisions based on sound reasoning or planning accordingly. Ultimately, an ability to properly control profit and loss turns the fortunes in favor of high-value businesses from every sector.

What is Set Off of Losses?

Setting off losses is a technique employed to reduce or adjust taxable income by offsetting losses made from one source of income against profits gained from another. The technique has the effect of reducing a taxpayer’s overall tax liability. Losses are classified into three categories: business losses, capital losses, and losses from outside sources. The Income Tax Act of 1961 spells out certain rules for the offsetting of these losses.

There are two kinds of set-offs: intra-head and inter-head. Intra-head set off permits losses from one source of income to be offset against income from another source in the same category. On the other hand, inter-head set off permits losses from one category (e.g., business losses) to be offset against income from a different category (e.g., salary or rental income), provided certain conditions are met. In case losses cannot be fully absorbed within a specific tax year, they can be brought forward for subsequent adjustments in accordance with applicable tax regulations.

Types of Set Off of Losses

As per the Income Tax Act of 1961, the loss set off concept enables taxpayers to set off losses against income and thereby decrease taxable income, so that tax is charged only on net income. The Act sets out elaborate rules concerning the circumstances and manner for loss set off, which fall into two major categories:

1. Intra-Head Set Off (Section 70)

Setting off a loss from one head of income against income from a different head falling within the same category. Losses from one business, for example, may be set off against profits from another under the ‘Profits and Gains of Business or Profession’ category. Except where there are exceptions:

• Speculative losses can be set off only against speculative gains, gambling losses do not qualify
• Long-term capital losses can only be set off against long-term capital gains, and
• Losses arising from keeping racehorses can be balanced against income from the same activity alone.

2. Inter-Head Set Off (Section 71)

This permits a balancing of losses in one income head against income in another. Non-speculative business losses can be claimed against salary or rent income, but with some restrictions:

• Losses on capital gains cannot be offset against other categories of income.
• Business losses cannot be claimed against salary income.
• Losses on residential property can only be claimed against other expenditures by Rs. 2 lakh every year, and
• Losses on speculative businesses, specified businesses under section 35AD, or gambling cannot be claimed in other categories.

What is Meant by Carry Forward of Losses?

Carry forward of losses under the Income Tax Act of 1961 is the process of transferring unadjusted losses from one financial year to another year in order to set off against future revenues. The provision assures that taxpayers who experience losses in one year are able to lower taxable revenues in future years when they make profits, granting tax relief while assisting in company continuity.

Losses can arise from a range of sources, such as company or profession, capital gains, residential property, or other specified activities. Where these losses cannot be offset against revenue in the same year because of insufficient income or statutory ceilings, they can be brought forward in accordance with the provisions laid down in the Act.

Every type of loss has to be reported within a period. For instance, business losses of the company can be brought forward for eight assessment years, capital losses for eight years, and real estate losses for eight years. Speculative business losses and losses from activities like horse racing, however, are brought forward only for four years. Unabsorbed depreciation, in contrast to other losses, can be brought forward indefinitely.

For forwarding a loss, taxpayers are required to lodge the income tax return on or by the due date prescribed in the Act, excluding dwelling property losses.

Rules to Follow to Carry Forward Losses

The Income Tax Act of 1961 allows for the carry forward of losses in order to ease the tax burden for taxpayers during years when their assets or businesses make losses. This is provided for in order to allow businesses to write off their losses against subsequent profits to limit their taxable income. Nevertheless, the procedure for carrying forward losses differs depending on the nature of the loss, the carry-forward time limits, and the conditions prescribed under the Act. The mechanism for carry forward and set off of losses under the Income Tax Act of 1961 promotes a fair and equitable taxation system by considering the cyclical pattern of business and investment. It sustains individuals during trying times and promotes investment and entrepreneurship. To gain the utmost from these benefits, taxpayers need to make sincere efforts to observe the rules of time restrictions, eligible income types, and requirements for filings. Proper documentation and timely filing are necessary to help losses be used in future years.

General conditions relating to the carry forward of losses:

1. Filing Within Time [Section 139(3)]: • With the sole exception of loss under the head ‘Income from House Property’, losses can only be carried forward if the return is filed before the due date prescribed under Section 139(1). Failure to do so leads to the forfeiture of the right to carry forward, except in relation to loss in respect of house property.
2. Departmental Assessment: The Assessing Officer evaluates the loss during the process of review.
3. Set off Against Qualifying Income: Losses carried forward have to be set off against income of the same category (with some exceptions).

Types of losses and their provisions to carry forward

1. Business Loss (Section 72)

1. Carryforward Period: up to 8 assessment years after the year to which the loss relates.
2. Set off for business income relating to the same or different business only.
3. Conditions:

• The business need not be an ongoing business and can be ceased.
• Such a loss cannot be speculative.
• Tax returns have to be submitted within the stipulated time limit.
• Set-offs cannot be made against salary or other forms of income, such as capital gains or residential property income.

2. Speculative Business Loss (Section 73)

1. The carry forward period is 4 assessment years.
2. A set off can be made only against income from speculative business operations.
3. Conditions:

• Speculative business refers to intraday dealing in shares.
• The tax returns have to be filed on time.
• Losses can’t be carried forward against normal business income or any other class.

3. Loss from Specified Business (Section 73A)

1. This is applicable to businesses under Section 35AD, like cold storage and warehousing.
2. The carry forward period is indefinite until the loss is completely set off.
3. Set off can only be allowed against income arising from the same business.
4. There must be separate accounting records for the particular business, which is the primary condition.

4. Capital Loss [Section 74]

1. Loss Types: Short Term Capital Loss (STCL) which is allowed to set off against BOTH short term and long term capital gains (STCG and LTCG) and Long Term Capital Loss (LTCL) which can set off ONLY against LTCG.
2. Carry Forward Period: 8 years of assessment.
3. Conditions:

• Return must be within the due date.
• Cannot be set off against any other head of income.

5. Loss of House Property [Section 71B]

1. Carry Forward Period: 8 years of assessment.
2. Set off available against: House property only.
3. Inter-Head set off is permitted in the same year, up to Rs. 2 lakhs, against any other head of income such as salary or business income.
4. Conditions: No obligation to file an income tax return within the due date for carry forward.

6. Unabsorbed Depreciation [Section 32(2)]

1. Carry Forward Period: Indefinite.
2. Set Off Permitted Against: Any other head of income except salary.
3. Order of Priority of Set Off:

• Depreciation in the current year is to be set off first.
• Then, it brought forward the business loss.
• Then, unabsorbed depreciation.

7. Loss on Owning and Keeping Race Horses [Section 74A(3)]

1. Carry Forward Period: 4 assessment years.
2. Set Off Permitted Against: Only the income of the same activity.
3. Conditions:

• It cannot be set off against any other income.
• Must file the return within the due date.

Priority of Set Off

Where both current year and carried forward losses are available, the priority for set off is usually as follows:

1. Current year depreciation (Section 32).
2. Current year business loss (Section 71).
3. Brought forward business loss (Section 72).
4. Unabsorbed depreciation [Section 32(2)].

Illustrative Example

Look at a taxpayer with the following income and losses:

Income from house property: Rs. 2,000,000

Business loss of current year: Rs. 3,000,000

Long-term capital gain: Rs. 5,000,000

Brought forward long-term capital loss: Rs. 200,000

Brought forward unabsorbed depreciation: Rs. 1,000,000.

Set off order:

1. The business loss of Rs. 3,000,000 cannot be adjusted against LTCG but can be carried forward.
2. The long-term capital loss of Rs. 200,000 can be adjusted against LTCG.
3. Unabsorbed depreciation of Rs. 1,000,000 can be adjusted against income from house property.

Conclusion

Rules of setting off and carrying forward losses as provided by the Income Tax Act of 1961 play an essential role in ensuring equity in taxation, as they enable taxpayers to effectively set off and absorb losses. These provisions are helpful for both persons and companies in times of financial distress and encourage sound financing, as well as conformity to tax laws. To avail themselves fully of these benefits, tax returns must be filed within the due dates properly, thereby reducing tax liability legally and systematically.

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