Expert Advisory Committee

Query No. 19

Subject:  

Recognition of deferred tax asset in respect of carried forward loss

in the books of a company carrying on microfinance business.1

A.  Facts of the Case

1. A company (hereinafter referred as ‘the company’) is a non-deposit taking Non-Banking Financial Company (NBFC) registered with the Reserve Bank of India (RBI) and has 59 lakh members over 1,765 branches across 19 states in India with a gross loan portfolio of Rs. 1,810 crore as on 31st December, 2011. The company extends microloans to its rural women borrowers for productive purposes through the Joint Liability Group (JLG) model.

2. External challenges in the Microfinance industry - the impact and evolving situation:

• Andhra Pradesh Microfinance Institutions (Regulation of Money Lending) Act, 2011 (AP MFI Act)

(i) In October, 2010, the Andhra Pradesh Government promulgated the Microfinance Institutions (Regulation of Money Lending), Ordinance 2010, later passed as the AP MFI Act, 2011.

(ii) The AP MFI Act requires each and every credit application to be pre-approved by a State Government authority. The hindrances caused by this requirement resulted in reduction in loan disbursement by Micro Finance Institutions (MFIs) in Andhra Pradesh from Rs. 5,035 crore in first half of the financial year 2011 to a meager Rs. 8.5 crore in second half of the financial year 2011.

(iii) The collection efficiency of loans outstanding in the State fell to 10-15% from the historical 99%.

•   RBI's regulatory intervention post the AP MFI Act: .

(i) RBI appointed the Malegam Committee to review various aspects of microfinance and the Committee submitted its report (MCR) on January 19, 2011.

 

(ii) RBI vide its circular DBOD.BP.BC.No.74/21.04.132/2010-11 dated January 19, 2011, noted that the problems afflicting the MFI sector were not on account of any credit weakness per se, but were mainly due to ‘environmental factors’ and allowed restructured bank loans to MFIs to be classified as standard.

 

(iii) RBI vide its notification DNBS.PD.No.234/CGM (US)-2011 dated December 2, 2011, notified a comprehensive regulatory framework as per the Malegam Committee recommendations.

•  Draft MFI Bill by the Government of India:

 

In July 2011, the Ministry of Finance, Government of India, unveiled the draft Microfinance (Development and Regulation) Bill 2011, specifying the RBI as the sole regulator for all MFIs. The Finance Minister has said that the MFI

 

Bill will be tabled in the Parliament during the budget session. Upon passage, this Act would override the AP MFI Act.

3. The impact of AP MFI Act on the company:

• As on 1st October, 2010, the company had an outstanding gross loan portfolio of Rs. 1,491 crore in Andhra Pradesh. Following the AP MFI Act and resultant challenges, collection efficiency of the AP portfolio dropped from 99% in second quarter (Q2) of financial year (F.Y.) 2010-11 to 11% in Q2 of F.Y. 2011-12 and the portfolio has turned sub-standard.

 

• The company prudently wrote-off Rs. 831 crore of AP portfolio, in excess of the RBI prudential norms. As on December 31, 2011, the AP loan portfolio was Rs. 537 crore and with provisions of Rs. 53 crore, the net AP exposure is Rs. 484 crore (emphasis supplied by the querist). .

•  Due to the voluntary write-offs and provisions made, the company has reported losses.

4. Recognition of Deferred Tax Assets (DTA)

The company has not availed DTA totaling to Rs. 355 crore (refer Annexure A) for want of more clarity on the nature of convincing evidence to establish virtual certainty of future taxable profits for an entity engaged in financial services, especially an MFI.

5.The company submits that virtual certainty can be established based on the following:

(i)  Significant unmet demand and potential in non-AP states:

• The MFI sector's non-AP portfolio outstanding reduced from Rs. 30,000 crore approx. in September, 2010 to Rs. 20,000 crore approx. in September, 2011 purely on account of supply side constraints. With no adverse impact on demand, the demand-supply gap has further increased. Demand generation is not a constraint.
• The non-AP portfolio of the company reduced from Rs. 3,942 crore as on September, 2010 to Rs. 1,184
  crore as on December, 2011. This indicates significant pent-up demand even without factoring any growth beyond the level of September, 2010.
• A conservative estimate pegs demand for financial year 2012-13 at Rs. 4,454 crore for the company only among the company’s current non-AP member base. Each member of the company is eligible for an Income Generation Loan (IGL), current duration 50 weeks and a Mid Term Loan (MTL) on prompt repayments of IGL for at least 6 months.  Following table details the calculations:

(ii)  AP exposure is limited:.

As on 31st December, 2011, the net loan portfolio outstanding in AP was Rs. 484 crore.  However, in terms of future receivables, the AP exposure is only Rs. 8 crore, representing a mere 0.8% of total future receivables.

(iii). Normal  business operations in non-AP states:

 

The company operates in 18 states other than AP and has not witnessed any contagion effect on the business in these states.  The average collection efficiency over last one year is 96%.  Additionally, no other state has issued any legislation on the lines of the AP MFI Act..

(iv)  Change in the competitive landscape adds to the company’s strength:

 

(a)The second, third, fourth and fifth largest MFIs have opted for Corporate Debt Restructuring (CDR). Three of these had a combined market share of 40%.

(b) The company has met all obligations to its credit grantors and repaid Rs. 2,700 crore since October, 2010 and has not opted for the CDR route given its strong financials evidenced by – .

(i)Strong net worth of Rs. 762 crore and high capital adequacy of 44% as on 31st December, 2011.
(ii) High liquidity - cash and bank balance of Rs. 292 crore as on 31st December, 2011.

(v) Recent regulatory clarity and funding certainty augurs well for future growth:

(a)The RBI notification of 2nd December, 2011 brings in much awaited clarity on regulation of MFIs. Key points of the directions are -

(i)  RBI will be the sole regulator.
(ii) New category of NBFC for MFIs.
(iii) Priority sector status continues - MFIs to be the only NBFC category eligible for priority sector dispensation.

(b)No signs of contagion in other states:

(i) 96% repayments in 18 other states.

(ii) More than 14 months have lapsed since the promulgation of the AP MFI ordinance and no other state has followed suit.
(iii)7 State Governments are part of the Central Government panel that drafted the MFI Bill.

(c) Equity raise – Qualified Institutional Placement (QIP): The shareholders have approved the QIP plan and the company is on track with its capital raising plan.  The transaction is likely to be completed at the earliest.

(d) Banks have voiced their support to the MFI sector – Heads of several public sector and private sector banks, such as, SIDBI, IDBI Bank, Yes Bank, Indian Overseas Bank and others have indicated their plans to continue lending and support to the MFI sector.

(e) Revival in debt funding – Following the regulatory clarity, coupled with the company’s spotless repayment record for all of 18 months post AP MFI ordinance, the company has seen complete revival in funding in 4th Quarter (Q4) of financial year 2011-12.  The company accessed incremental debt funding of Rs. 1,158 crore for Q4 of F.Y. 2011-12 alone, which is 2.8 times the incremental funding for the first 9 months of F.Y. 2011-12.  This further enhances the company’s ability to fund growth in non-AP states.

(vi) The company has a track record of profits; recent losses are primarily due to voluntary write-offs:

 

The company has been profitable every year since inception (including F.Y. 2010-11)

Losses reported in last three quarters are primarily on account of voluntary write-offs, in excess of the requirement of the RBI prudential norms:

(vii) Stable profitability in F.Y. 2012-13 onwards:

The business plan given below is conservative, based on the following assumptions:

(i)Disbursements only in non-AP states.

(ii)No member acquisition for F.Y. 2012-13.

(iii)Ticket sizes for F.Y. 2012-13 based on F.Y. 2010-11 actuals.

B. Query

6. On the basis of the above, the company believes that the aforementioned factors provide the necessary convincing evidence on virtual certainty of future taxable profits in line with the requirements of Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’ and Accounting Standard Interpretation (ASI) 9, ‘Virtual certainty supported by convincing evidence’ ², issued by the Institute of Chartered Accountants of India (ICAI).  Accordingly, the querist has sought the opinion of the Expert Advisory Committee on the company’s eligibility to avail DTA.

C. Points considered by the Committee

7.  The Committee notes from the Facts of the Case that the company, in the extant case, was earning profits till the financial year 2010-11 and has incurred business losses in first 3 quarters of F.Y. 2011-12.  However, it is not clear from the Facts of the Case that whether such business losses have also resulted in taxable loss as per the Income-tax Act or not. The Committee notes that the querist has referred to meeting criteria of ‘virtual certainty’ when raising the query;  accordingly, the Committee has presumed that the company has incurred taxable loss as per the Income-tax Act also due to which it will have unabsorbed depreciation and/or carry forward losses under the tax laws. The Committee notes that the basic issue raised by the querist relates to whether the projections about future profitability of the company based on certain assumptions in the facts and circumstances of the company can be considered as 'convincing evidence' for virtual certainty to recognise deferred tax asset (DTA). Therefore, the Committee has examined only this issue and has not examined any other issue that may arise from the Facts of the Case, such as,  calculation of timing difference for recognition of DTA, etc. Further, the Committee wishes to point out that its opinion is expressed purely from accounting point of view.

8.The Committee notes paragraphs 17 and 18 of Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’), which provide as follows:

“17. Where an enterprise has unabsorbed depreciation or carry forward of losses under tax laws, deferred tax assets should be recognised only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such deferred tax assets can be realised.

Explanation:

 

1.  Determination of virtual certainty that sufficient future taxable income will be available is a matter of judgement based on convincing evidence and will have to be evaluated on a case to case basis. Virtual certainty refers to the extent of certainty, which, for all practical purposes, can be considered certain. Virtual certainty cannot be based merely on forecasts of performance such as business plans. Virtual certainty is not a matter of perception and is to be supported by convincing evidence. Evidence is a matter of fact. To be convincing, the evidence should be available at the reporting date in a concrete form, for example, a profitable binding export order, cancellation of which will result in payment of heavy damages by the defaulting party. On the other hand, a projection of the future profits made by an enterprise based on the future capital expenditures or future restructuring etc., submitted even to an outside agency, e.g., to a credit agency for obtaining loans and accepted by that agency cannot, in isolation, be considered as convincing evidence.

18. The existence of unabsorbed depreciation or carry forward of losses under tax laws is strong evidence that future taxable income may not be available. Therefore, when an enterprise has a history of recent losses, the enterprise recognises deferred tax assets only to the extent that it has timing differences the reversal of which will result in sufficient income or there is other convincing evidence that sufficient taxable income will be available against which such deferred tax assets can be realised. In such circumstances, the nature of the evidence supporting its recognition is disclosed.”

9.From the above, the Committee notes that where an enterprise has carry forward of losses under tax laws, DTA should be recognised only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such DTA can be realised. The Committee further notes that the determination of virtual certainty that sufficient future taxable income will be available is a matter of judgement based on convincing evidence and should be evaluated on a case to case basis.Virtual certainty refers to the extent of certainty, which, for all practical purposes, can be considered certain. Virtual certainty cannot be based merely on forecasts of performance such as business plans. Virtual certainty is not a matter of perception and is to be supported by convincing evidence. Evidence is a matter of fact. To be convincing, the evidence should be available at the reporting date in a concrete form, for example, existence of a deferred tax liability which will get reversed in future that will result in sufficient future taxable income against which deferred tax assets can be realised. The Committee notes that in the extant case, the company wishes to avail DTA based on certain factors which are claimed to be convincing evidence, such as, increase in demand-supply gap of loans in future, favourable future regulations towards company, reduction in future competition in market, past track record of profits of the company, projections of future year profits, etc. The Committee is of the view that these factors are based on future business plans, estimation of future market activity, and future business environment.  Therefore, these factors cannot be considered as convincing evidence as per AS 22 as these are based on mere projections.  The management in the extant case should evaluate the convincing evidence as discussed above for recognising deferred tax assets in the books of account of the company.

D. Opinion

10. On the basis of the above, the Committee is of the opinion that the company cannot recognise deferred tax asset based on the factors as provided by the querist in the Facts of the Case since these provide mere projections/forecast about future income and business environment which cannot be considered as convincing evidence on virtual certainty of future taxable income as per AS 22, as discussed in paragraph 9 above

Annexure – A

1.  AP collection efficiency for 6 quarters up to September 2011:

2.DTA not availed as on December 31, 2011 – primarily driven by voluntary write-offs:

3. Debt fund sanctions received in Q 4 of F.Y. 2011-12:

*Rs. 50 crore yet to be drawn down in these two transactions.

_____________________________

¹Opinion finalised by the Committee on 31.7.2012.

²ASI 9 has been withdrawn by the Institute of Chartered Accountants of India and the consensus portion of ASI 9 has been included as an ‘Explanation’ to paragraph 17 of AS 22.