Calculation of Profits: Section 198 Explained

The calculation of profits under section 198 of the Companies Act, 2013 is the arithmetic that decides how much a company may pay its managerial personnel. It is not accounting profit. Section 198(1) frames the whole exercise as four lists: credit is given for the sums in sub-section (2), withheld for those in sub-section (3), the sums in sub-section (4) are deducted, and those in sub-section (5) are not.

Why does the calculation of profits need its own section?

Because the number section 197 uses is a constructed one. The eleven per cent ceiling, the five per cent single-managing-director sub-limit and the one and three per cent non-executive sub-limits in managerial remuneration under section 197 are all percentages of a figure that section 198 defines from scratch. Section 197(8) makes the link explicit: the net profits for the purposes of that section are computed in the manner referred to in section 198.

Section 197(1) also carries an adjustment that would otherwise be circular. In computing the eleven per cent base, the remuneration of the directors is not deducted from gross profits, even though section 198(4)(b) lists directors' remuneration as a deduction for the general computation. Without that carve-out the ceiling would depend on the payment it is meant to limit.

What is credited and what is not?

Sub-section (2) is short. Credit is given for bounties and subsidies received from any Government or any public authority constituted or authorised in that behalf by a Government, unless and except in so far as the Central Government otherwise directs.

Sub-section (3) is the exclusion list, and it is where the statutory figure separates from the reported one.

Two of those rows are amendment history worth carrying. The investment-company words in clause (a) were inserted by Act 1 of 2018, section 68, with effect from 12 September 2018, and clause (f) was inserted by the same amendment on the same date. Clause (d) carries a proviso: where a fixed asset is sold for more than its written-down value, credit is given for so much of the excess as does not exceed the difference between original cost and written-down value.

What is deducted and what is not?

Sub-section (4) lists fifteen deductions, from clause (a) to clause (o). They cover the usual working charges; directors' remuneration; bonus or commission paid or payable to a member of the company's staff or to any engineer, technician or person employed or engaged by the company on a whole-time or part-time basis; taxes on excess or abnormal profits and taxes on business profits imposed for special reasons, in each case as notified by the Central Government; interest on debentures; interest on mortgages and on loans and advances secured by a charge on fixed or floating assets; interest on unsecured loans and advances; non-capital repairs; outgoings including contributions under section 181; depreciation to the extent specified in section 123; carried-forward excess of expenditure over income from earlier years, in so far as it has not already been deducted; compensation or damages payable by virtue of a legal liability including breach of contract; insurance against the risk of such a liability; and bad debts written off or adjusted during the year.

Clause (l) lost a limiting phrase. The words "which begins at or after the commencement of this Act" were omitted by Act 1 of 2018, section 68, so the carry-forward is no longer confined to years beginning after the Act commenced.

Sub-section (5) is the mirror image, and it is the short list that most often surprises a reader.

1. Income-tax and super-tax 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).
2. Compensation, damages or payments made voluntarily, meaning otherwise than in virtue of a liability such as is referred to in clause (m) of sub-section (4).
3. Loss of a capital nature, including loss on the sale of the undertaking or any part of it, but not including any excess of written-down value over sale proceeds or scrap value on an asset sold, discarded, demolished or destroyed.
4. Any change in the carrying amount of an asset or liability recognised in equity reserves, including surplus in the profit and loss account, on fair-value measurement.

Read section 198(5)(b), the second item above, against clause (m) of sub-section (4), and the distinction is the point of both: a payment the company was legally obliged to make comes off, and a payment it chose to make does not. The same distinction runs through compensation for loss of office under section 202, where the cap is stated in terms of remuneration the person would have earned rather than what the board decides to offer.

Note also the symmetry between sub-section (3)(e) and sub-section (5)(d): the identical fair-value adjustment is excluded from both the credit side and the deduction side, so remeasurement does not move the managerial pay base in either direction.

Where the calculation of profits shows up in a filing

Section 198 produces no filing of its own. It surfaces indirectly, through the two disclosures that section 197 requires: the Board's report ratio of each director's remuneration to the median employee's remuneration under section 197(12), and the auditor's statement under section 197(16) on whether remuneration paid is within the section's limits. An auditor asserting compliance is asserting a section 198 computation, which is why the section matters to a reader who never sees the working.

Where this sits in the disclosure picture

• Managerial remuneration under section 197 covers the ceilings this computation is the base for.
• Appointment of a managing director under section 196 covers the appointment whose terms section 197 and Schedule V price.
• Compensation for loss of office under section 202 covers the separate cap on a severance payment.
• The nomination and remuneration committee covers the committee that recommends the remuneration policy.
• What is in the annual return under section 92 covers the return that carries remuneration particulars of directors and key managerial personnel.

Flock reports the filings themselves, each stamped with its date and linked back to the exchange or regulator that published it. What any of it means for you is your call to make.