Query No. 12

Subject:

Recognition of deferred tax asset in respect of brought forward depreciation in the books of the company.1

A. Facts of the Case

1. A company is a public sector undertaking engaged in the manufacture and sale of paper and sugar. The Government of Karnataka (principal shareholder) holds 65% of its shares. The company is 67 years old and was earning profits upto financial year 2001. It has sustained losses for the last 3 years from financial year ending 31st March, 2002 to financial year ending 31st March, 2004. The accumulated losses upto financial year ending 31st March, 2004 are Rs. 37.45 crore. The querist has also provided copies of audited accounts for the last 3 years for the perusal of the Committee. Summary of financial results for the last 4 years has been provided by the querist as under:

(Rs. lakh)

Year ending	Profit (loss) before	Depreciation	Profit (loss) after
	depreciation		depreciation & tax /
			Net profit/(loss)
31/03/2001	2051.28	1178.73	796.55
31/03/2002	(3210.62)	1534.60	(3486.22)
31/03/2003	(1149.30)	1479.75	(2085.60)
31/03/2004	0.72	950.44	(942.72)

2. The querist has stated that the main reason for the company incurring huge losses over the past 3 years is on account of a depressed market for the newsprint industry. The position of carry forward of business losses and depreciation as per income tax returns submitted by the company as on 31st March, 2003 has been supplied by the querist as under:

(Rs. lakh)

Year ending                             Business loss                                     Depreciation                             Total loss

31/03/1997	0	2267.22	2267.22
31/03/1998	780.62	333.67	1114.29
31/03/1999	377.07	425.54	802.61
31/03/2000	1569.33	676.89	2246.22
31/03/2001	0	877.19	877.19
31/03/2002	4819.76	2933.49	7753.25
31/03/2003	3571.54	2224.60	5796.14
Total	11118.32	9738.60	20856.92

As per the querist, the loss returned by the company has been accepted by the income tax department till 31st March, 2001 and intimation under section 143(1) of the Income-tax Act, 1961, has been received. For the year ending 31st March, 2002, the case has been selected for scrutiny and hearings are yet to be held. For the year ending 31st March, 2003, no intimation has so far been received.

3. The querist has stated that the company has, as a measure of prudence, taken credit for deferred tax assets amounting to Rs.1072.45 lakh on brought forward depreciation as per income tax records since the same is available as per current tax laws for setoff over an unlimited period of time (emphasis supplied by the querist). A disclosure in this regard has been made in the notes to accounts for the year ending 31st March, 2003. The Comptroller and Auditor General of India (C&AG), in the review for the year ended 31st March, 2003, has observed as under:

"This represents deferred tax assets created in respect of unabsorbed depreciation. As per paragraph 17 of Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, where an enterprise has unabsorbed depreciation or carry forward of losses under tax laws, deferred tax assets should be recognised only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such deferred tax assets can be realised. Considering the facts that the company:

 

(i) has incurred a loss of Rs. 26.29 crore (excluding deferred tax credit of Rs.5.43 crore) during the year against the projected profit of Rs.16.25 crore;

 

(ii) had been filing income tax return for loss for the last six years; and

 

(iii) has not disclosed the evidence in support of the recognition of deferred tax assets, as required in paragraph 32 of AS 22, the company should have refrained from accounting for deferred tax assets.This has resulted in overstatement of deferred tax assets by Rs.10.72 crore, understatement of loss for the year, prior period expenses and accumulated loss carried forward to the balance sheet by Rs.5.43 crore, Rs.5.29 crore and Rs.10.72 crore respectively."

4. The company has not accepted the comments of the C&AG and replies furnished by way of addendum to the Directors’ Report are as under:

"During the financial year ending 2002, an amount of Rs. 1791 lakh has been accounted for as deferred tax assets as per AS 22. However, during the year under review, the company, on re-examination of future profitability and as a consideration of prudence has decided to account for the deferred tax assets in respect of unabsorbed depreciation as per income tax assessments only. As per AS 22, deferred tax can be recognised provided there is sufficient future income available against which deferred tax can be realised. Further, there is no time limit fixed under AS 22 for set-off of deferred tax. Similarly, there is no time limit under Income-tax Act for set-off of unabsorbed depreciation against future profits. As the depreciation is available for set-off for unlimited period and the company cannot perennially continue to sustain losses, it would be reasonable to recognise the unabsorbed depreciation as deferred tax asset for set off against future profits of the company."

5. In addition to the above, the querist has stated that the company has continuously earned profits till 31st March, 2001. The losses have occurred only during the last 3 years. Despite net profits earned by the company till 31st March, 2001, the company has filed loss return with the income tax department after availing benefits in accordance with the Supreme Court decisions, which has been upheld by the Income Tax Appellate Tribunal also. Copies of statement of income filed with the income tax department from the year ending 31/03/1997 to 31/03/2003 have been submitted by the querist for the perusal of the Committee.

6. As per the querist, the company, as a measure of prudence, has recognised deferred tax asset only on brought forward depreciation (and not business losses) (emphasis supplied by the querist) since the same is available for set-off over an unlimited period of time as per the current tax laws.

7. According to the querist, although the company could not achieve projected results for year ending 31st March, 2003 and 31st March, 2004, yet, taking into account the revenue concessions under negotiation with the principal shareholder, the company is confident of turn-around during the current financial year. The financial projections of the company for the next five years ending 31st March, 2005 to 31st March, 2009 are as given below:

(Rs. lakh)

Year ending	Profit before	Depreciation	Profit after
	depreciation (PBD)		depreciation (PAD)
31/03/2005	439.68	1048.44	(-) 554.76
31/03/2006	2082.34	1100.00	982.34
31/03/2007	2795.45	1534.54	1260.91
31/03/2008	2364.84	1350.40	1014.44
31/03/2009	2292.51	1188.35	1104.16

8. The company has decided to seek the opinion of the Expert Advisory Committee on the matter. Pending the opinion of the Committee, the company proposes:

(i) not to recognise the deferred tax asset in the books of account of the company for the financial year ending 31st March, 2004; and

 

(ii) to continue deferred tax assets already accounted for up to 31.3.2003 without their withdrawal/reversal in the books of account for financial year ending 31st March, 2004.

B . Query

9. In the light of the above and considering the fact that the accounts continue to be prepared on going concern basis, the querist has sought the opinion of the Expert Advisory Committee as to whether the company is justified in recognising deferred tax asset on brought forward depreciation as per income tax returns in its accounts.

C. Points considered by the Committee

10. The Committee notes that the basic issue in the query relates to recognition of deferred tax asset in respect of brought forward depreciation. The Committee has, therefore, considered only this issue and has not touched upon any other issue arising from the facts of the case such as recognition of deferred tax asset in respect of the brought forward losses.

11. The Committee notes paragraphs 17 and 18 of Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Institute of Chartered Accountants of India, which provide as follows:

"17. Where an enterprise has unabsorbed depreciation or carry forward of losses under tax laws, deferred tax assets should be recognised only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such deferred tax assets can be realised.

 

18. The existence of unabsorbed depreciation or carry forward of losses under tax laws is strong evidence that future taxable income may not be available. Therefore, when an enterprise has a history of recent losses, the enterprise recognises deferred tax assets only to the extent that it has timing differences the reversal of which will result in sufficient income or there is other convincing evidence that sufficient taxable income will be available against which such deferred tax assets can be realised. In such circumstances, the nature of the evidence supporting its recognition is disclosed."

12. The Committee further notes that the Institute of Chartered Accountants of India has issued Accounting Standards Interpretation (ASI) 9, ‘Virtual certainty supported by convincing evidence’ in relation to paragraph 17 of AS 22. Paragraphs 3 and 4 of ASI 9 provide as below:

"3. Determination of virtual certainty that sufficient future taxable income will be available is a matter of judgement and will have to be evaluated on a case to case basis. Virtual certainty refers to the extent of certainty, which, for all practical purposes, can be considered certain. Virtual certainty cannot be based merely on forecasts of performance such as business plans.

 

4. Virtual certainty is not a matter of perception and it should be supported by convincing evidence. Evidence is a matter of fact. To be convincing, the evidence should be available at the reporting date in a concrete form, for example, a profitable binding export order, cancellation of which will result in payment of heavy damages by the defaulting party. On the other hand, a projection of the future profits made by an enterprise based on the future capital expenditures or future restructuring etc., submitted even to an outside agency, e.g., to a credit agency for obtaining loans and accepted by that agency cannot, in isolation, be considered as convincing evidence."

13. On the basis of the above, the Committee is of the view that mere projections made by the company indicating the earning of profit and the confidence of the company that it will turn-around are not convincing evidence as per ASI 9. The Committee is further of the view that the mere fact that the unabsorbed depreciation can be carried forward for unlimited number of years as per the current tax laws can also not be a ground for recognising a deferred tax asset since paragraph 17 of AS 22 requires virtual certainty supported by convincing evidence at the date of the balance sheet. The Committee, however, wishes to point out that deferred tax asset can be created in respect of unabsorbed depreciation to the extent that future taxable income will be available from future reversal of any deferred tax liability recognised at the balance sheet date. To that extent, it would not be necessary to consider the level of virtual certainty supported by convincing evidence.

14. The Committee notes that the querist proposes to continue deferred tax assets already accounted for upto 31.3.2003 without withdrawal/ reversal thereof in the books of account for financial year ending 31st March, 2004. In this context, the Committee notes paragraph 26 of AS 22 as reproduced below:

"26. The carrying amount of deferred tax assets should be reviewed at each balance sheet date. An enterprise should write- down the carrying amount of a deferred tax asset to the extent that it is no longer reasonably certain or virtually certain, as the case may be (see paragraphs 15 to 18), that sufficient future taxable income will be available against which deferred tax asset can be realised. Any such write-down may be reversed to the extent that it becomes reasonably certain or virtually certain, as the case may be (see paragraphs 15 to 18), that sufficient future taxable income will be available."

15. On the basis of the above, the Committee is of the view that the carrying amount of deferred tax asset should be reviewed on 31st March, 04 and at every subsequent balance sheet date. To the extent it is no longer virtually certain that there will be sufficient future taxable income as discussed in paragraphs 12 and 13 above, the carrying amount of the deferred tax asset should be written down and charged to the profit and loss account.

D. Opinion

16. On the basis of the above, the Committee is of the opinion, on the issue raised by the querist in paragraph 9 above, that the company is not justified in recognising deferred tax asset on brought forward depreciation as per income tax returns in its accounts merely on the basis of its confidence of turn-around and the financial projections. However, to the extent of the availability of future taxable income, if any, by virtue of the future reversal of any deferred tax liability recognised at the balance sheet date, the deferred tax asset can be recognised. The Committee also wishes to add that the carrying amount of deferred tax asset balance as appearing on 31.3.2004 should also be reviewed as required by paragraph 26 of AS 22 and to the extent that deferred tax asset cannot be recognised on the considerations stated aforesaid, the carrying amount in respect thereof should be written down and charged to the profit and loss account.

1 Opinion finalised by the Committee on 5.8.2004