2.7 Query

Creation of higher investment allowance reserve.

1.A public limited company has equity holding by Government and financial institutions exceeding 74%. The statutory auditors are appointed by the Comptroller and Auditor General of India (CAG) under sub-section (2) of section 619 of Companies Act read with the Department of Company Affairs’ Notification No. GSR/ 443(F) dated 18.10.1972. After the accounts are audited by the statutory auditors, the supplementary audit is taken up by the Accountant General (AG) on behalf of CAG pursuant to the provisions of section 619(4) of the Companies Act.

2. The company is consistently following the accounting practice of creating higher investment allowance reserve to the extent of about 80% of the investment allowance claim against the statutory requirement of creating 75% of the investment allowance claim actually allowed under section 32A of the Income-tax Act. In the context of aging of plants, the company is required to spend heavily on major repairs of critical equipments to maintain efficiency of the plants. In the income-tax assessments, it has been the experience of the company that the plant and machinery repairs, if of substantial amount, are sometimes disallowed and treated as capital expenditure. In such an event of disallowance of revenue expenditure and treatment thereof as capital expenditure, the company is required to create additional investment allowance reserve to avail the benefit of additional investment allowance claim. In the recent income tax decision in the case of Shree Shubhlaxmi Mills Ltd. V. Addl. CIT (1989) 177 ITR 193, the Supreme Court has held that the development rebate reserve has to be created in the year in which the claim for the same has been admitted in the income-tax assessment.

3.The CAG, while conducting the supplementary audit, has remarked that investment allowance reserve has been overstated as it is in excess of the limit prescribed under sub-section 4(ii) of section 32A of the Income-tax Act.

4.The querist has referred the following issued for the opinion of the Expert Advisory Committee:

a) Whether the limit of 75% prescribed under the Income-tax Act for creating investment allowance reserve is a minimum or maximum limit? In other words, whether the company can provide higher reserve in the context of eventuality of disallowance of certain revenue expenditure and treatment thereof as capital expenditure by the income tax authorities.

b) Whether the fact of creation of higher investment allowance reserve is required to be disclosed in the accounts.

c) Whether creation of higher investment allowance reserve amounts to understatement of profit.

                                                                         Opinion                                        March 13, 1990

1.The Committee notes para 8.11 and 14.04 of the ‘Guidance Note on Terms Used in Financial Statements’, issued by the Accounting Standards Board of the Institute of Chartered Accountants of India, which define, inter alia:

                      “8.11            Investment Allowance Reserve

A reserve created in compliance with one of the conditions for claiming investment allowance under the Income-tax Act, 1961.

14.04Reserve

The portion of earnings, receipts or other surplus of an enterprise (whether capital or revenue) appropriated by the management for a general or specific purpose other than a provision for depreciation or diminution in the value of assets or for a known liability. The reserves are primarily of two types: capital reserves and revenue reserves.”

2.The Committee notes Circular No. 7-P (XIX) dated 8.8.1968, issued by Central Board of Direct Taxes, which is reproduced below:

“In para 3 of the Board’s Circular No. 2-P (XV-6), dated 5.2.1968 relating to computation of the capital of a company for the purposes of super profits tax, it was stated that a development rebate reserve which is either less than the statutory percentage [specified in section 10(2) (vi b) of the 1922 Act and section 34(3) of the 1961 Act] or, in excess of the prescribed percentage could not be said to have been created in compliance with the statutory provisions in the Income-tax Act, and, therefore, could not be treated as a “reserve” for the purpose of computing the capital of the company under rule 1 of the Second Schedule to the Super Profits Tax Act, 1963. These observations in the circular were not made with reference to the question of admissibility of the development rebate itself but wholly in the context of the computation of capital for the purpose of super profits tax.

It has come to the notice of the Board that the above observations in the circular dated 5.2.1968 have been interpreted in some quarters to imply that the deduction for development rebate should be entirely denied or withdrawn in a case where the amount credited to the development rebate reserve is in excess of the statutory requirement. This interpretation is not correct. The allowance of development rebate is not to be denied in cases where the reserve created in excess of the statutory requirement, because this does not result in any violation of the requirement of creation of reserve equal to the statutory percentage of the development rebate to be actually allowed.”

3.The Committee also notes Circular No. 305[F.No. 202/56/79-IT (A-II)] dated 12.6.1981, which is as follows:

                        “…………

3. Investment allowance is admissible in accordance with the provisions of section 32A in respect of the year of installation of the machinery or plant or in the immediately succeeding year if the machinery or plant is put to use in that year. The allowance is, however, granted subject to creation of a reserve equal to 75 per cent of the amount actually to be allowed which should be debited to the profit and loss account of that year. It has been further provided in section 32A(3) that only so much of the investment allowance is to be allowed in any year as is sufficient to reduce the total income to nil and the balance of the investment allowance has to be carried forward to the following assessment year and so on upto eight assessment years. Thus, insofar as the above matters are concerned, the provisions relating to the grant of investment allowance are in pari materia with the provisions governing the grant of development rebate……..”  

4. The Committee is accordingly of the following opinion:

(a) The language of sub-section (4) of section 32A as it stands at present, requires an assessee to create investment allowance reserve equal to 75% of the investment allowance to be actually allowed. However, as a measure of abundant caution for the purposes of assessment under Income-tax law, a reserve higher than 75% may be created subject to disclosure as stated in paragraph (b) below. Obviously, the reserve so created must not exceed the investment allowance actually to be allowed. Investment allowance reserve in excess of 75% of the investment allowance actually to be allowed will not be treated in the nature of investment allowance reserve for the purposes of various legislations, such as, the Companies Act, 1956.

(b) The company should disclose in the notes to the accounts the fact of creation of higher investment allowance reserve. The excess percentage and the excess quantum of investment allowance reserve should also be disclosed along with reason for creation of higher reserve.

(c) Since the transfer to investment allowance reserve is an appropriation of profits, the creation of higher investment allowance reserve does not amount to under-statement of profit.

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