The term depreciation has no specific definition under the Income Tax Ordinance, 2001. However, we may understand its concept through general meanings given in accounting
For Example
“A decrease in the value of an asset through normal wear and tear, or obsolescence is called depreciation”
In other words, “depreciation is the process of allocating the cost of a depreciable asset over its estimated useful life by applying the rate specified in Part-1 of the Third Schedule of the Income Tax Ordinance, 2001”.
Now, question arises, what is the role of depreciation in the income tax law?
Remember it; in computing the taxable profit of a business, the income tax law permits the deduction of depreciation against the business income.
However, this deduction is subject to the following conditions:
Depreciable asset
Depreciation shall be charged only on depreciable asset.
Business use of asset
Depreciable asset shall be used in that business of a person whose taxable income is being determined.
Amount of Depreciation
Where asset is exclusively used for business
It must be computed by applying the rates specified in part-1 of the Third Schedule of the Income Tax Ordinance, 2001, against the written down value of the asset at the beginning of the tax year.
Where asset is partly used for business
Amount of depreciation allowed as deduction shall be restricted to the fair proportional part of the amount that would be allowed if the asset were wholly used to derive income from business chargeable to tax.
Example Illustration
Miss Alex owns a building having cost Rs. 600,000. He used 3/4th of its building for his business and remaining for his family residence. Compute the amount of depreciation chargeable to business.
Solution
Written down value (WDV) at the beginning (i.e. cost) 600,000.
Depreciation rate as per Third Schedule 10% of WDV
Total depreciation for the building (600,000×10%) 60,000
Depreciation chargeable to business (60,000×3/4) 45,000
Depreciation shall be charged against written down value (WDV)
Depreciation shall be charged against written down value (value at the beginning of the tax year) of a depreciable asset
How written down value of depreciable asset is calculated
Example
Where asset is acquired during the tax year:
Total cost of the asset XXX
Less: Initial allowance, if any XXX
Written down value (WDV) at the beginning of the tax year XXX
Note: In the absence of initial allowance total cost of the asset is considered as WDV at the beginning of the year.
Example:
Where asset acquired prior to the tax year is wholly used for business:
Total cost of the asset XXX
Less: Initial allowance, if any XXX
Total depreciation which has been already charged in previous tax years XXX XXX
WDV at the beginning of the year XXX
WDV when
It shall be computed on the basis that the asset has been solely used to derive income from business chargeable to tax.
Aggregate of depreciation allowance should not exceed actual cost of the asset
The total deductions allowed to a person during the period of ownership of a depreciable asset as depreciation (u/s 22) and initial allowance (u/s 23) should not exceed the actual cost of asset
Disposition of asset during the tax year
No depreciation deduction shall be allowed to a person against income from business chargeable to tax for the tax year in which asset is disposed (sold)
What is the treatment of profit or loss on the disposition (sale) of asset ?
If sale proceeds exceeds WDV, difference shows profit:
Tax Treatment
It is chargeable to tax under the head income from business
If WDV exceeds sale proceeds,
Asset with useful life up to one year
No depreciation allowance shall be allowed for
Depreciation allowance in case of immovable property
The cost of immovable property or structural improvement to immovable property shall not include the cost of land.
In other words, if depreciable asset consist of building, the value of land is not considered for depreciation.
For
Depreciation allowance to lessor
Where any asset owned by lessor like:
- A leasing company;
- An investment bank;
- A Modaraba;
- A scheduled bank;
- A development finance institution.
is leased to another person. Depreciation allowance is allowed to such persons because asset is being used in their leasing business.
Limitation on depreciation allowance against leased asset
Depreciation allowance on leased asset shall be allowed against income from lease rental only. Any un absorbed depreciation shall be adjusted in the following /coming tax years.
Initial Allowance
In addition to a normal depreciation allowance (u/s 22 and part-1 of the Third Schedule), an additional depreciation allowance (u/s 23 and Part-11 of the Third Schedule) is allowed as deduction against the income from business chargeable to tax. Such an additional depreciation allowance is called initial allowance.
In nut shell, there are two forms of depreciation allowance under the Income Tax Ordinance, 2001.
- Normal depreciation allowance
- Initial allowance
Major difference between depreciation allowance and initial allowance:
Normal depreciation allowance is allowed against depreciable asset while initial allowance is allowed against eligible depreciable asset for one time in the life of asset.
Conditions Applicable to Allow-ability of Initial Allowance
Eligible depreciable asset
It is allowable on “eligible depreciable asset” only,
Place of Service
Eligible depreciable asset has been placed into service in Pakistan for the first time in a tax year.
Year of allowability
It is allowable in later of the following tax years:
- A tax year in which the asset is used first time in Pakistan; or
- A tax year in which commercial production is commenced.
Rate of Initial Allowance
It is allowed @ 50% of the cost of the asset.
Note: In case of lease, it shall be restricted upto lease rental income only. Any unabsorbed amount of initial allowance may be carried forward for deduction in next years.
Asset must be owned by the person
For admissibility of initial allowance, asset must be owned by the person whose taxable income is being determined.
Eligible Depreciable Asset
“Eligible Depreciable Asset” means a depreciable asset other than the following assets:
- Any road transport vehicle unless the vehicle is plying for hire;
- Any furniture includes fittings;
- Any plant or machinery that has been used previously in Pakistan; or
- Any plant or machinery whose entire cost has already been allowed as
deduction in the tax year in which it was purchased.
Some Examples of
| Eligible depreciable assets | Not eligible depreciable assets |
| Vehicle plying for hire | Vehicle not plying for hire (only used by employees or buses used by labor) |
| Plant and machinery being used first time in Pakistan. | Plant and machinery previously used in Pakistan. |
| Structural improvement to immovable property | Unimproved land |
The Third Schedule
[Part-l]
Depreciation rates specified for the purposes of section 22 shall be:
- Building (all types) 10%
- Furniture (including fitting), machinery and plan
- (Not otherwise specified), motor vehicles (all types), ships,
- technical or professional books. 15%Furniture (including fittings), machinery and plant
Computer hardware including printer, monitor and allied items
- (Machinery and equipment used in manufacture of IT products),
- aircrafts and aero engines. 30%
In case of mineral oil concerns the income of which is liable to be computed in accordance with the rules specified in Part-1 of the Fifth Schedule.
- Below ground installations 100%
- Offshore platform and production installations. 20%
[Part-ll]
Initial Allowance
- The rate of initial allowance u/s 23 and 23A shall be 50%
- The rate of First Year Allowance (FYA) u/s 23A shall be 90%
[Part-III]
The rate of amortization of pre-commencement expenditures u/s 25 shall be 20%
Depreciable Asset
“Depreciable asset” means any:
- Tangible movable property
- Immovable property (other than unimproved land)
- Structural improvement to immovable property owned by a person that
- has a normal useful life exceeding one year
- is likely to
loose value as a result of normal wear and tear, or obsolescence; and - is used wholly or partly by the person in deriving income from business chargeable to tax.
Note: Where the total cost of any asset has been allowed as a deduction in the year of its purchase, then such asset shall not be treated as “depreciable asset”.
Unimproved Land
An open plot of land represents unimproved land. If any road or railway track or airport runway etc. is constructed on land, such land is called improved land. So, only land is not included in the definition of depreciable asset.
Structural Improvement to Immovable Property:
Structural improvement to immovable property means construction or installation of any building, road, driveway, car park, railway line, pipeline, bridge, tunnel, air port runway, canal, dock, wharf, retaining wall, fence, power lines, water or .sewerage pipes, drainage, landscaping or dam on immovable property like land.
Tangible Movable Property
It includes machinery, furniture, motor vehicles, ships, technical or professional books, computer hardware, aircrafts etc.
Immovable Property
It includes buildings like admin office, factory, workshop, cinema, hotel, hospital, school and flats or residential quarters for labour.
Random Examples
Q: What is depreciation and what are the conditions laid down under the Income Tax Ordinance, 2001 for depreciation allowance?
Depreciation
The term depreciation has no specific definition under the Income Tax Ordinance, 2001.
For example
“A decrease in the value of an asset through normal wear and tear, or obsolescence”
In other words, “depreciation is the process of allocating the cost of a depreciable asset over its estimated useful life by applying the rates specified under Part-1 of the Third Schedule of the Income Tax Ordinance, 2001”.
There are three types of depreciation allowance:
- 1) Normal depreciation
- 2) Initial depreciation allowance
First Year Allowance (FYA)
Normal depreciation allowance
A depreciation allowance which is allowed on WDV of depreciable asset by applying the rate given in Part-1 of the Third Schedule is called normal depreciation allowance.
Conditions applicable to Allowability of Normal Depreciation:
Depreciable asset
Depreciation shall be charged only on depreciable asset.
Business use of asset
Depreciable asset shall be used in the business of a person whose taxable income is being determined.
Amount of depreciation
Amount of depreciation shall be computed with the help of rates given under Part-1 of the Third Schedule of the Income Tax Ordinance, 2001.
Depreciation shall be charged against written down value (WDV)
Depreciation shall be charged against written down value of a depreciable asset (WDV at the beginning of the tax year).
Aggregate of depreciation allowance shall not exceed actual cost of the asset
The total deductions allowed to a person on a depreciable asset as depreciation (u/s 22) and initial allowance (u/s 23) shall not exceed the actual cost of asset.
Sale of depreciable asset during the tax year
No depreciation deduction shall be allowed to a person against income from business chargeable to tax for the tax year in which depreciable asset is sold.
Asset having useful life upto one year
No depreciation allowance shall be allowed for asset whose normal useful life does not exceed one year.
Depreciation allowance in case of immovable property
The cost of immovable property or structural improvement to immovable property shall not include the cost of land for computation of depreciation.
In other words, if depreciable asset consist of building, the value of land is not considered
Depreciation allowance to lessor
Where any asset owned by lessor like:
- A Leasing company;
- An Investment bank;
- A Modaraba;
- A Scheduled bank;
- A Development finance institution.
is leased to another person. Depreciation allowance is allowed to such persons because asset is being used in their leasing business.
Limitation on depreciation allowance against leased asset
Depreciation allowance on leased asset shall be allowed against income from lease rental only. Any un absorbed depreciation shall be adjusted in the following tax years
Initial Depreciation Allowance
A depreciation allowance which is allowed on cost of eligible depreciable asset @ 50% in the tax year in which asset is being used first in Pakistan or in the tax year in which commercial production is commenced, whichever is later is called initial allowance.
Conditions Applicable to Allow-ability of Initial Allowance
i) Eligible depreciable asset
It is allowable on “eligible depreciable asset” only.
ii) Place of service
Eligible depreciable asset has been placed into service in Pakistan for the first time in a tax year.
iii) Year of allow-ability
It is allowable in later of the following tax years:
- A tax year in which the asset is used first time in Pakistan; or
- A tax year in which commercial production is commenced.
Rate of Initial Allowance
It is allowed @ 50% of the cost of the asset.
Asset must be owned by the person
For admissibility of initial allowance, asset must be owned by the person whose taxable income is being determined.
3) First Year Allowance (FYA)
A depreciation allowance which shall be allowed on cost of plant, machinery and equipment installed in an industrial undertaking set up in specified rural and under developed areas notified by the Federal Government after the 1st July, 2008 @ 90% is called First Year Allowance.
Conditions Applicable to Allow-ability of First Year Allowance (FYA)
Plant, machinery and equipment
It is allowable on plant, machinery and equipment installed by an industrial undertaking.
Place of service
The asset has been placed into service in rural and under developed areas as specified by the Federal Government.
Year of allow ability
It shall be allowed on the asset used after 1st July, 2008.
Rate of First Year Allowance (FYA)
It is allowed @ 90% of the cost of the asset.
Asset must be owned by the person
For admissibility of FYA, asset must be owned and managed by an industrial undertaking working in rural and under developed areas.
Note: FYA and initial allowance are substitute to each other. In other words, if FYA is allowed, than initial allowance shall not be allowed.
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