Business Income & Deductions: Section 19 (Rules, Cases & Calculations)

TAKEAWAYS:

• Business income is computed as gross receipts minus allowed deductions (Section 19), not accounting profit.
• Disallowed expenses (e.g., personal, capital, or non-business-related costs) must be excluded even if recorded in books.
• Depreciation (Block D) and Profit & Loss Carry Forward (PCC) are critical deductions with strict rules.
• Withholding tax applies to certain expenses (e.g., rent, interest) at source, reducing net deductions.
• Real-world tie-ins: Daraz’s supplier payments (withholding tax), Ncell’s depreciation claims (Block D), and eSewa’s transaction fees (disallowed expenses).
• Exam focus: Numerical problems (e.g., calculating taxable income after deductions) and definitions (e.g., "business income" vs. "accounting profit").

1. Definitions: What Counts as Business Income?

Key Terms

Why the Difference?

The Income Tax Act ignores accounting profit and instead defines taxable business income as:

Taxable Business Income = Gross Receipts – Allowed Deductions (Section 19)

flowchart TD
    A["Gross Receipts\n(Revenue)"]
    B["- Disallowed Expenses\n(Section 19)"]
    C["= Accounting Profit\n(Books)"]
    D["- Additional Adjustments\n(PCC, Depreciation, etc.)"]
    E["= Taxable Business Income\n(Section 19)"]
    A --> C
    C --> D
    D --> E
    B --> D

2. Allowed Deductions Under Section 19

A. General Rules for Deductions

1. Directly Related to Business: Expenses must be wholly and exclusively for business.

   • Allowed: Salaries of employees, rent for office, raw materials.
   • Disallowed: Salary of owner’s spouse (unless employed), personal travel.

2. Incurred During Income Year: Expenses must be paid or accrued in the same income year (April 1 – March 31).

   • Example: If a shop pays rent for April 2023 in May 2023, it’s deductible in 2023–24 (not 2024–25).

3. Reasonable Amount: No "lavish" or "excessive" expenses.

   • Example: A Rs 50,000/month office in Thapathali for a small shop in Bhaktapur may be questioned.

B. Specific Allowed Deductions

C. Worked Example: Kathmandu Retail Shop

Scenario: Mr. Ram of Ram Stores (Kathmandu) provides the following for Income Year 2023–24:

• Gross Sales: Rs 5,000,000
• Cost of Goods Sold (COGS): Rs 3,000,000
• Salaries: Rs 800,000 (all paid)
• Rent (Office): Rs 200,000 (leased property)
• Rent (Owner’s Home): Rs 150,000 (claimed as business)
• Depreciation (Block D): Rs 150,000 (computers, furniture)
• Donation to School: Rs 50,000
• PCC from 2021–22: Rs 100,000 (loss carried forward)
• Personal Car Expenses: Rs 50,000 (used 60% for business)

Step-by-Step Calculation:

1. Accounting Profit: Gross Sales – COGS – Salaries – Rent (Office) – Depreciation = Rs 5,000,000 – 3,000,000 – 800,000 – 200,000 – 150,000 = **Rs 850,000**

2. Adjustments for Tax:

   • Add Back Disallowed Expenses:
     • Owner’s home rent: + Rs 150,000
     • Personal car (40% non-business): + Rs 20,000 (40% of Rs 50,000)
   • Deduct Allowed Adjustments:
     • Donation (max 10% of taxable income; provisional deduction first): - Rs 50,000
     • PCC: - Rs 100,000

3. Taxable Business Income:

   | Particulars               | Amount (Rs) |
   |---------------------------|-------------|
   | Accounting Profit         | 850,000     |
   | + Disallowed Expenses     | 170,000     |
   | = Adjusted Total          | 1,020,000   |
   | - Donation                | 50,000      |
   | - PCC                     | 100,000     |
   | **Taxable Income**        | **870,000** |
   

Key Takeaway: The taxable income (Rs 870,000) is higher than accounting profit (Rs 850,000) because disallowed expenses were added back.

3. Disallowed Expenses (Section 19 Exclusions)

A. Common Disallowed Items

B. Worked Example: Disallowed Expenses in a Daraz Seller’s Books

Scenario: A Daraz seller reports the following for 2023–24:

• Gross Sales: Rs 2,000,000
• COGS: Rs 1,200,000
• Salaries (Employees): Rs 300,000
• Rent (Warehouse): Rs 150,000
• Owner’s Salary: Rs 200,000 (claimed as business)
• Personal Car (Used 30% for Business): Rs 100,000
• Fine for Late Tax Filing: Rs 50,000
• Gift to Client (Rs 10,000): Exceeds Rs 5,000 limit.

Calculation:

1. Accounting Profit: Rs 2,000,000 – 1,200,000 – 300,000 – 150,000 = **Rs 350,000**

2. Add Back Disallowed Expenses:

   • Owner’s salary: + Rs 200,000
   • Personal car (70% non-business): + Rs 70,000
   • Fine: + Rs 50,000
   • Excess gift: + Rs 5,000 (only Rs 5,000 allowed)

3. Taxable Income:

   | Particulars               | Amount (Rs) |
   |---------------------------|-------------|
   | Accounting Profit         | 350,000     |
   | + Disallowed Expenses     | 325,000     |
   | **Taxable Income**        | **675,000** |
   

Real-World Tie-In: Daraz sellers often underreport expenses to reduce taxable income. However, personal expenses (e.g., owner’s salary, personal car) are always disallowed unless properly documented as business use.

4. Special Deductions: Depreciation (Block D) and PCC

A. Depreciation Under Block D

• Mandatory for tangible assets (e.g., computers, vehicles, machinery).
• Not optional: Even if not claimed in books, the Income Tax Act requires depreciation.
• Rates:
  • Machinery/Equipment: 10%–20% (depends on asset type).
  • Vehicles: 15%–25% (higher for luxury cars).
  • Building: 5% (longer useful life).

Example (Ncell’s Depreciation Claim): Ncell purchases Rs 5,000,000 worth of servers in 2023–24.

• Depreciation Rate: 20% (Block D).
• Annual Depreciation: Rs 5,000,000 × 20% = Rs 1,000,000 (deductible in first year).

| Asset               | Cost (Rs) | Depreciation Rate | Year 1 | Year 2 | Year 3 | Total Depreciated |
|---------------------|-----------|--------------------|--------|--------|--------|-------------------|
| Coffee Machines     | 800,000   | 20%                | 160,000| 128,000| 102,400| 390,400           |
| Refrigerators       | 600,000   | 15%                | 90,000 | 76,500 | 61,200 | 227,700           |
| **Total**           | **1,400,000** |                    | **250,000** | **204,500** | **163,600** | **618,100**       |

B. Profit & Loss Carry Forward (PCC)

• Losses from previous years can be carried forward for up to 7 years.
• Conditions:
  • Must be from same business.
  • Not due to fraud or negligence.
  • Must be claimed in order (oldest first).

Example (Pathao’s PCC Claim): Pathao incurs a loss of Rs 2,000,000 in 2021–22 due to COVID-19. In 2023–24, it reports a profit of Rs 5,000,000.

• PCC Deduction: Rs 2,000,000 (fully deductible in 2023–24).
• Taxable Income: Rs 5,000,000 – 2,000,000 = Rs 3,000,000.

Mermaid Diagram: PCC Carry Forward Rules

flowchart TD
    A["Loss in Year 1
(2021–22)"]
    B["Profit in Year 2
(2022–23)"]
    C["Profit in Year 3
(2023–24)"]
    D["PCC Deduction
(Oldest First)"]
    E["Unabsorbed Loss
(If Profit < Loss)"]
    A -->|"Carry Forward"| D
    D --> B
    D --> C
    C -->|"If Profit > Loss"| E

5. Withholding Tax on Expenses (Section 111)

A. When Does Withholding Apply?

Withholding tax is deducted at source on certain payments and reduces the deductible amount in the payer’s books.

B. Worked Example: NTC’s Withholding Tax on Rent

Scenario: NTC pays Rs 500,000 rent to a landlord in 2023–24.

• Withholding Tax: 10% of Rs 500,000 = Rs 50,000.
• Amount Paid to Landlord: Rs 500,000 – 50,000 = Rs 450,000.
• NTC’s Deduction in Books: Rs 500,000 (but only Rs 450,000 is net expense).

Tax Impact:

• NTC’s taxable income is higher because the gross rent (Rs 500,000) is deducted, but the net payment (Rs 450,000) is lower.
• The Rs 50,000 withheld is paid to the government by NTC (as deductor).

6. In the Real World

A. eSewa: Transaction Fees as Disallowed Expenses

• Scenario: eSewa charges a 1.5% fee on transactions.
• Tax Treatment:
  • The fee is revenue, not an expense.
  • If eSewa wrongly claims fees as a deduction, the Income Tax Office will disallow it (personal expense rule).

B. Daraz: Withholding Tax on Supplier Payments

• Scenario: Daraz pays Rs 2,000,000 to a supplier.
• Tax Treatment:
  • 10% withholding tax (Rs 200,000) is deducted.
  • Supplier receives Rs 1,800,000.
  • Daraz’s books show Rs 2,000,000 as expense, but net payment is Rs 1,800,000.

C. Ncell: Depreciation on Network Equipment

• Scenario: Ncell buys Rs 200,000,000 worth of 5G towers.
• Tax Treatment:
  • Depreciation (20%): Rs 200,000,000 × 20% = Rs 40,000,000 (deductible in first year).
  • Reduces taxable income by Rs 40,000,000, saving tax (e.g., 25% corporate rate = Rs 10,000,000 tax saved).

D. Kathmandu Traffic Police: PCC from COVID Losses

• Scenario: A Kathmandu auto-rickshaw union lost Rs 5,000,000 in 2020–21 due to lockdowns.
• Tax Treatment:
  • PCC carried forward for 7 years.
  • In 2023–24, if they earn Rs 8,000,000 profit, they can deduct Rs 5,000,000, reducing taxable income to Rs 3,000,000.

7. Exam Tip: How to Score Full Marks

A. Numerical Problems (Most Common)

1. Always start with accounting profit (given or calculated).
2. Add back disallowed expenses (personal, capital, non-business).
3. Deduct allowed adjustments (depreciation, PCC, donations).
4. Check withholding tax if payments are involved (e.g., rent, interest).
5. Verify donation limit (max 10% of taxable income).

Example Question: A trader shows accounting profit of Rs 1,500,000. Disallowed expenses: Rs 200,000 (personal car), Rs 100,000 (capital expenditure). Depreciation: Rs 150,000. PCC: Rs 50,000. Donation: Rs 80,000. Compute taxable income.

Solution:

| Particulars               | Amount (Rs) |
|---------------------------|-------------|
| Accounting Profit         | 1,500,000   |
| + Disallowed Expenses     | 300,000     |
| = Adjusted Total          | 1,800,000   |
| - Depreciation            | 150,000     |
| - PCC                     | 50,000      |
| - Donation (10% of 1,600,000) | 80,000*    |
| **Taxable Income**        | **1,420,000** |

Donation limited to 10% of (1,800,000 – 150,000 – 50,000) = Rs 1,600,000 → Max Rs 160,000. Since Rs 80,000 < Rs 160,000, fully deductible.

B. Definitions (Short Answer)

• Business Income: Income from trade/profession after allowed deductions (Section 19).
• Assessable Income: Business income after disallowed expenses and adjustments.
• Withholding Tax: Tax deducted at source on payments (e.g., rent, interest).

C. Common Mistakes to Avoid

1. Forgetting to add back disallowed expenses (e.g., personal car, capital costs).
2. Incorrect donation limit (max 10% of taxable income, not gross income).
3. Depreciation not deducted (mandatory under Block D).
4. PCC not claimed in order (oldest loss first).
5. Withholding tax not adjusted (gross payment vs. net payment).

D. Model Answer Structure for Numerical Problems

1. State the formula: Taxable Income = Gross Receipts – Allowed Deductions (Section 19).

2. List all adjustments:

   • Add: Disallowed expenses (personal, capital, etc.).
   • Deduct: Depreciation, PCC, donations (with limit check).

3. Show calculations in a table (like above).

4. Final answer in bold.

E. Past Exam Questions Solved

Q1: A businessman has adjusted taxable income of Rs 1,000,000 and donates Rs 200,000 to a public school. Compute allowable donation. Solution:

• Donation limit: 10% of taxable income = 10% of 1,000,000 = Rs 100,000.
• Allowable donation: Rs 100,000 (since Rs 200,000 > limit).

Q2: A trader has profits/losses over 7 years: (50k), (40k), 100k, 50k, (30k), 80k, 150k. Donation: Rs 20k. Compute taxable income for Year 7. Solution:

1. PCC from Year 1–6:
   • Year 1: (50k) → Deduct in Year 7.
   • Year 2: (40k) → Deduct in Year 7.
   • Year 3: 100k (no PCC).
   • Year 4: 50k (no PCC).
   • Year 5: (30k) → Deduct in Year 7.
   • Year 6: 80k (no PCC).
   • Total PCC: 50k + 40k + 30k = Rs 120,000.
2. Year 7 Profit: Rs 150,000.
3. Taxable Income: 150,000 – 120,000 (PCC) – 20,000 (donation) = **Rs 10,000**.

F. Quick Revision Checklist

G. Final Worked Example: Comprehensive Problem

Scenario: Mr. Bikram of Bikram Electronics (Pokhara) provides:

• Gross Sales: Rs 12,000,000
• COGS: Rs 7,000,000
• Salaries: Rs 1,500,000
• Rent (Office): Rs 500,000
• Rent (Owner’s Home): Rs 300,000 (claimed as business)
• Depreciation (Block D): Rs 400,000
• Interest on Business Loan: Rs 200,000
• Interest on Personal Loan: Rs 100,000 (claimed as business)
• Donation to Hospital: Rs 150,000
• PCC from 2021–22: Rs 200,000 (loss)
• Withholding Tax on Rent: 10% (paid to landlord)

Solution:

1. Accounting Profit: 12,000,000 – 7,000,000 – 1,500,000 – 500,000 – 400,000 = **Rs 2,600,000**

2. Add Back Disallowed Expenses:

   • Owner’s home rent: + Rs 300,000
   • Personal loan interest: + Rs 100,000

3. Deduct Allowed Adjustments:

   • Depreciation: - Rs 400,000
   • PCC: - Rs 200,000
   • Donation (10% of taxable income; provisional deduction):
     • Provisional taxable income before donation: 2,600,000 + 300,000 + 100,000 – 400,000 – 200,000 = Rs 2,400,000
     • Donation limit: 10% of 2,400,000 = Rs 240,000 (but only Rs 150,000 given → fully deductible).

4. Taxable Income:

   | Particulars               | Amount (Rs) |
   |---------------------------|-------------|
   | Accounting Profit         | 2,600,000   |
   | + Disallowed Expenses     | 400,000     |
   | = Adjusted Total          | 3,000,000   |
   | - Depreciation            | 400,000     |
   | - PCC                     | 200,000     |
   | - Donation                | 150,000     |
   | **Taxable Income**        | **2,250,000** |
   

Withholding Tax Note:

• The Rs 500,000 rent had 10% withheld (Rs 50,000).
• Net rent paid: Rs 450,000 (but books show Rs 500,000 as expense).
• No further adjustment needed in taxable income calculation (withholding is a source deduction, not a business expense adjustment).

H. Summary Table: Key Deductions vs. Disallowed Items

I. Final Mermaid: Accounting Profit vs. Taxable Income Flow