Taxing times — IFRS and Taxation

On 22 January 2010, the Ministry of Corporate Affairs (MCA)
in India issued a press release setting out the roadmap for International
Financial Reporting Standards (IFRS) convergence in India.

It is now a widely held view that in addition to accounting
issues, transition to IFRS would trigger implications under various
legislations, including taxes, corporate laws and other regulations.

Through this article we aim to bring to light a few key
direct tax issues that are likely to arise when companies transition to IFRS.

Accounting policies and practices for many transactions will
change on convergence with IFRS. The discussion below provides an illustrative
listing of items involving a change in accounting, where the tax implications of
the change need to be evaluated. Several additional changes may require a
similar assessment from a taxation perspective.

Currently preference shares are treated as part of share
capital, consequently the dividend on preference shares is charged to the
profit and loss appropriation account. Under IFRS, preference shares will be
treated as a financial liability and dividend thereon will be in the nature of
a finance expense. Under Indian GAAP, the premium or discount on redemption of
preference shares is adjusted from the securities premium account. IFRS
requires such premium or discounts to be charged to the income statement.

Presently, dividend and premium on redemption of preference
shares is considered to be capital in
nature and hence not tax deductible.

The Government would need to clarify whether such costs
charged to income statement would be allowed as a tax deductible expense.

Also, this would lead to reduction in the tax liability of
a company under MAT provisions. The Government would need to clarify whether
this would be acceptable from a tax perspective.

Under Indian GAAP, the employee stock options are
recognised at their intrinsic value. IFRS requires the stock options to be
recognised at their fair value. The impact of the same will be in the employee
cost.

The Government would need to clarify whether the employee
costs resulting from fair valuation of the stock option will be a deductible
expense.

Cost of stock options granted by a related entity to
employees of the reporting entity would need to be recorded e.g. : companies
would need to accrue for notional compensation cost for options granted by
parent to subsidiary employees with a corresponding impact on the cost of
investments or dividend distribution, respectively.

The Government would need to consider the deductibility of
such compensation cost in the hands of the entity receiving the grant and
impact on cost of acquisition for tax purposes to compute capital gain tax or
tax impact on dividend distribution in the hands of the entity giving the
grant.

IFRS requires all financial assets and liabilities to be
measured initially at fair value. Subsequent measurement of the financial
instrument would depend on their classification. This accounting treatment
results in unrealised gains and losses in the income statement. For instance —
all derivatives will have to be fair valued at each reporting date and the
gain or loss on such fair valuation is charged to the income statement (unless
hedge accounting is followed).

The Government would need to clarify whether the unrealised
gains and losses will be taxable in the reporting period in which they arise.
This may pose difficulty to entities, given that they may not have the
liquidity to settle the tax dues on these unrealised gains. Alternatively, the
Government could tax these instruments based on the actual realised gains or
losses.

Further, the Government would also need to consider the tax
implications of unrealised gains/losses on financial instruments which are
permitted to be adjusted directly in the reserves without impacting the income
statement. For example : Unrealised gains/losses related to available for sale
(AFS) securities and effective portion of cash flow hedges are recognised
through other comprehensive income within equity.

In many instances, the accounting treatment envisaged by
IFRS could result in recognition of notional gains and expenses. The following
are examples of instruments which could give rise to notional gains or
expenses :

(1) Low interest or interest-free loans to employees —
Loans given to employees at lower than market interest rates should be
measured at fair value which is the present value of anticipated future cash
flows discounted using a market interest rate. Any difference between the fair
value of the loan and the amount advanced shall be a prepaid employee benefit.
The Government will need to consider implication of tax deducted at source on
salaries.

(2) Inter-group loans, advances and deposits at
concessional interest rates — If low interest/interest-free loans and
deposits have been forwarded among group entities, the loan or deposit is
initially measured at fair value using market rate of interest. Thus, where
the parent has granted a loan to the subsidiary, in the separate financial
statements of the parent, the difference between the nominal value and fair
value of the loan should be recognised as an additional investment in the
subsidiary and notional interest income is recognised by the parent and
corresponding interest expense by the subsidiary during the loan period. On
the other hand, where a loan has been given by the subsidiary to the parent,
in the separate financial statements of the subsidiary, the difference shall
be accounted for as dividend distribution to the parent and notional interest
income is recognised by the subsidiary and interest expense by the parent
company.

The Government will need to consider the taxation aspects of these notional interest and expenses and also implications on provision for tax deducted at source for such interest. Authorities will also need to consider impact on cost of acquisition for tax purposes to compute capital gain tax or tax impact on dividend distribution in the hands of the entity giving the loan at concessional interest rate.

    Interest-free security deposit on leasing arrangements — If an interest-free deposit is given as part of leasing transaction, the interest-free deposit will have to be discounted at the market rate and the difference will be treated initially as prepaid rent. The prepaid rent will be amortised to the income statement over the life of the lease.

The Government will have to clarify the tax treatment for such notional gains and expenses. Also the Government will need to consider implications on provision for tax deducted at source on rent.

    Revenue recognition :

Some of the revenue recognition principles under IFRS are different and will need to be carefully evaluated from tax perspective. For example :

    Under IFRS, if a contract contains multiple elements which have stand-alone value to the customer, the contract will have to be split and only revenue relating to the delivered component will be recorded in the reporting period. Further, the split of revenue between components will have to be done based on their relative fair values. For instance, if an entity sells machinery along with operations and maintenance services (O&M) for the machinery, the entity can recognise the fair value of the machinery in the reporting period in which the risk and rewards of the machinery are transferred to the buyer and the revenue from operations and maintenance will be deferred and recognised over the life of the O&M contract. The Government would need to clarify whether the entity will be taxed upfront only on the revenue recognised in a reporting period, or also on the deferred portion of the contract or will the tax impact of the deferred income also be deferred and taxed in the year in which such income is recognised in the accounts.

    In some cases two or more transactions may be linked so that the individual transactions have no commercial effect on their own. In these cases, IFRS requires that the combined effect of the two transactions together is ac-counted for. For instance a telecom company may sell mobile subscription to the customer and charge them the activation fees and talk time separately. However, in practice, these are linked transaction and the activation fee does not have any stand-alone value to the customer (in absence of the talk time or subscription agreement). Thus the telecom operator cannot recognise the activation revenue upfront and will have to defer it over the average life of the subscription agreement. The Government would need to clarify the method of taxation in such cases and consider to defer the tax implications in consonance with the deferral of revenue.

    IFRS provides guidance on accounting treat-ment of service concession agreements. For concession agreements, the contractor recognises certain profit (unrealised) dur-ing the construction phase and the balance during the operations phase when realised e.g., Company incurs cost of Rs.1,000 for construction of road and in consideration for the same has received a right to charge toll of Rs.30 on all vehicles plying on that road for 30 years (after which the road is handed over to the Government body). Under Indian GAAP, Company would capitalise Rs.1,000 as a fixed asset and depreciate it over 30 years.

However under IFRS, Company would need to accrue a notional margin on the construction activity as well and the cost of Rs.1,000 plus 10% margin (assumption) i.e., Rs.1,100 will be accounted as an intangible asset and amor-tised over 30 years. Although the manner of accounting will not result in any change in the total amount of profit or loss from the contract during the concession period (since the notional gain of 10% margin is offset by higher amortisation charge over the concession period), the proportion of the profit or loss over different reporting periods within the concession arrangement may differ.

The Government would need to consider the method of taxation in such cases. In this in-stance, entities may need to recognise profit margins upfront, though they would not have received cash inflows from the customers, thus entities may not have sufficient liquidity to settle tax dues, in case tax is charged based on the net profit reported in the financial statements.

Minimum Alternate Tax (‘MAT’) :

In case companies in India do not have sufficient taxable profits in India, as per the Income-tax Act companies are required to pay MAT as a specified percentage of book profits. Further, the new direct tax code proposes to charge MAT as a specified percentage of the total assets of the company.

Various differences discussed above and in particular the fair value implications and notional gains/ losses would have substantial impact on the reported profits or reported assets by companies.

The Government would need to assess the implications of such impacts on the tax liability arising due to provision of MAT, given that companies may find it difficult to pay tax dues (actual cash outflow) on unrealised gains which have not yet resulted in cash inflows for the company.

Further the proposal to charge MAT as a percentage of asset poses the following challenges for companies converging with IFRS, which need to be considered by tax authorities in formulating appropriate provisions :
    IFRS provides an option to account for its property, plant and equipment and investment properties at fair value at each reporting date. This could also result in increase in tax liability without any cash inflow to the company.

    Under IFRS, companies may need to account for certain embedded leases in normal sale/ purchase transactions e.g., Company has contracted to buy the entire output from suppliers production line and also given a minimum commitment to reimburse the fixed cost including capital cost of the supplier (these arrangements are commonly used as take or pay arrangement), in such cases, companies will need to account the production plant of the supplier as its own plant. This would increase the gross asset base of the Company and the corresponding MAT liability.

The above, being notional accounting aspects would cause significant issues for companies, if these are considered for taxing the entities and result in potential cash outflows.

The taxation model needs to be framed to ensure that companies that are required to follow the IFRS converged standards are not at a disadvantage as compared to other entities that are not required to follow the IFRS converged standards from April 1, 2011.

Matters for consideration by the Government :

Overall the Government will need to consider how to incorporate the implications of IFRS in the tax rules to be applied by companies, such that they do not result in unintended difficulties and adverse cash flow implications for companies.

The options to be considered to manage this transition :

Option 1 — Taxation based on current Indian accounting standards :
Require companies to prepare reconciliation of profit reported/assets reported under IFRS with profits and assets per the current accounting standards. Taxation based on such reconciled profits, assets and book balances. This is also generally followed in many of the European countries where taxation is determined based on the GAAP of the respective countries. For example : Germany, Spain.

Option 2 — Taxation based on IFRS with additional differences between IFRS financial statements and taxable income :

IFRS financial statements as a starting point for taxation. However, tax laws to be modified to identify additional areas where taxation (both current taxation and MAT) will be different from the basis used in the IFRS financial statements. These areas may be limited in number, and would not necessarily cover all differences that arise due to transition from current accounting standards to the IFRS converged standards. Additionally, under Option 2, the Government would need to determine how the one-time adjustments recorded in the books of accounts to transition to IFRS are treated for tax purposes.

It is important to note that the Income-tax Act in India applies to all entities i.e., corporate, partnership firms, trusts, individuals, etc. and IFRS will be applicable from 1st April 2011 only for a limited number of companies covered by Phase 1. If Option 2 is followed, this would result in different IFRS-based taxable models for some entities and a different model for other entities (that are not required to converge with IFRS immediately).

While Option 1 appears to be attractive, it poses challenges relating to maintaining two sets of records — one under IFRS and the other under current accounting standards. The benefits and costs of each of these options may need to be further debated to decide the best option from an Indian perspective.