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November 2013

GAP in GAAP— Deferred Tax Liability (DTL) on Special Reserves

By Dolphy D’Souza, Chartered Accountant
Reading Time 7 mins
Under section 36 (1)(viii) of the Income-tax Act, certain specified entities such as a banking company or a housing finance corporation carrying on the business of providing long term finance for industrial or agricultural development or development of infrastructure or housing in India are allowed a special deduction. The deduction shall not exceed 20% of the profits, computed under the head “Profits and gains of business or profession”. For claiming the deduction, an equivalent amount is transferred from the profits to special reserves. Where the aggregate of the amounts carried to such reserve account exceeds twice the amount of the paid up share capital and of the general reserves of the entity, no allowance will be available in respect of such excess.

Any amount subsequently withdrawn from the special reserves (mentioned above) created to claim deduction u/s. 36(1)(viii), shall be deemed to be the profits and gains of business or profession and chargeable to income-tax as the income of the previous year in which such amount is withdrawn.

The accounting debate is whether DTL needs to be created in respect of the special reserves created u/s. 36(1)(viii). This question has been asked frequently to the Expert Advisory Committee and the Institute of Chartered Accountants of India.

It may be noted that under AS 22 Accounting for Taxes on Income, “Timing differences are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods.”

The Expert Advisory Committee (EAC) has always held the view that creation of a special reserve creates difference between accounting income and taxable income in the period in which special reserve is created. Further, this difference is capable of reversal in the period in which the special reserve is utilised or withdrawn, since the amount utilised/ withdrawn would be treated as taxable income in that year under the Income-tax Act. In support of its position, the EAC states in its opinion that deferred taxes are measured either under full provision method or partial provision method. Under the full provision method, deferred taxes are recognised and measured for all timing differences without considering assumptions regarding future probability, future capital expenditure, etc, with the exception of applying the prudence principles for recognising deferred tax assets. Under the partial provision method, the tax effect of timing differences which will not reverse for some considerable period ahead are excluded. However, this involves considerable subjective judgment and therefore AS-22, has been worded based on the full provision method. In other words, the EAC feels that DTL should be created on the special reserves, as deferred taxes are required for all timing differences (subject to application of prudence in case of deferred tax assets) which are capable of reversal. Whether those timing differences actually reverse or not in the subsequent periods is not relevant for this assessment.

Most of the querists believe that creation of DTL on special reserves will not reflect a true and fair picture of the entity’s financial statements, as experience over many years is clearly indicative that the special reserves have not been utilised by most entities as there was no need and in view of the tax impact. In other words, the querists believe that creation of DTL on special reserves is merely a theoretical construct, and distorts the true and fair picture of the entity’s financial statements by putting in the financial statements a fictitious liability.

This is an impasse between the preparers of financial statements and the ICAI/regulators that has carried on for several years. The author has a different take on the subject, which is to look at the requirements of Ind-AS/IFRS on this issue, since those are the applicable standards in the near future. This may probably end the impasse.

First let’s look at Para 52A and 52B of Ind-AS. 52A:

In some jurisdictions, income taxes are payable at a higher or lower rate if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity. In some other jurisdictions, income taxes may be refundable or payable if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity.
In these circumstances, current and deferred tax assets and liabilities are measured at the tax rate applicable to undistributed profits.

52B: In the circumstances described in paragraph 52A, the income tax consequences of dividends are recognised when a liability to pay the dividend is recognised. The income tax consequences of dividends are more directly linked to past transactions or events than to distributions to owners.
Example illustrating paragraphs 52A and 52B
The following example deals with the measurement of current and deferred tax assets and liabilities for an entity in a jurisdiction where income taxes are payable at a higher rate on undistributed profits (50%) with an amount being refundable when profits are distributed. The tax rate on distributed profits is 35%. At the end of the reporting period, 31st December 20X1, the entity does not recognise a liability for dividends proposed or declared after the reporting period. As a result, no dividends are recognised in the year 20X1. Taxable income for 20X1 is Rs. 100,000. The net taxable temporary difference for the year 20X1 is Rs. 40,000.

The entity recognises a current tax liability and a current income tax expense of Rs. 50,000. No asset is recognised for the amount potentially recoverable as a result of future dividends. The entity also recognises a deferred tax liability and deferred tax expense of Rs. 20,000 (Rs. 40,000 at 50%) representing the income taxes that the entity will pay when it recovers or settles the carrying amounts of its assets and liabilities based on the tax rate applicable to undistributed profits.

Subsequently, on 15th March 20X2 the entity recognises dividends of Rs. 10,000 from previous operating profits as a liability. On 15th March 20X2, the entity recognises the recovery of income taxes of Rs. 1,500 (15% of the dividends recognised as a liability) as a current tax asset and as a reduction of current income tax expense for 20X2.

Let’s convert the above example to the tax regime prevailing in India, where a company pays higher tax rate on distributed profits. The company has a 31st March year end. Assume that the tax rate for distributed profits is higher than that for undistributed profits; say 40% and 30% respectively. A dividend of Rs. 500 was declared in April 20X4, payable in May 20X4. Under Ind-AS, no liability will be recognised for the dividend at 31st March 20X4. The PBT is Rs. 3,000. The tax rate applicable to undistributed profits should be applied, because the tax rate for distributed profit is used only where the obligation to pay dividends has been recognised. So the current income tax expense for year end 31st March 20X4 is Rs. 900 (3,000 x 30%). For year 20X4- 20X5, a liability of Rs. 500 will be recognized for dividends payable. An additional tax liability of Rs. 50 (500 x 10%) is also recognised as a current tax liability.

The above examples are equally applicable in the case of distribution of special reserves created u/s. 36(1)(viii). In simple words, current tax liability is recognised for special reserves when they are distributed/ withdrawn, and no DTL is recognised when the special reserve is created.

In light of the above requirements of Ind -AS, the author believes that the issue of creating DTL on special reserves under AS-22 may be kept at abeyance. Rather the focus should be on understanding the right interpretation under Ind-AS 12. Even under Indian GAAP, the author believes that no DTL should be created on special reserves, in as much, no tax liability is provided under existing Indian GAAP, on general reserves or profit and loss surplus, that are subsequently distributed and on which dividend distribution tax is paid.

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