Depreciation Under Section 32 After Book Rejection: Separate Claim or Embedded in Estimated Net Profit Rate?

When an Assessing Officer invokes Section 145(3) of the Income Tax Act, 1961 to reject an assessee's books of account and proceeds to estimate income by applying a flat net profit rate on gross turnover, a significant and often litigated question surfaces — can the assessee still claim depreciation under Section 32 as a separate deduction, or is it already absorbed within that flat estimated rate?

At first glance, this may seem like a straightforward administrative question. In practice, however, it sits at the intersection of statutory interpretation, CBDT policy, and genuinely divergent High Court positions across jurisdictions. The answer is neither absolute nor uniform — it depends on specific factual circumstances, the precise language of the assessment order, and the judicial precedents binding in the relevant jurisdiction.

Understanding the Framework: What Happens When Books Are Rejected?

Under Section 145(3), the Assessing Officer is empowered to reject the method of accounting or the books of account if they are found to be incorrect, incomplete, or otherwise unreliable. Once books are rejected, the AO typically proceeds to a best judgment assessment under Section 144, estimating the assessee's income using a percentage-based net profit rate applied to the declared or reconstructed turnover.

This approach replaces the entire profit and loss computation that would otherwise flow from Section 29 of the Income Tax Act, 1961. The estimated rate becomes a surrogate for the full income computation mechanism.

The fundamental question: When such a surrogate rate is applied, does it extinguish the assessee's right to claim statutory deductions — particularly depreciation — that would have been available under the normal computation process?

The General Rule: Ordinary Expenses Stand Eliminated

Once a flat net profit rate is applied to estimate income following book rejection, routine and recurring business expenditures — such as wages, rent, fuel costs, administrative overheads, transportation charges, and repair expenses — are treated as having been factored into the estimated rate. These are considered ordinary expenses within the meaning of the profit and loss computation, and the AO's estimation is assumed to have already accounted for them.

This principle has been consistently upheld across jurisdictions and is largely settled law. The estimated net profit rate operates as a "package deal" — it substitutes the entire computation under Section 29 of the Income Tax Act, 1961, subsuming all standard business deductions into a single composite figure.

The Punjab & Haryana High Court in CIT vs. Gian Chand Labour Contractors (2007) authoritatively affirmed this position, holding that once income is estimated using a flat rate, ordinary profit and loss deductions are not separately admissible because the rate itself is presumed to incorporate them.

In short: For routine business expenses, the book rejection effectively closes the door to separate deduction claims.

Depreciation under Section 32 of the Income Tax Act, 1961 is fundamentally different in character from ordinary operating expenses, and this distinction is critical to understanding why it cannot be automatically lumped together with general business costs.

Key Characteristics That Distinguish Depreciation

  • It is not a cash outflow. Unlike salaries, rent, or fuel, depreciation does not represent actual money spent during the year. It is a statutory allowance — a legal mechanism that recognises wear, tear, and obsolescence of capital assets over time.