Expert Advisory Committee

Query No. 11

Subject:  

Whether accumulated differences on transition out of

the tonnage tax scheme is a permanent difference.1

A.   Facts of the Case

1. A company is a public limited company, having wide base of shareholders and listed at various stock exchanges. The company is primarily engaged in manufacturing of fertilizer and textile; trading of fertilizers and other agri-inputs; and in shipping business, which qualify for Tonnage Tax Scheme under Chapter XII-G of the Income-tax Act, 1961.

2.The company acquired the shipping business through amalgamation of another company (X Ltd.) into company with effect from September 1, 2004. The amalgamation was confirmed by the orders of the Hon’ble High Courts dated 22nd June, 2005 and 16th August, 2005, respectively. X Ltd. applied for Tonnage Tax scheme under section 115VP of the Income-tax Act, 1961 in December 2004 as, according to the querist, the scheme was open to the existing shipping companies upto December 31, 2004 only. Accordingly, the company, after seeking amalgamation confirmation by Hon’ble High Courts, also sought approval under the Tonnage Tax Scheme with effect from April 1, 2005 for its shipping business income. The other businesses of company are covered under normal tax regime under the Income-tax Act, 1961.

3.The querist has stated that the main reason of the merger of X Ltd. with the company was to provide financial support to shipping business as X Ltd. had huge expansion plans by way of acquisition of ships. The decision to opt for tonnage tax was taken by the company due to the following reasons:

a)Time charter rate for a ship at that point of time was ranging around USD 30,000-40,000 per day; which could yield a profit at EBITDA level of almost USD 24,000-34,000 per ship per day or almost USD 8.50-12.00 million per annum. This profit would otherwise have been taxed at the then prevailing normal rates of tax, and would have lowered the NPV (net present value) of the asset.

 

b)The proposed expansion plans and substantial increase in the fleet of the ships, was expected to result in substantial upliftment in the income of shipping; and

 

c)Tonnage tax window to the existing shipping units was available for a very short period (3 months upto December 31, 2004) and considering the market scenario at that point of time, it was decided to opt for tonnage tax.

The segment results of the company for the financial years (F.Y.) 2005-06, 2006-07 and 2007-08 have been provided by the querist as Annexure ‘A’

4. The querist has further stated that after acquiring the shipping business, the company purchased 5 new first class Aframax Tankers of 1,05,000 DWT (Dead Weight Tonnage) during the financial years 2006-07 to 2009-10. These ships were financed by the company at a highly competitive interest rate in foreign currency for long term period by leveraging the strong balance sheet of the company. The last ship was delivered in March’ 10.  The shipping division of the company was doing well till the financial year 2009-10 as it had long term contracts with Charters parties at a fixed return with profit sharing on returns in excess of fixed returns for most of its new ships (emphasis supplied by the querist).  However, the last long term contract expired in Quarter 1 of the financial year 2011-12. The market rates of Time Charters in shipping have thereafter gone down substantially over the last two years and are expected to continue their downward trend for the next 2-3 years. The Time Charter rates currently prevailing are around USD 12,000-15,000 per day, which results in a cash negative situation for the business as it is not able to service the rincipal repayment of its loans. The current forecasts for the shipping business are also not encouraging, and recovery, if at all, in rates is not visible before the end of next two or three years.

5.Till financial year 2010-11, the company was paying tonnage tax on the income derived from operation of qualifying ships as per applicable provisions of the Income-tax Act, 1961, which is a presumptive tax and is not based on the actual profit and loss. The computation of 'tonnage' income is based on a formula involving the (presumptive) amount of daily tonnage income of each ship as prescribed under the Income-tax Act and the number of days as specified. During the financial year 2011-12, the company has opted to move out of the Tonnage Tax Scheme with regard to income derived from the operation of qualifying ships and has accordingly filed a declaration before IT authorities.

6. The management of the company during the financial year 2011-12 decided to opt out of tonnage tax for its shipping business income as according to the querist, the company is a high tax paying company since its tax block has dwindled considerably due to the fact that the block additions for Plant I took place in 1994 and for Plant II in 1999.   By opting out of tonnage tax, the company would be able to at least offset the normal business losses of its shipping division as well as utilise the available, but so far unutilised tax block, of the shipping assets against its income from other businesses (Fertilizer and Textile). This would reduce the tax burden of the company as a whole considerably and this saved cash outflow on taxation could be beneficially used to offset the burden of loan outflows in the shipping division.  This was a commercial decision taken by the Board of Directors in the large interest of shareholders of the company.

7. During the period the company was paying tonnage tax, the company recognised the tonnage tax payable as the income-tax expense. During the aforementioned period, the company did not apply Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’), on the basis that the situation of tonnage tax, which is a presumptive tax rather than a tax based on actual income, is not contemplated by AS 22 and hence, as per the querist, the application of AS 22 in this situation would not be appropriate. This querist has stated that this view is unequivocally supported by two opinions issued by the Expert Advisory Committee (EAC) in the year 2005 (published as Query No. 10 and

Query No. 14 in the Compendium of Opinions, Volume XXV). The querist has also reproduced the relevant extract from the above-mentioned Query No. 10 as follows:

“9. The Committee notes from the above-reproduced sections of the Income-tax Act, 1961, related to Tonnage Tax Scheme for shipping companies, that the taxable income of a shipping company, which has opted for the scheme is arrived at on the basis of tonnage rather than the relevant revenues and expenditure of the business of operating qualifying ships. The Committee is of the view that this scheme of presumptive taxation has not been contemplated in AS 22 as is apparent from the paragraphs of the Standard reproduced in paragraph 8 above since AS 22 requires tax effect accounting in respect of differences between the accounting income and taxable income, arising because the items of revenue and expenditure are recognised/taxed or allowed by way of deduction for accounting purposes and tax purposes differently. Thus, in the view of the Committee, once a shipping company opts for the Tonnage Tax Scheme, it is not required to give effect to timing differences as contemplated under AS 22.”

8.  As mentioned earlier, w.e.f. 1st April, 2011, the company has opted out of Tonnage Tax Scheme and would therefore, be taxed as per the normal provisions of the income-tax law. In this regard, the depreciation allowance to which the company would be entitled in respect of assets of shipping division under the normal provisions is affected by the following requirements of section 115VL of the Income-tax Act 1961:

“115VL. (iv)    in computing the depreciation allowance under section 32, the written down value of any asset used for the purposes of the tonnage tax business shall be computed as if the company has claimed and has been actually allowed the deduction in re­spect of depreciation for the relevant previous years.”

9. As a result of application of clause (1)(iv) of section 115VL, the written-down value of assets relating to shipping division as at 1st April, 2011 (i.e., the date of change over from Tonnage Tax Scheme to normal provisions) under section 32 of Income-tax Act is different than the written down value (WDV) of those assets as per books of account of the company. The issue is whether deferred taxes (assets or liabilities, as the case may be) should be recognised as at 1st April, 2011 with regard to these differences.

10. The querist has examined the issue with reference to the following requirements of AS 22, notified under the Rules:

“4.1     Accounting income (loss) is the net profit or loss for a period, as reported in the statement of profit and loss, before deducting income tax expense or adding income tax saving.

4.2 Taxable income (tax loss) is the amount of the income (loss) for a period, determined in accordance with the tax laws, based upon which income tax payable (recoverable) is determined.”

 

“4.6 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.

4.7 Permanent differences are the differences between taxable income and accounting income for a period that originate in one period and do not reverse subsequently.”

“5. Taxable income is calculated in accordance with tax laws. In some circumstances, the requirements of these laws to compute taxable income differ from the accounting policies applied to determine accounting income. The effect of this difference is that the taxable income and accounting income may not be the same.”

 

It is clear from the above that a deferred tax liability can be created only with respect to a ‘timing difference’ within the meaning of the Standard. The issue in the present case is whether in the given facts there is a  “timing difference”.  A timing difference arises when the same total amount of an item of income or expense is recognised in both accounts and in computation of taxable income, but there is a difference in the timing of recognition in the accounts and for tax purposes. As mentioned by the querist, AS 22 is based on the ‘income statement’ approach and not the ‘balance sheet’ approach. In this regard, the querist has made reference to the following extracts from Background Material for Seminars on AS 22, brought out by Accounting Standards Board of the Institute of Chartered Accountants of India:

"Income Statement Approach

Income Statement Approach of accounting for taxes on income is based on analysis of differences between profit chargeable to tax and profit as per the statement of profit and loss. These differences are classified into ‘permanent differences’ and ‘timing differences’. According to this approach, timing differences between profit chargeable to tax and profit as per the statement of profit and loss are determined and deferred tax assets/liabilities are created for such timing differences subject to the requirements of the concept of prudence in case of deferred tax assets.

Balance Sheet Approach

Balance Sheet Approach of accounting for taxes on income is based on difference between tax base of an asset/liability and its carrying amount in the balance sheet. The tax base of an asset/liability is the value thereof for tax purposes. For example, tax base of an asset generating taxable economic benefits is the amount deductible for tax purposes in the future. Difference between tax base of an asset/liability and its carrying amount in the balance sheet is known as ‘temporary difference’, which may be either deductible or taxable in the future. According to this approach, deferred tax asset/liability is created for all deductible/taxable temporary differences with certain exceptions and keeping in view the requirements of the concept of prudence.”

11. It appears to the querist that the difference in opening Written Down Value (WDV) as on 1st April, 2011 is not in the nature of a timing difference as defined in AS 22. Under AS 22, timing differences with regard to fixed assets arise on account of the different method/rate used for computing depreciation as per tax laws and for statutory books. However, where a different value of the asset is considered for tax purposes and for statutory books, such difference would be in the nature of a permanent difference. The querist has cited following in this regard:

12.The querist has also emphasized that in the given case, the requirements of AS 22 relating to deferred taxation can be applied only with effect from 1st April, 2011, i.e. the date of change over to the normal tax regime. Since the accounting for tax payable during the period the company was covered under Tonnage Tax Scheme was in conformity with the afore-mentioned opinions of the EAC, it is clear that there was no accounting error, which needs to be rectified on the date of change over to the normal tax regime. Also, it is clear from the following extract from Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’, notified under the Rules, that the adoption of AS 22 w.e.f. 1st April, 2011 does not represent a change in accounting policy (which might arguably have to be applied retrospectively):

“31.The following are not changes in accounting policies :

(a)the adoption of an accounting policy for events or transactions that differ in substance from previously occurring events or transactions, e.g., introduction of a formal retirement gratuity scheme by an employer in place of ad hoc ex-gratia payments to employees on retirement; and

(b)the adoption of a new accounting policy for events or transactions which did not occur previously or that were immaterial.”

According to the querist, the present case is neither of a prior period item nor of a change in accounting policy, the application of AS 22 in the present case can only be prospective, i.e., from 1st April, 2011 onwards, it is to be determined, with reference to the position at this date, as to whether the difference in WDV of relevant assets is capable of reversal in future years or not. The answer is ‘no’. The above arguments, as per the querist, clearly establish that the difference under consideration is not a timing difference.

B. Query

13.On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee as to whether the difference in opening WDV as on 1st April, 2011 is a permanent or timing difference.

C. Points considered by the Committee

14.The Committee notes that the basic issue raised in the query relates to whether the differences in the carrying value/WDV of depreciable assets for accounting and taxation purposes in the beginning of the financial year when the company opts out of the Tonnage Tax Scheme will be timing differences or permanent differences.  The Committee notes that as per the provisions of AS 22, timing or permanent differences arise in the context of accounting income and taxable income for a year. Accordingly, the issue that arises in the extant case is whether the originating timing differences i.e., differences in accounting income and taxable income which were not recognised in the past relying on the earlier opinion of the Committee as referred to by the querist in paragraph 7 above, but which were capable of reversal in future should now be provided for or not when the company is opting out of the Tonnage Tax Scheme. Accordingly, the Committee has examined only this issue and has not examined other issues that may arise from the Facts of the Case, such as, accounting implication of any penalty imposed on the company for opting out of the Scheme, etc.

15.At the outset, the Committee wishes to point out that each opinion expressed by the Committee is expressed in the specific facts and circumstances of that case. Accordingly, an earlier opinion of the Committee cannot be applied generally in all situations by all the companies. Therefore, the Committee has first examined as to whether the accounting treatment followed by the company of not recognizing the differences between the accounting income and taxable income arising during the period when the company was covered by the Tonnage Tax Scheme by applying the earlier opinion in its own facts and circumstances is correct or not.

16.In the above context, the Committee notes the definition of the term ‘timing differences’ contained in AS 22, as 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.”

From the above, the Committee is of the view that there are two essentials 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 as per the scheme of AS 22, all those differences between accounting income and taxable income which are capable of reversal in future are timing differences and deferred tax effect of these differences is to be provided for in the books of account as deferred tax asset/liability. 

 

17. The Committee notes that its earlier opinions as mentioned by the querist pertained to the shipping companies, which were engaged in the shipping business only. Accordingly, it was opined by the Committee in those cases that “once a shipping company opts for Tonnage Tax Scheme, it is not required to give effect to timing differences as contemplated in AS 22” (emphasis supplied by the Committee). In those cases, the Committee presumably felt that a shipping company would not come out of the Tonnage Tax Scheme since it is carrying only shipping business and therefore, the differences between accounting income and taxable income in those cases are not capable of reversal in future.  The Committee notes that, in the extant case, the company is engaged in various diversified business activities apart from shipping business. In fact the segment data furnished indicates that shipping business is not the main / core business of the company. Therefore, it should be examined whether the differences between accounting income and taxable income calculated as per the normal tax provisions are capable of reversal in the extant case. The Committee is of the view that in the extant case, continuity of the company in Tonnage Tax Scheme would also depend upon the taxable income of other businesses of the company. Accordingly, the Committee is of the view that in the extant case, it cannot be said that the company would not come out of the Scheme, which is also evidenced by the situation that has arisen now in the case of the company. Therefore, the condition of capability of reversal in future as per the definition of ‘timing difference’ would have been met in past also. Thus, in the view of the Committee, the earlier opinions referred to by the querist were not applicable to the company in the extant case and the opinions have been wrongly applied in its case.  Accordingly, the Committee is of the view that deferred tax effect of all those timing differences which originated in the past and were capable of reversal in future, but not recognised should now be recognised in the current reporting period  as a ‘prior period item’ as per the provisions of AS 5. The Committee is also of the view that for determining the quantum of ‘prior period item’, deferred tax effect of those timing differences which originated in past and reversed till the reporting period in which the ‘prior period item’ is recognised should not be recognised.

D.Opinion

18.The Committee is of the view that as per the provisions of AS 22, timing or permanent differences arise in the context of accounting income and taxable income for a year. Accordingly, the issue raised by the querist, as to whether the differences between opening WDV of depreciable assets for accounting and taxation purposes, as on 1st April, 2011 is a permanent or timing difference, does not arise as discussed in paragraph 14 above. The company should recognise all the timing differences which were not recognised in the past in the current reporting period by considering it as a ‘prior period item’ as per the provisions of AS 5, as discussed in paragraph 17 above.

Annexure A

Details of segment revenue and results as per audited accounts

(Amount Rs. Crores)

____________________________

¹Opinion finalised by the Committee on 24.5.2012