Query No. 38

Subject:

Recognition of revenue in respect of deferred tax liability

recoverable on actual payment.¹

A. Facts of the Case

1. A company owns and operates a Combined Cycle Power Plant in India. The plant was installed and commissioned under a turnkey engineering, procurement and construction (EPC) contract by a foreign company. The commercial operation of the company was achieved in the year 2001-02.

2. The company has entered into a Power Purchase Agreement (PPA) with a State Electricity Board (SEB) for sale of its entire power generated. As per the querist, the pricing is consistent with the standard norms as per the policy of the Government of India (GOI) in respect of Independent Power Producers (IPP) based on capacity of operation, i.e., Plant Load Factor (PLF), including fuel cost on Axiomatic Standard Efficiency including post tax return. The querist has separately supplied the summary of the components of pricing and the basis adopted for the perusal of the Committee. According to the querist, the PPA is backed by a sovereign guarantee of the State Government.

3. In view of the contractual provisions of the PPA with the SEB, the deferred tax liability is recoverable from the SEB on actual payment, the details with regard to which, as provided by the querist, are as follows:

(a) The project is an infrastructure project, as defined under the Income-tax Act, 1961 and is notified under section 10 (23G) of the Act. The company is eligible for 100% tax exemption under section 80-IA of the Income-tax Act for the first ten consecutive assessment years of its commercial operations. The company has thus been providing for Minimum Alternative Tax (MAT) on its book profits.

(b) The company provides depreciation in the books as per the rates set out in Schedule XIV to the Companies Act, 1956, on a straight-line basis. For the purpose of income-tax, the company provides depreciation as per the rates applicable under the Income-tax Act, which are different from the rates set out in Schedule XIV to the Companies Act, 1956.

 

(c) PPA provides as follows:

 

(i) The PPA provides for reimbursement of taxes paid by the company on its net income (limited to tax as grossed up to provide a return on equity of 16%) pursuant to its business of delivering power to the State Electricity Board as part of its tariff, when the taxes are actually paid by the company, excluding the investment of cash reserves, which the company is required by law to maintain and any increase in tax or penalty levied on the company by reason of its default in reporting or paying any tax. Further, the taxes on net income attributable to the incentive charges shall be excluded.

 

(ii) Specified taxes shall not form part of normal billing. Any advance tax payable for the project in any month supported by a certificate from a Chartered Accountant will be reimbursed separately. After the tax assessment is completed for any year and the liability therefor is determined, the excess or shortfall shall be adjusted separately.

 

(iii) Definition of FCC as given in the PPA: ‘Fixed Capacity Charge’ (FCC) with respect to any month is the sum of O & M expenses, debt payment, interest on working capital, depreciation, return on equity and specified taxes applicable to that month as further described in the tariff.

 

4. The querist has mentioned that the underlying technical point involved in the issue relates to the matching principle of accounting. ‘Accrual’ is a fundamental accounting assumption. Implicit in the concept of accrual, the focus is on matching of revenues and costs. The querist has also reproduced paragraph 2.5 of the Guidance Note on Accrual Basis of Accounting, issued by the Institute of Chartered Accountants of India, which states as follows:

“The following are the essential features of accrual basis of accounting:

(i) Revenue is recognised as it is earned.

 

(ii) Costs are matched either against revenues so recognised or against the relevant time period to determine periodic income, and

 

(iii) Costs which are not charged to income are carried forward and are kept under continuous review. Any cost that appears to have lost its utility or its power to generate future revenue is written-off as a loss.”

 

5. The querist has further stated that section 211(3B) and section 211(3C) of the Companies Act, 1956 have conferred statutory status to Accounting Standards. Section 211(3B) of the Act deals with a situation where Accounting Standards may not be followed whereupon disclosure is called for in regard to the extent of deviation, the reason therefor and the financial impact. It can, therefore, be derived, according to the querist, that while a mandatory Accounting Standard (AS) may be generally applicable, there could be special situations where following the same is not appropriate and the disclosure of the peculiarities is, therefore, considered appropriate. This position is to be compared with one where accrual basis is not followed. In such cases, section 209(3)(b) of the Act specifically provides that proper books shall not be deemed to have been maintained. The position is reinforced by section 217(2AA)(ii) of the Act wherein the Directors’ Responsibility Statement discloses material departures from Accounting Standards with ‘proper’ explanation for the same. According to the querist, it is, therefore, probable for a company in peculiar circumstances not to follow an Accounting Standard and not have qualification in the audit report in this regard.

6. With regard to above, the querist has informed about the accounting practice being followed by the company as below:

(i) The company accounts for deferred tax liability in the books of account, to give effect to the timing differences on account of differential depreciation rates. The company is also grossing up to the same extent in revenue as it is recoverable from SEB at the same time when the liability actually occurs.

(ii) As per the PPA, the SEB would reimburse the taxes paid as part of the tariff as and when the taxes are remitted to the government.

(iii) The structure of taxes in tariff is such that the exact amount of taxes paid by the company is to be billed separately on actual payment by the company for reimbursement by the SEB (unlike all other components of tariff that are normative, which are billed with the tariff and whose actual outflows do not match). This is to be distinguished from other components of FCC, which are billed once a month on a normative basis.

7. The querist has suggested the following alternatives to account for the transactions:

Alternative 1

(i) There is deferred tax and corresponding recoverable from the SEB. Hence, the profit and loss account would show a below the line item, deferred tax, in the inner column and offset the same by an exact amount of deferred tax recoverable on materialisation of the liability and the net amount charged to the profit and loss account would be nil.

(ii) This method, according to the querist, would ensure disclosure of the deferred tax as also its recoverability without impacting the current year’s results.

Alternative 2

(i) In the profit and loss account, the quantum of deferred tax liability would be shown. The receivable will be shown as the grossed up revenue towards reimbursement of tax liability by the SEB. If this method is followed, the MAT on the accrued revenue in respect of deferred tax becomes payable immediately. The same would also be receivable on payment thereof. However, as the payment of such deferred tax liability occurs only later, the receipt of such deferred tax from SEB also occurs correspondingly. In other words, the revenue relating to deferred tax reimbursable is recognised as soon as provision for deferred tax is made and well before the tax liability itself becomes actually payable to the government with a corresponding enforceable right of recovery against the SEB.

(ii) While the amount recoverable from the SEB is treated as revenue, it is offset by the corresponding charge of deferred tax in the profit and loss account. Hence, it is revenue neutral with respect to the ‘profits after tax’.

(iii) The deferred tax is shown on the liabilities side of the balance sheet and a corresponding amount is shown as an amount recoverable from the SEB.

8. In the view of the querist, Alternative 1 seems to be appropriate. According to the querist, this would ensure that the disclosures are complete, whilst also ensuring the compliance of Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Institute of Chartered Accountants of India.

9. The querist has mentioned that a third alternative is also possible, whereby AS 22 is not followed, given the fact that the deferred tax liability is fully recoverable contractually from the SEB, backed by a sovereign guarantee. Attention in this context is invited to section 211(3B) of the Companies Act, 1956. According to the querist, this section provides for a situation where accounting standards are not complied with. As per the querist, the section does not mandate that such non-compliance would result in a qualification or even violation of the requirements to maintain proper books of account which is a positive proof of the fact that the law contemplates situations where accounting standards may not be fully complied with.

10. According to the querist, the situation, where tax reimbursements are matched by recoveries, which are not uncertain, is a peculiar situation warranting side-stepping of AS 22, with appropriate disclosures as mandated by section 211(3B). The querist has stated that in such a situation, even the auditor’s report could contain reference to the same, but not as a qualification.

11. The querist has further stated as below:

(i) The revenue components under the PPA can be categorised as under:

(a) Components that are pure reimbursements

(b) Components that are only normative

It would follow that while (a) insulates the business entity from certain costs, (b) provides a transparent mechanism of pricing.

(ii) Since there is clarity in respect of components that are accrued as revenue on normative basis, the treatment of components that insulate the business entity from the impact of certain costs (e.g., exchange fluctuation and specified taxes) only remains to be addressed.

(iii) The querist has separately provided the details of the components of Fixed Capacity Charges (FCC) forming part of the tariff. It has been mentioned therein also that components, viz., debt payment, depreciation, O&M expenses, return on equity and interest on working capital are normative, and are not relatable to the actual expenditure, whilst components,
viz., specified taxes and foreign exchange variation are reimbursements as enshrined in the PPA. (Emphasis supplied by the querist.)

(iv) In addition, the tariff provides for variable fuel cost (VFC) on a normative basis. (Emphasis supplied by the querist.)

(v) The purpose behind such a distinction in the PPA between the two categories (normative and pure reimbursements) is primarily to ensure efficiencies being built in on operating parameters, whilst pure reimbursements are restricted to factors outside the control of the business.

(vi) The querist has separately provided the data relating to the fixed monetary categories of tariff within the components of FCC such as debt repayment, depreciation and working capital interest and VFC to demonstrate that the aforesaid components of tariff and actual are different in each of the completed 4 years of operations.

(vii) With regard to the specific issue of depreciation, according to the querist, the income and expenditure streams are not relatable at all. Depreciation for revenue is on 90% of an artificial fixed asset base, which is lower than the actual fixed asset base and is recovered (through pricing of power) over a period of around 12 years at a rate not relatable to the useful life of the assets. Further, recovery of depreciation through tariff is not available for additions to fixed assets made after the initial start up. Depreciation (charge) as amortised in the books is of 95% of actual fixed asset costs (including additions to fixed assets over the years), over the useful life of the assets or as per the rates mandated under the Companies Act, 1956. Further, if in a year, the plant is not operated due to technical inadequacies,
no revenue would accrue under depreciation, whilst the company is mandated to provide depreciation as expenditure. Hence, none of the parameters relating to depreciation is common to the revenue and expenditure (amortisation) streams.

B. Query

12. On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee in respect of the contractual rights to receive taxes paid from the SEB, as to whether the company is right in accruing the revenue to the extent of deferred tax liability for any year which is recoverable from the SEB on payment, following the matching principle.

C. Points considered by the Committee

13. The Committee notes from the Facts of the Case that the electricity tariff comprises two parts, namely, normative and reimbursements. The Committee is, however, of the view that from the accounting point of view, there is no distinction between the two parts since these comprise the sale consideration for the power supplied to the customer. In the view of the Committee, the nature of the components of the tariff from the accounting point of view is as follows:

(i) In the initial years, the amount of certain expenses considered for tariff fixation purposes is higher than the expenses recognised in accordance with the generally accepted accounting principles in the financial statements and the position gets reversed in the later years. As a consequence of the aforesaid, excess revenue arises in the initial years and the position is reversed in the later years.

 

(ii) In the initial years, the amount of expenses recognised in accordance with the generally accepted accounting principles in the financial statements is higher than the amount of expenses considered for tariff fixation purposes. As a consequence of the aforesaid, less revenue arises in the initial years and the position is reversed in the later years.

 

(iii) In respect of certain expenses, such as interest on working capital, the expenses are recognised in the financial statements and considered for tariff fixation purposes in the same year although the amounts for the two may be different. These do not get reversed in the subsequent years as in the case of (i)

and (ii) above.

 

14. The consequence of the above peculiarities of tariff fixation in the electricity companies is that there would be a divergence between the accounting income, i.e., the income computed by applying the generally accepted accounting principles and the income computed by applying the tariff fixation requirements, including those laid down in a PPA. With a view to reflect a true and fair view of the profit (loss) for the period, the revenues and expenses need to be matched. The Committee is of the view that the matching can be achieved in respect of the situations mentioned at paragraph 13(i) above, i.e., where excess revenue arises in the initial years because higher costs are considered for tariff purposes as compared to those recognised in the financial statements, by recognising a deferred liability which gets reversed in the later years when the expenses for tariff purposes become lower as compared to those recognised in the financial statements. Similarly, the matching can be achieved in respect of the situations mentioned at paragraph 13(ii) above, i.e., where an expense is recognised earlier in the financial statements as compared to that for tariff purposes, by recognising a deferred asset subject to the consideration of prudence, i.e., the realisability of the asset is reasonably certain or where the company has a history of business losses, the realisability of the asset is virtually certain. In respect of the situations mentioned at paragraph 13(iii) above, where the differences between the expenses/revenue do not get reversed in the subsequent years, no effect is required to be given.

15. Regarding the issue raised by the querist in the present case related to accounting for deferred tax liability, which is recognised in the financial statements on the balance sheet date for accounting purposes in one year but is recovered in a later year for tariff purposes, the opinion given by the Committee hereafter is based on the above principles as well as the relevant accounting standards.

16. The Committee does not agree with the argument advanced by the querist as stated in paragraph 5 above that the accounting standards may not be followed where appropriate in view of the fact that the disclosures of departures from accounting standards are required by the Companies Act, 1956. The Committee is of the view that section 211(3A) of the Companies Act, 1956, is absolutely clear in requiring compliance with the accounting standards as it states “every profit and loss account and balance sheet of the company shall comply with the accounting standards” (emphasis supplied by the Committee). The Committee is of the view that this is an unfettered requirement of law; and a ‘duty’ to disclose departures from the accounting standards as required by section 211(3B) of the Act, does not confer a ‘right’ of departure to a company where in its own wisdom it considers it appropriate to depart. Such a disclosure requirement under section 217(2AA) of the Act, also does not confer such a right. In other words, in the view of the Committee, the requirement to disclose departure from the accounting standards cannot be construed to provide a license to a company to depart from the accounting standards merely because a disclosure from departure is required. In view of this, the company will have to comply with the requirements of AS 22 and other accounting standards.

17. On the basis of the above, accounting for deferred tax liability in the context of tariff fixation for electricity companies, in the view of the Committee, should be as follows:

(i) Deferred tax liability should be recognised and presented in the financial statements of the company in accordance with the requirements of AS 22.

 

(ii) The company should create a ‘deferred asset for recovery of deferred tax liability’, subject to the consideration of prudence, as discussed in paragraph 14 above, with a credit to the relevant profit and loss account.

 

(iii) ‘Deferred asset for recovery of deferred tax liability’ should be credited when amount in this regard is received from the SEB. Any balance in the said account should be transferred to the relevant profit and loss account.

18. The Committee is of the view that the above treatment meets the requirements of accrual basis of accounting including the matching principle while recognising the peculiarities of the electricity companies in respect of tariff fixation.

D. Opinion

19. On the basis of the above, the opinion of the Committee on the issue raised by the querist in paragraph 12 is that deferred tax liability recoverable should be accounted for as recommended in paragraph 17 above.

¹ Opinion finalised by the Committee on 25.1.2006