Opting Out of Section 44AD: The Five-Year Lock-out and the Audit That Cannot Be Avoided
Mr Arun Kumar runs a wholesale garment business as a sole proprietor at Ludhiana. For FY 2023-24 his turnover was ₹2,20,00,000, received wholly through bank transfers and UPI with no cash receipts. He opted for section 44AD and declared income of ₹13,20,000, being 6% of turnover. For FY 2024-25 a fire in his godown destroyed stock and disrupted sales; turnover fell to ₹1,60,00,000, again with no cash receipts. His accountant computes profit at ₹3,80,000 after charging depreciation of ₹2,10,000 on plant and a provision of ₹75,000 for an anticipated warranty claim. Arun now proposes to declare ₹4,00,000 as business income and to remain under section 44AD, arguing that turnover is below ₹2 crore and that the section is therefore available to him. He has also bought a car in his wife's name out of business funds; the car is registered in her name and is used partly by the sales team. His other income for FY 2024-25 is ₹9,50,000.
1. Examine Arun's proposal to declare ₹4,00,000 for FY 2024-25 while claiming to remain under section 44AD. What are the consequences?
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Section 44AD does not permit a voluntary lower figure
An eligible assessee opting for section 44AD must declare income at 6% (receipts through prescribed banking/digital modes) or 8% (cash receipts) of turnover, or higher. Declaring 2.5% of ₹1,60,00,000 is not a declaration "under" section 44AD; it is in effect opting out of it. The argument that turnover is below ₹2 crore is irrelevant - turnover decides whether he may enter the section, not whether he can stay in it at a figure of his choosing.
Consequence 1 - the five-year lock-out under section 44AD(4)
Where an eligible assessee declared income under section 44AD in an earlier year and then declares income not in accordance with the section, he cannot claim section 44AD for that year and for the four immediately succeeding assessment years. Arun is therefore barred for AY 2025-26 to AY 2029-30. Even if turnover later falls below the threshold, he cannot re-enter section 44AD during this window.
Consequence 2 - audit under section 44AD(5)
Having claimed profit lower than the deemed profit, he must maintain books under section 44AA(2) and get them audited, furnishing the report under section 44AB.
Consequence 3 - income is computed normally
Profit ₹3,80,000, plus the warranty provision of ₹75,000 (a contingent liability, not an allowable deduction, unless it is an ascertained liability under the mercantile system). Depreciation of ₹2,10,000 is allowed provided the ownership condition is met. His business income would be computed on that basis, not at his chosen figure.
2. What is the tax audit position for FY 2024-25 and for the four succeeding years? Would the ₹10 crore relaxed threshold help him?
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FY 2024-25 - audit is compulsory
The relaxed turnover threshold of ₹10 crore in section 44AB(a) applies where cash receipts and cash payments do not exceed 5% of total receipts and payments respectively. Arun has no cash receipts, so on turnover alone he would escape audit at ₹1,60,00,000.
But section 44AD(5) is a separate and overriding trigger: an assessee who claims that his profit is lower than the deemed profit under section 44AD must keep books and get them audited under section 44AB. That obligation does not depend on turnover. The ₹10 crore relaxation therefore gives him no relief for FY 2024-25.
The report is to be furnished in the prescribed form (3CB with 3CD) electronically at least one month before the due date for filing the return under section 139(1).
FY 2025-26 to FY 2028-29 - no automatic audit
The audit obligation in section 44AD(5) attaches only to a year in which he claims profit below the deemed profit under section 44AD. In the four succeeding years he is simply outside section 44AD. Audit in those years depends on the ordinary thresholds: turnover above ₹1 crore, or above ₹10 crore where cash receipts and payments are within 5%. With turnover near ₹1.60 crore and no cash receipts, no audit would be required.
Practical point
If Arun expects losses to be temporary, declaring 6% of ₹1,60,00,000 (₹9,60,000) may cost less in tax than losing the presumptive option for five years and bearing audit cost in the first year. The decision is a cost comparison, not a formality.
3. Is depreciation on the car registered in his wife's name allowable to Arun? How should the transaction be handled?
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Ownership is the test
Section 32 allows depreciation to the assessee who is the owner (or part-owner) of the asset, or who has acquired it under a hire-purchase or similar arrangement. The registered owner of a motor vehicle, for the purposes of the Motor Vehicles Act and generally for section 32, is the person in whose name it is registered.
Here the car is registered in the wife's name. Arun's payment out of business funds and part-use by his sales team do not make him the owner. Depreciation of ₹2,10,000 on plant is a separate matter; depreciation on the car is not allowable to him at all - not even on the business-use proportion.
Other consequences
- Running and maintenance expenses incurred by Arun on a car he does not own are not deductible as his business expenditure; at best a hire charge paid to the wife could be considered, and would be allowed only if it is reasonable and paid.
- If the wife derives income from the car, section 64(1)(iv) may apply to club that income in Arun's hands if the asset was transferred to her without adequate consideration. A pure gift of money used by her to buy the car is more likely to fall under section 64(1)(iv) only to the extent income arises from the transferred asset.
- If the car had been registered in the company's or proprietor's name, depreciation would still be restricted to the business-use proportion where there is personal use.
Correct approach: register the vehicle in the name of the person who will claim depreciation, and document any transfer to the spouse with the clubbing implications in mind.