Query No. 10

Subject:

Accounting for brought forward deferred tax liability/assets upon adoption

of Tonnage Tax Scheme by a shipping company.¹

A. Facts of the Case

1. A Government company (owned by Government of India) is carrying on the business of operating ships.

2. The querist has stated that the Institute of Chartered Accountants of India (ICAI) issued Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, which became applicable to the company with effect from accounting period commencing on 01.04.2001. Accordingly, the company started to provide for deferred tax liability with effect from financial year (F.Y.) 2001-02. Consequently, the company recognised the deferred tax liability/assets accumulated prior to 1st April, 2001 and charged the net deferred tax liability of Rs. 21,500 lakh as on 1st April, 2001, to general reserve and charged to the profit and loss account, the deferred tax liability (net) of Rs.370 lakh for the financial year 2001-02. Similarly, during the financial year 2002-03, the company recognised the deferred tax liability/ assets (net) of Rs. 1,200 lakh relating to the period prior to 31st March, 2001 and charged the same to general reserve account. During the financial year 2002-03, the company further recognised the deferred tax liability/ assets (net) of Rs. 227 lakh for the financial year 2002-03, which was charged to the profit and loss account. During the financial year 2003-04, the company recognised deferred tax liability/assets (net) of Rs. 6,251 lakh for the financial year 2003-04, which was charged to the profit and loss account. During the F.Y. 2003-04, no deferred tax liability/assets relating to the prior period were recognised/charged. Accordingly, the carried forward deferred tax liability/assets (net) as on 31.03.2004 amounted to Rs. 29,548 lakh as detailed hereunder:

3. The Finance (No.2) Act, 2004 introduced an optional ‘Tonnage Tax Scheme’ for taxation of shipping profits with effect from financial year 2004-05. According to the querist, it is a scheme of presumptive taxation whereby the notional income arising from the operation of a ship is determined based on the tonnage of the ship. The shipping companies have the option to compute income tax either under the Tonnage Tax Scheme or under the normal income tax provisions. However, on adopting either of the provisions for determining tax, the same provisions will be applicable for a period of 10 years. The company in question has elected to opt for Tonnage Tax Scheme with effect from financial year 2004-05.

4. The querist has expressed his view that the deferred tax liability is basically reflective of the concept of timing differences between the book profits and the taxable profits. Under the Tonnage Tax Scheme, taxable income is arrived at independent of depreciation. Therefore, in the view of the querist, the introduction of Tonnage Tax Scheme renders the concept of deferred taxation irrelevant for the shipping companies as there would be no deferred tax liability in future with the adoption of Tonnage Tax Scheme. Also, the provisions created in this regard in the balance sheet for eventual impact from changes in tax liability are made redundant. The deferred tax liability/assets already created/provided in the balance sheet have to be written back and adjusted in the view of the querist.

B. Query

5. In the light of above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) What accounting treatment is required to be made for brought forward deferred tax liability/asset (net) balance upon adoption of Tonnage Tax Scheme?

(b) Whether the entire balance of the deferred tax liability/assets as on 31.03.2004 can be transferred to general reserve. If so, whether it will be necessary to route the transfer to general reserve through the profit and loss account.

(c) Whether the entire balance in the deferred tax liability/assets as on 31.03.2004 can be transferred to the profit and loss account.

(d) If the entire balance in the deferred tax liability/assets as on 31.03.2004 cannot be transferred to general reserve or profit and loss account, then whether the part of balance which was initially charged to the profit and loss account can be transferred to the profit and loss account and whether the part of balance which was initially charged to general reserve can be transferred directly to general reserve.

(e) Whether entire balance or part of the balance, as the case may be, in the deferred tax liability/assets, which is being transferred to the profit and loss account can be charged to the profit and loss account (above the line) before arriving at the profit/loss for the year or whether same is to be charged to the profit and loss appropriation account (below the line).

C. Points considered by the Committee

6. The Committee notes that the issues raised by the querist in paragraph 5 above relate only to the treatment of brought forward deferred tax assets/liabilities upon adoption of the Tonnage Tax Scheme and has, therefore, not examined any other issue that may be contained in the Facts of the Case, for example, creation of deferred tax assets/liabilities accumulated on 1-4-2001 in two years against general reserve.

7. The Committee notes the salient features of the Tonnage Tax Scheme as per sections 115VA, 115VE, 115VF, 115VG, 115VL, 115VO, 115VP,115VQ, 115VR and 115VS of the Income-tax Act, 1961, as reproduced below:

“Computation of profits and gains from the business of operating qualifying ships

115VA. Notwithstanding anything to the contrary contained in sections 28 to 43C, in the case of a company, the income from the business of operating qualifying ships, may, at its option, be computed in accordance with the provisions of this Chapter and such income shall be deemed to be the profits and gains of such business chargeable to tax under the head “Profits and gains of business or profession”.”

“Manner of computation of income under tonnage tax scheme

115VE. (1) A tonnage tax company engaged in the business of operating qualifying ships shall compute the profits from such business under the tonnage tax scheme.

(2) The business of operating qualifying ships giving rise to income referred to in sub-section (1) of section 115V-I shall be considered as a separate business (hereafter in this Chapter referred to as the tonnage tax business) distinct from all other activities or business carried on by the company.

(3) The profits referred to in sub-section (1) shall be computed separately from the profits and gains from any other business.

(4) The tonnage tax scheme shall apply only if an option to that effect is made in accordance with the provisions of section 115VP.

(5) Where a company engaged in the business of operating qualifying ships is not covered under the tonnage tax scheme or, has not made an option to that effect, as the case may be, the profits and gains of such company from such business shall be computed in accordance with the other provisions of this Act.”

“Tonnage Income

115VF. Subject to the other provisions of this Chapter, the tonnage income shall be computed in accordance with section 115VG and the income so computed shall be deemed to be the profits chargeable under the head “Profits and gains of business or profession” and the relevant shipping income referred to in sub-section (1) of section 115V-I shall not be chargeable to tax.”

“Computation of tonnage income

115VG. (1) The Tonnage income of a tonnage tax company for a previous year shall be the aggregate of the tonnage income of each qualifying ship computed in accordance with the provisions of sub- sections (2) and (3).

(2) For the purposes of sub-section (1), the tonnage income of each qualifying ship shall be the daily tonnage income of each such ship multiplied by –

(a) the number of days in the previous year; or

(b) the number of days in part of the previous year in case the ship is operated by the company as a qualifying ship for only part of the previous year, as the case may be.

(3) For the purposes of sub-section (2), the daily tonnage income of a qualifying ship having tonnage referred to in column (1) of the Table below shall be the amount specified in the corresponding entry in column (2) of the Table:

TABLE

 

“General exclusion of deduction and set off, etc.

115VL. Notwithstanding anything contained in any other provision of this Act, in computing the tonnage income of a tonnage tax company for any previous year (hereafter in this section referred to as the “relevant previous year”) in which it is chargeable to tax in accordance with this Chapter –

(i) sections 30 to 43B shall apply as if every loss, allowance or dedution referred to therein and relating to or allowable for any of the relevant previous years, had been given full effect to for that previous year itself;

(ii) no loss referred to in sub-sections (1) and (3) of section 70 or sub-sections (1) and (2) of section 71 or sub-section (1) of section
72 or sub-section (1) of section 72A, in so far as such loss relates to the business of operating qualifying ships of the company, shall be carried forward or set off where such loss relates to any of the previous years when the company is under the tonnage tax scheme;

(iii) no deduction shall be allowed under Chapter VI-A in relation to the profits and gains from the business of operating qualifying ships; and

(iv) in computing the depreciation allowance under section 32, the written down value of any asset used for the purposes of the tonnage tax business shall be computed as if the company has claimed and has been actually allowed the deduction in respect of depreciation for the relevant previous years.”

“Exclusion from provisions of section 115JB

115VO. The book profit or loss derived from the activities of a tonnage tax company, referred to in sub-section (1) of section 115V- I, shall be excluded from the book profit of the company for the purposes of section 115JB.”

“Method and time of opting for tonnage tax scheme

115VP. (1) A qualifying company may opt for the tonnage tax scheme by making an application to the Joint Commissioner having jurisdiction over the company in the form and manner as may be prescribed, for such scheme.

…”

“Period for which tonnage tax option to remain in force

115VQ. (1) An option for tonnage tax scheme, after it has been approved under sub-section (3) of section 115VP, shall remain in force for a period of ten years from the date on which such option has been exercised and shall be taken into account from the assessment year relevant to the previous year in which such option is exercised.

(2) An option for tonnage tax scheme shall cease to have effect from the assessment year relevant to the previous year in which –

(a) the qualifying company ceases to be a qualifying company;

(b) a default is made in complying with the provisions contained in section 115VT or section 115VU or section

115VV;

(c) the tonnage tax company is excluded from the tonnage tax scheme under section 115VZC;

(d) the qualifying company furnishes to the Assessing Officer, a declaration in writing to the effect that the provisions of this Chapter may not be made applicable to it, and the profits and gains of the company from the business of operating qualifying ships shall be computed in accordance with the other provisions of this Act.”

“Renewal of tonnage tax scheme

115VR. (1) An option for tonnage tax scheme approved under sub- section (3) of section 115VP may be renewed within one year from the end of the previous year in which the option ceases to have effect.

(2) The provisions of sections 115VP and 115VQ shall apply in relation to a renewal of the option for tonnage tax scheme in the same manner as they apply in relation to the approval of option for tonnage tax scheme.”

“Prohibition to opt for tonnage tax scheme in certain cases

115VS. A qualifying company, which, on its own, opts out of the tonnage tax scheme or makes a default in complying with the provisions of section 115VT or section 115VU or section 115VV or whose option has been excluded from tonnage tax scheme in pursuance of an order made under sub-section (1) of section 115VZC, shall not be eligible to opt for tonnage tax scheme for a period of ten years from the date of opting out or default or order, as the case may be.”

8. The Committee further notes the ‘objective’ and paragraphs 5 to 7 of AS 22 as reproduced below:

“Objective

The objective of this Statement is to prescribe accounting treatment for taxes on income. Taxes on income is one of the significant items in the statement of profit and loss of an enterprise. In accordance with the matching concept, taxes on income are accrued in the same period as the revenue and expenses to which they relate. Matching of such taxes against revenue for a period poses special problems arising from the fact that in a number of cases, taxable income may be significantly different from the accounting income. This divergence between taxable income and accounting income arises due to two main reasons. Firstly, there are differences between items of revenue and expenses as appearing in the statement of profit and loss and the items which are considered as revenue, expenses or deductions for tax purposes. Secondly, there are differences between the amount in respect of a particular item of revenue or expense as recognised in the statement of profit and loss and the corresponding amount which is recognised for the computation of taxable income.”

“5. Taxable income is calculated in accordance with tax laws. In some circumstances, the requirements of these laws to compute taxable income differ from the accounting policies applied to determine accounting income. The effect of this difference is that the taxable income and accounting income may not be the same.

6. The differences between taxable income and accounting income can be classified into permanent differences and timing differences. Permanent differences are those differences between taxable income and accounting income which originate in one period and do not reverse subsequently. For instance, if for the purpose of computing taxable income, the tax laws allow only a part of an item of expenditure, the disallowed amount would result in a permanent difference.

7. Timing differences are those 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. Timing differences arise because the period in which some items of revenue and expenses are included in taxable income do not coincide with the period in which such items of revenue and expenses are included or considered in arriving at accounting income. For example, machinery purchased for scientific research related to business is fully allowed as deduction in the first year for tax purposes whereas the same would be charged to the statement of profit and loss as depreciation over its useful life. The total depreciation charged on the machinery for accounting purposes and the amount allowed as deduction for tax purposes will ultimately be the same, but periods over which the depreciation is charged and the deduction is allowed will differ. Another example of timing difference is a situation where, for the purpose of computing taxable income, tax laws allow depreciation on the basis of the written down value method, whereas for accounting purposes, straight line method is used. Some other examples of timing differences arising under the Indian tax laws are given in Appendix 1.”

9. The Committee notes from the above-reproduced sections of the Income-tax Act, 1961, related to Tonnage Tax Scheme for shipping companies, that the taxable income of a shipping company, which has opted for the scheme is arrived at on the basis of tonnage rather than the relevant revenues and expenditure of the business of operating qualifying ships. The Committee is of the view that this scheme of presumptive taxation has not been contemplated in AS 22 as is apparent from the paragraphs of the Standard reproduced in paragraph 8 above since AS 22 requires tax effect accounting in respect of differences between the accounting income and taxable income, arising because the items of revenue and expenditure are recognised/taxed or allowed by way of deduction for accounting purposes and tax purposes differently. Thus, in the view of the Committee, once a shipping company opts for the Tonnage Tax Scheme, it is not required to give effect to timing differences as contemplated under AS 22.

10. In respect of the accumulated balances of the deferred tax assets/ liabilities, the Committee notes the following paragraphs of the Framework for the Preparation and Presentation of Financial Statements, issued by the Institute of Chartered Accountants of India:

“49. …

(a) An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.

(b) A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

(c) …”

“91. Income is recognised in the statement of profit and loss when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. …”

“93. Expenses are recognised in the statement of profit and loss when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. …”

11. The Committee also notes that paragraph 5 of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes
in Accounting Policies’, issued by the Institute of Chartered Accountants of India, provides as below:

“5. All items of income and expense which are recognised in a period should be included in the determination of net profit or loss for the period unless an Accounting Standard requires or permits otherwise”.

12. On the basis of the above, the Committee is of the view that on the adoption of the Tonnage Tax Scheme by the company, the accumulated balances of deferred tax assets/liabilities no longer meet the definitions of the terms ‘assets’ and ‘liabilities’ as reproduced above and the same should be recognised as expense and income respectively in the profit and loss account since no Accounting Standard requires or permits otherwise.

D. Opinion

13. On the basis of the above, the opinion of the Expert Advisory Committee on the issues raised by the querist in paragraph 5 above is as below:

(a) The accounting treatment for brought forward deferred tax assets/liabilities on adoption of Tonnage Tax Scheme is given in (c) below.

(b) No, the entire balance of the deferred tax liabilities/assets as on 31-3-2004 cannot be transferred to general reserve.

(c) Yes, the entire balance of the deferred tax liabilities/assets as on 31-3-2004 should be transferred to the profit and loss account in the year of adoption of the Tonnage Tax Scheme.

(d) No.

(e) The entire balance of the deferred tax liabilities/assets should be transferred to the profit and loss account before arriving at the profit/loss for the year, i.e., above the line.

¹ Opinion finalised by the Committee on 28.4.2005