1.12 Query Accounting and tax implications of loss on fixed assets destroyed in fire.
1.A public limited company is a Government of India enterprise engaged in the manufacture of large scale integrated circuits, assembly of computers and electronic watch modules.
2.The company was set up in 1978. The trial run was started in October, 1983 and the commercial production started from April, 1984. During the finalisation of accounts of the year 1983-84, the expenditure incurred upto September, 1983 and thereafter upto March, 1984, was capitalized as ‘Expenditure During Construction Period’ and ‘Trial Run Expenditure’ respectively. The company also purchased ‘Know-How’ from USA and Japan for Rs. 4.00 crores which was also capitalised along with the equipments. Till date, the company has also received Rs. 55.00 crores as revenue and capital grants from Government of India. The capital grant was given to purchase capital equipment to develop process technology. The revenue grant of Rs. 2.50 crores is on a yearly basis to meet the expenditure relating to raw material, salary and wages of research and development staff. The capital grants were capitalised as capital reserve.
3. There was a major fire on 7th February, 1989, which caused a major loss of Rs. 60.00 crores and the total manufacturing and research and development facility was destroyed.
4.The insurance claim amount has been transferred at the book value (including ‘Expenditure During Construction Period’, ‘Know-How Fees’ and ‘Trial Run Expenditure’) of the destroyed assets. Insurance company is not agreeing to compensate the amount of ‘Know-How Fees’, ‘Expenditure During Construction Period’ and ‘Trial Run Expenditure’, which was capitalised along with the capital assets. The total amount on this account is Rs. 7.00 crores. From the year 1984-85 to 1988-89, depreciation on above account has been charged to the extent of Rs. 3.00 crores.
5. Some assets still exist in the relevant blocks of destroyed assets, as defined in Income-tax Act, 1961.
6.The querist has also stated that depreciation on equipments purchased out of the capital grant has not been routed through profit and loss account but the same has been reduced from the capital reserve.
7.The querist has also supplied a copy of terms and conditions governing the Grant in Aid. The relevant extracts of the same are reproduced below:
8. The querist has also stated that the moneys receivable from insurance company in respect of the assets purchased out of the grant will now be utilised only to purchase the same type of equipment. There may be some variation, 5 to 10%, because of advanced technology.
9. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
Opinion April 12, 1990
6. If the subsidy or grant is given for the acquisition of a specific fixed asset, the same may be reduced from the cost of that fixed asset as stated in para 3 (iii) above. This is a simple way of apportioning the amount of the grant or subsidy to revenue over the life of the asset through a lower depreciation charge. This method is also in conformity with that provided under the Income-tax Act for computing the actual cost of such fixed asset.
7. The method at para 3(iv) is an alternative to the method suggested in para 3(iii). Under this method, the depreciation on the fixed asset will be charged with reference to its original total cost, as against which the amount of grant or subsidy kept as special reserve will be apportioned over the life of the asset through transfer to the Profit and Loss Account.”
2.The Committee is of the view that the company should change the nomenclature of the reserve created out of capital grant for purchase of capital equipment and should not treat it as a capital reserve. The same should be termed and treated as a special reserve.
3.The Committee is of the view that the treatment given by the company in respect of depreciation on assets purchased out of capital grants is not correct. Instead of reducing the depreciation from special reserve created out of the grants, the company should have routed the same through profit and loss account and should have transferred an amount equal to depreciation on proportionate cost of the assets purchased out of the capital grant from special reserve to profit and loss account.
4.In view of para 3 above, the Committee is of the view that in the current year, the company should debit the profit and loss account with depreciation which has been so far debited to the special reserve. The company should also transfer an amount from the special reserve to the credit of profit and loss account, which should be equal to the total depreciation charged upto date on the proportionate cost of the asset purchased out of the capital grant. The said amounts, i.e., depreciation and transfer from special reserve should be disclosed separately as prior period items in the current statement of profit and loss together with their nature in a manner that their impact on the current profit or loss can be perceived (Para 9 of AS 5 on ‘Prior Period and Extraordinary Items and Changes in Accounting Policies’ issued by the Institute of Chartered Accountants of India). The Committee notes that in view of the above adjustments, balances of the special reserve, assets purchased out of the grant and profit and loss account will not, however, be affected.
5.The Committee presumes that the company has capitalised the ‘Expenditure During Construction Period’, ‘Trial Run Expenditure’ and ‘Know-How Fees’ in accordance with recommendations contained in the ‘Guidance Note on Treatment of Expenditure During Construction Period’ issued by the Research Committee of the Institute of Chartered Accountants of India. The Committee also presumes that expenditure on ‘Know-How Fees’ which has been incurred after the commencement of commercial production by the company, has been capitalised in accordance with para 3.21 of the ‘Statement on Auditing Practices’ and para 38 of AS 10 on ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India.
6.The Committee is of the view that mere non-admittance of certain properly capitalised expenditure by the insurance company for the purpose of determination of insurance claim does not change the nature of the expenditure and, therefore, its accounting treatment. The amount of ‘Know-How Fees’, ‘Expenditure During Construction Period’ and ‘Trial Run Expenditure’, to the extent properly capitalised, cannot be treated as deferred revenue expenditure. Thus, for accounting purposes, the same should be treated as part of the original cost of the asset to which it has been capitlaised.
7.The Committee is also of the view that the loss arising on destruction of assets, i.e., the book value of the destroyed assets in excess of the insurance claim admitted in respect thereof should be recognised in the profit and loss account. The loss being an extra-ordinary item, should be disclosed separately in the statement of profit and loss in a manner that its relative significance and effect on the current operating result of the period can be perceived (para 10 of AS 5 on ‘Prior Period and Extra Ordinary Items and Changes in Accounting Policies’, issued by the Institute of Chartered Accountants of India).
8.The Committee notes that the terms and conditions of the grant do not stipulate the situation of destruction of assets in fire. It is, therefore, for the relevant Government authorities to consider whether destruction of assets in fire, subsequent reimbursement by the insurance company and the acquisition of new assets out of the insurance claim in place of the assets which have been destroyed in fire and which were acquired out of capital grant, violates any of the terms and conditions governing the grant-in-aid. In case the Government considers that the aforesaid are in accordance with the terms and conditions, the Committee is of the view that an amount equal to loss arising on destruction of assets purchased out of the grants, i.e., book value in excess of insurance claim admitted, should be transferred from special reserve to profit and loss account. The balance of the special reserve would represent the proportionate cost of new assets purchased out of the insurance claim in place of assets created out of capital grant and destroyed in fire.
9.The Committee notes sub-section (6) of section 43 and section 50 of the Income-tax Act, 1961, which state, inter alia:
50. Notwithstanding anything contained in clause (42A) of section 2, where the capital asset is an asset forming part of a block of assets in respect of which depreciation has been allowed under this Act or under the Indian Income-tax Act, 1922 (11 of 1922), the provisions of sections 48 and 49 shall be subject to the following modifications: -
(1) where the full value of the consideration received or accruing as a result of the transfer of the asset together with the full value of such consideration received or accruing as a result of the transfer of any other capital asset falling within the block of assets during the previous year, exceeds the aggregate of the following amounts, namely: -
(2) where any block of assets ceases to exist as such, for the reason that all the assets in that block are transferred during the previous year, the cost of the acquisition of the block of assets shall be the written down value of the block of assets at the beginning of the previous year, as increased by the actual cost of any asset falling within that block of assets, acquired by the assessee during the previous year and the income received or accruing as a result of such transfer or transfers shall be deemed to be the capital gains arising from the transfer of short-term capital assets.”
10. The Committee also notes that in the following cases it was held that where an assessee receives money form an insurance company on account of destruction of assets, it results in the extinguishment of the right of the assessee in the capital asset and amounts to transfer.*
11.The Committee notes that as per the facts of the query, some assets still exist in the relevant blocks of destroyed assets, as defined in Income-tax Act, 1961.The Committee is of the view that for income-tax purposes, the written down value of the block of assets should be reduced by the amount payable by the insurance company in respect of the assets included in the relevant block of assets. In case, the moneys payable by the insurance company in respect of assets falling in any block of assets does not exceed the written down value of that block of assets at the beginning of the year as increased by the cost of assets falling within that block of assets acquired during the year, there will be no capital gains under the Income-tax Act. If, however, the moneys payable by the insurance company in respect of the assets falling in any block of assets exceeds the written down value of that block of assets at the beginning of the year as increased by the cost of assets falling within that block of assets acquired during the year, short term capital gain shall be computed in accordance with the provisions of sub-section (1) of section 50.
12. The Committee is of the following opinion, subject to para 8 above, in respect of the issues raised by the querist in para 9 of the query:
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* Dissenting views in ‘C. Leo Maclodo v. CIT (1988) 172 ITR 744(Mad.) |