Capital Subsidies and Accounting

It is well settled for the last
many years, that the question as to whether subsidies are income receipts or
capital receipts depends upon whether they are intended to supplement
the trade receipts or received otherwise {see Seaham harbour dock Co.
Crook 16 tC 333 (hl) and CIT vs. Poona Electric Supply 14 ITR 622 (Bom).} it
would depend upon the nature and content of the subsidy, the scheme, its
objective and the purpose for which subsidy is given. In other words, the ‘purpose’
test is decisive and not the mode or manner or time or source of payment.

In Sadichha Chitra vs. CIT 189 ITR
774, the Bombay high Court referred to the decision in CIT vs. Ruby Rubber
Works 178 ITR 181 and held that nature of the subsidy depends on the purpose
for which it is granted. In that case, the subsidy was in the form of refund of
entertainment tax  already  collected 
as  income.  It agreed 
with  the opinion of the M.P. high
Court in CIT vs. Dusad Industrial 162 ITR 784.

Following observations by the
Bombay high Court are apposite. “In a given case, subsidy may be granted with
the object of supplementing trade receipts and profits of the recipient.
In another case, the scheme of subsidy may have been formulated by the
authority concerned to assist the assessee in acquiring a capital asset or for
the growth of the industry generally in public interest without any objective
of supplementing trade receipts or recoupment of revenue expenses. Whether the
receipt of subsidy amount is a capital receipt or revenue receipt would depend
upon the nature and content of the subsidy the scheme, its objective and the
purpose for which subsidy is given.”

In CIT vs. Chaphalkar Brot. 351 ITR
309, the Bombay high Court held that subsidy granted to encourage setting up of
multiplexes (a capital asset) was a capital receipt.

The following observations of the
Supreme Court in Ponni Sugars case 306 ITR 392 at page 401 are extremely
relevant.

“The judgement of the house of
lords shows that the source of payment or the form in which the subsidy
is paid, or the mechanism through which it is paid is immaterial and
that what is relevant is the purpose for payment of assistance. Ordinarily,
such payments would have been on revenue account, but since the purpose of the
payment was to curtail obliterate unemployment and since the purpose was dock
extension, the house  of lords  held that payment was of capital nature.

In the above case 306 ITR 392,
the Supreme Court reviewed the entire case law on the subject and reiterated
that the character of the receipt of the subsidy under a scheme has to be
determined with respect to the purpose for which the subsidy is granted. In
other words, one has to apply the purpose test. The point of time at which the
subsidy is paid is not relevant. The source is not material. If the object of
the subsidy is to enable the assessee to run the business more profitably, then
the receipt is on revenue account. On the other hand, if the object of the
assistance under the subsidy scheme is to enable the assessee to set up a new
unit or to expand an existing unit, the receipt of subsidy would be on capital
account. See also CIT vs. Reliance Industries Ltd. 339 ITR 632 (Bom.)

Same view was taken by CBDT in
its Circular no.142 dated 1st   august,
1974 in respect of 10% Central outright Grant Subsidy Scheme. In the said
circular, it is stated that since the scheme is framed by the Govt. for the
growth of industries and not for supplementing the trade profits, it is a
capital receipt.

The following parapraphs from
different chapters of a report on industrial dispersal by Planning Commission
in the year 1980 for a similar Central Government subsidy introduced in the
fourth  five  year plan for backward areas, where the
quantum of subsidy was linked to capital investment is relevant and confirm
that such Government subsidies are not for acquiring fixed assets but for
locating projects in backward areas and level of capital investment is merely
used for calculating the quantum of subsidy.

Para 3.15 and 3.16 of the Report
……………..

“3.15 The approach to industrial
dispersal followed in the first three plans had some effect, but the results
achieved were   not   considered  
satisfactory.   Thus    the  
fourth Plan states:

“In terms of regional development, there has
been a natural tendency for new enterprises and investments to gravitate
towards the already overcrowded metropolitan areas because they are better
endowed with economic and social infrastructure. Not enough has been done to
restrain this process. While a certain measure of dispersal has been achieved,
a much larger-effort is necessary to bring about greater dispersal of
industrial activity.

(fourth five year Plan, page 11,
para 1.23)”

3.16 In its approach to industrial
development, the fourth Plan lays great stress on the need for industrial
dispersal:

“The requirement of non-farm
employment is so large and so widely spread throughout the country that a
greater dispersal of industrial development is a matter of necessity. Even from
the narrow and immediate economic view point, the society stands to gain by
dispersed development.

The cost of providing necessary
infrastructure for further expansion of existing large urban and industrial
centres is often much larger than what it might be if development was
purposefully directed to occur in smaller towns and rural areas.”

Thus,  it is certain that the primary condition for
this Government  subsidy  is  not  acquisition 
of  fixed  assets and hence, this is not a grant related
to assets in terms of Ind AS 20.

Since, as mentioned above, the
Grant is not supposed to compensate any particular cost of any particular asset
and is a capital receipt which when invested in business generates income to
compensate for higher costs of operations in backward region, in accordance
with Ind AS 10, no amount of Government Grant can be taken to profit and loss
account of any year.

In the following paragraph, the Ind
AS 20 seems to suggest that Government Grant results in a benefit for an entity
when compared to other entries which do not get the grant while the fact for
this Grant is exactly the opposite. The Government Grant, in this case, is
given to compensate for the benefits which other entities enjoy by virtue of
operating in developed regions.

“5. the  receipt of government assistance by an entity
may be significant for the preparation of the financial statement for two
reasons. Firstly,  if resources have been
transferred, an appropriate method of accounting for the transfer must be
found. Secondly, it is desirable to give an indication of the extent to which
the entity has benefited from such assistance during the reporting period. This
facilitates comparison of an entity’s financial statements with those of prior
periods and with those of other entities.”

Guidance note under Indian GAAP
states that it is generally considered appropriate that accounting for Govt.
grants should be based on the nature of the relevant grant. Grants which have
the characteristics similar to those of promoters’ contribution should be
treated as part of shareholders’ funds. Income approach may be more appropriate
in cases of other grants. (as.12-Para 5-4).

This paragraph which supports the
view that when subsidy granted is for capital purposes, it should be treated as
shareholder funds i.e. part of reserves. But this para is not there in ind. AS/IFRS. Para 12 of Ind AS-20”. (Accounting for Government grants and
disclosures of Govt. assistance) clearly states that. “Govt. grants shall be
recognized in profit and loss a/c. on a systematic basis over the periods in
which the entity recognises as expenses the related costs for which the grants
are intended to compensate. (Emphasis Supplied). Thus matching
concept/principle is adopted and it can apply to grants of a revenue nature
which seek to compensate revenue expenses incurred over a period.

Ind AS-20, however suddenly takes
a U-turn. Definition of Govt. grant says that grants related to assets are
Govt. grants whose primary condition is that an entity qualifying
for them should purchase, construct or otherwise acquire long term assets.
Subsidiary conditions may be attached restricting the type or location of the
asset. This makes it amply clear that the definition is merely talking of
qualifying or eligibility condition. It is significant to note that it uses the
expression ‘primary or subsidiary conditions for eligibility’ and not primary
purpose of giving the grant. then  it
talks of  transfer  of 
resources,  but  recognises 
in  para  4  that
Govt. grants take many forms varying both in the nature of the assistance and
in the conditions attached to it. (Emphasis supplied).

Then after citing capital
approach and income approach in para 14 and 15, para 19 states that “Grants are
sometimes received as part of a package of financial or fiscal aids to which
number of conditions may be attached. In such cases, care is needed in
identifying conditions giving rise to costs and expenses which determine
period over which, the grant will be earned. It may be appropriate to
allocate a part of a grant on one basis and part on another? (emphasis
supplied).

There can be no dispute that
revenue grants given to compensate for costs and expenses (such as employee
expenses, interest, waiver of taxes) can be treated as on revenue account.

However, it appears that para 20
takes a complete u-turn from the established principles and says that “a Govt.
grant that becomes receivable as compensation  for expenses or losses already incurred or for
the purpose and giving immediate financial 
support with no further related costs (?) (without defining or
specifying the purpose or nature of the financial support) shall be recognised
in profit and loss of the period in which it becomes receivable. the expression
‘giving immediate financial support’ is too vague and cannot be read in
derogation to the basic principles laid down by the Supreme Court and old
accounting standards and CBDT‘s own view held earlier. It will be against the
principles of commercial accounting adopted by the accounting community so far.

Para 21, surprisingly still
recognises this doctrine of making distinction between grants awarded for the
purpose of giving immediate financial support rather than as an incentive to
undertake specific expenditure. Para 22 again speaks of expenses or
losses.

By para 34 read with appendix –
i, confusion is worst confounded. it talks of “grants related to costs” being
deferred income and appendix –a which really deals with Govt. assistance which
are not to be related to specific operating activity, quietly takes them into
account as ‘transfer of resources’ to start or continue to run their business
in underdeveloped area.

It is respectfully submitted that
there is an urgent need to clarify this confusion and make it clear whether the
accounting standards advocate or support the view of treating all subsidies as
revenue receipts to be treated as income–immediate or deferred in derogation
with established principles laid down by the S.C. or reason for departure, if
any, which means that the distinction between capital receipts and revenue
receipts are no longer relevant in accounting. Also whether article 265 of the
constitution of india is no longer relevant or valid. it may be noted that
income computation and disclosure standards, which have to be now mandatorily
followed u/s.145 also make an exception in the preamble to the effect that if
the legal position is different from that adopted in the ICDS, legal position
is to be followed. Some view is taken in Accounting Standards for SMC notified
on 7^th December 2006 by ministry of Corporate affairs. Para 4.1.1 of
the preface to the accounting Standards issued by ICAI States as under:

“However, if a particular
accounting standard is found to be not in accordance with law, the provision of
the said law will prevail and the financial statements should be prepared in
conformity with such law.

Para 4.2 says

“The accounting  Standards 
by their very nature cannot and do not override the local regulation
which govern the preparation and presentation of financial statements in the
country.

Before parting with the subject,
it is necessary to deal with one important aspect. The finance  act, 2015 has inserted sub cl.(xviii) in
s.2(24) defining ‘income’ inclusive–wise to include within its sweep
‘assistance in the form of a subsidy or grant. But it also excludes those
subsidies and grants which are deducted while calculating actual cost under
explanation10 to section 43(1), thus indirectly recognising the distinction
between capital subsidy and income subsidy. But it may be argued that this is
the later law and hence, even otherwise, there is no conflict between AS 20 and
legal provision.

But the words “assistance”
clearly supports the reasoning of the Supreme Court cited above. The word
‘assistance’ means the provision of money, resources or information to help
someone. Thus the word ‘assistance’ seems to have been used in the sense of
supplement (the trade receipts). At least, it is capable of being interpreted
so. if two interpretations are possible, the courts have always adopted that
interpretation which is in favour of the taxpayer and which will uphold the
constitutional validity of the taxing provision (see 131 ITR 597 S.C).

If the amendment in section
(24(xviii) is taken to mean that it includes each and every kind of subsidy –
whether capital or revenue – it will be clearly violative of the constitution –
both article 265 and entry 82 and 86 – leave alone the Supreme Court decisions.
Thus, the provision will have to be read down to cover only income subsidies.
object of Govt. assistance can never be to take away something given by the
Govt. by one hand and taken away by the other hand.

Thus,  both in equity and law, capital subsidies can
in no sense and no manner be treated as income liable to tax. Equity and law or
accounting may be strangers, but they need not be sworn enemies!