1.20 Query: Accounting treatment of income-tax liability on income earned during construction period.
1. A public limited company in joint sector is engaged in the business of refining of crude and has set up an oil refinery at Mangalore with an installed capacity of 3 MMTPA. The refinery was commissioned on 25.3.1996 and has commenced commercial production.
2. With a view to meet a part of the cost of construction, the company in question had made a public issue in the month of May, 1992, consisting of convertible and non-convertible debentures. Pending utilisation of the proceeds of the issue in the construction, the company had invested the temporary surplus funds from time to time, resulting in the earning of the following income during the financial year 1992-93.
(i) Income from capital gains Short term capital gains : Rs. 1.07 crores (ii) Income from other sources (a) Interest on equity funds : Rs 23.69 crores (b) Interest on debenture funds : Rs. 59.26 crores Total income : Rs. 84.02 crores
3. As per the opinions obtained by the company from eminent tax counsels, the income earned during the construction period on the investments of the temporary surplus funds would merely go to reduce the cost of construction and as such shall not be liable to income-tax. The counsels had also opined that in view of the contradicting judicial pronouncements on this issue, the company should pay income-tax on the income earned from the investments of ‘equity funds’ and on the ‘short term capital gains’ and contest the issues in the assessments. Accordingly, the income-tax was paid.
4. However, in the assessment, the Assessing Authority had taken a contrary view and held that the entire income was liable to tax and accordingly raised the demand. The issue was escalated upto Income Tax Appellate Tribunal, Bombay, and the stand of the department was confirmed. Now the company is filing the reference in Bombay High Court. The company has been adopting a similar treatment for the subsequent accounting years also.
5. In this background, the company is faced with a question as to the treatment to be given in respect of the tax liability on the income earned during the construction period.
6. Para 8.1 of the Guidance Note on Treatment of Expenditure During Construction Period, issued by the Institute of Chartered Accountants of India, is reproduced herebelow:
“It is possible that a new project may earn some income from miscellaneous sources during its construction or pre-production period. Such income may be earned by way of interest from the temporary investment of surplus funds prior to their utilisation for capital or other expenditure or from sale of products manufactured during the period of test runs and experimental production. Such items of income should be disclosed separately either in the profit and loss account, where this account is prepared during construction period, or in the account/statement prepared in lieu of the profit and loss account, i.e., Development Account/Incidental Expenditure During Construction Period Account/Statement on Incidental Expenditure During Construction (Refer to para 14.7). The treatment of such incomes for arriving at the amount of expenditure to be capitalised/deferred, has been dealt with in para 15.2.”
7. Para 8.2 of the Guidance Note deals with the tax liability and the same is reproduced herebelow:
“The question relating to tax liability on the income during the construction or pre-production period needs to be considered. Necessary provision for such liability should be made in the accounts.”
8. As per para 15.2 of the Guidance Note, the income earned during the period of construction should be deducted from the various items of indirect expenditure incurred during the construction period and net amount should be allocated to the specific assets heads. Para 15.2 is reproduced herebelow:
“From the total of the aforesaid items of indirect expenditure would be deducted the income, if any, earned during the period of construction, provided it can be identified with the project.”
9. On a harmonious reading of the above paragraphs of the Guidance Note, it is the understanding of the querist that the tax liability on the income earned during the construction period should be deducted from such income and only the income net-of-tax has to be taken for the purpose of deducting from the indirect expenditure on construction pending allocation thereof to the specific asset heads. Moreover, no profit and loss account is prepared during the construction period and there is no operating profit generated during this period.
10. The company accordingly is making a disclosure in its accounts for the financial year 1995-96, as illustrated below:
(a) Capital Work-in-Progress xxxx
(b) Projected/pre-operative expenses to be capitalised xxxx Total (a + b) xxxx
(c) Income xxx Less: Provision for income-tax xxx xxx
Capital work-in-progress net of income during construction period xxxx
11. Thequerist has sought the opinion of the Expert Advisory Committee as to whether the treatment of accounting of the liability for income-tax on the income earned during the construction period is correct and in accordance with the Guidance Note and whether the disclosure as above gives a true and fair picture.
Opinion December 9, 1996
1. The Committee notes that the basic issue raised by the querist relates to accounting treatment of liability for income-tax on the income earned during construction period. The Committee restricts its opinion to the accounting aspects in this regard, viz., disclosure and treatment of the income-tax liability. The Committee has accordingly not gone into issues on other accounting aspects dealt with in the query, e.g., capitalisation of projected/ pre-operative expenses.
2. The Committee notes that para 14.7 of the Guidance Note on Treatment of Expenditure During Construction Period, issued by the Institute of Chartered Accountants of India, deals with the disclosure of various items of income and expenses. The said para is reproduced below:
“14.7 There is some doubt on the question whether or not a company is obliged to prepare a profit and loss account during the period of construction when it is not in fact engaged in any revenue operations. In view of the requirement of Section 210(3) of the Companies Act, every company has to prepare its profit and loss account from the date of incorporation. However, to prepare a profit and loss account from the date of incorporation might be somewhat misleading as it may give an impression to the lay shareholder that the company was engaged in revenue operations during this period and has incurred a substantial loss in those operations. It is true that the requirements of Part II of Schedule VI to the Companies Act relating to disclosure of specific items of expenditure have to be complied with. However, these requirements can be adequately complied with if the relevant items of expenditure requiring specific disclosure are suitably disclosed under the heading “Development Account”, “Expenditure During Construction Account”, “Statement of Incidental Expenditure During Construction” or by any other suitable name. This practice has also been recommended by the Department of Company Affairs, Government of India, as per their circular No. 2/17/64, dated 29th January, 1964 which is given in Appendix B.
Where the aforesaid practice is followed, it is desirable that a note be inserted in the financial statements explaining the reason for not preparing a profit and loss account. It appears that this would represent reasonable compliance with the legal requirements, since, the specific disclosure requirements of Schedule VI, Part II are complied with. Whether the disclosure should be made in the conventional profit and loss account form or through an account/statement as per the recommendation made in the above paragraph, is a matter for each company to decide. In this connection, it may be noted that Schedule VI, Part II of the Act only contains disclosure requirements and does not prescribe specific form of profit and loss account unlike Schedule VI, Part I which does so for the balance sheet.”
3. On the basis of the above, it is clear that income-tax liability should be disclosed in a manner as is normally done in the profit and loss account of a company, although, in the present case, the disclosure may be made in the Expenditure During Construction Account or Statement of Incidental Expenditure During Construction Account or an account under any suitable name of similar nature.
4. With regard to the treatment of the income-tax liability on the income earned during construction period for the purpose of capitalisation of indirect expenditure, the Committee notes para 15.2 of the Guidance Note as below:
“15.2 From the total of the aforesaid items of indirect expenditure would be deducted the income, if any, earned during the period of construction, provided it can be identified with the project.”
5. From the above para, the Committee notes that for the purpose of capitalisation of expenditure, any income during construction period should be deducted from the indirect expenditure, provided it can be identified with the project. Thus, for the purpose of computing the amount of indirect expenditure during construction to be capitalised, any income-tax liability on such income should either be included as an indirect expenditure during construction or the relevant income, net of the related income-tax, should be deducted from the indirect expenditure. In the present case also, since the income earned during construction appears to be identifiable with the project in question, the aforesaid treatment should be made in respect of the income-tax liability.
6. On the basis of the above, the Committee is of the opinion that the accounting treatment of income-tax liability on the income earned during construction period should be as suggested in paras 3 and 5 above. ____________________________________
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