Net Profit Calculation for CSR: Why Section 198 Is Not the Same as Your P&L

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Under Section 135 of the Companies Act 2013, every qualifying company must spend at least 2% of its average net profits — computed over the three immediately preceding financial years — on CSR activities. The law is clear that this net profit is not the figure appearing on your profit and loss account. It is a distinct, adjusted number calculated under Section 198 of the Act, read with Rule 2(h) of the Companies (CSR Policy) Rules, 2014. Getting this calculation wrong — in either direction — has direct regulatory consequences.

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Every year, finance teams and Company Secretaries across India sit down to calculate their company's CSR obligation for the coming financial year. And every year, a surprisingly large number of them use the wrong number as their starting point.

The instinct is understandable. The audited financial statements are readily available. The Profit Before Tax figure is prominent. It seems like the obvious place to begin. But Section 135 of the Companies Act 2013 does not ask for your PBT. It asks for your average net profits calculated in accordance with Section 198 of the Act — and these two numbers can be materially different.

This article explains what that difference is, why it exists, how the calculation should actually be done, and the mistakes that consistently appear in CSR obligation workings prepared without CA-level oversight.

The Legal Foundation: Section 135 Read with Section 198

Section 135(5) of the Companies Act 2013 requires the Board to ensure that the company spends, in every financial year, at least two per cent of its average net profits made during the three immediately preceding financial years on CSR activities pursuant to its CSR policy.

The Explanation to Section 135(5) is decisive: it states that for the purposes of this section, average net profit shall be calculated in accordance with the provisions of Section 198. This was made explicit by the Companies (Amendment) Act, 2017, which substituted the earlier explanation to remove any ambiguity.

Section 198 is titled 'Calculation of Profits' and it sets out a methodology that deliberately diverges from conventional accounting. Its purpose — originally designed for managerial remuneration — is to measure a company's genuine operational earnings by stripping out capital gains, certain notional items, and income tax. The same methodology now governs CSR obligation.

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Rule 2(1)(h) — The Two Exclusions That Sit Above Section 198

Rule 2(1)(h) of the Companies (CSR Policy) Rules, 2014 adds two further exclusions on top of Section 198:

  (i)  Any profit arising from any overseas branch or branches of the company, whether operated as a separate company or otherwise.

  (ii) Any dividend received from other companies in India that are themselves required to comply with CSR provisions under Section 135.

The correct computation is therefore: Section 198 adjusted net profit, minus these two additional items under Rule 2(1)(h).

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It is worth pausing on the purpose behind this design. The legislature's intent was that CSR should be funded from a company's domestic, operational earnings — not inflated by overseas windfalls, capital transactions, or inter-company dividend flows. Section 198, read with Rule 2(1)(h), implements that intent arithmetically.

How the Calculation Actually Works

Start with Profit Before Tax — Not Profit After Tax

One of the most frequently asked questions in CSR compliance circles is whether the starting point for the Section 198 computation should be Profit Before Tax or Profit After Tax.

The answer, confirmed by MCA FAQs and professional consensus, is Profit Before Tax.

Income tax is not a deductible item under Section 198. If you begin with Profit After Tax, you have already removed income tax from the figure, which then needs to be added back in the Section 198 computation. Starting with PBT avoids this step and reduces the risk of error.

Adjustments Required Under Section 198

Once PBT is established as the base, Section 198 requires a series of additions and deductions. The underlying logic is consistent: items that inflate profits beyond genuine operational performance are excluded; losses from operations that have already been captured in prior years are deducted to avoid double-counting.

Some of the adjustments covered under section 198 are as under:

Treatment	Items	Effect on PBT
Credit given — add back if already deducted	Bounties and subsidies received from Government or public authority	+ Add
No credit — remove if included	Profits by way of premium on shares or debentures  which are issued or sold by the company (unless investment company)	− Remove
No credit — remove if included	Profits on sale of forfeited shares	− Remove
No credit — remove if included	Profits of a capital nature, including profits from sale of undertaking or part thereof	− Remove
No credit — remove if included	Profits from sale of fixed assets or immovable property of a capital nature (unless company's business is buying/selling such assets)	− Remove
Deduct — if not already in P&L	All usual working charges	− Deduct
Deduct — if not already in P&L	Directors' remuneration (to the extent not already charged)	− Deduct
Deduct — if not already in P&L	Depreciation to the extent specified in Section 123	− Deduct
Deduct — if not already in P&L	Excess of expenditure over income from prior Section 198 computation years, to the extent not already deducted	− Deduct
Deduct — if not already in P&L	Bad debts written off during the year	− Deduct
Cannot deduct — add back if already deducted	Income tax and sur-tax	+ Add back
Cannot deduct — add back if already deducted	Losses of a capital nature (including on sale of fixed assets or immovable property)	+ Add back
Cannot deduct — add back if already deducted	Any compensation or damages paid by virtue of legal liability	+ Add back — no deduction permitted

The practical implication of the 'cannot deduct' category is particularly important: items that companies routinely charge to their P&L — such as capital losses on asset disposals — are not allowable deductions under Section 198. If they have already reduced PBT, they must be added back before arriving at the Section 198 profit.

Best Practices for Preparing the Calculation

The legal framework is clear, but the mechanics of preparing a defensible, auditable Section 198 computation require deliberate process choices. These are the practices that distinguish a well-prepared calculation from one that will not withstand scrutiny.

Maintain a Standalone Section 198 Working

The Section 198 computation should exist as a separate, documented working — not as a note appended to the CSR policy or buried in a Board presentation. It should show PBT as the opening figure, each adjustment line-item with the statutory basis for the adjustment, and the resulting Section 198 profit for each of the three years. This working becomes part of the company's CSR records and may be examined in the event of regulatory enquiry.

Compute Each Year Separately

Average net profit under Section 135 is the mean of the Section 198 profits for each of the three preceding financial years individually computed. This is not the same as applying the Section 198 adjustments to a three-year aggregate.

Companies that calculate a three-year aggregate PBT figure and then apply adjustments to the total are using an incorrect methodology — one that may also obscure the impact of loss years, which we return to below.

Handle New Companies Correctly

A company that has not yet completed three financial years uses the data available to it. If the company is in its third financial year, it uses the prior year’s only. If it is in its first financial year, no obligation arises for that year since there is no preceding financial year from which to compute the average.

This is straightforward in principle but frequently mishandled in practice when companies extrapolate hypothetical profits for missing years.

Apply Consistent Treatment Across All Three Years

Section 198 requires judgement on certain line items — particularly where items may or may not constitute 'capital' receipts or 'capital' losses in specific fact patterns. Whatever treatment is adopted must be applied consistently across all three years that form part of the calculation.

If a company determines that a particular item should be treated differently from prior years, that change in treatment must be applied retrospectively to all three years involved. The justification for any change in treatment should be documented.

This consistency requirement is not merely procedural tidiness. If a company adopts a more favourable treatment of a specific item in one year to reduce its obligation, while retaining a different treatment in the other two years, the resulting average is methodologically indefensible and cannot be sustained if reviewed.

Common Mistakes in CSR Net Profit Calculation

These errors appear regularly in CSR obligation workings prepared without CA-level oversight. None of them are edge cases — each involves a straightforward misapplication of the statutory framework.

Using PBT Directly as the Obligation Base

The most widespread error is calculating the CSR obligation by taking the average PBT of the three preceding years and applying 2% to that figure — without making any of the adjustments required under Section 198.

This is not a minor shortcut. For companies with significant capital payments/receipts, large government subsidies or a new accounting transaction in a particular year, the unadjusted PBT figure may be materially different from the Section 198 profit. The resulting obligation— are calculated on the Section 198 figure, not on PBT.

Omitting the Rule 2(h) Exclusions

Section 198 and Rule 2(h) are two distinct sources of adjustment, and both must be applied. Companies that correctly perform the Section 198 computation but fail to then exclude overseas branch profits and dividends from Indian CSR-obligated companies are stopping the calculation one step short. For companies with significant overseas operations or holding company structures, this omission can be material.

Not Adding Back CSR Expenditure Itself

If a company charges its current year CSR expenditure to the profit and loss account — which reduces PBT — that amount has already reduced the starting figure for the Section 198 computation. Since CSR expenditure is not an allowable deduction the question of whether to add it back requires careful analysis. Companies that do not address this create an inconsistency in their calculation.

Using Consolidated Figures

The CSR obligation under Section 135 is determined and discharged at the standalone company level. A holding company calculates its obligation on its own standalone profits. A subsidiary calculates its obligation on its own standalone profits. The group consolidated financial statements are irrelevant for this purpose.

Companies — particularly those where the holding company's standalone profits differ significantly from the consolidated picture — sometimes use consolidated numbers for convenience. This is incorrect and may result in a systematically overstated or understated obligation.

Excluding the Loss Year

When one of the three preceding years results in a loss under the Section 198 computation, some companies simply exclude it from the average on the grounds that a 'negative contribution' does not feel meaningful. This is the opposite of what the law requires — and, notably, it may actually work against the company's interests.

A loss year, when included in the three-year average, reduces the average net profit and therefore reduces the CSR obligation. Excluding it inflates the average. The loss year must be included in the computation.

The Role of a CSR Consulting Firm in Net Profit Calculation

CSR consulting services firms are typically engaged to manage the full lifecycle of a company's CSR programme — from policy drafting and implementing agency selection through to monitoring and year-end reporting.

Within that broader scope, the obligation calculation under Section 198 represents the foundational step on which everything else depends. An error here does not just affect a number on paper; it determines whether a company is underspending (and therefore in violation of Section 135) or overspending (and therefore leaving value on the table).

For ThinkCap Advisors, this calculation is not outsourced to a generalist. It is performed by Chartered Accountants who work within the same team that advises on NGO due diligence, impact assessment, and CSR programme design.

This integration matters for one straightforward reason: the Section 198 profit, once correctly determined, directly shapes the size of the CSR programme that needs to be designed, monitored, and reported on. An accurate opening number leads to accurate planning.

What CA-Led CSR Consulting Firms Do Differently

A qualified CSR consulting firm with CA expertise approaches the Section 198 computation as an audit-quality exercise, not as a financial planning estimate. In practice, that means the following:

• Preparing a line-by-line Section 198 working for each of the three preceding years, with statutory references for each adjustment, held as part of the client's permanent CSR records.

• Reviewing the company's P&L for items that require careful classification — distinguishing operational from capital gains, identifying government subsidies, set off past losses— before any adjustment is made.

• Applying the Rule 2(1)(h) exclusions as a separate step after the Section 198 profit is established, with particular care for companies with overseas branches or holding company relationships involving other CSR-obligated entities.

• Examining how CSR expenditure itself has been treated in the P&L and whether it needs to be added back to PBT before beginning the Section 198 computation.

• Confirming that the calculation is done on a standalone basis and flagging immediately if the client's finance team has been working from consolidated numbers.

• Including loss years in the three-year matrix explicitly, documenting the resulting reduction in average profit, and noting this in the CSR obligation working as a favourable outcome for the client.

• Maintaining consistency in the treatment of judgement items across all three years and documenting the basis for any change in treatment.

The consequence of getting this calculation wrong goes beyond the arithmetic. Under Section 135(7), a company that fails to spend its mandatory obligation — in full and in the prescribed manner — faces penalties that can extend to twice the unspent amount plus an additional fine.

Directors are personally accountable for compliance. A CSR obligation that has been understated through a flawed calculation does not provide any protection from these consequences. Regulatory scrutiny of CSR filings has increased since the 2021 amendments, and obligation calculations that cannot be substantiated under examination present a material compliance risk.

The obligation calculation is also, in a practical sense, the single number that determines whether the company's CSR programme is appropriately sized. A company that has underestimated its obligation may find itself with insufficient programme commitments in the final quarter of the year, scrambling to identify eligible spend. A company that has overestimated it will have committed to a programme larger than its statutory minimum requires.

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How ThinkCap Advisors Approaches CSR Obligation Calculation

As part of ThinkCap Advisors' CSR consulting services, we calculate CSR obligations under Section 198 for mid-to-large corporates across multiple business lines

Our Chartered Accountants prepare standalone Section 198 workings for each of the three preceding years, document all adjustments with statutory references, apply Rule 2(1)(h) exclusions, and deliver a Board-ready obligation calculation that forms the foundation of your company's annual CSR programme.

Written by the CSR Consulting team at ThinkCap Advisors LLP