1.53 Query: Accounting for taxes on income.
1.The querist is a public limited company registered under the Companies Act. The non-resident interest in the company is more than 40% of its paid up share capital. During the year ended 31st March, 1991, the company has sold an office building situated at Bombay for a total consideration of Rs. 18.9 crores to another Indian company. In terms of Section 31 (1) of the Foreign Exchange Regulation Act, 1973, the company applied to Reserve Bank of India for permission to sell the above property. This application contained in the prescribed form an undertaking that the company will not, at any time, seek repatriation outside India the sale proceeds of the property. The Reserve Bank of India accorded its permission for sale of the above property.
2. Under the Companies Act, the company can distribute as dividend only the profit after tax on the sale and not the sale proceeds of the property. The profit after tax on sale will constitute the excess of sale proceeds over the written down value of the property on original cost basis in the company’s books less the tax on the taxable income from this sale. The taxable income from sale of this property on a stand-alone basis would be the sale proceeds of the property less the written down value of the property as per tax records, as the property is a depreciable asset (Section 50 of the Income-tax Act, 1961).
3. In computing the taxable income of the company for the fiscal year, the sale proceeds of the building will be credited to its block of non-residential buildings as on 31st March, 1991, as the property was used as an office building, and the excess deemed to be short term capital gain. Further, losses from the business of the company during the year or any unabsorbed allowance like depreciation or investment allowance can be set off against this short term capital gain and the taxable income of the company will be computed after these set offs and tax computed on this income at the applicable tax rate.
4.The set offs in para 3 mentioned above reduce the tax shield against the future profits of the company and thereby reduce the distributable profits of the future years. These set offs have no nexus to the property that has been disposed of and have arisen from the other business activities of the company.
5. Following from the above, the company believes that the correct computation of the profits from the sale of this property would be, profit on sale of the property with an imputed tax on a stand-alone basis as mentioned in para 2 above at the applicable tax rate.
6. The company proposes to appropriate the difference between the tax computed in para 5 above and the actual tax payable for the 31st March, 1991, to an account called Deferred Tax Reserve A/c and this reserve account shall be used as under:
“Amount equivalent to tax payable on future years profits by virtue of the loss of depreciation shield on the set off of the block of non-residential buildings and the unabsorbed allowances set off against the aforesaid short term capital gain will be withdrawn from this Deferred Tax Reserve A/c and credited to the profit and loss account till its full depletion by adjusting the provision for taxation in future years.”
7. The company’s Accounting Policy is to appropriate to the Capital Reserve A/c that portion of the profit which is not available for remittance to all shareholders. The transfer to the capital reserve account will be computed as under:
Profit on sale of the property:
Less: Income-tax on sale of property at the applicable rate computed as per para (5) ___________ Amount transferred to capital reserve
The querist has furnished an illustration of the workings involved, which is given in the Annexure to the query.
8. The querist has sought the opinion of the Expert Advisory Committee on the following issues arising from the above:
(a) Does the undertaking to Reserve Bank of India, not to seek repatriation of sale proceeds of the property in the context of the company, refer to the profit after tax from the sale of the property?
(b) Whether the tax on sale of the property is the tax that is attributable to the income from the sale of property on a stand-alone basis though the actual incidence of tax may be spread over one or more years?
(c) Is the method of computation of capital reserve outlined above correct in the context of the company’s policy of setting apart the profits not available for distribution to all shareholders?
(d) Will the withdrawal from the reserve account to the profit and loss account in the manner stated above to meet future taxation liabilities and payment of dividends from the resultant balance in profit and loss account be deemed to be declaration of dividends out of reserves under Section 205 A (3) of the Companies Act?
(e) Will the abovementioned Deferred Taxation Reserve be construed as free reserve under the Companies Act?
Annexure
Assumptions
Accounting Entries/Calculations
1. Taxable income on sale of the property (para 2)
2. Tax computation for the year (paras 3 and 4)
3. Tax on profit from sale of property (Para 5)
4. Accounting entry proposed (paras 6 and 8)
The net effect of the above two entries will be that the tax charged to account for that year will be ‘Nil’. However, the closing balance of Deferred Taxation Reserve will be reduced to Rs. 6.8 crores (against the opening balance of Rs. 9.8 crores).
Profit and Loss Account
Alternative 1.
Alternative 2.
Opinion February 6, 1992
1.The question whether RBI’s prohibition on repatriation of sale proceeds of the property is with reference to the profit after tax from the sale of property, involves interpretation of law. As per Rule 2 of the Advisory Service Rules, the Committee does not offer opinions on questions involving interpretation of law. The Committee, therefore, refrains from giving an opinion on this issue. The Committee’s opinion is, thus, restricted to the accounting treatments involved in the query.
2.The Committee notes that the querist prorposes to appropriate a part of profits from sale of property to a Deferred Tax Reserve to be used for a adjusting tax expense (provision for taxation) pertaining to the next year. Since this treatment affects the amount of tax expense and, consequently, profit after tax, it has to be seen whether the tax expense for two periods is in accordance with the sound accounting principles in this regard as laid down in the Guidance Note on Accounting for Taxes on Income, issued by the Institute of Chartered Accountants of India.
3. The Committee further notes that none of the two alternatives suggested by the querist (as per the Annexure) result in proper tax charge to the profit and loss account as they are not in a accordance with either of the two methods of accounting for taxes on income which are recommended in the above-mentioned Guidance Note, as explained below:
(a) One of the methods recommended in the Guidance Note is ‘taxes payable method’. As per this method, “the amount of tax charged in the profit and loss statement is equal to the amount payable to revenue authorities” (para 8 of the Guidance Note). The Committee notes that under both the alternatives given in the above Annexure, the amount of tax charged in the second year is not equal to the taxes payable to revenue authorities. Whereas, the taxes payable in second year are Rs. 3 crores, the amount of tax provision is ‘Nil’ in that year. In the second alternative also, the tax charge is nil (i.e., tax provision minus adjustment from Deferred Taxation Reserve). The Committee notes that such an adjustment is not permissible under the ‘tax payable method’.
(b) According to the other method recommended in the Guidance Note, viz., the ‘tax effect accounting method’, “taxes on income are accounted for and accrued in the same periods as the revenues and expenses to which they relate. The resulting tax effects of timing differences are reflected in the tax charge in the profit and loss statement and in the deferred tax balance in the balance sheet.” (Para 10 of the Guidance Note). The expression ‘timing difference’ has been defined in para 5 of the Guidance Note as follows:
“5. ‘Timing differences’, on the other hand, are those differences between tax profit and accounting profit for a period which arise because the period in which some items of revenues and expenses or the amounts thereof are included in tax profit do not coincide with the period in which such items of revenues and expenses or the amounts thereof are included in accounting profit. ‘Timing differences’ originate in one period and reverse in one or more subsequent periods. An example of a ‘timing difference’ would be a situation where, for the purpose of computing tax profit, the tax rules allow depreciation on the basis of the written down value method, whereas for the purpose of accounting in the profit and loss statement, the straight line method has been used.”
The Committee notes that in the present case the difference in accounting income and taxable income arises because of set-off of business losses etc. Such losses will not reverse in future, and, therefore, these are not ‘timing differences’, but are ‘permanent differences’ (para 3 of the Guidance Note) which are not taken into account as per the ‘tax effect accounting method’. Thus, in such a case, as far as the set-off of business losses is concerned, deferred credit cannot be created in the first year to be adjusted for arriving at the tax charge for the next year. In view of this, the tax provision as far as this item is concerned, for the two years should be the same amount as per the tax payable method [see (a) above]. Since it is not so, the amount of tax provision in both the two alternatives in the Annexure is not correct. The Committee further notes that the company cannot follow the tax effect accounting method on selective basis in view of para 24(c)(i) of the Guidance Note, according to which: “Where the tax effect accounting method is used, it should be applied to all timing differences……”
4. On the basis of the above, the opinion of the Committee on the issues raised by the querist in para 8 of the query, subject to para 1 above, is as below:
(a) The Committee refrains from offering its opinion on this issue in view of para 1 above.
(b) From the accounting point of view tax should not be computed on profit on sale of property on stand- alone basis.
(c) Creation of Deferred Tax Reserve for the purpose of its subsequent utilisation affects the amount of tax provision which is not in accordance with the recommendations of Guidance Note on Accounting for Taxes on Income. Therefore, the company cannot create a Defferred Tax Reserve. However, the company can decide to transfer the profit from sale of property to a capital reserve.
(d) No answer required in view of (c) above.
(e) No answer required in view of (c) above. _______________________________ |