Query No. 24

Subject:           Recognition of deferred tax asset on unabsorbed business loss and unabsorbed depreciation.[1]

A.        Facts of the Case

1. A company, which is a public sector undertaking, is a subsidiary of an oil company. The company is engaged in the business of petroleum refining and its products are sold predominantly to Oil Marketing Companies (OMCs). The company has two refineries located at Chennai and Nagapattinam in the State of Tamilnadu with a combined refining capacity of 11.50 MMTPA.

2. The cost of raw material (crude oil) is based on the prices quoted in the international markets and applicable foreign exchange rates. Similarly, the sale price of products, i.e., refinery transfer price is based on the product prices prevailing in the international markets and applicable foreign exchange rates. Thus, profitability of the company is dependent on factors like (a) volatility in international crude oil and product prices, (b) volatility in foreign exchange rates, and (c) under-recoveries arising out of discount, lower export realisation, Central Sales Tax (CST) payment, coastal movement, etc. The company incurred losses in the last two financial years mainly due to the above factors which were beyond the control of the company.

3.The aggregate carry forward unabsorbed depreciation/unabsorbed business loss/short term capital loss available for set off against future taxable income as per the income tax return of the company is as below:                                                                                             

(Rs. In Crore)

*          Unabsorbed depreciation for financial year (F.Y.) 2013-14 is provisional as income tax return for F.Y. 2013-14 is yet to be filed.  Deferred tax liability (DTL) on timing difference on depreciation recognised in the balance sheet is as follows:

(Rs. In crore)

4. The relevant extract of the accounting policy of the company on taxes on income is as follows:

“Provision for current tax is made as per the provisions of the Income-tax Act, 1961. Deferred tax liability/asset resulting from ‘timing difference’ between book and taxable profit is accounted for considering the tax rate and laws that have been enacted or substantively enacted as on the balance sheet date. Deferred tax asset is recognised and carried forward only to the extent that there is virtual certainty that the asset will be realised in future.”

5. The querist has stated that deferred tax asset (DTA) on the above unabsorbed carry forward loss/depreciation was not recognised in the books of account as on 31.03.2014 in line with paragraph 17 of Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, which, inter alia, states as below:

“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”.

In the oil refining industry, the future taxable income based on profit projections, would be difficult to demonstrate with certainty, as the profits are subject to external factors, like volatility in international crude and product prices and foreign currency exchange rates and change in government policies, etc.

6. Views of the company on recognition of DTA: 

Paragraph 17 of AS 22, mentioned above, refers to availability of taxable income with virtual certainty in the future, such that the DTA created can be realised. Paragraph 4.2 of AS 22 defines taxable income / (tax loss) as follows:

“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.”

While determining ‘taxable income’ as per the Income-tax Act, 1961, the book depreciation would be disallowed and the tax depreciation be allowed. Hence, any excess of tax depreciation claimed in the current year will get reversed in the future years, since in the future years the tax depreciation claimed would be lower as compared to book depreciation resulting in higher future taxable Income.  It is clear from the above that the reversal of depreciation itself would result in increase in taxable income in the future years, notwithstanding any operational profits / losses made by the company, which if positive, may further contribute to increase in taxable income. Thus, to the extent of such reversal of timing differences on account of depreciation, there is a virtual certainty in taxable income.

7.  Also, in the scenario of continued losses in the future years, there would be no liability to pay tax even with the reversal of timing differences.  Thus, even in the event of future profits and future losses, company’s tax liability is reduced or there would be no liability for payment of tax. Accordingly, the company should recognise only a lower net deferred tax liability by way of creation of deferred tax asset. Hence, to the extent of the availability of future taxable income, if any, by virtue of the future reversal of any timing differences recognised at the balance sheet date, the deferred tax assets should be recognised.

8. Further, the querist has stated that it is worth referring paragraph 18 of AS 22, which provides as follows:

“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.”

It is clear from the above that a company with history of losses can recognise DTA to the extent of deferred tax liability subject to the following:

a. Certainty in reversal of timing differences that would result in sufficient income (or)

b. Other convincing evidence that sufficient future taxable income will be available.

9.         The querist has stated that in the case of the company, there is a certainty in ‘reversal of timing differences’ arising on account of depreciation. Hence, the same justifies the creation of deferred tax asset on unabsorbed business loss/depreciation to the extent of deferred tax liability.  Accordingly, DTA that can be recognised by the company on unabsorbed depreciation and unabsorbed business loss works out to Rs. 822 crore as detailed below:

(Rs. in crore)

However, DTA on unabsorbed depreciation and unabsorbed business loss has to be restricted to the extent of DTL of Rs. 704.4 crore (representing timing differences on depreciation) as per paragraph 18 of AS 22.

10.       The querist has also reproduced certain pronouncements of the Institute of Chartered Accountants of India (ICAI) in support of the above treatment as follows:

(i) Expert Advisory Committee (EAC) Opinion

In this regard, the querist has stated that for recognising deferred tax asset on unabsorbed depreciation/unabsorbed business loss to the extent of reversal of deferred tax liabilities, it would not be necessary to consider the level of virtual certainty supported by convincing evidence based on the opinion of the Expert Advisory Committee, published in Volume XXIX of the Compendium of Opinions as query no. 18 and 27.

(ii) Financial Reporting Review Board (FRRB) publication

The FRRB publication, ‘A Study on Compliance of Financial Reporting Requirements’ (published in January, 2010 at page No. 146) has stated, inter alia, that “ However, in the instant case, the company has not recognised deferred tax assets even to the extent of deferred tax liability recognised in the financial statements, which is contrary to AS 22”.

(iii) Background Material for Seminars on AS 22 (published in April 2003, by the ICAI)

The view expressed in this regard, in the Background Material for Seminars on AS 22 (published in April 2003 by the ICAI) is also worth referring.Reply to Frequently Asked Questions (FAQs) – Question 9(ii) (Page 22 of the Material) clarifies that in respect of tax losses of the company, which can be carried forward at the balance sheet date, deferred tax asset can be recognised to the extent that the reversal of the deferred tax liability will give rise to sufficient future taxable income against which such deferred tax asset can be realised. (Emphasis supplied by the querist.)

11.       Statutory auditors’ view on recognition of DTA

(i) The company’s contention of recognising deferred tax asset on unabsorbed business loss/depreciation to the extent of deferred tax liability based on paragraph 18 of AS 22 is not acceptable as the reversal of the timing differences should result in sufficient taxable income, as defined in paragraph 4.2 of AS 22.

(ii) Reversal of timing differences on depreciation is one such component of the taxable income determined in accordance with tax laws and hence, the reversal of timing differences on depreciation in isolation will not contribute to sufficient future taxable income. Sufficient taxable income, in the opinion of auditors, means positive net taxable income after all adjustments including timing differences.

(iii) Recognition of deferred tax asset to the extent of deferred tax liability based on the principle that the reversal of timing differences on depreciation alone would result in sufficient future taxable income is not in line with the ICAI’s publications.

B. Query

12.       In the light of the above, the opinion of the Expert Advisory Committee is sought on the following:

(i) Can the company recognise DTA on unabsorbed depreciation/unabsorbed business loss?

(a) to the extent of DTL entirely (Rs. 704.4 crore in the extant case), based on paragraph 18 of AS 22 considering the future taxable income arising out of reversal of timing differences.

(b) to the extent of unabsorbed business loss restricted to the reversal of DTL within the 8 year period (being the maximum period for which the business loss can be carried forward) plus entire unabsorbed depreciation  (since the same is available for set off without time limit) ? 

(ii) Can the reversal of timing difference alone be construed as sufficient future taxable income for the purpose of recognition of DTA as per paragraph 18 of AS 22,  i.e., does the term taxable income imply only positive net taxable income after all adjustments including timing differences or it denotes individual elements like reversal of timing differences which contributes to increase in the taxable income/decrease in tax loss.

(iii) Since, the facts and circumstances remain the same for the previous years also, will the non–recognition of DTA as above in the previous years amount to prior period item under Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’?

 

(iv) a.   Will the recognition of DTA on unabsorbed depreciation/unabsorbed business loss to the extent of DTL (based on the principle of sufficient future taxable income arising out of reversal of timing differences) amount to change in the       company’s accounting policy?

        b.   If the company can recognise DTA to the extent of DTL as per (i) above, is the company required to change/reword its accounting policy?

(v) If the company does not recognise DTA even to the extent of DTL (based on the principle of sufficient future taxable income arising out of reversal of timing differences), would it be in contravention of AS 22?  

 

(vi) What additional disclosures are to be made by the company in this regard?

 

C.        Points considered by the Committee

13.       The Committee notes that the basic issue raised in the query relates to recognition of deferred tax asset on unabsorbed depreciation and carry forward of losses to the extent of deferred tax liability as on the reporting date. The Committee has, therefore, considered only this issue and has not examined any other issue arising from the Facts of the Case, such as, offsetting of deferred tax assets and deferred tax liabilities, deferred tax implications of short-term capital loss, etc. Further, the Committee’s opinion is based on accounting principles and it has not gone into the calculations or computation of deferred tax assets. Further, the Committee wishes to point out that its opinion is expressed purely from accounting point of view.

14.       The Committee notes paragraphs 8, 15, 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:

“8. Unabsorbed depreciation and carry forward of losses which can be setoff against future taxable income are also considered as timing differences and result in deferred tax assets, subject to consideration of prudence (see paragraphs 15-18).”

“15. Except in the situations stated in paragraph 17, deferred tax assets should be recognised and carried forward only to the extent that there is a reasonable certainty that sufficient future taxable income will be available against which such deferred tax assets can be realised.”

“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.
…

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.”

From the above, the Committee notes that deferred tax assets should be recognised only to the extent that there is a reasonable certainty (or virtual certainty supported by convincing evidence in case of unabsorbed depreciation and carry forward of losses under tax laws), that sufficient future taxable income will be available against which such deferred tax assets (DTA) can be realised. The Committee further notes from paragraph 18 of AS 22 that when an enterprise has a history of recent losses, the enterprise can recognise deferred tax assets only to the extent that it has timing differences the reversal of which will result in sufficient income against which such deferred tax assets can be realised. The Committee also notes that the FAQ referred to by the querist also states that “deferred tax asset can be recognised to the extent that the reversal of the deferred tax liability will give rise to sufficient future taxable income against which such deferred tax asset can be realised”.Similarly, the EAC opinion (published as Query No. 18 of Volume XXIX of the Compendium of Opinions) referred to by the querist also, inter alia, states as follows:

“A deferred tax asset can be created to the extent that future taxable income will be available from future reversal of any deferred tax liability recognised at the balance sheet date. To that extent, it would not be necessary to consider the level of virtual certainty supported by convincing evidence.” (Emphasis supplied by the Committee.)

Thus, the EAC opinion also states that in case deferred tax liability (DTL) is used as the basis of recognsing deferred tax asset, it is not necessary to consider the level of virtual certainty supported by convincing evidence and the DTA should be recognised to the extent that future taxable income will be available from future reversal of deferred tax liabilities against which deferred tax assets can be realised. Thus, the Committee is of the view that all the above-mentioned pronouncements of the Institute provide the same view that in case of carry-forward of losses and unabsorbed depreciation, to the extent of reversal of DTL resulting into sufficient future taxable income, the company should recognise DTA.

15.       In the above context, the Committee notes that when DTL arises due to lower expense from the accounting perspective as compared with taxation perspective, then, in such situations, the reversal of timing differences due to DTL would lead to lower expense from income-tax perspective in future and thus, to that extent, it would generally lead to a taxable income in future. Similarly, there may be situations where an item of income receivable might accrue in the financial statements in one year, but may be taxed in a subsequent year when actually received. Such situations would give rise to DTL in the first year, the reversal of which would generate taxable income in subsequent year. Thus, even in case of continued future losses from tax perspective, reversal of DTL in future would give rise to taxable income and the DTA would be realised in financial statements. Therefore, the reversal of timing differences should be construed as sufficient future taxable income. Accordingly, the Committee is of the view that in case of carry forward of losses and unabsorbed depreciation, the company should recognise deferred tax assets only to the extent that it has timing differences, the reversal of which will result in sufficient taxable income. The Committee notes that in the extant case, the company has DTL of Rs. 704.40 crore as on 31st March, 2014, representing timing differences on depreciation, which will get reversed in future years irrespective of whether the company incurs any business loss or not. Therefore, the Committee is of the view that to the extent of deferred tax liability which is capable of reversal in future, it would be correct to recognise DTA on unabsorbed depreciation and carry forward of losses, as being contended by the company.

16.       With regard to the accounting treatment to be followed by the company in the financial year 2013-14 for rectifying the treatment made by it in previous years in relation to the above transaction, the Committee notes the definitions of the terms ‘prior period items’ and ‘accounting policy’ as defined in Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’, notified under the ‘Rules’ and paragraph 15 thereof, as follows:

“4.3     Prior period items are income or expenses which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods.

4.4 Accounting policies are the specific accounting principles and the methods of applying those principles adopted by an enterprise in the preparation and presentation of financial statements.”

“15. The nature and amount of prior period items should be separately disclosed in the statement of profit and loss in a manner that their impact on the current profit or loss can be perceived.”

On the basis of the above, the Committee is of the view that since the company in the extant case has not recognised deferred tax asset on the unabsorbed depreciation and carry forward of losses inspite of there being DTL as on 31.03.2014,  there is an error in the preparation of the financial statements. Therefore, it is a prior period item and cannot be treated as a change in accounting policy. Accordingly, the company should rectify its error of prior accounting periods by making appropriate changes in the current reporting period by treating it as a ‘prior period item’ as per the principles of AS 5.

17.       As far as disclosures to be made by the company are concerned, the Committee is of the view that the company should make disclosures as per paragraphs 27 to 32 of AS 22 and paragraph 15 of AS 5.

D.        Opinion

18.       On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 12 above:

(i) In case of carry forward of losses and unabsorbed depreciation, the company should recognise deferred tax assets only to the extent that it has timing differences the reversal of which will result in sufficient taxable income. Accordingly, the company can recognise DTA on unabsorbed depreciation and carry forward of losses to the extent of DTL of Rs. 704.40 crore, which will get reversed in future, as discussed in paragraph 15 above.

 

(ii) For the purpose of recognition of DTA as per paragraph 18 of AS 22, the reversal of timing difference should be construed as sufficient future taxable income, as discussed in paragraph 15 above.

(iii) The non–recognition of DTA as above in the previous years would amount to prior period item under AS 5, as discussed in paragraph 16 above.

 (iv) The recognition of DTA on unabsorbed depreciation/unabsorbed business loss to the extent of DTL (based on the principle of sufficient future taxable income arising out of reversal of timing differences) would not amount to change in the company’s accounting policy, as discussed in paragraph 16 above.

(v) If the company does not recognise DTA to the extent of DTL (based on the principle of sufficient future taxable income arising out of reversal of timing differences), it would be in contravention of AS 22 as discussed in paragraph 15 above.  

 

(vi) The company should make disclosures as per paragraphs 27 to 32 of AS 22 and paragraph 15 of AS 5, as discussed in paragraph 17 above.

 

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