A debt which does not contain a contractual obligation to pay to the holder of the instrument both the principal and interest amount is known as perpetual debt. That does not mean that the issuer will not redeem the debt or pay interest on it. Generally, the instrument will contain an economic compulsion so that the issuer will be compelled to redeem the debt and pay interest, such as step up of interest rates on the instrument, liquidation of the issuer company, dividend blocker, etc. In accordance with Ind AS 32, such a debt is not a liability but is classified as an equity instrument. The interest paid on such a debt is treated as a distribution to equity holders.
Interestingly, from the Income-tax Act perspective, certain tax advisors argue that perpetual bonds are issued as bonds and hence result in a debtor-creditor relationship. Merely classifying them as ‘equity’ in the financial statements and showing interest payments in a manner similar to dividend to equity holders should not deprive the company of claiming these interest payments for tax deduction. This article assumes that interest payments on perpetual bonds are deductible under the Income-tax Act.
Query
Under Ind AS 12 Income Taxes, should the tax deduction on interest payments be recognised in profit or loss, or directly in equity of the issuer company?
View 1
Paragraph 35 of Ind AS 32 Financial Instruments: Presentation requires that distributions to holders of an equity instrument and transaction costs of equity transactions should be recognised directly in equity. Consequently, the interest payments on, and the costs of issuing, financial instruments themselves are recognised directly in equity. Paragraph 57 of Ind AS 12 requires that presentation of income tax consequences should be consistent with the presentation of the transactions and events themselves that give rise to those income tax consequences.
View 2
Paragraph 52B of Ind AS 12 provides more guidance on the presentation of the income tax consequences of dividends, which requires those income tax consequences to be recognised in profit or loss.
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.
Author’s View
View 1 is the preferred view. With respect to income tax consequences of interest payments on financial instruments that are classified as equity, it is important to understand whether those income tax consequences are linked to past transactions or events that were recognised in profit or loss. This is because, in accordance with paragraph 52B of Ind AS 12, the rationale for the accounting requirement in example above is because income tax consequences of dividends are more directly linked to past transactions or events than to distributions to owners.
Income tax consequences arising from interest payments on financial instruments that are classified as equity would not be linked to past transactions or events that were recognised in profit or loss, because:
(a) these interest payments that trigger a tax deduction could be made, irrespective of the existence of retained earnings; and
(b) income tax consequences arising from these interest payments cannot be associated with anything other than the interest payments themselves, because it is these interest payments that create a tax deduction.
Consequently, View 2 is not preferred. However, a plain technical reading of Ind AS 12 does allow the recognition of the tax credit in the P&L account. Without the amendment of Ind AS 12, View 2 should also be acceptable. The view selected should be applied consistently.
