The Companies Act, 2013
CHAPTER XIII: APPOINTMENT AND REMUNERATION OF MANAGERIAL PERSONNEL
Section 198: Calculation Of Profits
Bare Act
(1) In computing the net profits of a company in any financial year for the purpose of section 197, -
- 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
- 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 authorised 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:
- profits, by way of premium on shares or debentures of the company, which are issued or sold by the company unless the company is an investment company as referred to in clause (a) of the Explanation to section 186;
- profits on sales by the company of forfeited shares;
- 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;
- 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; - 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.
- any amount representing unrealised gains, notional gains or revaluation of assets.
(4) In making the computation aforesaid, the following sums shall be deducted, namely:
- all the usual working charges;
- directors remuneration;
- 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;
- any tax notified by the Central Government as being in the nature of a tax on excess or abnormal profits;
- any tax on business profits imposed for special reasons or in special circumstances and notified by the Central Government in this behalf;
- interest on debentures issued by the company;
- interest on mortgages executed by the company and on loans and advances secured by a charge on its fixed or floating assets;
- interest on unsecured loans and advances;
- expenses on repairs, whether to immovable or to movable property, provided the repairs are not of a capital nature;
- outgoings inclusive of contributions made under section 181;
- depreciation to the extent specified in section 123;
- the excess of expenditure over income, which had arisen in computing the net profits in accordance with this section in any year, 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;
- any compensation or damages to be paid in virtue of any legal liability including a liability arising from a breach of contract;
- any sum paid by way of insurance against the risk of meeting any liability such as is referred to in clause (m);
- 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:
- income - tax and super - tax payable by the company under the Income - tax Act, 1961 (43 of 1961), or any other tax on the income of the company not falling under clauses (d) and (e) of subsection (4);
- 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);
- 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;
- 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.
Simplified Act
Explanation:
When a company calculates its net profits for a financial year to determine how much it can pay its directors (as per section 197), it must:
- Add certain amounts (as mentioned in part 2) and ignore others (as in part 3).
- Subtract specific expenses (listed in part 4) but not subtract others (as in part 5).
Amounts to be added (part 2):
- Money received from government grants and subsidies, unless the central government says otherwise.
Amounts not to be added (part 3):
- Profits from selling shares or debentures at a premium, unless the company is an investment company.
- Money made from selling forfeited shares.
- One-time profits from selling part or all of the company or its assets.
- Profits from selling real estate or fixed assets, unless the company's business involves such sales.
- Increases in asset values or decreases in liabilities that are recorded in the company's equity or profit and loss reserves.
- Unrealized gains or estimated increases in asset values.
Expenses to be subtracted (part 4):
- Regular operating costs.
- Pay for directors.
- Bonuses or commissions for employees or contractors.
- Certain taxes on extra or abnormal profits.
- Special taxes on business profits.
- Interest paid on company-issued debentures.
- Interest on mortgages and secured loans and advances.
- Interest on unsecured loans and advances.
- Repair costs, as long as they are not for upgrades.
- Charitable donations (as per section 181).
- Depreciation of assets (as per section 123).
- Previous years' losses that haven't already been accounted for.
- Legal liabilities, including breach of contract.
- Insurance against such legal liabilities.
- Bad debts that are written off.
Expenses not to be subtracted (part 5):
- Income tax or any other tax on income, except for the taxes mentioned in part 4.
- Voluntary payments, such as those not required by legal obligations.
- Losses from selling part or all of the company or its assets, except for certain asset write-downs.
- Changes in the value of assets or liabilities recorded in equity reserves.
Explanation using examples
Imagine a company, ABC Ltd., is calculating the remuneration payable to its directors at the end of a financial year. To comply with Section 198 of the Companies Act, 2013, ABC Ltd. must calculate its net profits correctly.
During the year, ABC Ltd. received a government subsidy for setting up a new plant. According to Section 198(2), this subsidy will be credited to the net profits. However, ABC Ltd. also made a profit by selling some of its office furniture, which is a capital asset. As per Section 198(3)(c), this profit won't be credited to the net profits since it's of a capital nature.
Additionally, ABC Ltd. had to pay interest on the loans it took to finance its operations. This interest, as stated in Section 198(4)(g), will be deducted from the net profits. However, the income tax paid by the company cannot be deducted as per Section 198(5)(a).
By following Section 198, ABC Ltd. ensures that the remuneration paid to its directors is in accordance with the profits legally available for distribution.
