1.19 Query
Treatment of profit on sale of investments by a public financial institution.
1. A public financial institution incorporated as a company under the Indian Companies Act, 1913, acquires shares and other securities in the course of its activities, generally by way of underwriting obligations or on conversions of loans and interest. Such investments are however never purchased from the market or acquired in any other manner so as to possess them after they have been initially allotted to another party.
2. According to the querist, these investments are held by the company as capital assets. It revolves its investments as rapidly as prudent, usually by selling the same through the stock exchanges, so as to make funds available for reinvestment. In recent years, investments have been sold only after they have been held for a specified period of three to five years. The company unloads all its investment in shares in a project when the project takes off. It never retains its investments with a view to earning profits. The querist has further informed that these investments are disclosed in the annual balance sheet under the head ‘Investments’.
3. For the purpose of the Income-tax Act, 1961, the investments of the company are treated as capital assets. Accordingly, the gains/losses realised on sale of investments are taxed as capital gains. The querist has also informed that the write-off of investments made in the accounts due to shrinkage or the diminution in the value of an investment is never allowed as a deduction merely on the basis of the write-off. The deduction for the loss/gain on such written off investments is normally allowed only when the conditions are fulfilled for bringing such gains/losses under the capital gains as per the provisions of the Income-tax Act, 1961. The Tribunal observed, in this context, as follows:
“In our opinion this is a case where the sale of the shares is merely incidental to the administration of the company. As part of its assistance to industrial enterprises it subscribes for shares but they are merely held as capital assets to be looked for at any time for realisation so as to enable further assistance being given to other companies. In the appellant’s case the main business is rendering assistance to industrial enterprises and as the realisation on shares is only an incidental one it does not partake of a business character……….. In our opinion, the nature of the activity is not one of turning over the shares with a view to making profit and therefore we do not consider the activity here in question as being of a business character.”
4. Regarding the accounting treatment for the gains/losses on sale of investment, the querist mentions that right from the beginning till the Accounting Year 1985, the net gains/losses realised on sale of such investments were transferred directly to a reserve account styled “Capital Reserve Not Available For Dividend Account”. The Board of Directors of the company passed a resolution in the first year itself to credit such gains in this manner and not to consider these for the purpose of distributing dividends. The write-off of investments, if any, was made from this Account.
5. For the Accounting Year 1986, the method of directly taking the net gains/losses realised on sale of investments to the reserve account was changed. In the Revenue Account for the year 1986, the profit/loss realised on sale of the investments, during the year, arrived after deducting the write-offs of investments, was disclosed as an income of the year. The same was transferred to ‘Capital Reserve’ by making a deduction from the figure of profit after taxation so as to exclude such gains while ascertaining the disposable profits in line with the practice adopted earlier. The Capital Reserve Account is shown under the head “Reserves and Surplus”, along with the disclosure of additions to/deduction from the capital reserve arising because of profit/loss on sale of investments.
6. This change in practice was made, according to the querist, mainly to have uniformity with the accounting practice of recording all the incomes in a single income statement followed by other all India public financial institutions, to be on par with the international accounting practice in this regard and to strictly comply with the requirements of item (xii)(a) of clause 3 of Part II of Schedule VI to the Companies Act, 1956. The immediate transfer of the net profit on sale of investments from the figure of profit after taxation was made in accordance with the earlier practice of the company of not considering such receipts for paying dividends and to emphasisE the capital nature of its investment portfolio.
7. The querist has informed that Audit under Section 619(4) of the Companies Act, 1956, however, did not approve of the new practice. The Govt. audit made an observation that the new practice resulted in overstatement of revenue profit before taxation by including therein the net profit on sale of investments. According to the Govt. Audit, this profit being capital profit should have been directly transferred to the Capital Reserve instead of including it in the profit before taxation and then transferring it to a Capital Reserve. This draft comment was dropped when it was agreed by the company that this accounting practice would be further examined.
8. With regard to the taxes payable on the gains realised on sale of investments, the practice followed by the company till 1985 was as follows:
9. On the basis of above-mentioned facts, the querist has solicited the opinion of the Expert Advisory Committee on the following issues: -
(i) Whether the accounting method of disclosing the net profit on sale of investments in the Revenue Account is a permissible accounting practice having regard to the facts and circumstances of the case?
(ii) Whether it is in order for the company to transfer to the capital reserve, the net profit on sale of investments, arrived at after deducting the write-off of investments, by making a deduction from the figure of ‘profit after taxation’?
(iii) Whether the accounting practice adopted by the querist in the Revenue Account for the year 1986 meets with the requirements of Schedule VI to the Companies Act, 1956?
Opinion September 7, 1988
1. The Committee notes that the querist prepares a Revenue Account and not a Profit and Loss Account, as required under Section 211 (2) of the Companies Act, 1956. The Committee has not gone into the propriety of this practice, since the question has not been raised by the querist. The opinion of the Committee is however based on the requirements of the Companies Act, 1956. The Committee has also not considered whether the investments maintained by the company are of the nature of a capital asset or a current asset, as the querist has not raised this question also. The querist’s question is primarily on whether a transfer to capital reserve could be made through the profit and loss account. The Committee has, therefore, restricted its reply only to that issue.
2. Regarding the first part of the query [para 9(i)] the Committee notes that clause 3(xii)(a) of Part-II of Schedule VI to the Companies Act, 1956, requires a company to disclose in its Profit and Loss Account “the profits or losses on investments to the extent not adjusted from any previous provision or reserve.
Note: Information in respect of this item should also be given in the balance sheet under the relevant provision or reserve account.”
3. The Committee also notes that para 50 of the International Accounting Standard 25, ‘Accounting For Investments’, recommends that “on disposal of an investment the difference between net disposal proceeds and the carrying amount should be charged or credited to income.”
4. The Committee is of the view that the requirements of clause 3(xii)(a) of Part-II of Schedule VI to the Companies Act, 1956 would be satisfied by the accounting treatment adopted by the querist since 1986, i.e., disclosure of profit or loss on sale of investments in the profit and loss account. It will also be in line with the recommendation contained in para 50 of IAS-25.
5. With regard to the question whether the transfer to capital reserve, in respect of profit on sale of investments, can be made by deducting the same from ‘profit after taxation’, the Committee notes that the querist has not informed about the treatment of applicable taxes on the capital gains arising on sale of investments in respect of the accounts for the year 1986 when the company changed its accounting policy to “disclose the net profit on sale of investments in the Revenue Account.” The relevant Note 15 on page 36 of the 1986 Annual Report also is silent on the treatment of related taxes. The Committee is of the view that, in the particular circumstances of the query, the net profit on sale of investments arrived at after deducting the write-off of investments but before the related taxes payable on such profits should be transferred to capital reserve by making a deduction from ‘profits before taxation’. However, it is also permissible to transfer to capital reserve the net profit on sale of investments arrived at after deducting the write-off of investments by making a deduction from the figure of ‘profit after taxation’, provided the said deduction is net of related taxes payable on the said profits on the sale of investments.
6. On the basis of the above, the Expert Advisory Committee is of the following opinion regarding the queries raised in para 9 above:
(i) The manner of disclosing the net profit on sale of investments in the profit and loss account is as per the requirement of Part II to Schedule VI to the Companies Act, 1956.
(ii) In the particular circumstances of the query, the net profit on sale of investments arrived at after deducting the write-off of investments but before the related taxes payable on such profits, should be transferred to capital reserve by making a deduction from the figure of ‘profit before taxation’. However, it is also permissible to transfer to capital reserve the net profit on sale of investments arrived at after deducting the write-off of investments by making a deduction from the figure of ‘profit after taxation’, provided the said deduction is net of related taxes payable on the said profit on sale of investments.
(iii) As per (i) above the accounting practice adopted by the company with regard to treatment of profit on sale of investments for the year 1986 meets with the requirements of Schedule VI to the Companies act, 1956.
_____________________________ |