Query No. 36

Subject:

Adjustment of deferred tax liability on special reserve created under

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

A. Facts of the Case

1. A company, which is a Government of India undertaking, 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 wholly owned by the Government of India and was incorporated under the Companies Act, 1956 in the year 1987. 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 for which lease rent is charged from the lessees.

2. According to the querist, the company has been claiming a deduction from the taxable income under section 36(1)(viii) of the Income-tax Act, 1961, on account of special reserve created and maintained @ 40% of profits derived from the business of long term finance. The company had also provided deferred tax liability on the special reserve as per Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Institute of Chartered Accountants of India, and an earlier opinion sought by the company from the Expert Advisory Committee. The following are the brief details of the opinion earlier sought by the company.

Issue on which Opinion was earlier sought by the company:

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, which may or may not happen.

Opinion given by Expert Advisory Committee:

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).

3. The querist has stated that consequent to the opinion of the Expert Advisory Committee of the Institute, the company had created deferred tax liability on special reserve created under section 36(1)(viii) of the Income-tax Act, 1961 amounting to Rs.745.14 crore upto 31.03.2004 out of the reserves and Rs.142.87 crore against the current year’s profit (2004-05) (emphasis supplied by the querist), by applying the current tax rate applicable for the financial year 2004-05, i.e., at 36.5925%. The net deferred tax liabilities computed as per AS 22 as on 31.03.2005 are Rs. 899.78 crore (previous year’s net deferred tax assets are Rs.14.11 crore). According to the querist, the current tax rate applicable to the company has been reduced to 33.66% for the financial year 2005-06 and deferred tax liability would thus be required to be computed for the financial year 2005-06 by following tax rate for the financial year 2005-06 (i.e.) 33.66% and liability for previous years also needs to be adjusted/ reduced by applying the current tax rate applicable for the financial year 2005-06.

4. The querist has supplied the annual reports for the last three years for the perusal of the Committee.

B. Query

5. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(i) Whether the company is required to reduce the deferred tax liability upto 31.03.2005, on special reserve created under section 36(1)(viii) of the Income-tax Act, 1961 by 2.9325%, i.e., the difference between the current tax rate of 33.66% and the tax rate of 36.59% at which deferred tax liability was provided earlier upto 31.3.05 and reverse the deferred tax liability amounting to Rs. 71 crore by crediting the profit and loss account and then carrying it to reserves and surplus.

 

(ii) Whether the same treatment is to be given to deferred tax assets/liabilities in respect of other items such as exchange loss, depreciation, lease equalisation, lease income on new lease, etc., as mentioned in (i) above and whether the company has to follow in future the same course of action on all items noted in (i) and (ii) as and when the rates are increased or decreased by the Finance Act.

 

C. Points considered by the Committee

6. At the outset, the Committee notes that the company in question has created a deferred tax liability amounting to Rs. 745.14 crore upto 31st March, 2004, out of the reserves. The Committee notes from paragraph 33 of AS 22 related to the Transitional Provisions that on AS 22 first coming into force, i.e., from 1st April, 2001, the accumulated deferred tax liability should be created out of the reserves. In other words, the benefit of the Transitional Provisions was available only at the beginning of the first year of the application of AS 22, i.e., 1st April, 2001. Thereafter, the annual charge in respect of deferred tax liability should have been made to the profit and loss account for the relevant year, which has not been done by the company in respect of the financial years 2001-02 and 2002-03. The Committee is, therefore, of the view that the deferred tax liability, which the company has created out of the reserves in respect of the years 2001-02 and 2002-03, on 31st March, 2004, should be treated as a ‘prior period item’ within the meaning 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, as it was an error pertaining to those years. The error should be accounted for in the current financial year by crediting the reserves and debiting the profit and loss account and should be disclosed as a prior period item in accordance with AS 5.

7. Regarding the adjustment of deferred tax liability due to changes in the enacted/substantively enacted tax rates at the balance sheet date, the Committee notes that paragraphs 21 and 22 of AS 22 provide as follows:

“21. Deferred tax assets and liabilities should be measured using the tax rates and tax laws that have been enacted or substantively enacted by the balance sheet date.

22. Deferred tax assets and liabilities are usually measured using the tax rates and tax laws that have been enacted. However, certain announcements of tax rates and tax laws by the government may have the substantive effect of actual enactment. In these circumstances, deferred tax assets and liabilities are measured using such announced tax rate and tax laws.”

8. The Committee also notes Illustration 2 of Appendix 2 to AS 22, which, inter alia, states that “If the rate of tax changes, it would be necessary for the enterprise to adjust the amount of deferred tax liability carried forward by applying the tax rate that has been enacted or substantively enacted by the balance sheet date on accumulated timing differences at the end of the accounting year (see paragraphs 21 and 22).”

9. From the above, the Committee is of the view that the amounts of deferred tax assets/liabilities carried forward from the last reporting date may require an adjustment if there is a change in the enacted or substantively enacted tax rates and/or tax laws at the current reporting date. In such a case, in the view of the Committee, the deferred tax assets/liabilities carried forward from the last reporting date should be remeasured using the enacted or substantively enacted tax rates and tax laws at the current reporting date. The resultant adjustment should be recognised in the statement of profit and loss for the current year. In respect of adjustment to deferred tax assets, the Committee also notes paragraph 26 of AS 22, which states as follows:

“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.”

10. Thus, the Committee is of the view that the enterprise should adjust the carrying amount of deferred tax assets, only to the extent it is reasonably certain or virtually certain, as the case may be, that sufficient future taxable income will be available against which those deferred tax assets can be realised (see paragraphs 15 to 18 of AS 22).

D. Opinion

11. On the basis of the above, the Committee is of the following opinion, read with paragraph 6 above, on the issues raised in paragraph 5 above:

(i) Yes, the company is required to reduce the deferred tax liability created upto 31.03.2005 on special reserve under section 36(1)(viii) of the Income-tax Act, 1961, for giving effect to the changes in the enacted/substantively enacted tax rates and to recognise the resultant adjustment by crediting the profit and loss account and then carrying it to reserves and surplus, if the company so desires. The Committee, however, does not express its opinion on the specific percentages of tax, viz., 33.66%/36.59%, as mentioned by the querist.

 

(ii) Yes, the same treatment is to be given to deferred tax assets/ liabilities in respect of other items and the same treatment should also be followed in future as and when there is any change in the enacted/substantively enacted tax rates and/or tax laws. However, the considerations of reasonable/virtual certainty would apply in relation to deferred tax assets as stated in paragraph 10 above.

¹ Opinion finalised by the Committee on 25.1.2006