Query No. 22

Subject:

Creation of deferred tax liability in respect of special reserve

created under section 36(1)(viii) of the Income-tax Act, 1961.¹

A. Facts of the Case

1. A housing bank is established under an Act of Parliament. The bank has been established to promote housing finance institutions and to provide financial and other support to such institutions. The whole of the paid up capital of the bank as on date is owned by the Reserve Bank of India. Till financial year ended 31st March, 2001, the income of the bank was exempt from taxation under the Income-tax Act, 1961. The bank got itself listed in August 2004 in respect of its bonds issued from time to time with the Bombay Stock Exchange and the National Stock Exchange.

2. The statutory year ending for the bank is 30th June each year. However, the bank also prepares accounts for the financial year in order to file the income-tax return. From the financial year commencing on 01-04-2001, the bank became a taxable entity and, therefore, its income became subject to tax under the Income-tax Act, 1961. Being a housing finance institution, the bank is creating a special reserve under section 36(1)(viii) of the Income-tax Act, 1961, by appropriating 40% of its profit for long-term housing finance business. The special reserve created during the years commencing from Assessment Year 2002-2003, is as follows:

                                                                                    Amount in crore (Rs.)
 

3. During the audit for the financial year 2004-05, a question arose as to whether deferred tax liability needs to be created on the special reserve created under section 36(1)(viii) of the Income-tax Act, 1961.

4. The querist has stated that the bank had first created deferred tax asset/liability in its accounts for the year ended 30th June, 2003. Subsequently, the bank has been creating deferred tax asset/liability for each year depending on the items as applicable and prescribed by Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Institute of Chartered Accountants of India.

5. According to the querist, the question, ‘whether deferred tax liability needs to be created on special reserve created under section 36(1)(viii) of the Income-tax Act, 1961’, has arisen in view of an opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India (ICAI), which has been hosted on the website of ICAI since March 2005. Though the opinion given by the Committee is in respect of a particular person or situation, the querist has raised a question as to whether it is normally expected that if a similar situation exists then the opinion given earlier should also be followed by other persons.

6. The auditors of the bank are of the opinion that in the view of the opinion of the Expert Advisory Committee, the bank should create deferred tax liability on the special reserve created under section 36(1)(viii) of the Income-tax Act, 1961. As per the querist, if the bank has to create deferred tax liability in respect of the entire reserve created till date, then it will affect the profitability of the bank for the current year. Since the operations of the bank, such as lending, investments, etc., are with respect to the net worth of the bank for each year, the same would be affected to the extent of the deferred tax liability created.

B. Query

7. On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(i) Whether it is necessary for the bank to create deferred tax liability in respect of special reserve created under section 36(1)(viii) of the Income-tax Act, 1961.

(ii) Whether the bank can create the deferred tax liability on the opening balance of special reserve as on 1st April, 2004 out of the general reserve available with the bank as on that date and the deferred tax liability for the current year from the profits of the current year.

(iii) Whether the bank can create the deferred tax liability on the opening balance of special reserve in a phased manner.

C. Points considered by the Committee

8. The Committee notes section 36(1)(viii) of the Income-tax Act, 1961, which states as follows:

“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 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.”

9. The Committee also notes the definition of the term ‘timing differences’ contained in AS 22, as 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.”

10. From the above, the Committee is of the view that there are two essentials 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.

11. 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 (Section 41(4A) of the Income-tax Act, 1961) thus, resulting into a higher taxable income than the accounting income of that period (emphasis supplied by the Committee). Therefore, the Committee is of the view that the creation of special reserve results into timing differences as per AS 22. Accordingly, a deferred tax liability is required to be created in this regard, which was also the opinion of the Committee in respect of the earlier query as referred to by the querist.

12. Regarding the question raised by the querist that whether an opinion of the Committee applies to persons other than the querist, the Committee wishes to state that if the facts and circumstances in the query opined earlier are same in another case then the accounting and other recommendations made in the opinion hold good.

13. The Committee further notes the transitional provisions of AS 22, which state in paragraph 33 as follows:

“33. On the first occasion that the taxes on income are accounted for in accordance with this Statement, the enterprise should recognise, in the financial statements, the deferred tax balance that has accumulated prior to the adoption of this Statement as deferred tax asset/liability with a corresponding credit/charge to the revenue reserves, subject to the consideration of prudence in case of deferred tax assets (see paragraphs 15-18). The amount so credited/charged to the revenue reserves should be the same as that which would have resulted if this Statement had been in effect from the beginning.”

14. On the basis of the above, the Committee is of the view that the creation of deferred tax liability against the opening balance of general reserve is permissible only under transitional provisions laid down in AS 22 to ensure smooth switchover from a situation when AS 22 had not come into force to the situation when it becomes applicable to an enterprise as per its requirements. Thus, the transitional provisions are not applicable to a situation where a company failed to follow deferred tax accounting as per the Standard in past. Accordingly, in the view of the Committee, deferred tax liability in respect of past years, i.e., on the opening balance of special reserve as on 1.4.2004, cannot be created out of the opening balance of general reserve. The Committee further notes that AS 22 no where allows creation of deferred tax liability – whether past or the current year – in a phased manner. Accordingly, the entire amount of the deferred tax liability should be charged to the profit and loss account.

D. Opinion

15. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 7 above:

(i) Yes, it is necessary for the bank to create deferred tax liability in respect of special reserve created under section 36(1)(viii) of the Income-tax Act, 1961.

(ii) No, the bank cannot create the deferred tax liability in respect of special reserve out of the general reserve available with the bank as on 1.4.2004.

(iii) No, the bank cannot create the deferred tax liability in a phased manner.

¹ Opinion finalised by the Committee on 17.8.2005