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Query No. 33
Subject:
Creation of deferred tax asset in respect of provision
for final mine
closure expenditure.1
A. Facts of the Case
1. A public sector undertaking is engaged in mining of manganese ore at several
locations. Due to different chemical compositions required by end-users (mainly
ferro manganese producers), ore extracted from a single mine, which has a
particular chemical composition, is not sold as such; instead, blend of ore of
various mines is sold.
2. The querist has stated that as per Rule 23B of Mineral Conservation and
Development Rules, 1988 (MCDR) amended in April, 2003, it is obligatory on the
part of the user (lessee) to submit progressive mine closure plan at the time of
obtaining lease or at the time of lease renewal or, in case of continuing
leases, every five years. The Indian Bureau of Mines (IBM), which is a
regulatory body, is also insisting upon bank guarantees which can be invoked if
activities stated in progressive mine closure plan are not carried out to their
satisfaction. Further, as per Rule 23C of MCDR, it is also necessary to submit
final mine closure plan one year prior to proposed closure. As per Rule 23(5) of MCDR, the leaseholder cannot abandon a mine or part thereof unless the final
mine closure plan is implemented to the satisfaction of the IBM. As per the
regulations, the leased area can be surrendered only after restoring the same by
carrying out reclamation, surface back filling, removing dumps, plantation over
waste rock dumps, etc. These activities involve substantial expenditure which is
called ‘final mine closure expenditure’. The querist has also submitted
separately relevant extracts of the Mine Conservation and Development Rules for
the perusal of the Expert Advisory Committee.
3. According to the querist, as estimated, the ore reserves in the present
leases are expected to last for about 35-40 years, based on the current rate of
extraction of ore. The expected year of closing down a particular mine cannot,
however, be predicted based on available ore reserves because extraction rate
also depends on demand of various grades of ore and blend of ore which the
company decides to sell from time to time. The longevity of the mine also
depends on factors like (a) technological developments in the steel industry,
which may result in alternative cheaper substitute in place of manganese, and
(b) identification of ore reserves at lower underground levels, which can be
extracted at an economical cost.
4. As per the querist, as the final mine closure is a result of extraction of
ore during the operating period of lease of a mine, it is necessary that profits
of a financial year should be worked out after providing for estimated liability
on account of final mine closure expenditure. In view of this and due to
Accounting Standard (AS) 29, ‘Provisions, Contingent Liabilities and Contingent
Assets’, issued by the Institute of Chartered Accountants of India, becoming
mandatory for accounting periods commencing on or after 01.04.2004, the company
has provided for the estimated liability on account of final mine closure
expenses in the financial year 2004-05 for the first time. According to the
querist, mine- wise estimated expenditure on final mine closure, proven ore
reserves and actual production during the year have been considered for the
purpose of working out the estimated liability for final mine closure
expenditure.
5. The querist has stated that the provision for final mine closure expenses is
not allowable under the Income-tax Act, 1961 since the same
is not incurred during the current year. Thus, in the view of the querist, as
per paragraph 4 of Accounting Standard (AS) 22, ‘Accounting for Taxes on
Income’, issued by the Institute of Chartered Accountants of India, the item
falls under the category of ‘timing differences’ for the purpose of working out
deferred tax assets.
6. According to the querist, as a matter of prudence, the company has not
recognised the deferred tax assets on this account. The querist has stated that
the company has considered the following aspects while taking this decision:
(a) The possibility of mine closure and, in turn, incurring
restoration/reclamation expenditure will take effect not in the near future but
probably after a period of 35-40 years. The mines under reference are being
operated for more than 50 years and there is no event during the current year
which necessitates closure of any of the mines in the near future.
(b) Although the company has been consistently reporting very good profits, it
cannot be predicted whether there will be sufficient taxable income after 35-40
years (especially when large mines/all mines of the company will be closed down)
to realise the deferred tax assets, if created.
(c) Possibility of the company making any profit in the year of incurrence of
mine closure expenses to claim tax benefits on these expenses is an assumption,
which may or may not prove to be correct.
(d) One of the major considerations governing selection and application of
accounting policies is ‘prudence’, which stipulates that in view of uncertainty
attached to future events, profits are not anticipated but recognised only when
realised.
(e) It is too early to predict conditions of profitability and taxable income
which would exist 35-40 years later.
7. According to the querist, paragraph 16 of AS 22 requires exercise of prudence
at the time of creating deferred tax assets by taking into account past trends
only. However, factors like uncertainty attached to future events, especially
for fairly long periods, have not been highlighted in the Accounting Standard.
8. As per the querist, the government auditors have pointed out that the factors
enumerated in paragraph 6 above have not been specified in the Accounting
Standard and hence, the deferred tax asset should have been created in view of
the timing differences as contemplated in AS 22. The government auditors have
also taken a stand that there is a provision for reassessment of deferred tax
assets at each balance sheet date in AS 22, and if it is felt later that there
would not be sufficient taxable income to realise the deferred tax assets, the
company can reassess the same.
9. According to the querist, in support of the treatment given by the company,
it has been pointed out to the auditors that one of the major considerations
governing selection and application of accounting policies is ‘prudence’, which
stipulates that “in view of the uncertainty attached to future events, profits
are not anticipated but recognised only when realised though not necessarily in
cash” (paragraph 17(a) of Accounting Standard (AS) 1, ‘Disclosure of Accounting
Policies’, issued by the Institute of Chartered Accountants of India).
Therefore, the company has chosen to postpone the recognition of the deferred
tax asset and to create the same only when it is absolutely sure of realising
such assets.
10. The company’s view-point has not been accepted by the government auditors
and, hence, an assurance has been given by the company to seek the opinion of
the Expert Advisory Committee and to review the position next year. The querist
has separately provided the photocopies of the government auditors’ views,
explanations thereto given by the company and the final comments of the
government auditors for the perusal of the Committee.
11. The querist has emphasised that the provision should not be considered for
working out deferred tax assets till it is absolutely sure that the assets would
be realised and/or final mine closure is foreseen in the near future.
B. Query
12. The querist has sought the opinion of the Expert Advisory Committee as to
whether any deferred tax asset needs to be created as per AS 22
(especially bearing in mind the concept of prudence) in respect of provision
made on account of final mine closure expenditure, which is a remote event and
the expenditure is likely to be incurred after a period of 35-40 years.
C. Points considered by the Committee
13. The Committee, while expressing its opinion, has restricted itself to the
issues raised in paragraph 12 above and has not considered any other issue that
may arise from the Facts of the Case such as, allowability of provision for
final mine closure expenses under the Income-tax Act, 1961.
14. The Committee notes that the nature of final mine closure expenditure in the
present case is similar to that of abandonment costs in case of oil and gas
producing companies. In this context, the Committee notes paragraph 53 of the
Guidance Note on Accounting for Oil and Gas Producing Activities, issued by the
Institute of Chartered Accountants of India, which states as follows:
“53. Abandonment costs are the costs incurred on discontinuation of all
operations and surrendering the property back to the owner. These costs relate
to plugging and abandoning of wells, dismantling of wellheads, production and
transport facilities and to restoration of producing areas in accordance with
license requirements and the relevant legislation.”
15. Regarding the accounting treatment of final mine closure expenditure, the
Committee notes paragraph 54 of the above-mentioned Guidance Note and Example 3
of Appendix C to AS 29 in the context of oil and gas industry, which state as
follows:
Guidance Note on Accounting for Oil and Gas Producing Activities
“54. The full eventual liability for abandonment cost net of salvage
values should be recognised at the outset on the ground that a liability
to remove an installation exists the moment it is installed. Thus, an enterprise
should capitalise as part of the cost centre the amount of provision
required to be created for subsequent abandonment. Charge for abandonment costs
should not be discounted to its present value. The provision for estimated
abandonment costs should be made at current prices considering the environment
and social obligations, terms of mining lease agreement, industry practice,
etc.” (Emphasis supplied by the Committee).
AS 29
“Example 3: Offshore Oilfield
An enterprise operates an offshore oilfield where its licensing agreement
requires it to remove the oil rig at the end of production and restore the
seabed. Ninety per cent of the eventual costs relate to the removal of the oil
rig and restoration of damage caused by building it, and ten per cent arise
through the extraction of oil. At the balance sheet date, the rig has been
constructed but no oil has been extracted.
Present obligation as a result of a past obligating event – The
construction of the oil rig creates an obligation under the terms of the licence
to remove the rig and restore the seabed and is thus an obligating event. At the
balance sheet date, however, there is no obligation to rectify the damage that
will be caused by extraction of the oil.
An outflow of resources embodying economic benefits in settlement -
Probable.
Conclusion - A provision is recognised for the best estimate of ninety
per cent of the eventual costs that relate to the removal of the oil rig and
restoration of damage caused by building it (see paragraph 14). These costs are
included as part of the cost of the oil rig. The ten per cent of costs that
arise through the extraction of oil are recognised as a liability when the oil
is extracted.” (Emphasis supplied by the Committee).”
16. The Committee also notes paragraphs 17 and 19 of the Exposure Draft of the
Revised Accounting Standard (AS) 10, ‘Tangible Fixed Assets’, issued by the
Institute of Chartered Accountants of India, which propose the following
accounting treatment:
“17. The cost of a tangible fixed asset comprises:
(a) its purchase price, including duties and taxes (other than those
subsequently recoverable by the enterprise from the taxing authorities), after
deducting trade discounts and rebates.
(b) any costs directly attributable to bringing the asset to the location and
condition necessary for it to be capable of operating in the manner intended.
(c) the initial estimate of the costs of dismantling and removing the asset and
restoring the site on which it is located, the obligation for which an
enterprise incurs either when the asset is acquired or as a consequence of
having used the asset during a particular period for purposes other than to
produce inventories during that period.”
“19. The obligations for the costs of dismantling and removing the asset and
restoring the site on which it is located are recognised and measured in
accordance with AS 29, Provisions, Contingent Liabilities and Contingent Assets.
The underlying nature and association of an obligation for dismantling, removing
and restoring the site on which a tangible fixed asset is located with the asset
remains the same irrespective of whether the obligation is incurred upon
acquisition of the asset or while it is being used. Therefore, the cost of an
asset also includes the costs of dismantlement, removal or restoration, the
obligation for which is incurred as a consequence of having used the asset
during a particular period other than to produce inventories during that period.
An enterprise applies AS 2, Valuation of Inventories, to the costs of
obligations that are incurred as a consequence of having used the asset during a
particular period to produce inventories during that period. This is because the
accounting for these costs in accordance with AS 2 acknowledges
their nature.”
17. It appears from the Facts of the Case that the final mine closure is a
result of extraction of ore during the operating period of lease of a mine,
rather than the result of dismantlement of plant and equipment which is used for
the purpose of extracting the ore from the mine. In view of this, creation of
provision every year to the extent of the ore extracted during the year,
representing the estimated liability on account of final mine closure expenses,
is appropriate. However, in case a part or the whole of the final mine closure
expenses relate to the dismantlement of plant and equipment used for the
extraction of ore, the provision for the relevant amount should be made in the
year in which the cost of acquisition/ construction of plant and equipment is
capitalised. In this case, the amount
of the provision should be capitalised as a part of the cost of the plant and
equipment, instead of the amount of provision being debited to the profit and
loss account.
18. With regard to creation of deferred tax asset, the Committee is of the view
that if the provision for final mine closure expenses gives rise to timing
differences under AS 22, leading to creation of deferred tax asset,
consideration of prudence should be kept in mind as recognised in paragraph 13
of AS 22, which states as follows:
“13. Deferred tax should be recognised for all the timing differences,
subject to the consideration of prudence in respect of deferred tax assets as
set out in paragraphs 15-18.”
19. The Committee also notes that in the present case since the company under
consideration is making profits, paragraphs 15 and 16 of AS 22 are also relevant
for considering whether the deferred tax asset should be created or not. The
said paragraphs are reproduced below:
“15. …deferred tax assets should be recognised and carried forward only to
the extent that there is a reasonable certainty that sufficient future taxable
income will be available against which such deferred tax assets can be realised.
16. While recognising the tax effect of timing differences, consideration of
prudence cannot be ignored. Therefore, deferred tax assets are recognised and
carried forward only to the extent that there is a reasonable certainty of their
realisation. This reasonable level of certainty would normally be achieved by
examining the past record of the enterprise and by making realistic estimates of
profits for the future.”
20. The Committee notes from the above that AS 22 envisages creation of a
deferred tax asset if there is ‘reasonable’ certainty that sufficient
future taxable income will be available against which such deferred tax asset
can be realised rather than ‘absolute’ certainty as argued by the querist in
paragraphs 9 and 11 above. The Committee also notes that this ‘reasonable’ level
of certainty would normally be achieved by examining the past records of the
enterprise and by making ‘realistic estimate’ of profits for the future. The
Committee is of the view that while the realistic estimate would take account of
the future uncertainties, the possibility of occurrence or non-occurrence of any
unforeseen event leading to absence of sufficient future taxable income, may not
be sufficient ground for not creating the deferred tax asset. This is because
such unforeseen events are a part of every business. Further, it is appreciated
that the longer the period for which an estimate is to be made, the lesser is
the degree of accuracy of making the estimate. However, in such situations also,
keeping in view the past experience of not only the company concerned but also
of the industry as a whole, making of a realistic estimate may still be
possible. The Committee also notes that sufficient future taxable income may
also arise from the reversal of deferred tax liabilities created, for example,
on account of the timing differences between the tax depreciation and the
accounting depreciation. In view of this, the company should make a ‘realistic
estimate’ of profits for the future and, if such an estimate can be made, create
the deferred tax asset. However, in case the ‘realistic estimate’ indicates that
there will not be any sufficient future taxable income to realise the deferred
tax asset, the company should not create the deferred tax asset.
21. In a situation where the final mine closure expenses relate to dismantlement
of plant and equipment and the provision therefor is capitalised as a part of
the cost of the plant and equipment, there would be no timing differences on
account of the provision since the same is not debited to the profit and loss
account. The timing difference, if any, will arise on account of the
depreciation for tax purposes and that for accounting purposes which may result
into creation of deferred tax asset/liability. In case it results in a deferred tax asset situation, the
considerations discussed in paragraph 20 above would apply in the creation
of the deferred tax asset.
D. Opinion
22. On the basis of the above, the Committee is of the opinion that deferred tax
asset may have to be created as per AS 22 in view of the considerations stated
in paragraphs 17 to 21 above.
1Opinion finalised by the Committee on 25.1.2006
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