Set Off and Carry Forward of Losses

Set Off and Carry Forward of Losses are provisions under the Income Tax Act that allow taxpayers to adjust their financial losses against income to reduce taxable income. Losses can be set off either within the same head (intra-head) or across different heads (inter-head) of income in a financial year. If not fully utilized, unadjusted losses can be carried forward to subsequent years for adjustment, subject to specific rules and time limits. These provisions help individuals and businesses optimize tax liabilities and manage financial setbacks effectively.

Set Off of Losses refers to the process of adjusting or balancing a loss incurred under one head of income against the profits or gains from another head of income in the same financial year. This mechanism, governed by the Income Tax Act, helps taxpayers reduce their overall tax liability by offsetting losses against eligible incomes. For instance, a business loss can often be set off against income from other sources, such as property rent or capital gains, subject to specific rules and restrictions.

Types of set off of losses

The process of setting off losses can be broadly categorized into two types: Intra-head Set Off and Inter-head Set Off. Here’s a detailed look at each type:

Intra-head Set Off

Intra-head set off refers to the adjustment of losses from one source of income against income from another source within the same head of income. This is the first level of loss adjustment allowed under the Income Tax Act. It ensures that losses in one area of a particular income head can reduce the taxable income from other sources within the same head, thereby lowering the overall tax liability.

Examples of Intra-head Set Off:

Income from House Property: A loss from one house property (e.g., a property rented out at a loss due to high maintenance costs) can be set off against income earned from another house property.

Profits and Gains from Business or Profession: A loss from one business (e.g., a manufacturing unit) can be set off against profits from another business (e.g., a trading activity), provided neither business has restrictions, such as speculative or specified businesses.

Capital Gains: Short-term capital losses can be set off against short-term capital gains or long-term capital gains within the same head of income.

Long-term capital losses can only be set off against long-term capital gains.

Key Exceptions to Intra-head Set Off:

While the mechanism seems straightforward, the Income Tax Act imposes certain restrictions on how losses can be adjusted:

Losses under Capital Gains: Long-term and short-term losses under the “Capital Gains” head cannot be set off against each other without adhering to their specific rules.

Speculative Business Losses: Losses from speculative transactions can only be set off against profits from speculative activities.

Losses from Specified Businesses (Section 35AD): Losses from businesses claiming deductions under Section 35AD (e.g., cold chain facility or hotels) can only be set off against profits from the same specified business.

Losses from Lotteries, Races, or Gambling: Losses incurred from these activities cannot be set off against any other source of income, even within the same head.

Importance of Intra-head Set Off:

By utilizing intra-head set off, taxpayers can reduce their taxable income at the source level, which provides immediate relief without carrying losses forward. This method is particularly beneficial for individuals and businesses with multiple income-generating activities under the same head.

Inter-head Set Off

Inter-head set off refers to the adjustment of losses from one head of income against the income from another head of income during the same financial year. This mechanism provides flexibility to taxpayers by allowing them to reduce their overall taxable income when intra-head adjustments are not sufficient to cover the losses.

Examples of Inter-head Set Off:

Loss from House Property: Losses under the head “Income from House Property” (e.g., due to a high interest payment on a home loan) can be set off against Income from Salary, Profits from Business or Profession, Income from Other Sources (e.g., interest income or dividends)

Business Losses:

Normal business losses can be set off against Income from other heads, such as Income from House Property or Income from Other Sources (but not salary income).

Key Exceptions to Inter-head Set Off:

Although inter-head set off provides broader flexibility, certain restrictions are imposed by the Income Tax Act:

1. Losses under Capital Gains:

   • Losses under the “Capital Gains” head cannot be set off against income from any other head.
   • For example, a shortfall in capital gains cannot be adjusted against business income or income from other sources.

2. Speculative Business Losses:

   • Losses incurred from speculative business activities can only be set off against profits from speculative businesses.

3. Specified Business Losses (Section 35AD):

   • Losses from businesses eligible for deductions under Section 35AD can only be set off against income from other specified businesses.

4. Losses from Lotteries, Races, or Gambling:

   • These losses cannot be set off against any other head of income, including other miscellaneous incomes.

5. Business Losses and Salary Income:

   • Losses from a business cannot be set off against salary income.

Summary of Intra-head and Inter-head Set Off

This table highlights the key differences and rules, helping taxpayers identify the appropriate method for optimizing their tax liabilities.

Carry Forward of Losses

• Capital losses occur when the sale of a capital asset results in a loss compared to its purchase price.
• Short-term capital losses (STCL) can be set off against both short-term capital gains (STCG) and long-term capital gains (LTCG).
• Long-term capital losses (LTCL) can only be set off against long-term capital gains (LTCG).
• Unadjusted capital losses can be carried forward for 8 assessment years.
• To carry forward capital losses, the income tax return must be filed on time under Section 139(1).
• Capital losses cannot be set off against income from other heads, such as salary, business, or house property.
• Example: A loss from selling shares at a lower price than the purchase can be adjusted against gains from selling mutual funds or real estate, subject to the rules mentioned above.

Losses from owning and maintaining race-horses

• Losses from owning and maintaining race-horses can only be set off against income from owning and maintaining race-horses in the same financial year.
• These losses cannot be set off against any other income, such as salary, business profits, or capital gains.
• Unadjusted losses can be carried forward for up to 4 assessment years.
• To carry forward these losses, the income tax return must be filed on time under Section 139(1).

Comparison Table for Different Types of Losses