Query No. 14

Subject:

Creation of deferred tax liability on special reserve created

u/s 36(1)(viii) of the Income-tax Act, 1961.1

1. A wholly owned Government of India undertaking, registered under the Companies Act, 1956, is engaged in financing the power generation projects, transmission and distribution works and renovation and modernisation of power plants etc. in India. The company is also notified as a ‘Public Financial Institution’ under section 4A of the Companies Act,1956. The company is giving term loans, working capital loans, bridge loans etc., to finance the power projects. The company is also engaged in leasing activities and has leased out equipments to power producing companies on which it is charging lease rent from the lessees.

2. The Institute of Chartered Accountants of India has issued Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, which is applicable from 1.4.2001 to all listed enterprises. The querist has stated that since the bonds issued by the company are listed on the National Stock Exchange (NSE), the company is a listed company, and therefore, AS 22 became applicable to the company w.e.f. 1.4.2001.

3. The querist has stated that AS 22 requires the recognition of deferred tax asset or liability for the timing differences. As per the Standard, the "timing differences are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods", and the "Permanent differences are the differences between taxable income and accounting income for a period that originate in one period and do not reverse subsequently. Permanent differences do not result in deferred tax assets or deferred tax liability."

4. According to the querist, at the time of implementation of AS 22, the following timing differences between accounting income and taxable income were identified by the company:

(i) Accrual of expenses and short term income

 

(ii) Translation loss on foreign currency loans

 

(iii) Lease equalisation amount

 

(iv) Depreciation on leased assets and owned assets

As per the querist, the tax effect on the above items was ascertained and dealt with in accordance with the Standard in the books of account by creation of deferred tax asset or liability.

5. The querist has reproduced extracts from section 36(1) of the Income- tax Act, 1961, which provides as under:

"36. (1) The deductions provided for in the following clauses shall be allowed in respect of the matters dealt with therein, in computing the income referred to in section 28 – 

....

(viii) in respect of any special reserve created and maintained (emphasis supplied by the querist) by a financial corporation which is engaged in providing long-term finance for industrial or agricultural development or development of infrastructure facility in India or by a public company formed and registered in India with the main object of carrying on the business of providing long- term finance for construction or purchase of houses in India for residential purposes, an amount not exceeding forty percent of the profits derived from such business of providing long-term finance (computed under the head "Profits and gains of business or profession" before making any deduction under this clause) carried to such reserve account:

Provided that where the aggregate of the amounts carried to such reserve account from time to time exceeds twice the amount of the paid-up share capital and of the general reserves of the corporation or, as the case may be, the company, no allowance under this clause shall be made in respect of such excess."

 

The querist has stated that the company has been claiming a deduction under section 36(1)(viii) on account of special reserve created and maintained (emphasis supplied by the querist) @ 40% of profits derived from the business of long-term finance from the taxable income every year.

 

6. Further, the querist has mentioned that section 41(4A) of the Income- tax Act, 1961, provides that in case the special reserve is utilised/withdrawn the same will become taxable in the year in which it is so utilised/ withdrawn. Hence, the deduction claimed in the year of creation of special reserve becomes taxable in the year of utilisation/withdrawal of special reserve.

7. The querist has also intimated that the special reserve is appropriated out of the profits available for appropriation every year. It is not charged to the profit and loss account, while the same is deducted from the taxable income. The company is treating special reserve as a permanent difference and is not creating deferred tax liability on it.

8. The querist has informed that in this regard, an expert opinion was obtained by the company from a practising chartered accountant who has opined as below:

"For an item to result in the timing difference, it must enter the computation of both accounting income and taxable income though in different periods. The various examples given in AS 22 (paragraph 7 and Appendix I) fully support this view. If an item enters the computation of only accounting income but not taxable income (or vice versa), it does not result in a timing difference. It may also be mentioned that the concept of ‘timing differences’ used in AS 22 is a somewhat restrictive concept and does not encompass all the items that may have future tax consequences.

 

The approach adopted in AS 22 is commonly referred to as ‘income statement approach’ since timing differences arise from differences in amounts of revenues and expenses recognised in the income statement (i.e. profit and loss account) and their respective amounts for tax purposes. By using the concept of ‘timing differences’ instead of the concept of ‘temporary differences’, AS 22 seems to take a restrictive view of differences leading to tax consequences, i.e., deferred tax consequences of only those items are to be considered that arise from differences in the amounts of revenues and expenses reported in accounts and those considered for tax purposes.

 

As far as special reserve under section 36(1)(viii) of the Income-tax Act, 1961 is concerned, it is created by way of an appropriation of profits. Likewise, upon utilisation, such reserve would be transferred to general or other reserves. Thus, while both the creation and the utilisation of special reserve affect taxable income, neither affects accounting income. Thus, the creation of special reserve does not cause a timing difference to originate nor does utilisation thereof cause a reversal of timing difference. Accordingly, creation and utilisation of special reserve do not have deferred tax consequences within the meaning of AS 22."

 

9. Besides the above, as per the querist, the company has also examined the matter and noted that in the various examples given in the Standard, the items identified as timing differences are capable of reversal subsequently themselves (emphasis supplied by the querist), such as the difference in the method of depreciation in case a company charges depreciation on straight-line method (SLM) basis in its books, which is different from the written down value (WDV) method acceptable under the Income-tax Act. This results in timing difference. In the books, the depreciation on SLM basis would be spread evenly over the life of the asset while on WDV basis under the Income-tax Act, depreciation would be more in initial years and would reduce in the later years of life of the asset. The total amount of depreciation would be the same under both the methods and differences and tax effects on the timing differences would square up themselves over the life of the asset. Whereas, in case of special reserve, the difference would square up only when the company utilises/withdraws the special reserve, otherwise not. Till the time the company utilises the special reserve, section 41(4A) of Income-tax Act does not become operative; thus, the difference remains of permanent nature. It is not squared up itself as in the case of revenue items.

10. During the course of audit, however, a view has arisen that deferred tax liability should be created on the special reserve u/s 36(1)(viii) of the Income-tax Act, 1961. The view expressed was that such reserves are created under the relevant sections of the Income-tax Act and are not free reserves as any withdrawals therefrom are subject to tax liability at prevalent rates. The tax implications of the reserves of aforesaid type stand deferred till withdrawal from such reserves. The creation of special reserve creates a difference between taxable income and accounting income, which is not a permanent timing difference.

11. The querist has informed that as on 31.3.2004, the balance sheet of the company carries the special reserve of Rs. 2636.29 crore and the deferred tax liability, if created on it, would amount Rs. 500 crore (approximately). Further, the paid-up share capital and general reserve of the company as at 31st March, 2004 stood at Rs. 3578.74 crore; and as per section 36(1)(viii) of the Income-tax Act, the company can create special reserve to the extent of twice its paid-up capital and general reserve (i.e. upto Rs.7157.48 crore) against which the special reserves so far created are Rs. 2636.29 crore. As there is a big gap between the paid-up capital and general reserve and the special reserve, need for withdrawal from special reserve may never arise. The deferred tax liability,if created on special reserve, would be carried forward in the balance sheet of the company for a number of years (and may be, during the entire life of the company) which would create an imbalance and distort the solvency ratios (emphasis supplied by the querist). Also, keeping in view the concept of going concern, the company may not utilise the special reserve for a sufficiently long time.

12. The querist has sought the opinion of the Expert Advisory Committee on the issue as to whether the company is required to create the deferred tax liability on the special reserve created and maintained under section 36(1)(viii) of the Income-tax Act, 1961 as of now, which will become chargeable to tax as per section 41(4A) of the Act, only in the event of withdrawal therefrom and which may or may not happen (emphasis supplied by the querist).

13. The Committee notes the definition of the term ‘timing differences’ contained in the Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Institute of Chartered Accountants of India, reproduced below:

"Timing differences are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods."

14. From the above, the Committee is of the view that there are two essentialities for timing differences to arise:

(i) There should be difference between taxable income and accounting income originating in one period; and

(ii) The difference so originated should be capable of reversal in one or more subsequent periods.

The Committee notes that there is no condition of any limitation of the period for reversal of such differences, i.e., as per the definition quoted above, the reversal of the difference can take place at any time in future.

15. The Committee notes that in the period in which special reserve is created, the accounting income remains unaffected as the same is created below the line. However, the taxable income for the same year gets reduced by the amount of the special reserve thus resulting into lesser tax liability. Thus, a difference arises between the accounting income and the taxable income for that period. The Committee also notes that this difference is capable of reversal in the period in which the special reserve is utilised or withdrawn as in the year of utilisation or withdrawal, the amount of special reserve would be added to taxable income thus resulting into a higher taxable income than the accounting income of that period. Therefore, the Committee is of the view that the creation of special reserve results into timing differences as per AS 22.

16. The Committee also notes paragraph 14 of AS 22 which states as below:

"14. This Statement requires recognition of deferred tax for all the timing differences. This is based on the principle that the financial statements for a period should recognise the tax effect, whether current or deferred, of all the transactions occurring in that period."

17. The Committee further notes paragraph 8 of Accounting Standards Interpretation (ASI) 6, ‘Accounting for Taxes on Income in the context of Section 115JB of the Income-tax Act, 1961’, which, inter alia, describes one of the principal conceptual bases of AS 22 as below:

"8. There are two methods for recognition and measurement of tax effects of timing differences, viz., the ‘full provision method’ and ‘partial provision method’. Under the "full provision method", the deferred tax is recognised and measured in respect of all timing differences (subject to consideration of prudence in case of deferred tax assets) without considering assumptions regarding future profitability, future capital expenditure etc. On the other hand, the ‘partial provision method’ excludes the tax effects of certain timing differences which will not reverse for some considerable period ahead. Thus, this method is based on many subjective judgements involving assumptions regarding future profitability, future capital expenditure etc. In other words, partial provision method is based on an assessment of what would be the position in future. Keeping in view the elements of subjectivity, the ‘partial provision method’ under which deferred tax is recognised on the basis of assessment as to what would be the expected position, has generally been discarded the world-over. AS 22 also does not consider the above assumptions and, therefore, is based on ‘full provision method’."

18. From the above, the Committee notes that even if an enterprise expects that a difference between accounting and taxable income will not reverse within a reasonable period (partial provision approach), the difference should be recognised as timing difference if it is capable of reversal at any time in future (full provision approach). Thus, deferred tax is to be provided for all timing differences. Accordingly, the Committee is of the view that in the present case, the eventuality of utilisation/withdrawal of special reserve is not of relevance. So long as the utilisation/withdrawal is capable of taking place, the creation of special reserve results into timing differences for which deferred tax should be provided.

19. On the basis of the above, the Committee is of the opinion that the company is required to create deferred tax liability on the special reserve created and maintained under section 36(1) (viii) of the Income-tax Act, 1961, irrespective of the fact that withdrawal of the reserve may or may not happen since the company is capable to withdraw the reserve resulting into reversal of the difference between accounting income and taxable income (i.e., timing difference).

1 Opinion finalised by the Committee on 6.10.2004