Explanation 1 to Section 115JB – A Clause-By-Clause Analysis Of Book Profit Adjustments

1. INTRODUCTION: THE ARCHITECTURE OF BOOK PROFIT

What is Explanation 1?

Explanation 1 to Section 115JB(2) is the rulebook for computing book profit. It specifies, with surgical precision, which items must be added to and subtracted from the net profit shown in audited financial statements.

Why it matters:

Without these rules, every company would compute book profit differently
The Explanation ensures uniform, standardized computation
It’s the difference between paying ₹10 crore tax and ₹20 crore tax for the same company

Structure of Explanation 1

Explanation 1 to Section 115JB(2) contains:

├── Clause (a) to (j): ADDITIONS to net profit

├── Clause (i) to (iig): DEDUCTIONS from net profit

├── The “Provided that” Clause: CAPS and LIMITS

└── Sub-clauses and Sub-sub-clauses for specific scenarios

Total adjustable items: 20+ (across all clauses and sub-clauses)

2. HOW TO READ EXPLANATION 1: THE FRAMEWORK

The Formula

text

BOOK PROFIT = Net Profit (per audited P&L)

+ Additions [Clauses (a) to (j)]

– Deductions [Clauses (i) to (iig)]

± Cross-adjustments (where applicable)

Key Principle: “Actual P&L Entries”

Golden Rule:

“Only items that are actually debited to or credited to the profit and loss account can be adjusted. Items that appear only in the tax computation (like Rule 8D disallowance) cannot be imported.”

This principle comes from the Vireet Investments Special Bench decision and is fundamental to understanding Explanation 1.

3. CLAUSE-BY-CLAUSE ANALYSIS OF SECTION 115JB(2) EXPLANATION 1

When an item is added to net profit, it means: “This reduced profit in the P&L, but for MAT, we’re adding it back because it shouldn’t have reduced book profit.”

Clause (a): Amount of Income Tax Paid or Payable

The Provision

“the amount or amounts paid or payable as income-tax in respect of the profits or gains of the previous year…”

What It Means

When a company pays income tax, it reduces profit. This amount is debited to the P&L account.

For book profit calculation, we add it back because:

We’re computing pre-tax book profit
Tax is a consequence of profit, not a measure of profit
We want book profit to be a pure operating/commercial figure

What to Add

Income tax paid in the current year
Income tax payable but not yet paid (accrued)
Education cess (if debited to P&L)
Surcharge (if debited to P&L)
Any other tax under IT Act

What NOT to Add

GST paid (separate tax system, not IT)
Professional tax (state levy, not IT)
Foreign taxes (except in specific cases)

Example

Company ABC Ltd.

─────────────────

Net profit (after IT) ₹50 crores

IT paid during year ₹8 crores (separately debited to equity/reserve)

But also appears in tax provision in P&L as ₹8 crores

For book profit:

Add back: ₹8 crores (IT paid/payable)

Judicial Note

The Supreme Court in Godrej & Boyce Manufacturing Co. Ltd. clarified that “income tax paid” means tax debited to the P&L account or tax actually remitted to the government that affected profit.

Clause (b): Amount Set Aside as Reserves

The Provision

“the amount or amounts set aside to, or withdrawn from, reserves (by whatever name called), not being a reserve for depreciation…”

What It Means

When company transfers profit to reserves (like General Reserve, Contingency Reserve, etc.), it reduces distributable profit. But the money still belongs to the company.

For book profit, we add it back because:

Reserves are an appropriation of profit, not an expense
The amount is still part of the company’s economic profit
MAT should apply to the profit, not how it’s allocated

What to Add Back

General Reserve created from profit
Dividend Equalization Reserve
Contingency Reserve
Asset Revaluation Reserve (partially)
Any named or unnamed reserve created by transfer from profit

Important Provision

“not being a reserve for depreciation”

Depreciation reserve is excluded because it’s already handled separately in Clause (g).

Example

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Company XYZ Ltd.

─────────────────

Net profit (after allocations) ₹40 crores

Transfer to General Reserve ₹15 crores (debited to P&L)

Transfer to Contingency Reserve ₹5 crores (debited to P&L)

For book profit:

Add back: ₹15 crores (General Reserve)

Add back: ₹5 crores (Contingency Reserve)

Total additions: ₹20 crores

Clause (c): Amount of Provisions for Unascertained Liabilities

The Provision

“the amount or amounts of provisions for unascertained liabilities, including provisions made on an ad hoc basis or on an actuarial basis for gratuity, leave encashment, statutory obligations (including warranty claims) or such other similar obligations…”

What It Means

Provisions for uncertain/contingent liabilities reduce profit but haven’t crystallized into actual liabilities.

For book profit, we add them back because:

These are conservative accounting provisions
They may or may not materialize
MAT should not be reduced by speculative/uncertain liabilities

What to Add Back

Provision for gratuity (actuarially calculated or ad hoc)
Provision for leave encashment
Provision for warranty claims
Provision for legal settlements (pending litigation)
Provision for restructuring costs
Provision for environmental obligations

What NOT to Add Back

Provisions for ascertained liabilities (e.g., known salary payable, bills payable)
Depreciation reserve (separately handled)
Provisions explicitly tied to IT Act deductions

Key Distinction: Ascertained vs. Unascertained

ASCERTAINED LIABILITY UNASCERTAINED LIABILITY

─────────────────────────────────────────────────────

Known liability Potential liability

Amount certain Amount uncertain

Payment date known Payment date uncertain

E.g., Salary payable E.g., Provision for gratuity

↓ ↓

NOT added back ADDED BACK

Example

Company PQR Ltd.

─────────────────

Provision for gratuity (actuarial) ₹3 crores (debited)

Provision for warranty claims ₹2 crores (debited)

Provision for legal settlement ₹1 crore (debited)

Salary payable (ascertained, not yet paid) ₹20 lakhs (debited)

For book profit:

Add back: ₹3 crores (gratuity – unascertained)

Add back: ₹2 crores (warranty – unascertained)

Add back: ₹1 crore (legal – unascertained)

Do NOT add: ₹20 lakhs (salary – ascertained)

Total additions: ₹6 crores

Clause (d): Amount of Dividends Paid or Proposed

The Provision

“the amount of dividends paid or proposed to be paid or any distribution made or proposed to be made…”

What It Means

When a company proposes to pay dividend (per AS 4, now Ind AS 10), it’s debited to P&L. For book profit, we add it back.

Why? Similar to reserves—it’s an appropriation of profit, not an expense. The profit itself hasn’t reduced; only its allocation has changed.

When to Add

Final dividend declared (even if not yet paid)
Interim dividend proposed
Special dividend
Any distribution to shareholders

Example

Company LMN Ltd.

─────────────────

Dividend proposed (50% of profit) ₹50 crores (credited to reserve;

proposed dividend shown as liability)

For book profit:

Add back: ₹50 crores (dividends proposed)

Clause (e): Amount of Provisions for Losses of Subsidiaries

The Provision

“the amount of any provisions or reserve made for diminution in the value of investments in, or for the goodwill of, any other company…”

What It Means

Parent company makes provisions for expected losses of subsidiary companies (or for diminution in investment value).

For book profit, we add it back because:

It’s a provision for a subsidiary’s loss, not the parent’s own loss
The parent hasn’t itself made a loss
The provision is speculative until the loss is actual

Example

Parent Company ABC Ltd. owns subsidiary XYZ Ltd.

─────────────────

Provision for expected loss in XYZ Ltd. ₹5 crores (debited to P&L)

For book profit:

Add back: ₹5 crores (provision for subsidiary loss)

Clause (f): Amount of Expenditure Relatable to Exempt Income

The Provision (This is the most important)

“the amount or amounts of expenditure relatable to any income to which section 10… or section 11 or section 12 apply…”

What It Means

If you earned exempt income (dividend, Section 10 income, etc.) and incurred expenses to earn it, these expenses are added back to book profit.

Why? If income is tax-free, its related costs shouldn’t reduce taxable book profit either.

Critical Principle from Vireet Investments

“Only actual expenditure debited to the P&L account that has direct and proximate nexus with exempt income is added back. Notional or formulaic disallowances (like Rule 8D) are NOT imported into Section 115JB.”

What to Add Back

Interest on borrowing specifically for exempt-income investments
Salary of staff managing exempt portfolio
Brokerage/commission paid for buying exempt-generating securities
Administrative costs directly traceable to exempt income

What NOT to Add Back

Rule 8D computed disallowance (not actually debited to P&L)
General administrative expenses allocated by formula
Notional or presumptive amounts

Example (Per Vireet – Correct Approach)

Company DEF Ltd.

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Business income ₹50 crores

Dividend income (exempt) ₹5 crores

Interest on specific loan (for dividend portfolio) ₹2 crores (debited to P&L)

Portfolio management salary ₹50 lakhs (debited to P&L)

Book profit calculation:

Net profit (per P&L) ₹52.5 crores (50+5-2-0.5, among others)

Add back: Interest (₹2 crores) [Wait, it was already debited; not added back to profit yet]

CORRECT APPROACH:

Take P&L as prepared: ₹52.5 crores

[Interest and salary are already reduced profit]

Deduct exempt dividend: (₹5 crores)

[No separate add-back needed if interest/salary already debited]

Result: Book profit ≈ ₹47.5 crores (simplified)

OR if computing P&L before interest/salary allocation:

Net profit (before allocations) ₹54.5 crores

Add back: Interest (₹2 crores) [to isolate]

Add back: Salary (₹0.5 crore) [to isolate]

Less: Dividend income (₹5 crores)

Result: ₹52 crores (for MAT purposes)

Clauses (fa), (fb), (fc), (fd): Special Adjustments for Specific Situations

These clauses handle special scenarios:

Clause (fa): Expenditure on AOP/BOI income (where income is exempt for a partner/beneficiary)
Clause (fb): Expenditure on foreign company income taxed below MAT rate
Clause (fc): Notional gains/losses on Business Trust units
Clause (fd): Expenses on patent royalty taxed at special rates

For most standard companies, these clauses rarely apply. They’re relevant for:

Partnership investments
Business Trust investments
Patent-income companies

Clause (g): Amount of Depreciation as per Books

The Provision

“the amount of depreciation as per the profit and loss account of the assessee…”

What It Means

Depreciation debited to P&L account (per accounting standards) is added back to net profit.

Why? Because we’ll later deduct IT Act depreciation (which is different). This allows us to capture the difference between accounting depreciation and tax depreciation.

The Mechanism

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Gross depreciation (accounting): ₹10 crores [ADD BACK]

Gross depreciation (IT Act): ₹15 crores [DEDUCT]

Net effect: -₹5 crores (net deduction to book profit)

This captures that tax depreciation is more favorable than accounting depreciation.

Example

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Company GHI Ltd.

─────────────────

Machinery purchased: ₹100 crores

Accounting depreciation (straight-line, 10%): ₹10 crores

Tax depreciation (IT Act 40%): ₹40 crores

For book profit:

Add back: Accounting depreciation = ₹10 crores

Deduct: Tax depreciation = (₹40 crores)

Net effect: (₹30 crores) reduction to book profit

[More tax depreciation → larger reduction in book profit → lower MAT]

Clause (h): Amount of Deferred Tax Liability/Expense

The Provision

“the amount of any deferred tax liability, or any deferred tax asset, as computed in accordance with Accounting Standard 22…”

What It Means

Deferred tax is an accounting concept reflecting timing differences between book profit and taxable income.

Add back: Deferred tax liability (because it reduced P&L)
Deduct: Deferred tax asset (because it increased P&L)

Why?

Deferred tax itself is not a cash outflow. We’re capturing the effect, not the provision itself.

Clause (i): Amount of Any Provisions/Revaluation Adjustments

The Provision

“the amount of any provision or reserve made for diminution in the value of any asset or for any contingent liability or any amount withdrawn from such a provision…”

What It Means

Provisions for bad debts, decline in investment value, revaluation losses, etc. are added back.

Example

text

Provision for bad debts: ₹5 crores [ADD BACK]

Provision for decline in investments: ₹2 crores [ADD BACK]

Revaluation loss on assets: ₹1 crore [ADD BACK]

Clause (j): Revaluation Reserve on Asset Retirement

Complex Clause for Asset Revaluation

When a revalued asset is retired/sold, the unrealized gain in the revaluation reserve is added back to book profit.

This is relevant mainly for companies that revalue assets upward and then dispose of them.

4. CLAUSE-BY-CLAUSE DEDUCTIONS UNDER EXPLANATION 1 TO SECTION 115JB

When an item is deducted from net profit, it means: “This increased profit in the P&L, but for MAT, we’re removing it because it shouldn’t increase book profit.”

Clause (i): Deduction of Brought-Forward Losses/Unabsorbed Depreciation

The Provision

“the amount of loss carried forward or unabsorbed depreciation as per the books of the assessee for the previous year (whichever is lower)…”

What It Means

If the company had losses in prior years (shown in books), or depreciation that couldn’t be fully claimed, these reduce book profit.

Critical Rule: LOWER of Two

Important: You deduct the LOWER of:

Brought-forward loss per books, OR
Unabsorbed depreciation per books

You don’t deduct the sum; you pick the lower amount.

Example

Company JKL Ltd.

─────────────────

Loss per books (AY 2022-23): ₹10 crores

Unabsorbed depreciation per books: ₹8 crores

For book profit:

Deduct LOWER of ₹10 crores or ₹8 crores = ₹8 crores

(NOT ₹18 crores, which would be the sum)

Clause (ii): Deduction of Exempt Income

The Provision

“the amount of income exempt under section 10 (other than section 10(38)) or section 11 or section 12, which has been credited to the profit and loss account…”

What It Means

If exempt income was credited to P&L, it’s deducted from book profit.

Why? If income is not taxable, it shouldn’t increase taxable book profit.

Important Exception: Section 10(38)

Section 10(38) = Long-Term Capital Gains on listed shares (under specific conditions)

This is NOT deducted from book profit. LTCG are subject to MAT.

Example

Exempt income included in P&L:

Dividend (Section 10(34)): ₹5 crores [DEDUCT]

Interest on Post Office savings (Section 10): ₹1 crore [DEDUCT]

LTCG on listed shares (Section 10(38)): ₹3 crores [DO NOT DEDUCT – these are taxed]

For book profit:

Deduct: ₹5 + ₹1 = ₹6 crores

(₹3 crores LTCG remain in book profit)

Clause (iia): Deduction of Depreciation per IT Act

The Provision

“the depreciation as per the Income Tax Act…”

What It Means

IT Act depreciation (Section 32) is deducted from book profit.

This is the flip side of adding back accounting depreciation (Clause g).

Mechanism

Effect of both clauses:

Add back: Accounting depreciation [Clause g]

Deduct: IT Act depreciation [Clause iia]

Net effect on book profit: Difference between the two

If IT Act depreciation > Accounting depreciation → Book profit reduced

(Usually the case for manufacturing companies with accelerated IT depreciation)

Clause (iib): Revaluation Adjustments (Specific)

Handles revaluation reserve withdrawals and other specific revaluation adjustments.

Mostly relevant for entities using fair value accounting with significant asset revaluations.

Clause (iii): Deduction of Losses & SEZ Profits

“The amount of loss as per the profit and loss account or the amount of relief or deduction available under section 33AB (Special Economic Zone profits)…”

Where applicable, SEZ units get deduction for SEZ profits.

Clauses (iic) to (iig): Special Deductions for Specific Income

These handle:

AOP/BOI exempt income
Foreign company low-tax income
Business Trust income
Patent royalty income

Relevant mainly for specialized entities.

5. THE CAP AND THE PROVISO

The “Provided that” Clause

“Provided that the amount of additions to net profit and the amount of deductions from net profit shall not exceed the total expenditure claimed by the assessee as per his profit and loss account.”

What It Means

Total adjustments (additions – deductions) should not exceed total claimed expenses.

Why This Safeguard?

Prevents absurd situations where adjustments create an unrealistic book profit.

Example

Company MNO Ltd.

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Total expenses claimed in P&L: ₹50 crores

Depreciation per books: ₹10 crores

Provisions: ₹5 crores

Total potential additions: ₹15 crores

Depreciation per IT Act: ₹20 crores

Potential deductions: ₹20 crores

Without the proviso, net adjustment could exceed claimed expenses.

The proviso ensures this doesn’t happen.

6. CROSS-REFERENCES & INTERPLAY BETWEEN CLAUSES

The Matching Principle

Key Principle: Additions and deductions often work in pairs to capture specific adjustments.

Pair 1: Depreciation (Clauses g & iia)

Clause (g): Add back accounting depreciation

Clause (iia): Deduct IT Act depreciation

Result: Net deduction/addition = Difference

Pair 2: Reserves (Clause b & i)

Clause (b): Add back reserves created

Clause (i): Deduct reserves withdrawn

Result: Net effect depends on which is higher

Pair 3: Exempt Income (Clauses f & ii)

Clause (f): Add back expenses for exempt income

Clause (ii): Deduct exempt income itself

Result: Net effect is exclusion of exempt-income related transactions

7. COMMON CALCULATION ERRORS & PREVENTIVE MEASURES

Error 1: Adding Back Expense When Deduction Allowed

Wrong: Adding back bad debt provision AND deducting brought-forward loss separately

Right: Bad debt provision is added back (Clause i), but brought-forward loss deduction (Clause iii) is separate.

Error 2: Double-Counting Depreciation

Wrong: Adding back both accounting depreciation (g) AND deducting IT Act depreciation (iia) without understanding net effect

Right: Understand these work together. Net effect is the difference.

Error 3: Ignoring the “Lower of” Rule

Wrong: Deducting BOTH loss and unabsorbed depreciation

Right: Deduct only the LOWER of the two

Error 4: Including Rule 8D in Clause (f)

Wrong: (Per Department’s Position) Adding Rule 8D computed Section 14A disallowance to book profit

Right: (Per Vireet Investments) Only actual P&L debited expenses relating to exempt income are added

8. PRACTICAL COMPREHENSIVE EXAMPLE

Complete Book Profit Calculation

Company XYZ Pvt. Ltd. – AY 2023-24

Starting Point: Audited P&L Account

text

Gross Revenue ₹500 crores

Less: COGS ₹300 crores

─────────────────

Gross Profit ₹200 crores

Less: Operating Expenses:

Salaries ₹40 crores

Rent ₹20 crores

Utilities ₹10 crores

Depreciation (accounting) ₹30 crores

Provision for bad debts ₹5 crores

Provision for gratuity ₹3 crores

Finance cost (interest) ₹15 crores

─────────────────

Total Expenses ₹123 crores

─────────────────

Profit Before Tax ₹77 crores

Less:

Income Tax ₹18 crores

Transfer to General Reserve ₹10 crores

─────────────────

NET PROFIT (Per P&L) ₹49 crores

Earnings Per Share ₹50

Proposed Dividend ₹5 crores

Book Profit Calculation

Net Profit (Starting Point) ₹49 crores

ADDITIONS (Clause-wise):

─────────────────────────

(a) Income Tax Paid + ₹18 crores

(b) Transfer to Gen. Reserve + ₹10 crores

(d) Proposed dividend + ₹5 crores

(f) Interest on loan (to earn

dividend income of ₹2 cr) + ₹0.5 crores

(g) Depreciation (per books) + ₹30 crores

(h) Deferred tax provision + ₹1 crore

(i) Provision for bad debts + ₹5 crores

─────────────────────────

Subtotal (Additions) ₹72.5 crores

DEDUCTIONS (Clause-wise):

─────────────────────────

(ii) Dividend income (exempt) – ₹2 crores

(iia) Depreciation (IT Act, 40%) – ₹50 crores

(iii) Brought-forward loss (lower

of loss and unabsorbed depr.) – ₹5 crores

─────────────────────────

Subtotal (Deductions) ₹57 crores

FINAL BOOK PROFIT:

₹49 + ₹72.5 – ₹57 = ₹64.5 crores

ALTERNATIVE CHECK (Direct):

Net profit + Net additions – Net deductions

= ₹49 + ₹72.5 – ₹57

= ₹64.5 crores ✓

MAT Computation

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Book Profit (as calculated) ₹64.5 crores

MAT Rate 15%

MAT Payable ₹9.68 crores (15% of ₹64.5 cr)

Plus:

Surcharge (if applicable) Based on income slab

Health & Education Cess 4%

Total MAT Liability ₹9.68 cr + surcharge + cess

9. CONCLUSION & PROFESSIONAL TIPS

Explanation 1 To Section 115JB – 10 Golden Rules For Book Profit Calculations

Start with audited P&L: Don’t invent items; only adjust what’s in the books.
Remember the matching principle: Additions and deductions often pair up.
Apply the “actual P&L” test: Only P&L-debited or credited items are adjustable.
Watch the “Lower of” rule: For brought-forward loss and depreciation, always pick the lower.
Cap at total expenses: Adjustments shouldn’t exceed claimed expenses.
Section 10(38) is NOT deducted: LTCG remain in book profit.
Rule 8D is NOT imported: Per Vireet Investments, only actual expenses.
Reserves and Dividends are appropriations: Add them back; they don’t reduce profit.
Provisions for unascertained liabilities are added back: They’re speculative.
Document everything: Maintain supporting schedules showing each adjustment.

Audit Checklist for Book Profit Calculation

Is net profit correctly identified from audited P&L?
Are all additions (clauses a-j) identified?
Are all deductions (clauses i-iig) identified?
Is the “lower of” rule applied for brought-forward loss?
Are any Rule 8D disallowances excluded (per Vireet)?
Are additions/deductions capped at total expenses?
Are supporting schedules prepared for each clause?
Is MAT computed correctly on final book profit?
Are surcharge and cess added to MAT?

References

[1] Minimum Alternate Tax (MAT) Available at: Minimum Alternate Tax (MAT): Eligibility, Rates, Calculation & MAT Credit

[2] Minimum Alternate Tax(MAT) Eligibility and Calculation Available at: Minimum Alternate Tax(MAT) : Eligibility and Calculation

[3] MAT AND AMT Available at: 10.mat-and-amt.pdf

[4] Computation of book profit & MAT credit U/S 115JB Available at: https://taxguru.in/income-tax/computation-book-profit-mat-credit-section-115jb.html

[5] Minimum Alternate Tax (MAT): Definitions, Rates, And Understanding How It Is Calculated

Available at: Minimum Alternate Tax (MAT) in India: Definition, Rates & Calculation

Book ProfitCorporate TaxDepreciation AdjustmentDividend TaxExempt IncomeFinancial ReportingIncome Tax IndiaMATMAT CreditMinimum Alternate TaxSection 115JBTax complianceTaxable Income

By Aaditya Bhatt