A. Facts of the Case
1. A company is engaged in the business of providing housing
loans to individuals and builders. The company is registered under
the Companies Act, 1956 and also notified as housing finance
company under the National Housing Bank (NHB) Act, 1987. As
per the querist, the company has shown excellent results for the
financial year ended 31-03-2006. During the year, the company
has the net profit before tax of Rs. 25.06 crore (52.34% growth),
total loan outstanding of Rs. 1100 crore (22.37% growth) and
capital adequacy ratio of 12.08%. The company is operating with
28 branches all over India.
2. The querist has stated that the company has been creating
and maintaining a special reserve under section 36(1)(viii) of the
Income-tax Act, 19612 (hereinafter referred to as ‘the Act’) to take
tax benefits. The company has accumulated special reserve of
Rs. 51.98 crore as on 31.03.2006. Under this section, the company
is allowed deduction to the extent of 40% of the profits of the
business of providing long-term finance for construction/purchase
of houses for residential purposes in India (emphasis supplied by
the querist). Section 36(1)(viii) of the Act is reproduced below for
ready reference:
“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 per cent 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.
Explanation — In this clause, —
(a) “financial corporation” shall include a public
company and a Government company;
(b) “public company” shall have the meaning
assigned to it in section 3 of the Companies
Act, 1956 (1 of 1956);
(c) “Government company” shall have the
meaning assigned to it in section 617 of the
Companies Act, 1956 (1 of 1956);
(d) “infrastructure facility” means —
(i) an infrastructure facility as defined in the
Explanation to clause (i) of sub-section
(4) of section 80-IA, or any other public
facility of a similar nature as may be
notified by the Board in this behalf in the
Official Gazette and which fulfils the
conditions as may be prescribed;
(ii) an undertaking referred to in clause (ii) or
clause (iii) or clause (iv) of sub-section
(4) of section 80-IA; and
(iii) an undertaking referred to in sub-section
(10) of section 80-IB;
(e) “long-term finance” means any loan or advance
where the terms under which moneys are
loaned or advanced provide for repayment
along with interest thereof during a period of
not less than five years”.
3. The querist has further stated that section 41(4A) of the
Income-tax Act, 1961 provides that in case the special reserve is
utilised /withdrawn, the same shall become taxable in the year in
which it is so utilised /withdrawn. Hence, deduction claimed on
special reserve in the year of its creation becomes taxable in the
year of its withdrawal/ utilisation.
4. During the course of audit of accounts of the company for the
year ending 31st March, 2006, the Comptroller and Auditor General
of India (C&AG) audit party had expressed reservation with regard
to non-creation of deferred tax liability on special reserve created
under section 36(1)(viii) of the Income-tax Act, 1961. The comment
of the C&AG is as under:
“The company has not made provision for deferred tax liability
amounting to Rs. 17.50 crore created and maintained under
section 36(1)(viii) of the Income-tax Act, 1961 as required by
the Accounting Standard (AS) 22 read with the opinion of the
Expert Advisory Committee of the Institute of Chartered
Accountants of India. This has resulted in understatement of
provision for deferred tax liability and overstatement of profit
after tax by Rs. 17.50 crore.”
5. The company takes note of the definition of the term ‘timing
differences’ as given in Accounting Standard (AS) 22, ‘Accounting
for Taxes on Income’, issued by the Institute of Chartered
Accountants of India, which is 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.”
6. The company is of the view that every year special reserve is
created by way of an appropriation of profits and not charged to
the profit and loss account, while the same is deducted to ascertain
the taxable income. Thus, it creates difference between taxable
income and accounting income in the year of creation of special
reserve. Deduction claimed on special reserve in the year of its
creation becomes taxable in the year of its withdrawal/utilisation.
7. The querist has argued that AS 22 only requires creation of
deferred tax liability on temporary timing differences, such as,
methods of charging depreciation, derecognition of income of NPAs
(which are capable of reversal on realisation), provision for NPAs
(capable of reversal on account of becoming regular), etc. Nowhere
a reserve created under the provisions of the Income-tax Act, can
be called a temporary timing difference, which will fluctuate every
year due to withdrawals, etc. All transfers to reserves and surplus
are on different footing as compared to depreciation or NPA
provision or derecognition of income on NPAs, which can change
every year. Further, according to the querist, the company has not
withdrawn any amount from special reserve during the last 18
years since the date of its incorporation. Moreover, as per section
29C of the NHB Act, housing finance companies are required to
transfer 20% of the net profit to special reserve and it cannot
withdraw any amount except for the purposes specified by the
NHB. Provision of section 29C of the NHB Act, 1987 are reproduced
herein below for ready reference:
“29C. (1) Every housing finance institution which is a company
shall create a reserve fund and transfer therein a sum not
less than twenty per cent of its net profit every year as
disclosed in the profit and loss account and before any dividend
is declared.
Explanation. - A housing finance institution creating and
maintaining any special reserve in terms of clause (viii) of
sub-section (1) of section 36 of the Income-tax Act, 1961,
may take into account any sum transferred by it for the year
to such special reserve for the purposes of this sub-section.
(2) No appropriation of any sum from the reserve fund including
any sum in the special reserve which has been taken into
account for the purposes of reserve fund in terms of subsection (1), shall be made by such housing finance institution
except for the purpose as may be specified by the National
Housing Bank from time to time and every such appropriation
shall be reported to the National Housing Bank within twentyone
days from the date of such withdrawal:
Provided that the National Housing Bank may, in any particular
case and for sufficient cause being shown, extend the period
of twenty-one days by such further period as it thinks fit or
condone any delay in making such report.
…”
8. The querist has stated that this has also been well established
in the industry and many companies which are transferring an
amount to special reserve are treating it as of permanent nature
and no deferred tax liability has been created on it. As per the
querist, the C&AG’s insistence to create deferred tax liability on
special reserve does not reconcile with the intention behind AS 22,
which aimed at matching of accounting income and taxable income.
9. According to the querist, creation of deferred tax liability on
special reserve would reduce the accounting profit of the company
immediately in the year of creation, which in the absence of
withdrawal would continue to be shown in the balance sheet of the
company in the subsequent periods. If deferred tax liability is to be
created, then why would any company create a special reserve as
in any case the net worth due to deferred tax liability would decline.
Further, it would affect the balance sheet of the company and
would reflect a distorted picture of financial position of the company
in technical terms, while in real terms creation of deferred tax
liability doesn’t involve any cash outflow. In this way, it takes away
the benefit of deduction under section 36(1)(viii) of the Income-tax
Act, 1961 and frustrates the purpose of introducing this section by
the legislature.
10. Keeping in view the above facts and its wider ramification for
housing finance companies (HFCs), the company considers the
special reserve as permanent difference and is not in favour of
creating deferred tax liability on special reserve (emphasis supplied
by the querist).
B. Query
11. The querist has 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 on 31.03.2006, which will become chargeable to tax under
section 41(4A) of the Act, only on the withdrawal therefrom in
subsequent years (which, according to the querist, in the case of
the company, has never happened in the last 18 years since the
date of its incorporation).
C. Points considered by the Committee
12. The Committee notes section 36(1)(viii) of the Income-tax
Act, 1961, as reproduced in paragraph 2 above and the definition
of the term ‘timing differences’, as reproduced in paragraph 5
above.
13. The Committee notes 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
of ‘timing differences’, the reversal of the difference can take place
at any time in future.
14. The Committee notes from the Facts of the Case that the
company has itself admitted in paragraph 6 above that creation of
special reserve under section 36(1)(viii) creates difference between
accounting income and taxable income in the period in which
special reserve is created. The Committee also notes that this
difference is capable of reversal in the period in which the special
reserve is utilised or withdrawn for the purposes specified by the
NHB, since 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.
15. 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.)
16. 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’,
issued by the Institute of Chartered Acccountants of India, 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’.”
17. From the above, the Committee notes that even if an enterprise
expects that a difference between accounting and taxable income
will not reverse and has not reversed in the past (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 or the past experience in this regard 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.
18. With regard to the other arguments advanced by the querist
in paragraphs 8 and 9 above, the Committee is of the view that an
industry-practice, if it is not in accordance with an accounting
standard, does not imply that the accounting treatment adopted by
the industry is correct. Further, 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. The objectives of the Incometax
Act do not govern the accounting treatment of an item.
D. Opinion
19. On the basis of the above, 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 as on 31.03.2006, irrespective of the
fact that withdrawal of the reserve may or may not happen and
has not happened in the past 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).
1Opinion finalised by the Committee on 9.8.2007.
2Clause (viii) of section 36(1) has since been revised.
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