Section 198 Companies Act: Calculation of profits

Section 198 of Companies Act: Corporate Governance & Statutory Compliance

Official Bare Act Text

Override / Mandate Mens Rea (Intent) Actus Reus (Conduct) Punishment Limitation Monetary

1. In computing the net profits of a company in any financial year for the purpose of section 197,

a. credit shall be given for the sums specified in sub-section (2 ), and credit shall not be given for those specified in sub-section (3 ); and

b. the sums specified in sub-section (4 ) shall be deducted, and those specified in sub-section (5 ) shall not be deducted.

2. In making the computation aforesaid, credit shall be given for the bounties and subsidies received from any Government, or any public authority constituted or authorized in this behalf, by any Government, unless and except in so far as the Central Government otherwise directs.

3. In making the computation aforesaid, credit shall not be given for the following sums, namely:—

a. profits, by way of premium on shares or debentures of the company, which are issued or sold by the company;

b. profits on sales by the company of forfeited shares;

c. profits of a capital nature including profits from the sale of the undertaking or any of the undertakings of the company or of any part thereof;

d. profits from the sale of any immovable property or fixed assets of a capital nature comprised in the undertaking or any of the undertakings of the company, unless the business of the company consists, whether wholly or partly, of buying and selling any such property or assets:

Provided that: where the amount for which any fixed asset is sold exceeds the written-down value thereof, credit shall be given for so much of the excess as is not higher than the difference between the original cost of that fixed asset and its written down value;

e. any change in carrying amount of an asset or of a liability recognised in equity reserves including surplus in profit and loss account on measurement of the asset or the liability at fair value.

4. In making the computation aforesaid, the following sums shall be deducted, namely:—

a. all the usual working charges;

b. directors' remuneration;

c. bonus or commission paid or payable to any member of the company's staff, or to any engineer, technician or person employed or engaged by the company, whether on a whole-time or on a part-time basis;

d. any tax notified by the Central Government as being in the nature of a tax on excess or abnormal profits;

e. any tax on business profits imposed for special reasons or in special circumstances and notified by the Central Government in this behalf;

f. interest on debentures issued by the company;

g. interest on mortgages executed by the company and on loans and advances secured by a charge on its fixed or floating assets;

h. interest on unsecured loans and advances;

i. expenses on repairs, whether to immovable or to movable property, provided the repairs are not of a capital nature;

j. outgoings inclusive of contributions made under section 181;

k. depreciation to the extent specified in section 123;

l. the excess of expenditure over income, which had arisen in computing the net profits in accordance with this section in any year which begins at or after the commencement of this Act, in so far as such excess has not been deducted in any subsequent year preceding the year in respect of which the net profits have to be ascertained;

m. any compensation or damages to be paid in virtue of any legal liability including a liability arising from a breach of contract;

n. any sum paid by way of insurance against the risk of meeting any liability such as is referred to in clause (m );

o. debts considered bad and written off or adjusted during the year of account.

5. In making the computation aforesaid, the following sums shall not be deducted, namely:—

a. income-tax and super-tax payable by the company under the Income-tax Act, 1961, or any other tax on the income of the company not falling under clauses (d ) and (e ) of sub-section (4 );

b. any compensation, damages or payments made voluntarily, that is to say, otherwise than in virtue of a liability such as is referred to in clause (m ) of sub-section (4 );

c. loss of a capital nature including loss on sale of the undertaking or any of the undertakings of the company or of any part thereof not including any excess of the written-down value of any asset which is sold, discarded, demolished or destroyed over its sale proceeds or its scrap value;

d. any change in carrying amount of an asset or of a liability recognised in equity reserves including surplus in profit and loss account on measurement of the asset or the liability at fair value.

Statutory Defined Terms in this Section: (Click any term for official legal definition)

Company Sec 2(20) Director Sec 2(34) Tribunal Sec 2(90)

Legal Commentary & Landmark Judgments: Section 198

Section 198 provides the statutory accounting mechanism for computing the net profits of a company in any financial year, serving as the mandatory benchmark for calculating managerial remuneration caps under Section 197 and charitable limits under Section 181.

Permissible Credit Additions: Net profit calculations must credit bounties and subsidies received from the Government or public authorities, while strictly excluding unrealized capital gains, profits from the sale of forfeited shares, and revaluation surpluses.
Statutorily Mandated Expense Deductions: Mandates deduction of all regular working charges, directors' remuneration, interest on debentures and loans, repairs, insurances, bad debts written off, legal expenses, and depreciation calculated under Section 123 Schedule II.
Prohibited Deductions: Explicitly prohibits deductions for income-tax paid or payable, voluntary compensation or damages, capital losses, and transfers to reserves, ensuring an unskewed operating profit figure.
Capital Profit Realization Constraints: Profits on the sale of immovable property or fixed capital assets cannot be credited to net profits unless realized in cash, and even then, credit is limited strictly to the excess of sale proceeds over the written-down value up to the original cost.

Key Landmark Precedents:

CIT v. Birla Gwalior (P) Ltd., (1973) 89 ITR 266 (SC): The Supreme Court held that net profits for determining managerial remuneration must be computed strictly in conformity with statutory accounting rules under the Companies Act, disallowing artificial accruals or unearned book entries.
Alkali & Chemical Corpn. of India Ltd. v. CIT, (1986) 161 ITR 820 (Cal): The High Court affirmed that statutory depreciation must be deducted at prescribed rates before computing managerial commission under Section 198, ensuring capital preservation before executive payout.

Courtroom Practice & Strategic Litigation Guidance:

In challenging managerial payouts as excessive under Section 197, perform a line-by-line reconciliation of the Section 198 computation annexed to the Directors' Report. If the company inflated net profits by including revaluation reserves, unrealized mark-to-market derivative gains, or government grants not yet accrued, file a petition before the NCLT for recalculation and recovery of excess remuneration.

Section 198: Calculation of profits

Section 198 of Companies Act: Corporate Governance & Statutory Compliance

Legal Commentary & Landmark Judgments: Section 198