Vinu: Hey Manu, I need your help! We're working on financials for 2023-24 for a company that operates in a rented factory. We've done some electrical fittings and spent money on it. But there are different opinions about how to treat this expense. Some say treat it as Plant & Machinery (P&M), others say treat it as part of the building, and another says treat it as deferred expense. What's the right accounting treatment for this under the Income Tax Act and Companies Act?
Manu: Sure, Vinu! This can be a bit tricky, but I’ll break it down for you with references to the Income Tax Act and Companies Act. Let’s go over the three options you’ve heard.
1. Treat it as Plant & Machinery (P&M):
If the electrical fittings are specific to the machinery or processes involved in the production activities, you could classify them as Plant & Machinery. Under the Companies Act, 2013, this would be treated as a fixed asset under the heading “Plant and Machinery.”
From an Income Tax Act, 1961 perspective, such assets would qualify for depreciation as part of Plant & Machinery. The depreciation rate applicable is typically higher than that of buildings, which is a benefit as it reduces taxable profits faster.
Vinu: That sounds like a practical option if the fittings are more related to production. But what if they are general electrical works?
Manu: Good point! Now let’s move to the second option.
2. Treat it as Part of the Building:
Since you're renting the factory for 3 years, some might suggest treating the electrical and fittings works as part of the building, even though the building is rented. However, the Companies Act, 2013 requires leased property improvements to be capitalized as separate assets, not merged with the building, since the building is not owned by the company.
Under the Income Tax Act, this would mean classifying the works as leasehold improvements. You’ll need to amortize the expenses over the remaining lease period (3 years). This way, the cost will be spread over the rental agreement’s duration, reflecting the fact that the benefit of the improvements is temporary.
Vinu: That makes sense, especially since the agreement is only for 3 years. But what about the idea of treating it as a deferred expense?
Manu: Let’s talk about that!
3. Treat it as a Deferred Expense:
This option suggests that the cost of electrical fittings should be spread over time, reflecting the benefit derived over multiple years. The Companies Act, 2013 does allow for deferred expenses in certain cases, but only for intangible items like preliminary expenses or research costs. Since electrical fittings are tangible in nature, they wouldn't qualify as deferred expenses.
Also, the Income Tax Act doesn’t favor deferred treatment for physical assets like electrical fittings. Instead, these should be capitalized and depreciated or amortized based on the nature of the asset and the lease term.
Vinu: So, I guess deferred expense treatment is not applicable here?
Manu: Exactly! So, here’s my conclusion:
If the electrical fittings are tied to specific production equipment, classify them as Plant & Machinery and depreciate them at the applicable rate.
If the works are general improvements to the rented property, treat them as leasehold improvements under the Companies Act and amortize them over the lease term (3 years).
Deferred expense treatment is not applicable since the works are tangible assets.
Would that help clarify things for you, Vinu?
Vinu: Absolutely, Manu! That clears it up perfectly. Thanks for explaining it with references to both the Income Tax Act and Companies Act!
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