Companies Act Section 198

Companies Act, Section 198: Calculation of Profits

Section 198 of the Companies Act, 2013 governs the methodology for computing the net profits of a company in a given financial year, specifically for the purposes of Section 197 regarding the payment of remuneration to directors. The section outlines the treatment of various sums both to be included and excluded while calculating the company’s net profits. These instructions ensure that the profits on which the remuneration calculations are based are both accurate and fair, in line with standard accounting practices.

1. Credit for Specific Sums

When calculating the net profits for the purposes of Section 197, the company must give credit for certain sums, specifically as laid out in Sub-Section 2. These are the amounts that will increase the net profit:

Bounties and Subsidies: Any bounties or subsidies received by the company from the Government or from any public authority authorized by the Government must be credited. This is so unless the Central Government directs otherwise.
The sums to be credited are not restricted to direct cash payments but may also include government financial assistance aimed at supporting the company's activities, particularly in sectors where the government plays a significant role in funding or incentivizing businesses.
2. Sums Not to Be Credited

On the flip side, Sub-Section 3 lists various sums that must not be credited while calculating net profits, thereby reducing the overall value of profits. These sums include:

a) Profits from Premiums on Shares or Debentures: Any profits arising from premiums on shares or debentures issued or sold by the company will not be credited, unless the company is an investment company under the specified explanation of Section 186.
b) Forfeited Shares Profits: Any profits from the sale of forfeited shares by the company are excluded.
c) Profits of a Capital Nature: Profits of a capital nature, such as those from the sale of the company’s undertakings, are excluded. This would cover profits from selling entire business units or parts of the company’s assets.
d) Sale of Immovable Property or Fixed Assets: Similarly, profits from the sale of immovable property or fixed assets that are part of the company’s capital stock are excluded unless the company’s business involves trading in such properties or assets. For instance, a company primarily engaged in buying and selling real estate would treat profits from asset sales differently.
e) Exemption for Fixed Assets: If any fixed asset is sold for an amount greater than its written-down value, the excess amount above the written-down value can be credited, provided the amount does not exceed the difference between its original cost and the written-down value.
f) Changes in Asset or Liability Measurement: Any adjustments in the carrying value of assets or liabilities recognized in equity reserves, including surplus in the profit and loss account due to revaluation, are excluded from the profit computation.
g) Unrealised Gains and Notional Gains: Any unrealised or notional gains (including revaluations of assets) are excluded from the net profit.
3. Deductions in Profit Calculation

Sub-Section 4 lists the sums that must always be deducted while calculating the net profits of the company. These deductions represent the normal operating costs and other expenses that reduce the company’s profits for the year. The following sums are to be deducted:

a) Usual Working Charges: These include the regular, operational expenses that are required for running the company, such as salaries, rent, and utilities.
b) Directors' Remuneration: Any remuneration paid to the directors including managing directors, whole-time directors, and others must be deducted.
c) Bonus or Commission: Any bonus or commission that is paid to company staff, engineers, technicians, or any person engaged by the company must also be deducted.
d) Excess or Abnormal Profit Taxes: Taxes imposed by the Central Government on excess profits or profits deemed abnormal in nature are deducted from the net profits.
e) Special Taxes on Business Profits: Any specific tax on business profits imposed for special reasons, as notified by the Central Government, is also to be deducted.
f) Interest on Debentures and Loans: The company’s payments in the form of interest on debentures or on loans secured by a charge on the company’s assets (both fixed and floating) must be deducted.
g) Interest on Unsecured Loans: Interest on unsecured loans is also deducted from the profit calculation.
h) Repairs and Maintenance Expenses: Costs incurred for repairs, whether to immovable or movable property, are deducted, provided these repairs are not of a capital nature (i.e., they do not significantly increase the value of the asset).
i) Outgoing Expenses: Other expenses, including contributions made under Section 181 (e.g., donations), are deducted.
j) Depreciation: Depreciation is deducted in the manner prescribed under Section 123.
k) Excess of Expenditure Over Income: If there is a deficit in the company's profits, where expenditure exceeds income in one year, the excess must be deducted, provided it has not been already deducted in previous years.
l) Legal Liabilities: Any compensation or damages the company is liable to pay due to breach of contract or any other legal liability must be deducted.
m) Insurance Against Liabilities: Any premiums paid for insurance policies that cover potential legal liabilities (like breach of contract) are to be deducted.
n) Bad Debts Written Off: Debts that are considered bad and have been written off during the financial year are also deducted.
4. Sums Not to Be Deducted

Sub-Section 5 specifies certain sums that must not be deducted from the net profits, even though they may appear to be operational expenses or losses. These sums include:

a. Income Tax and Super Tax: The income tax or super tax payable by the company, including taxes under the Income-tax Act, 1961 or any other tax on the company’s income (excluding taxes on excess or abnormal profits), is not deducted.
b. Voluntary Payments: Any compensation, damages, or payments made voluntarily (i.e., not under any legal obligation) are excluded from deductions.
c. Capital Losses: Losses of a capital nature, such as losses incurred from the sale of undertakings or parts of business, cannot be deducted. However, losses related to the sale of fixed assets are not deducted unless they exceed the written-down value of the asset sold, discarded, demolished, or destroyed.
d. Changes in Asset or Liability Measurement: Any adjustments in the carrying amount of assets or liabilities recognized in equity reserves, including surplus in the profit and loss account arising from revaluation or fair value measurement, are not deducted.