Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 18

Subject:

 

Creation of deferred tax liability on special reserve created

u/s 36(1)(viii) of the Income-tax Act, 1961. 1

 

A. Facts of the Case

1. A wholly owned Government of India undertaking, registered under the Companies Act, 1956, 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 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 on which it is charging lease rent from the lessees.

2. The Institute of Chartered Accountants of India has issued Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, which is applicable from 1.4.2001 to all listed enterprises. The querist has stated that since the bonds issued by the company are listed on the National Stock Exchange (NSE), the company is a listed company, and therefore, AS 22 became applicable to the company w.e.f. 1.4.2001.

3. The querist has stated that AS 22 requires the recognition of deferred tax asset or liability for the timing differences. As per the Standard,

 

“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”. “Permanent differences are the differences between taxable income and accounting income for a period that originate in one period and do not reverse subsequently.” The Standard also provides that permanent differences do not result in deferred tax assets or deferred tax liability.

 

4. According to the querist, at the time of implementation of AS 22, the following timing differences between accounting income and taxable income were identified by the company:


         (i) Accrual of expenses and short term income.


         (ii) Translation loss on foreign currency loans.


         (iii) Lease equalisation amount


         (iv) Depreciation on leased assets and owned assets


As per the querist, the tax effect on the above items was ascertained and dealt with in accordance with the Standard in the books of account by creation of deferred tax asset or liability.

5. The querist has reproduced extracts from section 36(1) of the Income-tax Act, 1961, which provides as under:

 

“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 (emphasis supplied by the querist) 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.”

The querist has stated that the company has been claiming a deduction under section 36(1)(viii) on account of special reserve created and maintained (emphasis supplied by the querist) @ 40% of profits derived from the business of long-term finance from the taxable income every year.

6. Further, the querist has mentioned that section 41(4A) of the Income-tax Act, 1961, provides that in case the special reserve is utilised/withdrawn the same will become taxable in the year in which it is so utilised/withdrawn. Hence, the deduction claimed in the year of creation of special reserve becomes taxable in the year of utilisation/withdrawal of special reserve.

7. The querist has also intimated that the special reserve is appropriated out of the profits available for appropriation every year. It is not charged to profit and loss account, while the same is deducted from the taxable income. The company is treating special reserve as permanent difference and is not creating deferred tax liability on it.

8. Besides the above, as per the querist, the company has also examined the matter and noted that in the various examples given in the Standard, the items identified as timing differences are capable of reversal subsequently themselves (emphasis supplied by the querist), such as the difference in the method of depreciation in case a company charges depreciation on straight-line method (SLM) basis in its books, which is different from the written down value (WDV) method acceptable under the Income-tax Act. This results in timing difference. In the books, the depreciation on SLM basis would be spread evenly over the life of the asset while on WDV basis under the Income-tax Act, depreciation would be more in initial years and would reduce in the later years of life of the asset. The total amount of depreciation would be the same under both the methods and differences and tax effects on the timing differences would square up themselves over the life of the asset. Whereas, in case of special reserve, the difference would square up only when the company utilises/withdraws the special reserve, otherwise not. Till the time the company utilises the special reserve, section 41(4A) of Income-tax Act does not become operative; thus, the difference remains of permanent nature. It is not squared up itself as in the case of revenue items.

9. During the course of audit, however, a view has arisen that deferred tax liability should be created on the special reserve u/s 36(1)(viii) of the Income-tax Act, 1961. The view expressed was that such reserves are created under the relevant sections of the Income-tax Act and are not free reserves as any withdrawals therefrom are subject to tax liability at prevalent rates. The tax implications of the reserves of aforesaid type stand deferred till withdrawal from such reserves. The creation of special reserve creates a difference between taxable income and accounting income, which is not a permanent timing difference.

10. The querist has informed that as on 31.3.2004, the balance sheet of the company carries the special reserve of Rs. 2636.29 crore and the deferred tax liability, if created on it, would amount Rs. 500 crore (approximately). Further, the paid-up share capital and general reserve of the company as at 31st March, 2004 stood at Rs. 3578.74 crore; and as per section 36(1)(viii) of the Income- tax Act, the company can create special reserve to the extent of twice its paid-up capital and general reserve (i.e. upto Rs.7157.48 crore) against which the special reserves so far created are Rs. 2636.29 crore. As there is a big gap between the paid-up capital and general reserve and the special reserve, need for withdrawal from special reserve may never arise. The deferred tax liability, if created on special reserve, would be carried forward in the balance sheet of the company for a number of years (and may be, during the entire life of the company) which would create an imbalance and distort the solvency ratios (emphasis supplied by the querist). Also, keeping in view the concept of going concern, the company may not utilise the special reserve for a sufficiently long time.

11. The querist had earlier sought the opinion of the Expert Advisory Committee on the issue as to 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 and which may or may not happen (emphasis supplied by the querist). In response to the aforesaid query, the Committee had expressed the following opinion:

 

“The Committee is of the opinion that 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).”



12. The querist has now submitted the following additional facts/ arguments in favour of not creating a deferred tax liability:

 


(i) The company has no intention whatsoever of making any withdrawal from the reserve. It has been earning a healthy profit, a large part of which has been retained resulting in a healthy net worth, which act as a cushion for any unforeseen losses. In this context, select data relating to the performance of the company has been submitted by the querist. The querist has also submitted the Board Resolution to the effect that the company does not have any intention of withdrawing from the reserve in question.


             To be a liability, the obligation must be probable

(ii) The querist strongly feels that the provisions of AS 22 relating to creation of a deferred tax liability need to be interpreted harmoniously with the definition of the term ‘liability’ as generally accepted in accounting. The querist believes that the following definitions of ‘liability’ have a universal application:


(a) “The financial obligation of an enterprise other than owners’ funds” (Guidance Note on Terms Used in Financial Statements).


(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.” (Accounting Standard (AS) 29, ‘Provisions, Contingent Liabilities and Contingent Assets’ and the Framework for the Presentation of Financial Statements).


The querist has stated that he is firmly of the view that since the chances of a future withdrawal from the special reserve are remote, it does not give rise to a ‘liability’. Generally accepted accounting principles require obligations of an enterprise to be classified into two categories:


(a) ‘Probable’ obligations (i.e., it is more likely than not that an obligation exists on the balance sheet date).


(b) ‘Possible but not probable’ obligations (i.e., it is not more likely than not that an obligation exists on the balance sheet date).

Even though AS 22 does not state so specifically, the timing differences contemplated (and illustrated) in AS 22 are only those that must be probable of reversal in a future period, though the reversal may take place at a point of time considerably distant in future. In the view of the querist, the term ‘capable of reversal’ used in the definition of ‘timing differences’ should be interpreted as ‘probable of reversal’. If this is not done, it will result in an item being recognised as a liability even though it does not meet the definition of ‘liability’. To take an extreme case, it will result in creation of a deferred tax liability the chances of whose settlement are one in a million. This would result in making the balance sheet not “true and fair”. The querist is of the view that the present case clearly does not fall in the category of obligations which are probable. The amount of deferred tax liability of Rs. 888.02 crore due to transfer to special reserve does not represent a liability since the chance of its having to be settled is remote. To the extent the liability is recognised, the balance sheet would misrepresent the reality.


(iii) In the view of the querist, the fact that a deferred tax liability is required to be recognised only when the outflow on account of the relevant obligation is probable is unequivocally recognised in Accounting Standards Interpretation (ASI) 3, ‘Accounting for Taxes on Income in the situations of Tax Holiday under Sections 80-IA and 80-IB of the Income-tax Act, 1961’, and Accounting Standards Interpretation (ASI) 5, ‘Accounting for Taxes on Income in the situations of Tax Holiday under Sections 10A and 10B of the Income-tax Act, 1961’. Relevant excerpts from ASI 3 are reproduced below (the position under ASI 5 is identical):

 

“In the situation of tax holiday under Sections 80-IA and 80-IB of the Act, it is probable that deferred tax assets and liabilities in respect of timing differences which reverse during the tax holiday period, whether originated in the tax holiday period or before that (refer provisions of section 80-IA (2) of the Act), will not be realised or settled. Accordingly, a deferred tax asset or a liability for timing differences which reverse during the tax holiday period does not meet the above criteria for recognition of asset or liability, as the case may be, and therefore is not recognised to the extent the gross total income of the enterprise is subject to the deduction during the tax holiday period.”

Thus, ASIs 3 and 5 clearly provide, in the view of the querist, that a deferred tax liability should be recognised only if it is probable that it will be settled. If it is possible but not probable that the obligation will need to be settled, the obligation does not meet the criteria for recognition as a liability. The querist has also emphasised that the applicability of the above principle is not restricted to tax holiday situations; it is all-pervasive.

 

(iv) Whether a possible obligation is ‘probable’ or ‘possible but not probable’ of crystallisation depends on the facts and circumstances of each case. In this case, in the view of the querist, the utilisation of special reserve implies a higher tax liability for the company. It is obvious that the company would not make a transfer from the above reserve except in the remotest circumstances making it inescapable. The company has been earning a healthy profit and is in sound financial health. Thus, the possibility of its having to withdraw from the special reserve is not more than remote. The querist has stated that he is aware that AS 29 does not deal with recognition of deferred tax liabilities. However, the querist also believes that the principles for recognition of liabilities laid down in AS 29 have, more or less, a universal application – other standards primarily apply these principles to specific types of transactions or situations. This fact is clearly recognised in ASIs 3 and 5 referred to above. In any case, the gulf between AS 29 (and the Framework referred to earlier) on the one hand and AS 22 on the other cannot be so wide that an item that is considered no more than a remote obligation under AS 29 has to be considered a probable obligation under AS 22.

 

(v) There are many other provisions in the Income-tax Act whereby the deductions/exemptions given to the assessee are withdrawn if the assessee does not fulfill the prescribed conditions. The withdrawals of the deductions are only contingent on the happening of a certain event and act more as a preventive penalty than anything else. In view of this, a distinction needs to be made between automatically reversible tax concessions/deductions and conditionally reversible tax concessions/deductions. In the latter case, reversibility of the tax concessions/deductions is often within the control of the assessee. In such cases, a deferred tax liability should be required to be recognised only when it becomes probable – due to the intent of the assessee or due to attendant circumstances – that the tax concessions/exemptions would get reversed. Until this happens, the situation remains one of a contingent liability, which should be disclosed on the basis of the principles laid down in AS 29.

 

              Is it a timing difference

(vi) Apart from the above, the querist has also requested the Committee to consider whether such a transfer really constitutes a timing difference. The opinion of the Committee that transfer to special reserve results in a timing difference is based on the following definition of ‘timing differences’ given in AS 22:

 

 “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.”

The earlier opinion of the Committee has observed as follows:


  “14. From the above, the Committee is of the view that there are two essentialities 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.

 

15. 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 thus resulting into a higher taxable income than the accounting income of that period. Therefore, the Committee is of the view that the creation of special reserve results into timing differences as per AS 22.”



                The querist has expressed his views on the above observations of the Committee as follows:


The definition of ‘timing differences’ given in the Standard and explanation of the nature of timing differences given in paragraph 7 of the Standard need to be given a harmonious interpretation. Paragraph 7 specifically notes that:


“… 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…”

In the view of the querist, the above statement is absolutely unequivocal – a timing difference arises (and arises only) if an item of revenue or expense enters the computation of both accounting income and taxable income in different periods. The various examples given in the Standard (paragraph 7 and Appendix 1) fully support this view. Nothing else can give rise to a timing difference. If an item enters the computation of only accounting income but not taxable income (or vice versa), it does not result in a timing difference. This view is strongly supported by the fact that the Standard contains specific deeming provisions for unabsorbed depreciation and carried forward losses. These items do not arise from the same items of revenues or expenses entering the computation of accounting income and taxable income in different periods and, in the absence of the specific dispensation in paragraph 8 of the Standard, would not have been covered in AS 22. It is, therefore, the view of the querist that special reserve under discussion does not constitute a timing difference. While both the creation and the utilization of Special Reserve affect taxable income, neither affects accounting income.


       Other reasons

(vii) The querist has also submitted that the industry practice is also such that no deferred tax liability is created on such transfer to reserves.


(viii) The querist has also pointed out that the concession under the Income-tax Act is aimed at encouraging infrastructure financing and providing a basis for higher earnings to such companies. The concession is not aimed at deferring or postponing the income-tax liability but at providing a relief from tax liability. The provision regarding taxability of withdrawal is meant only to ensure that this concession is not abused – it is only a penal measure. Thus, the relevant provisions have the effect of providing a permanent relief as a rule and a mere postponement only as an exception. Accounting, which is aimed at reflecting the economic substance, should be guided by the general rule; it should reflect the exception only when the circumstances so warrant – it cannot reflect the exception as a rule. If one has to create an income-tax provision (by way of deferred tax liability) for transfer to special reserve also, the very purpose of law is defeated since the profits after tax would be the same whether this concession exists or not.

(ix) There is very little economic justification for the company to make a withdrawal from the special reserve. As long as the company is making profits, there is no reason for it to withdraw from the reserve. Even hypothetically if it makes losses, why should it lose further by paying taxes on withdrawals specifically when it has substantial other reserves to cushion its losses.

B. Query

13. The querist has sought the opinion of the Committee whether it is necessary to create deferred tax liability on the special reserve created and maintained under section 36(1)(viii) of the Income-tax Act, 1961.

C. Points considered by the Committee

14. The Committee notes the definition of the term ‘timing differences’ contained in the Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Institute of Chartered Accountants of India, 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.”


15. From the above, the Committee is of the view that there are two essentialities 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.

 

16. 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 thus resulting into a higher taxable income than the accounting income of that period. Therefore, the Committee is of the view that the creation of special reserve results into timing differences as per AS 22.

17. The Committee also notes paragraph 14 of AS 22 which states as below:


 “14. This Statement requires recognition of deferred tax for all the timing differences. This is based on the principle that the financial statements for a period should recognise the tax effect, whether current or deferred, of all the transactions occurring in that period.” (Emphasis supplied by the Committee.)

18. The Committee further notes paragraph 8 of Accounting Standards Interpretation (ASI) 6, ‘Accounting for Taxes on Income in the context of Section 115JB of the Income-tax Act, 1961’, which, inter alia, describes one of the principal conceptual bases of AS 22 as below:

 

 “8. There are two methods for recognition and measurement of tax effects of timing differences, viz., the ‘full provision method’ and ‘partial provision method’. Under the ‘full provision method’, the deferred tax is recognised and measured in respect of all timing differences (subject to consideration of prudence in case of deferred tax assets) without considering assumptions regarding future profitability, future capital expenditure etc. On the other hand, the ‘partial provision method’ excludes the tax effects of certain timing differences which will not reverse for some considerable period ahead. Thus, this method is based on many subjective judgements involving assumptions regarding future profitability, future capital expenditure etc. In other words, partial provision method is based on an assessment of what would be the position in future. Keeping in view the elements of subjectivity, the ‘partial provision method’ under which deferred tax is recognised on the basis of assessment as to what would be the expected position, has generally been discarded the world-over. AS 22 also does not consider the above assumptions and, therefore, is based on ‘full provision method’.”



19. From the above, the Committee notes that even if an enterprise expects that a difference between accounting and taxable income will not reverse (partial provision approach), the difference should be recognised as timing difference if it is capable of reversal at any time in future (full provision approach). Thus, deferred tax is to be provided for all timing differences. Accordingly, the Committee is of the view that in the present case, the eventuality of utilisation/ withdrawal of special reserve is not of relevance. So long as the utilisation/withdrawal is capable of taking place, the creation of special reserve results into timing differences for which deferred tax should be provided.

20. With regard to the other arguments advanced by the querist in paragraph 12 above, the views of the Committee are as follows:


(i) Passing of a Board resolution that the company will not utilise the special reserve is only a voluntary action and is capable of reversal. Accordingly, the capability of reversal of the timing differences is not affected.


(ii) to (v) Had the intention in AS 22 been to consider the general requirements of creating a provision in terms of probability of incurrence of a liability, e.g., as laid down in AS 29, ‘Provisions, Contingent Liabilities and Contingent Assets’, the Standard would have laid down the probability requirements similar to those provided in that Standard or the Standard prevailing at the time of the issuance of AS 22, i.e., Accounting Standard (AS) 4, ‘Contingencies and Events Occurring After the Balance Sheet Date’. This was not done in view of the fact that the accounting standards on deferred taxation all over the World are based on the ‘full provision method’ rather than the ‘partial provision method’ as discussed in paragraph 17 to 19 above. Adoption of the criteria for creation of provision as per AS 4/AS 29 would have resulted in creation of deferred tax liability in accordance with the partial provision method. In any case, the specific requirements prescribed in a standard override the general requirements as has been recognised in the ‘Framework for the Preparation and Presentation of Financial Statements’, issued by the Institute of Chartered Accountants of India. Paragraph 3 of the Framework states as follows:

 

“3. The Accounting Standards Board recognises that in a limited number of cases there may be a conflict between the Framework and an Accounting Standard. In those cases where there is a conflict, the requirements of the Accounting Standard prevail over those of the Framework. As, however, the Accounting Standards Board will be guided by the Framework in the development of future Standards and in its review of existing Standards, the number of cases of conflict between the Framework and Accounting Standards will diminish through time.”

Further, ASI 3 and ASI 5 consider the probability of reversal of timing differences in the sense that, during the tax holiday period, the timing differences are not capable of reversal.


(vi) Whether creation of special reserve results in ‘timing differences’ or not has been dealt with in paragraphs 14 to 19 above. The Committee also does not agree with the contention that paragraph 7 of AS 22 requires that an item of revenue and expense must necessarily appear in the computation of accounting income as well as in the computation of taxable income. In the view of the Committee, paragraph 7 should be read along with the definition of the term ‘timing differences’ which does not stipulate that an item should affect both the accounting income as well as the taxable income.


(vii) An industry-practice, if it is not in accordance with an accounting standard, does not imply that the accounting treatment is correct.


(viii) The opinion is based on the requirements of AS 22 with the specific objective that accounts give a true and fair view. There are various instances where the treatment of items of income and expenses is different for accounting purposes than that under the Income-tax Act because the objectives of the two are different.


(ix) The argument is conjectural in nature as it presupposes ‘as long as the company is making profits there is no reason for it to withdraw from reserve’. Further, a company may have many other reasons to withdraw from reserve even at the expense of paying taxes, e.g., issue of bonus shares.

D. Opinion

21. On the basis of the above, the Committee reiterates its earlier opinion that 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).

 

1 Opinion finalised by the Committee on 15.5.2006