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Month: November

Scientific research expenditure : Deduction u/s.35 of Income-tax Act, 1961 : Research not restricted to applied or natural science but includes any scientific research which may lead to or facilitate extension of business.

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Reported :

20. Scientific research
expenditure : Deduction u/s.35 of Income-tax Act, 1961 : Research not restricted
to applied or natural science but includes any scientific research which may
lead to or facilitate extension of business.

[CIT v. Engineering
Innovation Ltd., 327 ITR 392 (HP)]

The assessee was carrying on
the business of manufacture and sale of metal components. The assessee decided
to manufacture and market automatic coffee machines. It imported an automatic
coffee machine from abroad and engaged the services of an engineer for
indeginising and copying the machine in such a fashion so as to make it suitable
for Indian conditions. In the A.Y. 1992-93, the assessee claimed the deduction
of the cost of the imported machine and the retainership fees paid to the
engineer as scientific research expenditure u/s.35 of the Income-tax Act, 1961.
The Assessing Officer disallowed the claim holding that the expenditure was not
incurred on research work. The Tribunal allowed the assessee’s claim.

On appeal by the Revenue,
the Himachal Predesh High Court upheld the decision of the Tribunal and held as
under :

“(i) The definition of
scientific research in S. 43(4) is comprehensive, but the use of the word
‘include’ in every clause of the Section clearly implies that the definition
is inclusive and not comprehensive. Therefore, the contention of the
Department that scientific research must be in the fields of natural or
applied science, could not be accepted.

(ii) Any methodical or
systematic investigation based on science into the study of any materials or
sources, is a scientific research.

(iii) The investigation
done by the assessee to improvise, indigenise and improve the imported machine
to suit the Indian market would have resulted in expanding and extending its
business and therefore fell within the meaning of the term ‘scientific
research’ as defined in S. 43(4)(iii) of the Act.

(iv) The assessee was entitled for
deduction in terms of S. 35(4).”

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Penalty : Failure to get accounts audited in time : S. 44AB and S. 271B : Condition precedent : Tribunal to record a finding whether assessee deliberately failed to submit audit report in time : Matter remanded

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19 Penalty : Failure to get accounts audited
in time : S. 44AB and S. 271B of Income-tax Act, 1961 : A.Y. 2001-02 : Condition
precedent : Tribunal to record a finding whether assessee deliberately failed to
submit audit report in time : Matter remanded.


[Gramin Vidyut Sahkari Samity Maryadit. v. ACIT, 305
ITR 89 (MP)]

For the A.Y. 2001-02, the assessee, a co-operative society
did not get its accounts audited as required u/s.44AB of the Act. The Assessing
Officer therefore, imposed a penalty of Rs.1,00,000. The CIT(A) deleted the
penalty. The Tribunal upheld the penalty order and held that there was no
illegality or infirmity in the order of the Assessing Officer.

 

On appeal, the Madhya Pradesh High Court remanded the matter
back to the Tribunal for fresh decision according to law, and held as under :

“(i) An order imposing penalty for failure to carry out a
statutory obligation is the result of a quasi-criminal proceeding and penalty
will not ordinarily be imposed unless the party obliged either acted
deliberately in defiance of law or was guilty of conduct contumacious or
dishonest or acted in conscious disregard of its obligation. The penalty will
not be imposed merely because it is lawful to do so. Whether the penalty
should be imposed for failure to perform a statutory obligation is a matter of
discretion of the authority to be exercised judicially and on consideration of
all the relevant circumstances. Even if minimum penalty is prescribed, the
authority competent to impose the penalty will be justified in refusing to
impose penalty, when there is a technical or venial breach of the Income-tax
Act, 1961, or where the breach flows from a bona fide belief that the
offender is not liable to act in the manner prescribed by the statute.

(ii) It is obligatory on the part of the Tribunal to record
a finding whether the assessee had acted deliberately in defiance of the
provisions of S. 44AB of the Act and is guilty of conduct contumacious or
dishonest, warranting imposition of penalty by the AO u/s.271B of the Act.

(iii) The Tribunal, apart from stating that there was no
denial by the assessee that the provisions of S. 44AB were not applicable to
it and there was delay in getting the accounts audited, had not applied its
mind and recorded any cogent or germane reasons as is imperative in law.
Therefore, the order of the Tribunal is liable to be set aside and the matter
remitted to it for reconsideration.”

Penalty : Failure to deduct tax at source : S. 194A and S. 271C : Bona fide belief based on opinion of senior counsel : Penalty not justified.

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18 Penalty : Failure to deduct tax at
source : S. 194A and S. 271C of Income-tax Act, 1961 : A.Ys. 1994-95 and
1995-96 : Bona fide belief based on opinion of senior counsel :
Penalty not justified.


[CIT v. Wishwapriya Financial Services and Securities
Ltd., 303 ITR 122 (Mad.)]

The assessee was engaged in retail and financial services,
corporate and advisory services and securities trading. An advertisement was
given in the newspaper in the name of the assessee, stating that the return on
the investment made with the company would not attract tax deduction at source
and accordingly, the assessee did not deduct tax at source on interest paid on
such investments. For the A.Ys. 1994-95 and 1995-96, the Assessing Officer
issued show-cause notice proposing to impose penalty u/s.271C of the Income-tax
Act, 1961 for failure to deduct tax at source u/s.194A on interest paid on such
investments. The assessee replied that he had acted under the bona fide
belief that the income received from the investments did not attract the
liability for deduction of tax at source and therefore, when the amounts were
distributed among the investors, no tax was deducted at source. It was also
contended that an opinion from a senior counsel was obtained before devising the
scheme to the effect that no tax need be deducted at source on the payments made
to the investors. The Assessing Officer rejected the contention and imposed the
penalty. The Tribunal deleted the penalty.

 

On appeal by the Revenue, the Madras High Court upheld the
decision of the Tribunal and held as :

“(i) The mere fact that the bona fide claim stood
disallowed did not itself lead to the inference that the company consciously
and deliberately flouted the provisions of the Act. The assessee thought that
there was no relationship of debtor and creditor or borrower and lender and
that, S. 194A, S. 201(1), S. 201(1A) read with S. 2(28A) of the Act were not
attracted. It was clear from the order of the Tribunal that it had accepted
the explanation and given a finding that there was a reasonable cause for not
deducting tax at source.

(ii) The assessee acted in a bona fide manner on the
basis of the opinion obtained from a senior counsel before devising the
scheme. The finding that there was a reasonable cause was a finding of fact
and it was not perverse. The concurrent findings given by both the authorities
below were based on valid materials and evidence and did not warrant
interference. The Tribunal was justified in deleting the penalty levied
u/s.271C of the Act.”

Penalty : Deposits/loans in cash in excess of prescribed limits : S. 269SS, S. 269T, S. 271D and S. 271E : Finding that the amounts were mere book entries and transactions on behalf of family members : No violation of S. 269SS and S. 269T : Penalty could

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17 Penalty : Deposits/loans in cash in
excess of prescribed limits : S. 269SS, S. 269T, S. 271D and S. 271E of
Income-tax Act, 1961 : A.Y. 1991-92 : Finding that the amounts were mere book
entries and transactions on behalf of family members : No violation of S. 269SS
and S. 269T : Penalty could not be imposed.


[CIT v. Natwarlal Purshottamdas Parekh, 303 ITR 5 (Guj.)]

The assessee was carrying on the business of money-lending
and trading in jewellery. For the A.Y. 1991-92, the AO imposed penalty u/s.271D
and u/s.271E of the Income-tax Act, 1961 on account of receipt/repayment of
deposits/loans otherwise than by way of account-payee cheque. The Tribunal found
that most of the amounts represented book entries except amounts of NSCs of
family members which had matured and which were reinvested. The Tribunal also
found that the assessee had acted under bona fide belief in view of the
opinion of an advocate and income-tax practitioner of standing of 33 years who
had opined that the assessee would not violate the provisions of S. 269SS and S.
269T of the Act if the assessee receives amounts from the family members and
repays to different family members. Accordingly the Tribunal cancelled the
penalty.

 

On appeal by the Revenue, the Punjab and Haryana High Court
upheld the decision of the Tribunal and held as under :

“(i) The Tribunal had found on the facts and in the light
of the evidence on record that there was no violation of either the provisions
of S. 269SS or S. 269T of the Act.

(ii) The Tribunal had further found that there was
reasonable cause, assuming that there was any violation by the assessee.

(iii) Hence the Tribunal had rightly deleted the penalties
levied u/s.271D and u/s.271E.”

 


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Penalty : Deposits in cash in excess of prescribed limits : S. 269SS, S. 269T, S. 271D and S. 271E : Firm accepting cash from partners in belief that it was not different from them : Reasonable ground : Penalty could not be imposed.

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15 Penalty : Deposits in cash in excess of
prescribed limits : S. 269SS, S. 269T, S. 271D and S. 271E of Income-tax Act,
1961 : A.Y. 1990-91 : Firm accepting cash from partners in belief that it was
not different from them : Reasonable ground : Penalty could not be imposed.


[CIT v. Lokhpat Film Exchange (Cinema), 304 ITR 172 (Raj.)]

In the A.Y. 1990-91 the Assessing Officer had levied
penalties u/s.271D and u/s.271E of the Income-tax Act, 1961 in respect of
transactions between the assessee-firm and its partners described as deposits
from the partners. The assessee had claimed that in view of the fact that the
partners and the firm are not independent of each other and the firm is not a
juristic person, these transactions cannot be considered as intra-person, but
were only for the purpose of carrying on partner’s own business. The fact that
under the Income-tax Act, the firm and the partners of the firm are recognised
as independent units, the same cannot be treated for all purposes to be separate
and independent. The assessee had contended that in that view of the matter,
they had not violated the requirement of S. 269SS and S. 269T while conducting
these transactions. However, the Assessing Officer did not accept this
explanation and imposed penalties u/s.271D and u/s.271E. The Tribunal relying on
a decision in CIT v. R. M. Chidambaram Pillai, (1977) 106 ITR 292 wherein
the Supreme Court had said that there cannot be a contract of service, in strict
law, between a firm and one of its partners, so as to consider the salary paid
to the partner as income from salary held that for the purpose of S. 269SS and
S. 269T also the firm and partners cannot be considered to be separate entities
and deleted the penalty.

 

The Rajasthan High Court dismissed the appeal filed by the
Revenue and held as under :

“The assessee had acted bona fide and its plea that
inter se transactions between the partners and the firm were not
governed by the provisions of S. 269SS and 269T was a reasonable explanation.
Penalty could not be imposed.”

 


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Penalty : Deposits/Loans in cash in excess of prescribed limits : S. 269T and S. 271E : Repayment of advance towards share application money : Neither deposit nor loan : Bona fide belief : Penalty not justified.

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16 Penalty : Deposits/loans in cash in
excess of prescribed limits : S. 269T, and S. 271E of Income-tax Act, 1961 : A.Y.
1990-91 : Repayment of advance towards share application money : Neither deposit
nor loan : Bona fide belief : Penalty not justified.


[CIT v. Rugmini Ram Ragav Spinners P. Ltd., 304 ITR
417 (Mad.)]

The assessee is a closely held company. For the A.Y. 1990-91
the Assessing Officer imposed penalty of Rs.5,90,416 u/s.271E of the Income-tax
Act, 1961 on the ground that during the year of account the assessee had repaid
some of the share application money which it had received earlier in cash. The
Tribunal cancelled the penalty.

 

The Madras High Court dismissed the appeal filed by the
Revenue and held as under :

“(i) The assessee had received cash over a period of time
as advance towards allotment of shares from 16 persons without stipulating any
time frame towards return/refund of money without interest, in case of
non-allotment of shares either fully or partly. The money retained by the
company was neither deposit nor loan, it was only share capital advance.

(ii) The advance of share application money and repayment
of such advances had not flowed from any undisclosed income of the assessee or
the concerned persons. The assessee had not paid any interest at all on any of
the advances repaid after some time. If the intention was to receive them as
loan or deposit, then certainly the lenders would not have made the advances
gratuitously. The assessee was not called upon to explain the default
u/s.269SS of the Act on receipt of the advances of the earlier years, which
would show that the assessee’s case was not governed by the said provisions.

(iii) Penalty u/s.271E is not automatic, and a bona fide
belief to the effect that the receipt of the advance against allotment of
shares would not be termed as loan or deposit, would be sufficient to drop the
penalty leviable unless and until the material on record positively showed
that the money received was only a deposit or loan.

(iv) There was no dispute that the advances were
only against allotment of shares and not by way of loans or advances. In this
case the reasonable cause was that the assessee was under bona fide
belief that the money received was only for the purpose of allotment of
shares. There was no material or evidence or any compelling reason produced by
the Revenue to prove that the money received was a deposit or loan.”

 


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Penalty : Concealment of income : S. 271(1)(c) : No penalty proceeding initiated in the preceding year on similar issue : Finding by Tribunal that a case of difference of opinion and not concealment of income : Proper.

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14 Penalty : Concealment of income : S.
271(1)(c) of Income-tax Act, 1961 : A.Y. 1983-84 : No penalty proceeding
initiated in the preceding year on similar issue : Finding by Tribunal that a
case of difference of opinion and not concealment of income : Proper.


[CIT v. Sood Harvester, 304 ITR 279 (P&H)]

For the A.Y. 1983-84, the Assessing Officer imposed penalty
u/s.271(1)(c) of the Income-tax Act, 1961 for concealment of income. The
Tribunal found that in respect of the addition made on the same issue for the
A.Y. 1982-83, the AO had not initiated penalty proceedings. The Tribunal
recorded that the assessee had disclosed complete facts before the AO along with
the return, as well as during the course of assessment proceedings and held that
it was a case of difference of opinion and not concealment of income. The
Tribunal also held that there was no reason for the Revenue to take a different
view for the A.Y. 1983-84 on the same set of facts and without assigning
reasons.

 

The Punjab and Haryana High Court dismissed the appeal filed
by the Revenue and held as under :

“(i) The Tribunal had followed the correct approach by
concluding that it was a case of difference of opinion and not concealment of
income on the reasoning that in the preceding year the facts were almost the
same and still no penalty proceedings u/s.271(1)(c) was initiated.

(ii) The Revenue had to maintain consistency for the
purpose of finality in all litigation and a decision on the same question
would not be re-opened unless some new facts were found with material
difference in the subsequent years.”

 


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Penalty : Concealment of income : S. 271(1)(c) : Cash compensatory support not included in original return, but in revised return : No concealment of income : Penalty could not be imposed.

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13 Penalty : Concealment of income : S.
271(1)(c) of Income-tax Act, 1961 : Cash compensatory support not included in
original return : Amount included in revised return: No concealment of income:
Penalty could not be imposed.


[CIT v. Mentha and Allied Products P. Ltd., 304 ITR
214 (All.)]

In the original return of income the assessee had not
included the cash compensatory support amounting to Rs.65,61,640. Subsequently,
the Finance Act, 1990, brought about an amendment, with retrospective effect,
that the cash assistance was taxable. In view of this amendment, the assessee
voluntarily filed a revised return and included the cash compensatory support
therein. The Assessing Officer levied penalty u/s.271(1)(c) of the Income-tax
Act, 1961. The Tribunal cancelled the penalty. In appeal before the High Court,
the Revenue contended that the Tribunal had cancelled the penalty wrongly on the
basis that the assessee has voluntarily filed the revised return when in fact
the revised return was filed after issuance of notice u/s.142(1) on 30-1-1991.

 

The Allahabad High Court dismissed the appeal filed by the
Revenue and upheld the decision of the Tribunal.

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Penalty : Concealment of income : S. 271(1)(c) Expl. 1 : Surrender of income by assessee : No separate enquiry necessary before imposing penalty : Assessee to explain about bona fides in penalty proceedings : Matter remanded

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12 Penalty : Concealment of income : S.
271(1)(c) Expl. 1 of Income-tax Act, 1961 : A.Y. 1989-90 and 1990-91 : Surrender
of income by assessee : No separate enquiry necessary before imposing penalty :
Assessee to explain about bona fides in penalty proceedings:
Matter remanded.


[Dy. Director of Income-tax v. Chirag Metal Rolling Mills
Ltd., 305 ITR 29 (MP)]

For the A.Ys. 1989-90 and 1990-91, in the course of
assessment proceedings the assessee offered incomes of Rs.74,92,919 and
79,00,198 by way of disallowance u/s.40A(3) of the Income-tax Act, 1961. The
Assessing Officer made the additions and also imposed penalty u/s.271(1)(c) for
concealment of the added amount. In appeal, the CIT(A) cancelled the penalty.
The Tribunal dismissed the appeal filed by the Revenue.

 

On appeal by the Revenue, the Madhya Pradesh High Court
remanded the matter back to the Tribunal for fresh decision according to law,
and held :

“(i) The combined reading of Explanation 1 to S. 271(1)(c)
of the Act and the verdict of the Hon’ble Apex Court in the matter of Sir
Shadilal Sugar and General Mills Ltd. v. CIT, (1987) 168 ITR 705 and K.
P. Madhusudhan v. CIT, (2001) 251 ITR 99, it is crystal clear that prior
to Explanation 1, the position of law was if the assessee agrees for addition
of his income to buy peace, then it will not follow that agreed amount to be
added was concealed income and the Revenue was required to prove the mens
rea. Because of this view taken by the Hon’ble Apex Court in the matter of
Sir Shadilal Sugar and General Mills Ltd. v. CIT, (1987) 168 ITR 705
Explanation 1 to S. 271(1)(c) of the Act was added to the Income-tax Act and
after taking into consideration the Explanation, the Hon’ble Apex Court, in
the matter of K. P. Madhu-sudhan (2001) 251 ITR 99, has laid down that no
separate enquiry is necessary for imposing the penalty. However, from a plain
reading of the Explanation, it is evident that some sort of enquiry is
necessary, therefore, the proceedings initiated by the Revenue for imposing
the penalty u/s.271(1)(c) of the Act shall be treated as proceedings and the
assessee is at liberty to show his bona fides in that proceedings. If
the assessee fails to show his bona fides, in that case penalty can be
imposed by the Revenue.

(ii) This Court is of the view that the learned Tribunal is
not justified in holding that the onus is on the Revenue to prove mala
fides, even when the primary onus was on the assessee to prove that there
was no concealment in view of Explanation 1 to S. 271(1)(c) of the Act. In
view of the answer to the first question, it appears that no separate enquiry
is necessary before imposing the penalty. In the penalty proceedings itself,
initiated by the Revenue, the assessee can explain his bona fides and
that all the facts relating to the same and material to the computation of his
total income have been disclosed by him.”

 


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Business expenditure — Interest on borrowings — Assessee has to establish, in the first instance, its right to claim deduction under one of the Sections between S. 30 to S. 38 and in the case of the firm if it claims special deduction, it has also to prov

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5 Business expenditure — Interest on
borrowings — Assessee has to establish, in the first instance, its right to
claim deduction under one of the Sections between S. 30 to S. 38 and in the case
of the firm if it claims special deduction, it has also to prove that it is not
disentitled to claim deduction of applicability of S. 40(b)(iv).


[Munjal Sales Corporation v. CIT, (2008) 298 ITR 298
(SC)]

In August/September, 1991, the appellant-assessee granted
interest-free advances to its sister concerns which were disallowed by the
Department on the ground that the said advances were not given from the firm’s
own funds but from interest bearing loans taken by the assessee-firm from third
parties. Accordingly, the assessee’s claim for deduction u/s.36(1)(iii) was
disallowed by the Department for the A.Y. 1992-93.

 

However, the Tribunal deleted the disallowance, saying that
the assessee had given such advance from its own funds. In the next A.Y. 1993-94
, the same situation look place. During the A.Y. 1994-95, no further advances
were made by the assessee-firm in favour of its concerns. However, during the
A.Y. 1995-96, a small interest-free loan of Rs.5 lakhs was advanced by the
assessee-firm to its sister concern and during the year in question the assessee
had profits of Rs.1.91 crores. The said advance/loan got finally repaid in the
A.Y. 1997-98.

 

For the A.Y. 1994-95, the Department disallowed the claim for
deduction u/s.40(b)(iv), saying that in this case there was diversion of funds
by raising of interest-free loans. The Assessing Officer did not accept the
submission of the assessee that advance(s) made by the assessee were out of
income of the firm. According to the Assessing Officer, the said interest-free
advances to sister concerns were out of monies borrowed by the firm from third
parties on payment of interest, hence the assessee was not entitled to deduction
u/s.40(b) of the 1961 Act. This view was confirmed by the Tribunal.

 

For the A.Ys. 1995-96 and 1996-97, the Tribunal held that
during the said years, no interest-free advances to sister concerns were made
and, therefore, there was no nexus between ‘interest-bearing loans’ taken and
‘interest-free advances’. However, the Tribunal found that there was no material
to show that advances were made to sister concerns out of the firm’s own income
and, therefore, the assessee was not entitled to deduction u/s.40(b)(iv) of the
1961 Act.

 

The Supreme Court after analysing the scheme of the Act and
in particular the provision of S. 36(1)(iii) and S. 40(b), held that every
assessee including a firm has to establish, in the first instance, its right to
claim deduction under one of the Sections between S. 30 to S. 38 and in the case
of the firm if it claims special deduction it has also to prove that it is not
disentitled to claim deduction by reason of applicability of S. 40(b)(iv).

 

The Supreme Court on the facts held that for the A.Y. 1992-93
and the A.Y. 1993-94, the Tribunal held that the loans given to the sister
concerns were out of the firm’s funds and that were advanced for business
purposes. Once it is found that the loans granted in August/September, 1991
continued up to A.Y. 1997-98 and that the said loans were advanced for business
purposes and that interest paid thereon did not exceed 18/12% per annum, the
assessee was entitled to deductions u/s.36(1)(iii) read with S. 40(b)(iv) of the
1961 Act.

 

Further, the Supreme Court observed that during A.Y. 1995-96,
apart from the loan given in August/September, 1991, the assessee advanced
interest-free loan to its sister concern amounting to Rs.5 lakhs. According to
the Tribunal, there was nothing on record to show that the loans were given to
the sister concern by the assessee-firm out of its own funds and, therefore, it
was not entitled to claim deduction u/s.36(1)(iii).

 

The Supreme Court held that finding of the Tribunal was thus
erroneous. The opening balance as on April 1, 1994, was Rs.1.91 crores, whereas
the loan given to the sister concern was a small amount of Rs.5 lakhs. According
to the Supreme Court, the profits earned by the assessee during the relevant
year were sufficient to cover the impugned loan of Rs.5 lakhs. The Supreme Court
accordingly allowed the appeal.

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Business expenditure — Interest on borrowed capital — Prior to insertion of proviso to S. 36(1)(vi) w.e.f. 1-4-2004, an assessee was entitled to claim deduction of interest on capital borrowed for the purposes of its business, irrespective of its use bein

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4 Business expenditure — Interest on borrowed
capital — Prior to insertion of proviso to S. 36(1)(vi) w.e.f. 1-4-2004, an
assessee was entitled to claim deduction of interest on capital borrowed for the
purposes of its business, irrespective of its use being for capital or revenue
purpose.


[Dy. CIT v. Core Health Care Ltd., (2008) 298 ITR 194
(SC)]

The assessee-company was engaged in the business of
manufacture and sale of intravenous solutions. For the A.Y. 1992-93 the assessee
claimed deduction towards expenses aggregating to Rs.2,12,05,459 which included
interest on borrowings of Rs.1,56,76,000 utilised for purchase of machinery.

 

During the assessment year under consideration the assessee
had installed new machinery. The Assessing Officer, disallowed the amount of
Rs.1,56,76,000 placing reliance on the judgment of this Court in Challapalli
Sugar Ltd. v. CIT, (1975) 98 ITR 167, inter alia, on the ground that
during the assessment year under consideration the assessee had installed new
machinery on which production had not started.

 

On appeal, the Commissioner of Income-tax (Appeals) confirmed
the addition of interest amount on borrowings of Rs.1,56,76,000. The matter was
carried in appeal by the assessee. The Tribunal held that the Department was not
justified in adding Rs.1,56,76,000 in the income of the assessee. This decision
was confirmed by the High Court.

 

On appeal by the Department, the Supreme Court noted that
before the High Court it was not the case of the Department that a new business
was set up or commenced during the assessment year under consideration. It was
undisputed before the High Court that three additional machines were installed
by the assessee during the assessment year under consideration for the
production of intravenous injectibles.

 

The Supreme Court upon reading the provisions of S.
36(1)(iii) held that interest on moneys borrowed for the purposes of business is
a necessary item of expenditure in a business. For allowance of a claim for
deduction of interest under the said Section, all that is necessary is that,
firstly, the money i.e., capital, must have been borrowed by the assessee;
secondly, it must have been borrowed for the purpose of business; and, thirdly,
the assessee must have paid interest on the borrowed amount. All that is germane
is : whether the borrowing was, or was not, for the purpose of business.

 

The expression ‘for the purpose of business’ occurring in S.
36(1)(iii) indicates that once the test of ‘for the purpose of business’ is
satisfied in respect of the capital borrowed, the assessee would be entitled to
deduction u/s.36(1)(iii). This provision makes no distinction between money
borrowed to acquire a capital asset or a revenue asset. All that the Section
requires is that the assessee must borrow capital and the purpose of the
borrowing must be for business which is carried on by the assessee in the year
of account.

 

What clause (iii) emphasises is the user of the capital and
not the user of the asset which comes into existence as a result of the borrowed
capital unlike S. 37 which expressly excludes an expenses of a capital nature.
The Legislature has, therefore, made no distinction in S. 36(1)(iii) between
‘capital borrowed for a revenue purpose’ and ‘capital borrowed for a capital
purpose’. An assessee is entitled to claim interest paid on borrowed capital
provided that capital is used for business purpose irrespective of what may be
the result of using the capital which the assessee has borrowed.

 

Further, the words ‘actual cost’ do not find place in S.
36(1)(iii) of the 1961 Act. The expression ‘actual cost’ is defined in S. 32,
32A, etc. of the 1961 Act, which is essentially a definition Section which is
subject to the context to the contrary. S. 43(1) defines ‘actual cost’. The
definition of ‘actual cost’ has been amplified by excluding such portion of the
cost as is met directly or indirectly by any other person or authority.
Explanation 8 has been inserted in S. 43(1) by Finance Act, 1986 (23 of 1986),
with retrospective effect from April 1, 1974.

 

It is important to note that the words ‘actual cost’ would
mean the whole cost and not the estimate of cost. ‘Actual cost’ means nothing
more than the cost accurately ascertained. The determination of actual cost in
S. 43(1) has relevance in relation to S. 32 (depreciation allowance), S. 32A
(investment allowance), S. 33 (development rebate allowance), and S. 41
(balancing charge). The ‘actual cost’ of an asset has no relevance in relation
to S. 36(1)(iii) of the 1961 Act, the Supreme Court however observed that in the
present appeal it was concerned with the A.Ys. 1992-93, 1993-94, 1995-96 and
1997-98.

 

The Supreme Court noted that a proviso has been inserted in
S. 36(1)(iii) of the 1961 Act which denies deductions of interest for the period
beginning from the date on which the capital was borrowed for acquisition of
asset till the date on which the asset was first put to use. The Supreme Court
held that proviso has been inserted by the Finance Act, 2003, with effect from
April 1, 2004. Hence, the said proviso will not apply to the facts of the
present case. The Supreme Court therefore held that the said proviso would
operate prospectively.

 

The Supreme Court held that the Assessing Officer was not
justified in making disallowance of Rs.1,56,76,000 in respect of borrowings
utilised for purchase of machines.

 


Note : The said decision was followed in the following
cases :

1. Jt. CIT v. United Phosphorous Ltd., (2008) 299
ITR 9 (SC)

2. ACIT v. Arvind Polycot Ltd., (2008) 299 ITR 12
(SC)

3. Dy. CIT v. Gujarat Alkalies & Chemicals Ltd.,
(2008) 299 ITR 85(SC)

 


In United Phosphorus Ltd.’s case there was another question
regarding option in law to claim partial depreciation in respect of any block of
assets. The matter was remanded back to the High Court.

 

Method of Accounting — Chit fund — Chit discount accounting on completed contract method cannot be rejected especially when it is revenue neutral.

New Page 2

3 Method of Accounting — Chit fund — Chit
discount accounting on completed contract method cannot be rejected especially
when it is revenue neutral.


[CIT v. Bilahari Investment P. Ltd., (2008) 299 ITR I
(SC)]

The assessees are private limited companies subscribing to
chits as their business activities. They were maintaining their accounts on the
mercantile basis and they were computing profit/loss, as the case may be, at the
end of the chit period following the completed contract method, which was
earlier accepted by the Department over several years.

 

However, for the A.Ys. 1991-92 to 1997-98, the Assessing
Officer came to the conclusion that the completed contract method was not
accurate in recognising/identifying ‘income’ under the 1961 Act, and according
to him, therefore, in the context of the ‘chit discount’, the correct method was
deferred revenue expenditure calculated on proportionate basis. In other words,
the Assessing Officer has preferred the percentage of completion method as the
basis for recognising/identifying ‘income’ under the 1961 Act in substitution of
the completed contract method.

 

According to the Department, chit dividend had to be
subjected to tax on accrual basis as the assessees were following the mercantile
system of accounting. As far as the chit dividend is concerned, the Department
rejected the completed contract method as suggested by the assessees, which has
been accepted by the Tribunal and the High Court. However, in the matter of chit
discount, the High Court, overruling the Tribunal, has held that the completed
contract method of accounting adopted by the assessees was valid and that the
Department had erred in spreading the discount over the remaining period of the
chit on proportionate basis.

 

In the matter of chit dividend, the assessees accepted the
view of the Tribunal and the High Court that the completed contract method was
not correct.

 

Before the Supreme Court the limited controversy was whether
the completed contract method of accounting adopted by the assessees as method
of accounting for chit discount was required to be substituted by the percentage
of completion method. The Supreme Court noted that Chit funds are basically
saving schemes in which a certain number of subscribers join together and each
contributes a certain fixed sum each month, the total number of months being
equal to the total number of subscribers. The subscriptions are paid to the
manager of the fund by a certain prescribed date each month and the total
subscriptions to the fund are auctioned each month amongst the subscribers. At
each auction, the lowest bidder is paid the amount of his bid and the balance
received from out of the total subscriptions received is distributed equally
amongst other subscribers, as premium. The manager is paid a certain percentage
of the collections each month on account of expenses and charges for conducting
the auction. In the auction, a maximum amount, which the highest bidder agrees
to forgo, is the amount, which is distributed to the other members, subject to
deduction of the manager’s commission.

 

Before the Supreme Court, it was the case of the assessees
that, profits (loss) accrued to the assessees only when the dividends exceeded
the discount paid and that the difference could be known only on the termination
of the chit when the total figure of dividend received and discount paid would
be available. That, it would be possible for the assessees to make profits only
when the sum total of the dividend received exceeded the sum total of discounts
suffered which is debited to the profit and loss account. According to the
assessees, the Department has all along been accepting the completed contract
method and, therefore, there was no justification in law or in facts for
deviating from the accepted practice. According to the assessees, a chit
transaction has been treated by the various Courts as one single scheme running
for the full period and, therefore, according to the assessees, the completed
contract method adopted by it over the years was not required to be substituted
by any other method of accounting.

 

The Supreme Court observed that recognition/identification of
income under the 1961 Act is attainable by several methods of accounting. It may
be noted that the same result could be attained by any one of the accounting
methods. The completed contract method is one such method. Similarly, the
percentage of completion method is another such method. Under the completed
contract method, the revenue is not recognised until the contract is complete.
Under the said method, costs are accumulated during the course of the contract.
The profit and loss is established in the last accounting period and transferred
to the profit and loss account. The said method determines results only when the
contract is completed. On the other hand, the percentage of completion method
tries to attain periodic recognition of income in order to reflect current
performance. The amount of revenue recognised under this method is determined by
reference to the stage of completion of the contract. The stage of completion
can be looked at under this method by taking into consideration the proportion
that costs incurred to date bear to the estimated total costs of contract.

 

The Supreme Court held that it was concerned with the A.Ys.
1991-92 to 1997-98. In the past, the Department had accepted the completed
contract method and because of such acceptance, the assessees, in these cases,
had followed the same method of accounting, particularly in the context of chit
discount. Every assessee is entitled to arrange its affairs and follow the
method of accounting, which the Department has earlier accepted. It is only in
those cases where the Department records a finding that the method adopted by
the assessee results in distortion of profits, can the Department insist on
substitution of the existing method.

 

Further, in the present cases, the Supreme Court noted from
the various statements produced before us, that the entire exercise, arising out
of change of method from the completed contract method to deferred revenue
expenditure, is revenue neutral. Therefore, the Supreme Court did not wish to
interfere with the impugned judgment of the High Court.

 Before concluding, the Supreme Court noted that u/s.211(2) of the Companies Act, Accounting Standards (‘AS’) enacted by the Institute of Chartered Accountants of India have now been adopted. The learned counsel for the Department, had placed reliance on AS-22 as the basis of his argument that the completed contract method should be substituted by deferred revenue expenditure (spreading the said expenditure on proportionate basis over a period of time). He also relied upon the concept of timing difference introduced by AS-22.

The Supreme Court observed that all these developments were of recent origin and it was open to the Department to consider these new accounting standards and concepts in future cases of chit transactions. The Supreme Court however expressed no opinion in that regard, stating that these new concepts and accounting standards had not been invoked by the Department in the present batch of civil appeals.

Interest on excess refund : S. 234D of Income-tax Act, 1961 : Section came on statute books w.e.f. 1-6-2003 : Provision not retrospective : Interest u/s.234D cannot be charged in respect of refunds granted prior to 1-6-2003.

New Page 1

Unreported :


12. Interest on excess
refund : S. 234D of Income-tax Act, 1961 : Section came on statute books w.e.f.
1-6-2003 : Provision not retrospective : Interest u/s.234D cannot be charged in
respect of refunds granted prior to 1-6-2003.

[CIT v. M/s. Bajaj
Hindustan Ltd. (Bom.), ITA No. 198 of 2009 dated 15-4-2009]

In an appeal by the Revenue
the following question was raised before the Bombay High Court :

“Whether in the facts and
circumstances of the case and in law the ITAT was right in holding that the
interest u/s.234D cannot be charged in respect of refunds granted prior to
1-6-2003 ?”

The High Court upheld the
decision of the Tribunal and held as under :

“It is seen that the
subject provision came on statute book w.e.f. 1-6-2003. If that be so, the
said provision does not have retrospective effect. In this view of the matter
we do not see the appeal giving rise to any substantial question of law.”

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Reassessment : Power and scope : S. 147 of Income-tax Act, 1961 : A.Ys. 1994-95 and 1995-96 : If the AO does not assess the income, which he had reason to believe had escaped assessment, then the reassessment order will be invalid.

New Page 6

13. Reassessment : Power and
scope : S. 147 of Income-tax Act, 1961 : A.Ys. 1994-95 and 1995-96 : If the AO
does not assess the income, which he had reason to believe had escaped
assessment, then the reassessment order will be invalid.


[CIT v. M/s. Jet Airways
(I) Ltd. (Bom.), ITA No. 1714 of 2009 dated 12-4-2010]

In an appeal by the Revenue
the following question was raised before the Bombay High Court :

“Where upon the issuance of
a notice u/s.148 of the Income-tax Act, 1961 r/w. S. 147, the Assessing Officer
does not assess or, as the case may be, reassess the income which he has reason
to believe had escaped assessment and which formed the basis of the notice
u/s.148, is it open to the Assessing Officer to assess or reassess independently
any other income, which does not form the subject matter of the notice ?”

The High Court upheld the
decision of the Tribunal and held as under :

“(i) S. 147 has the effect
that the Assessing Officer has to assess or reassess the income (such income)
which escaped assessment and which was the basis of the formation of belief
and if he does so, he can also assess or reassess any other income which has
escaped assessment and which comes to his notice during the course of the
proceedings. However, if after issuing a notice u/s.148, he accepts the
contention of the assessee and holds that the income in respect of which he
has initially formed has reason to believe had escaped assessment, has as a
matter of fact not escaped assessment, it is not open to him independently to
assess some other income. If he intends to do so, a fresh notice u/s.148 would
be necessary, the legality of which would be tested in the event of a
challenge by the assessee.

(ii) We have approached
the issue of interpretation that has arisen for decision in these appeals,
both as a matter of first principle, based on the language used in S. 147(1)
and on the basis of the precedent on the subject. We agree with the submission
which has been urged on behalf of the assessee that S. 147(1) as it stands
postulates that upon the formation of a reason to believe that income
chargeable to tax has escaped assessment for any assessment year, the AO may
assess or reassess such income ‘and also’ any other income chargeable to tax
which comes to his notice subsequently during the proceedings as having
escaped assessment. The words ‘and also’ are used in a cumulative and
conjunctive sense. To read these words as being in the alternative would be to
rewrite the language used by the Parliament.

(iii) In that view of the
matter and for the reasons that we have indicated, we do not regard the
decision of the Tribunal in the present case as being in error. The question
of law shall accordingly stand answered against the Revenue and in favour of
the assessee.”

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Interest for non/short payment of advance tax and on excess refund : S. 234B and S. 234D of Income-tax Act, 1961 : A.Y. 2001-02 : Interest not chargeable u/s.234B where short payment of advance tax is attributable to non/short deduction of tax at source :

New Page 1

Unreported :

11. Interest for non/short
payment of advance tax and on excess refund : S. 234B and S. 234D of Income-tax
Act, 1961 : A.Y. 2001-02 : Interest not chargeable u/s.234B where short payment
of advance tax is attributable to non/short deduction of tax at source : S. 234D
applies only for the A.Y. 2004-05 and onwards and is not retrospective.

[DIT v. M/s. Jacabs Civil
Incorporated (Del.), ITA No. 491 of 2008 dated 30-8-2010]

The assessee is a foreign
company. For the A.Y. 2001-02, the assessee had filed return of income declaring
income of Rs.96 lakhs. The assessee had claimed that it is not liable for
interest u/s.234B of the Income-tax Act, 1961 in view of the fact that it was
not liable to pay advance tax since whole of the tax liability was deductible
u/s.195 by the payee. The assessee had also claimed that S. 234D is not
applicable since it is operative only from the A.Y. 2004-05. The Assessing
Officer rejected the assessee’s claim and levied interest u/s.234B and u/s.234D
of the Act. The Tribunal accepted the assessee’s claim.

On appeal by the Revenue,
the Delhi High Court upheld the decision of the Tribunal and held as under :

“(i) U/s.209(1)(d), the
tax ‘deductible or collectible at source’ has to be reduced from the advance
tax payable. S. 195 puts an obligation on the payer to deduct tax at source.
Therefore, the entire tax is to be deducted at source which is payable on such
payments made by the payee to the non-resident. The non-resident recipient is
not liable to pay advance tax. Though in Anjum Ghaswala 252 ITR 1(SC), it was
held that S. 234B is mandatory, the present is a case where S. 234B does not
apply at all. Accordingly, it is not permissible for the Revenue to charge
interest u/s.234B.

(ii) S. 234D inserted by
the Finance Act, 2003 w.e.f. 1-6-2003 is in the nature of a substantive
provision and applies only for the A.Y. 2004-05 and onwards. It is not
retrospective.”

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Salary : S. 14, S. 15, S. 16 and S. 17 of Income-tax Act, 1961 and Article 164(5) of Constitution of India : A.Y. 1996-97 : Chief Minister of a State : Pay and allowances received is assessable under the head ‘salary’.

New Page 1

  1. Salary : S. 14, S. 15, S. 16 and S. 17 of Income-tax Act,
    1961 and Article 164(5) of Constitution of India : A.Y. 1996-97 : Chief
    Minister of a State : Pay and allowances received is assessable under the head
    ‘salary’.

[Lalu Prasad v. CIT, 316 ITR 186 (Patna)]

For the A.Y. 1996-97, the assessee was the Chief Mininster
of Bihar and he filed his return of income wherein the pay and allowances
received by him as the Chief Minister was shown under the head ‘Income from
other sources’. The Assessing Officer assessed the amount under the head
‘Salary’. The Assessing Officer allowed the standard deduction of Rs.15,000
and disallowed the claim for deduction of the incidental expenditure. The
Tribunal confirmed the assessment order.

On appeal by the assessee the Patna High Court upheld the
decision of the Tribunal and held as under :

“Article 164(5) of the Constitution of India expressly
provided for payment of salary to the Chief Minister. The assessee in his
return had himself stated that he was the Chief Minister of the State and
received salary from the Government of Bihar. The Assessing Officer had not
erred in changing the head of income to ‘Salary’.”

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Depreciation : Additional depreciation : S. 32(1)(iia) of Income-tax Act, 1961 : Increase in installed capacity of final product is not a requirement for claiming additional depreciation.

New Page 5

  1. Depreciation : Additional depreciation : S. 32(1)(iia) of
    Income-tax Act, 1961 : Increase in installed capacity of final product is not
    a requirement for claiming additional depreciation.


[CIT v. Hindustan Newsprint Ltd., 183 Taxman 257 (Ker.)]

The assessee was engaged in manufacture and sale of
newsprint. It claimed additional depreciation in respect of de-inking plant in
which pulp was made from waste paper. The Assessing Officer disallowed the
claim on the ground that the installed capacity of final product of the
company, viz., newsprint remained unaltered even after installation of
de-inking machinery. The Tribunal held that there was increase in installed
capacity of pulp and pulp though, an intermediary product is also marketable
and, hence, the assessee was entitled to additional depreciation u/s.32(1)(iia).

On appeal by the Revenue the Kerala High Court upheld the
decision of the Tribunal and held as under :

“(i) The provision of S. 32(1)(iia) was modified
dispensing with the requirement of increase in installed capacity as a
condition for eligibility for additional depreciation.

(ii) The fact that pulp is an intermediary product and is
generally consumed captively in the manufacture of newsprint does not mean
that pulp is not a product that can not be marketed by the assessee as and
when it desired. There is no dispute that pulp is a marketable commodity. If
there was reduction in the manufacture of the final product on account of
any reason, necessarily the assessee would have to market the excess pulp
produced.

(iii) The view of the Tribunal that pulp being marketable
commodity produced by the assessee, the increase of the installed capacity
of the pulp plant on account of the installation of de-inking machinery
would entitle the assessee to the benefit of additional depreciation was to
be accepted. The finding of the Tribunal that there has been increase in the
installed capacity of the production of pulp in terms of the requirement of
the provision in the statute was not disputed by the revenue.

(iv) On the other hand its contention was that the
installed capacity of an industry should always be understood with reference
to final product manufactured and sold by it, which was newsprint in the
instant case; that contention of the revenue could not be accepted.

(v) The intermediary product, viz., pulp produced
by the company being a marketable commodity, the increase in the installed
capacity for claiming benefit of additional depreciation under the above
provision could be in the production of intermediary, viz., pulp.
Therefore, the finding of the Tribunal was to be accepted.”

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Depreciation : User of asset : Assessee in leasing business : Lease of machinery in accounting year : Lessee installing machinery in subsequent year : Not relevant : Assessee entitled to depreciation.

New Page 5

  1. Depreciation : User of asset : Assessee in leasing
    business : Lease of machinery in accounting year : Lessee installing machinery
    in subsequent year : Not relevant : Assessee entitled to depreciation.

[CIT v. Kotak Mahindra Finance Ltd., 317 ITR 236 (Bom.)]

The assessee was in the business of leasing. In the
relevant accounting year the assessee had leased out breakers to TECL. The
lessee installed the breakers in the subsequent year. The Assessing Officer
disallowed the claim for depreciation on the ground that asset was not put to
use in the relevant year. The Tribunal allowed the assessee’e claim.

On appeal by the Revenue, the Bombay High Court upheld the
decision of the Tribunal and held as under :

“(i) The assessee, admittedly had supplied the machinery
before the end of the financial year and the assessee had received the lease
rental for the same. Whether the lessee had put to use the lease equipment
would be irrelevant as long as the machinery in fact had been given on lease
before the end of the financial year, as then it could be said that the
assessee for the purposes of business had ‘used’ the leased equipment.

(ii) The assessee was entitled to depreciation.”

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Business expenditure : S. 37 of Income-tax Act, 1961 : A.Y. 2004-05 : Assessee civil contractor : Constructed Hockey Stadium in the Collectorate Complex for securing DRDA contract : Expenditure on stadium is business expenditure allowable u/s.37.

New Page 1

  1. Business expenditure : S. 37 of Income-tax Act, 1961 : A.Y.
    2004-05 : Assessee civil contractor : Constructed Hockey Stadium in the
    Collectorate Complex for securing DRDA contract : Expenditure on stadium is
    business expenditure allowable u/s.37.

[CIT v. Velumanickam Lodge, 317 ITR 338 (Mad.)]

The assessee, a civil contractor, wrote a letter to the
District Collector to secure the DRDA contract from the office of the District
Collectorate, expressing its willingness to construct a hockey stadium in the
Collectorate Complex and after receipt of the letter the DRDA contract was
awarded by the Collector to the assessee. In the previous year relevant to A.Y.
2004-05 the assessee constructed the hockey stadium and the expenditure on the
construction of the hockey stadium of Rs.24 lakhs was claimed as revenue
expenditure. The Assessing Officer disallowed the claim treating the
expenditure as capital expenditure. The Tribunal allowed the assessee’s claim
holding that the assessee volunteered to construct the hockey stadium for
generating goodwill and for promoting its business activities, especially
where such construction of the hockey stadium was for the welfare of the
public, which was not prohibited by law. The Tribunal observed that the mere
willingness expressed by the assessee to construct the hockey stadium in the
District Collectorate Complex for a value of Rs.24 lakhs could not be
construed as bribe to a person or as contribution for a private fund or for
the benefit of any individual which could be regarded as a form of illegal
gratification.

On appeal by the Revenue, the Madras High Court upheld the
decision of the Tribunal and held as under :

“The construction of the hockey stadium by the assessee
was in the regular course of business apart from the fact that such
construction came to be made on property belonging to the District
Collectorate meant solely for the use of public at large. Thus, the
investment made by the assessee for construction of the hockey stadium was
in the regular course of business and such investment could be construed as
one made with a view to enlarge its scope of business and could be termed as
business expenditure.”

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Assessment : Cross-examination of witnesses : A.Y. 1996-97 : Assessment based on statement of witnesses : No opportunity afforded to assessee to cross-examine the witnesses : Matter remanded.

New Page 2

  1. Assessment : Cross-examination of witnesses : A.Y. 1996-97 : Assessment based on statement of witnesses : No opportunity afforded to assessee to cross-examine the witnesses : Matter remanded.

[CIT v. Land Development Corporation, 316 ITR 328 (Karn.)]

The assessee was carrying on the business of real estate and building apartments. For the A.Y. 1996-97, the assessee had claimed depreciation on certain machineries used for the purposes of the business. In the course of survey conducted at the premises of the assessee and the seller of the machinery, statements of different persons were recorded. On the basis of such statements the claim for depreciation was disallowed. The assessee contended that the witnesses whose statements have been relied on were not allowed to be cross-examined by the assessee and therefore the disallowance can not be sustained in law. The Tribunal accepted the contention.

On appeal by the Revenue the Karnataka High Court held as under :

“The matter was to be remanded to the Assessing Officer for affording an adequate and proper opportunity to the assessee for cross-examination of all the witnesses whose statements were recorded earlier and whose statements had been already supplied to the assessee.”

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Assessment : A.Ys. 1993-94 to 1995-96 : Business expenditure : Disallowance : Not to be based only on admissions of assessee : Admission not conclusive evidence.

New Page 1

  1. Assessment : A.Ys. 1993-94 to 1995-96 : Business
    expenditure : Disallowance : Not to be based only on admissions of assessee :
    Admission not conclusive evidence.

[Ester Industries Ltd. v. CIT, 316 ITR 260 (Del.)]

For the A.Ys. 1993-94 to 1995-96, the disallowances made by
the Assessing Officer were reversed by the CIT(A) and the additions were
deleted on the ground that the assessment order did not justify the additions.
The Tribunal reversed the order of the CIT(A) and restored the order of the
Assessing Officer on the ground that the assessee both in its original as well
as in its revised return had made admissions which formed the basis of the
additions made by the Assessing Officer.

On appeal, the assessee contended that had the assessee
been given an opportunity by the AO, it could have demonstrated that no
additions or disallowances were called for. The Delhi High Court allowed the
appeal and held as under :

“(i) The Tribunal ought to have examined the issue as to
whether the fact that the assessee had made an admission with respect to an
addition in its original return or in the revised return would ipso facto
bar the assessee from claiming an expense or disputing an addition, if it is
otherwise permissible under law.

(ii) The Assessing Officer did not call upon the assessee
to furnish any explanation at the time of making additions. The Tribunal
should have examined the matter based on the point that an admission is an
extremely important piece of evidence but it could not be said to be
conclusive. It was open to the person who made the admission to show that it
was incorrect.

(iii) The Tribunal’s order was to be set aside and it was
directed to rehear the parties.”

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Appeal : Right of payer to appeal : S. 246(1)(i) and S. 248 of Income-tax Act, 1961 : A.Y. 1997-98 : Even if tax is not effected by the payer, the payer has every right to question the tax liability of the payee to avoid vicarious consequences : Payer is

New Page 1

  1. Appeal : Right of payer to appeal : S. 246(1)(i) and S. 248
    of Income-tax Act, 1961 : A.Y. 1997-98 : Even if tax is not effected by the
    payer, the payer has every right to question the tax liability of the payee to
    avoid vicarious consequences : Payer is entitled to prefer appeal.

[Jindal Thermal Power Company Ltd. v. Dy. CIT, 225
CTR 220 (Karn.)]

In this case the appellant had made payment for which it
had not deducted tax at source. It preferred appeal disputing the tax
liability of the payee in respect of such payment. Dealing with the question
of the locus standi of the appellant to file appeals the Karnataka High Court
held as under :

“The decision (relied on by the Revenue) does not lay
down that the person who is obliged to effect TDS u/s.195 has no right to
question the assessment of tax liability. Since in law, if TDS is not
effected by the payer (Jindal), the payer would be ultimately responsible to
pay the tax liability of the payee. The conjoint reading of S. 195, S. 201
r.w. S. 246(1)(i) and S. 248 makes it clear that Jindal as a payer has every
right to question the tax liability of its payee to avoid the vicarious
consequences. Therefore, the contention that Jundal has no right of appeal
is to be rejected.”

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Arm’s length price : Determination : S. 92CA of Income-tax Act, 1961 : Amendment w.e.f. 1-6-2007 : Transfer Pricing Officer must give an opportunity of hearing : Assessee must be given opportunity to inspect material available with Transfer Pricing Office

New Page 1

  1. Arm’s length price : Determination : S. 92CA of Income-tax
    Act, 1961 : Amendment w.e.f. 1-6-2007 : Transfer Pricing Officer must give an
    opportunity of hearing : Assessee must be given opportunity to inspect
    material available with Transfer Pricing Officer and file further material.

[Moser Baer India Ltd. v. Addl. CIT, 316 ITR 1
(Del.)]

In this case the petitioners challenged the orders of the
Transfer Pricing Officer(TPO) on the following grounds :

(a) The TPO has not granted an oral hearing before
determining the arm’s length price in respect of international transactions
entered into by the petitioners with their associated enterprises; and

(b) There has been failure on the part of the TPO to
consider documents and information filed by the petitioners, as also,
non-disclosure of information and documents obtained by the TPO which were
used by him in the determination of the arm’s length price.

The Delhi High Court allowed the petitions and held as
under :

“(i) S. 92CA was inserted w.e.f. 1-6-2002 and was amended
w.e.f. 1-6-2007. Prior to the amendment, the Assessing Officer on receipt of
an order passed by the TPO under Ss.(3) of S. 92CA, would proceed to compute
the total income of the assessee u/s.92C(4) having regard to the arm’s
length price determined by the TPO. After the amendment, the Assessing
Officer is required to compute the total income of the assessee u/s.92C(4)
in conformity with the arm’s length price determined by the TPO. Thus, prior
to the amendment, the Assessing Officer while computing the total income of
the assessee, having regard to the arm’s length price so determined by the
TPO, was required to give the final opportunity to the assessee before
computing the assessee’s total income. This is clear from the language used
in Ss.(4) of S. 92CA prior to its amendment, as the determination by the TPO
was not binding on the Assessing Officer. The Assessing Officer was thus
empowered even at the stage of computation of total income to look into the
issues pertaining to the determination of the arm’s length price by the TPO.

(ii) Authorities which have power to decide and whose
decisions would prejudice a party, entailing civil consequences, would be
required to accord oral hearing even where a statute is silent. The
provisions of Ss.(3) of S. 92CA cast an obligation on the TPO to afford a
personal hearing to the assessee before he proceeds to pass an order of
determining of the arm’s length price in terms of S. 92CA(3).

(iii) Since such a requirement flows from a plain reading
of the provisions of S. 92CA(3), the determination of the arm’s length price
by the TPO could not be sustained by recourse of the fact that the assessee
did not demand an oral hearing.

(iv) To obviate any difficulty in future the show-cause
notice issued by the TPO just prior to the determination of the arm’s length
price u/s. 92CA(3) should refer to the documents available with the
Assessing Officer in relation to the international transaction in issue. The
show-cause notice should also give an option to the assessee: (a) both, to
inspect the material available with the Assessing Officer as also the leeway
to file further material or evidence if he so desires, and (b) to seek a
personal hearing in the matter.”

levitra

Comparison of IFRS Exposure Draft on Insurance Contracts and Insurance Accounting in India

Comparison of IFRS Exposure Draft on Insurance

On 30 July 2010, the International Accounting Standards Board
(IASB) issued its long-awaited exposure draft on Insurance Contracts. This
Exposure Draft (ED) has been many years in preparation and represents a
significant step forward towards the IASB’s goal of providing comprehensive
guidance for accounting for insurance contracts.

Although IFRS 4 Insurance Contracts (the existing accounting
standard) addressed some of the more urgent issues in insurance contract
accounting, it was only transitionary. It permits a wide variety of existing
accounting practices to continue, which hinders comparability for users.

Given the Indian context and impending convergence with IFRS
from 1 April 2012 for insurance companies in India, the provisions of this ED
are critically important and will guide the corresponding provisions of the
Indian accounting standard to be issued in this regard.

Insurance contracts often expose entities


to long-term and uncertain obligations. There are several complex policies,
principles and calculations involved in measuring these obligations. As a
result, stakeholders need to be informed adequately about the insurer’s business
model, risk management practices, measurement approaches, solvency, asset
management, profitability, etc. The ED is a step in the right direction.

This article is a summary of the ED. It provides an overview
of the main proposals published for public comment by the IASB and the
differences with regards to the existing practice in India for the insurance
industry.

Executive summary of the Exposure Draft on Insurance Contracts :

  • The
    ED proposes a new standard on accounting for insurance contracts which would
    replace IFRS 4 Insurance Contracts.
     


  • The
    ED proposes a comprehensive measurement model for all types of insurance
    contracts issued by entities with a modified approach
    for some short-duration contracts. The measurement model is based on a
    principle that insurance contracts create a bundle of rights and obligations
    that work together to create a package of cash inflows (premiums) and outflows
    (benefits, claims and costs). The measurement model, which applies to that
    package of cash flows, uses the following building blocks :



  • a
    current estimate of future cash flows;


  • a
    discount rate that adjusts those cash flows for the time value of money;


  • an
    explicit risk adjustment; and


  • a
    residual margin.




  • For
    short-duration contracts, a modified version of the measurement
    model applies. As a proxy for the measurement model, during the coverage
    period, the insurer measures the pre-claims liability by allocating premiums
    receivable across the coverage period. For these contracts, the insurer would
    apply the building block measurement model to measure claim liabilities for
    insured events that have already occurred and for onerous contracts.
     


  • The
    ED proposes that an insurer include incremental acquisition costs (i.e.,
    costs of selling, underwriting and initiating an insurance contract) as part
    of the contract’s cash flows. As a result, those costs would generally affect
    profit or loss over the coverage period rather than at inception. All other
    acquisition costs (i.e., fixed salary related to underwriting and
    front-line sales staff) would be expensed when incurred through profit and
    loss account.
     


  • The
    proposals also include revised unbundling criteria for non-derivative
    components of an insurance contract; a revised presentation for the statement
    of financial position and statement of comprehensive income; a building block
    measurement model for reinsurance contracts; an expected loss model for credit
    risk of reinsurance assets; accounting guidance for investment contracts with
    a discretionary participation feature (DPF) including an expanded definition
    of a DPF compared to IFRS 4; revised accounting guidance for business
    combinations and portfolio transfers; and extensive disclosure requirements.
    Below, we consider some of the critical areas in the ED.



Differences between the IFRS ED and existing practice of
recognition and measurement of insurance contracts in the Indian insurance
industry :

The differences are broadly classified and discussed below :


  • Classification of insurance contracts;



  • Measurement of insurance contracts;



  • Treatment of acquisition costs;



  • Unbundling;



  • Embedded derivatives



  • Derecognition;



  • Reinsurance;



  • Presentation, and



  • Disclosure



Classification of insurance contracts :

  • The
    proposals in the ED apply to all insurance contracts (including reinsurance
    contracts) that an entity issues and reinsurance contracts that an entity
    holds. Financial instruments containing a discretionary participation feature
    (DPF) that an entity issues are also in the scope of this proposal.

    Under the proposal, an insurance contract is de-fined as a contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncer-tain future event (the insured event) adversely affects the policyholder. This definition is consistent with the current definition of an insurance contract under IFRS 4.

    Under the proposals, insurers should begin recognising the contract when they are bound by the coverage, which could be prior to the effective date or the date on which a contract is signed (i.e., when there is an unconditional offer extended for coverage) and may be heavily influenced by local regulatory requirements.

Classification of insurance contracts in India:

    There is no specific standard for the purpose of classifying Insurance contracts under Indian GAAP. Currently, traditional, unit-linked insurance plan and pension products are sold by insurance companies and premium received on all these policies are accounted as premium income in revenue account.

    This will be a significant shift in the method of accounting for premium for life insurance companies as pension products having zero death benefits will not fall under the purview of insurance contracts and have to be accounted as Investment contracts and investment component pertaining to ULIP contracts would have to be accounted separately.

    However this will be a P/L neutral adjustment as currently they are adjusted as part of provision for insurance liabilities at the period end.

Measurement of insurance contracts — The building-block approach?:
The proposed model uses a building- block ap-proach to the measurement of insurance contracts The measurement model includes a ‘fulfilment’ objective which reflects the fact that an insurer generally expects to fulfil its liabilities over time by paying benefits and claims to policyholders as they become due, rather than transferring the li-abilities to a third party.

An insurer measures a contract as the sum of

    the present value of the fulfilment cash flows, being the expected present value of the future cash outflows less future cash inflows that will arise as the insurer fulfils the contract, including a risk adjustment for the effects of uncertainty about the amount and timing of those future cash flows; and

    a residual margin that eliminates any gain at inception of the contract. A residual margin arises when the present value of the fulfilment cash flows is less than zero. If the present value of the fulfilment cash flows at inception is positive (i.e., the expected present value of cash outflows plus the risk adjustment is greater than the expected present value of cash inflows), then this amount is immediately recognised as a loss in profit or loss.

The residual margin is determined on initial recognition at a portfolio level for contracts with a similar inception date and coverage period. This residual margin amount is ‘locked-in’ at inception. The residual margin is recognised in profit or loss over the coverage period in a systematic way that best reflects the exposure from providing insurance coverage, either on the basis of the passage of time or on the basis of the expected timing of incurred claims and benefits if that pattern differs significantly from the passage of time. Also, the insurer accretes interest on the carrying amount of the residual margin using the discount rate determined on initial recognition to reflect the time value of money.

The present value of the fulfilment cash flows contains the following ‘building blocks’ and is re-measured at each reporting period.

    an explicit, unbiased and probability-weighted estimate (i.e., expected value) of the future cash outflows less the future cash inflows that will arise as the insurer fulfils the insurance contract;

    a discount rate that adjusts those cash flows for the time value of money; and

    a risk adjustment — an explicit estimate of the effects of uncertainty about the amount and timing of those future cash flows.

Measurement of insurance liabilities by Indian insurance companies?:

The Gross Premium Methodology for life insurance contracts is governed by the IRDA (Assets, Liabilities and Solvency Margin of Insurers), Regulations, 2000 and Guidance Notes GN1, GN2 and GN7 issued by the Institute of Actuaries of India (IAI). The regulations govern the valuation of liabilities for both non -linked and linked business with some additional requirements for linked business.

Mathematical reserves are determined separately for each contract. The valuation method primarily takes into account all prospective contingencies including cost of any options that may be available to the policyholder. The reserves have to be at least as large as any guaranteed surrender value and never less than zero.

In addition, for unit-linked business?:

    The value to be placed on the unit reserve shall be the current value of the assets underlying the unit fund determined in accordance with the IRDA Regulations.

    If unit liabilities are not matched, a mismatch reserve shall be created.

    Separate unit and non-unit reserves shall be held. The sum of these reserves would represent the total reserve for a unit-linked policy.

    The total reserve in respect of a policy shall not be less than the guaranteed surrender value on the valuation date. Neither the unit reserve nor the non-unit reserve in respect of a policy shall be negative.

  • The proposed IFRS measurement model focusses on the key drivers of insurance contract profit-ability, and would provide users with a clearer insight than they gain from today’s patchwork of different models for different types of contract. The same model would apply to all insurance contracts. However a modified version would apply to short duration insurance contracts.


Insurers would present information in the financial statements that focusses on the drivers of performance, i.e.,?:

  •     release from risk, as the risk adjustment decreases


  •     what insurers expect to earn from providing insurance services


  •     investment returns on invested premiums, and


  •     the investment returns provided to policyholders (either implicitly through pricing or explicitly)     differences between expected and actual cash flows and changes in estimates and the discount rate.

The current problem in cash flow estimates is that insurers use ‘locked in’ estimates which do not provide current information about insurance liabilities. However the proposed changes in ED would require changes in cash flow estimates to be reflected in profit or loss in the period in which they arise. This would enhance transparency and provide more relevant information for users.

Pre-claims liabilities for short-duration contracts (General Insurance Contracts):

The proposals contain a modified measurement approach for pre-claim liabilities of short duration contracts. This model is intended to be a proxy for the building-block measurement model in the pre-claims period. In the proposals ‘short-duration’ contracts are defined as insurance contracts with a coverage period of approximately 12 months or less that do not contain any embedded options or derivatives that significantly affect the variability of cash flows.

In this measurement approach an insurer is required to measure its pre-claims obligation at inception as premiums received at initial recognition plus the present value of future premiums within the boundary of the contract less incremental acquisition costs.

This pre-claims obligation is reduced over the coverage period in a systematic way that best reflects the exposure from providing insurance coverage, either on the basis of the passage of time or the expected timing of incurred claims and benefits if this pattern differs significantly. Pre-claims liabili-ties are the preclaims obligation less the present value of future premiums within the boundary of the contract. The insurer is also required to accrete interest on the carrying amounts of the preclaims liabilities. If the contract is onerous, the excess of the present value of the fulfilment cash flows over the carrying amount of the pre-claims obligation is recognised as an additional liability and expense.

Liabilities for claims incurred are measured at the present value of fulfilment cash flows in accor-dance with the general measurement model.

Measurement of general insurance contracts by Indian insurance companies:

For short-duration contracts the IRDA regulations specifies

  •     reserve for unexpired risks as a percentage of the premium, net of reinsurances, received or receivable during the preceding twelve months, and


  •     reserve for outstanding claims reasonably estimated according to the insurer, on a ‘case-by-case method’ after taking into account the explicit allowance for changes in the settlement pattern or average claim amounts, expenses and inflation.


The ED on insurance contract gives a comprehensive measurement model for general insurance contracts as against the existing practice currently followed.

Acquisition costs:

  •     Incremental acquisition costs (costs of selling, underwriting, and initiating an insurance contract that would not have been incurred if the insurer had not issued that particular contract) are included in the present value of the fulfilment cash flows of a contract. All other acquisition costs are expensed when incurred in profit or loss.


  •     Non-incremental acquisition costs would be recognised as an expense.


  •     Indian insurers recognise acquisition costs as an expense immediately. This would result smaller losses at inception than they do today.


Unbundling:
Insurance contracts may include multiple elements, such as insurance coverage, investment compo-nents and embedded derivatives i.e., insurance contracts contain one or more components that would be within the scope of another IFRS if the insurer accounted for those components as if they were separate contracts, e.g., an investment (financial) component or a service component.

If a component is not closely related to the in-surance coverage specified in a contract, the ED proposes that an insurer does unbundle and ac-count separately for that component.

This would require Indian life insurance companies to unbundle the investment component from ULIP contracts from total premium and disclose it sepa-rately since inception. Currently the deposit portion is unbundled only at the end of the reporting period by way of including them in the actuarial reserves and then disclosing them in provision for linked liabilities.

Moreover, the pension and annuity products which are having no risk cover i.e., zero death benefits would not be under the purview of insurance contracts. These would have to be accounted as investment contracts under IAS 39 and the premium received on such contracts would have to separately shown in the balance sheet.

Embedded derivatives

Under the proposals, IAS 39 applies to an embed-ded derivative in an insurance contract unless the embedded derivative itself is an insurance contract. If the economic characteristics and risks of the embedded derivative are not closely related to those of the host insurance contract, the insurer is required to separate the embedded derivative and measure it at fair value with recognition of changes in fair value in profit or loss if the embed-ded derivative meets the following criteria?:

    a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host insurance contract

    b) a separate instruments with the same terms as the embedded derivative would meet the definition of a derivative and be within the scope of IAS 39 (e.g., the derivative itself is not an insurance contract).

Derecognition

An insurer shall remove an insurance contract liability (or a part of an insurance contract liability) from its statement of financial position when, and only when it is extinguished, i.e., when the obligation specified in the insurance contract is discharged or cancelled or expires. At that point, the insurer is no longer at risk and is therefore no longer required to transfer any economic resources to satisfy the insurance obligations.

The insurance liability ceases as soon as the policy lapses i.e., if the premium is not honoured on the due date including grace period provided by the insurance company.

However the Indian life insurance companies carry out an analysis of lapsed unit-linked policies not likely to be revived and likely to be revived. For policies not likely to be revived, the insurance reserves are transferred to funds for future appropriation and then to the profit and loss account after a period of two years and for policies likely to be revived the insurance liabilities are still maintained though the policy has lapsed and the risk cover has expired.

It appears that the ED on insurance contracts would require the risk reserves to be derecognised as soon as the policy lapses. Only the deposit component would be maintained as a liability for such policies with corresponding investments.

Reinsurance

At initial recognition, a cedant measures reinsurance contract as the sum of:

  •     the present value of the fulfilment cash flows, which is made up of the expected present value of the cedant’s future cash inflows plus a risk adjustment less the expected present value of the cedant’s future cash outflows less any ceding commissions received; and


  •     a residual margin that eliminates any loss at inception of the contract.


The expected present value of losses from default by the reinsurer or coverage disputes are incorporated in the measurement of reinsurance assets.

The ED on insurance contract requires reinsurance assets and reinsurance liabilities to be shown separately.

However the current practice in India is that the insurance companies net-off the reinsurance receivable and payable and disclose only the net amount as receivable or payable, as the case may be.

Presentation in the statement of financial position and the statement of comprehensive income

Statement of financial position

The ED proposes that an insurer present each portfolio of insurance contracts as a single-line item within insurance contract assets or insurance contract liabilities. It also proposes that an insurer present a pool of assets underlying unit-linked contracts as a single- line item separate from the insurer’s other assets and that the portion of the liabilities linked to the pool be presented as a single-line item separate from the insurer’s other liabilities. Reinsurance assets are not offset against insurance contract liabilities.


Statement of comprehensive income

The ED proposes a presentation model that focuses on margins and other key insurance performance information. The ED proposes a new presentation for the statement of comprehensive income which follows the proposed measurement model. The underwriting margin is subject to disaggregation requirements (in the notes or on the face of the financial statements), disclosing the change in risk adjustment and release of the residual margin. The margin presentation requires insurers to treat all premiums as deposits and all claims and benefits as repayments to the policyholder. An insurer is expected to present at a minimum, the following items?:

  •     Change in the risk adjustments;


  •     The release of the residual margin during the period;


  •     The difference between the expected and the actual cash flows;


  •     Changes in estimates; and


  •     Interest on insurance liabilities.


Other items to be presented in the statement of comprehensive income include?: gains and losses at initial recognition (further disaggregated on the face or in the notes into losses at initial recognition of an insurance contract, losses on insurance contracts acquired in a portfolio transfer, and gains on rein-surance contracts bought by a cedant); acquisition costs that are not incremental at the level of an individual contract; experience adjustments and changes in estimates (further disaggregated on the face or in the notes into experience adjustments, changes in estimates of cash flows and discount rates, and impairment losses on reinsurance as-sets); and interest on insurance contract liabilities. Income and expense from unit-linked contracts are presented as a separate single-line item.

Premiums and claims generally are not presented in the statement of comprehensive income on the basis that they represent settlements of insurance contract assets or liabilities rather than revenues or expenses. However, for short-duration contracts subject to the alternative measurement approach for pre-claims liabilities, the underwriting margin is disaggregated into line items reflecting each of pre-mium revenues, claims and other expenses, amortisation of incremental acquisition costs and changes in additional liabilities for onerous contracts.

Presentation of insurance accounts by Indian insurance companies

The financial presentation format currently comprises the Revenue Account, Profit and Loss Account and Balance Sheet. The Revenue account contains all insurance-related captions and income earned from investments out of policyholders’ funds.?The?Profit and Loss account includes deficit funding if any, profit transfers from revenue account and investment income earned out of shareholders’ funds.

The proposed method of accounting is a complete paradigm shift as compared to the existing financial reporting model.

Disclosures:

To help users of financial statements understand the amount, timing and uncertainty of future cash flows arising from insurance contracts, extensive disclosures are required that include qualitative and quantitative information about the amounts arising from insurance contracts, including?: the reconciliation of contract balances; methods and inputs used to develop the measurements; and the nature and extent of risks arising from insurance contracts.

Currently the insurance disclosures are not very extensive for Indian insurance companies. The current actuarial disclosures merely give basic assumptions, interest rates and references to mortality and morbidity tables published by Life Insurance Corporation of India.

Effective date, transition and impact on other aspects:

The ED does not include an effective date for the proposals or state whether they may be adopted early. The IASB plans an additional consultation, in conjunction with the FASB, on the effective dates of these proposals and other proposed standards to be issued in 2011, including consideration of IFRS 9 Financial Instruments. The Board will con-sider delaying the effective date of IFRS 9 (annual periods beginning on or after 1 January 2013) if the new IFRS on insurance contracts has a mandatorily effective date later than 2013 so that an insurer would not have to face two major rounds of change in a short period.

Additionally, an insurer is exempt from disclosing previously-unpublished information about claims development that occurred earlier than five years before the end of the first financial year in which it applies the proposals. An insurer is required to disclose if it is impracticable to prepare information about claims development that occurred before the beginning of the earliest period presented.

The ED requires that an insurer should measure each portfolio of insurance contracts at the present value of the fulfilment cash flows, starting at the beginning of the earliest period presented. If there is a difference between the new measure-ment amount and the amount under the insurer’s previous accounting policies, the difference should be recognised in retained earnings.

The insurer also should derecognise any existing balances of deferred acquisition costs.

The transition requirements apply both to a first-time adopter of IFRS and to an insurer currently reporting under IFRS.

Example measurement of insurance contracts — Indian GAAP v. IFRS ED:

An insurer issues an insurance contract, receives Rs.50 as the first premium payment and incurs acquisition costs of Rs.70, of which incremental acquisition costs are Rs.40. The insurer estimates an expected present value (EPV) of subsequent premiums of Rs.950 and a risk adjustment of Rs.50. In the example the insurer estimates that the EPV of future claims is Rs.900.

Measurement under Indian GAAP

Particulars

 

Indian
GAAP

 

 

 

 

 

 

 

Premium

 

50

 

 

 

 

 

 

 

Acquisition costs

 

(70)

 

 

 

 

 

 

 

Policy liability reserve (Estimate)

 

(40)

 

 

 

 

 

 

 

Loss
at initial recognition

 

60

 

 

 

 

 

 

 

Liability
at initial recognition

 

(40)

 

 

 

 

 

 

 

Measurement under IFRS ED

 

 

 

 

 

 

 

 

Particulars

 

IFRS
ED

 

 

 

 

 

 

EPV of cash outflows

 

940

 

 

 

 

 

 

Risk adjustment

 

50

 

 

 

 

 

 

EPV of cash inflows

 

(1000)

 

 

 

 

 

 

Present value of the fulfilment

 

 

cash flows

 

(10)

 

 

 

 

 

 

Residual margin

 

10

 

 

 

 

 

 

Liability
at initial recognition

 

0

 

 

 

 

 

 

Loss
at initial recognition

 

 

(Non-incremental acquisition costs)

 

30

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Financial instruments : Disclosures — Practical application and challenges

Disclosures regarding Amalgamation

From Published Accounts

1 TV Today Network Ltd.
(31-3-2010)

From Notes to
Accounts :

Pursuant to the
Composite Scheme of Arrangement under the provisions of the Companies Act,
1956 (The Scheme), approved by the shareholders, sanctioned by the High Court
at Delhi and the Ministry of Information and Broadcasting on November 21,
2009, February 24, 2010 and May 20, 2010, respectively, the undertaking of the
radio broadcasting business of Radio Today Broadcasting Limited, a company
engaged in the radio broadcasting and trading business (the Transferor
Company), was transferred to and vested in the Company (the Transferee
Company) with effect from 1st April, 2009 (Appointed Date). ‘The Scheme’, a
copy of which was filed with the Registrar of Companies subsequent to the
year-end on 13th April, 2010, is an amalgamation in the nature of merger and
has been given effect to in these accounts under pooling of interest method.

In accordance
with ‘The Scheme’, the Company will issue 1,655,999 equity shares of Rs.5 each
as fully paid up to the equity shareholders of Radio Today Broadcasting
Limited, in the ratio of 1 equity share of Rs.5 each fully paid up of the
Company for every 6 equity shares of the face value of Rs.10 each fully paid
up, held in Radio Today Broadcasting Limited towards consideration for the
aforesaid transfer and vesting of radio business, which will be credited in
its books at face value, pending issuance of the shares as at the year-end,
the face value of Rs.8,279,995 has been credited to Share Capital Suspense.

In accordance
with ‘The Scheme’, all assets and liabilities pertaining to the radio
broadcasting business of the Transferor Company, as on the appointed date,
have been incorporated in the books of the Company at book value and the
excess of the Share Capital Suspense over the book value of net assets
acquired, amounting to
Rs.423,622,791, has been adjusted against Securities Premium Account of the
Company. The unamortised licence fees pertaining to the Transferor Company and
transferred to the Company pursuant to the Scheme, amounting to Rs.244,229,509
has also been adjusted against the Securities Premium Account. Further, the
Company has determined the deferred tax assets, amounting to Rs.249,529,332,
based on the assets and liabilities of the radio broadcasting business which
has been adjusted with the General Reserve Account.

The accounting
treatment in respect of excess of Share Capital Suspense over the book value
of net assets acquired and unamortised licence fee are different from that
prescribed by the Accounting Standard (AS) 14, Accounting for Amalgamations,
notified u/s.211(3C) of the Companies Act, 1956 with respect of Amalgamation
in the nature of Merger. AS-14 requires the difference between the amount
recorded as share capital and the amount of share capital of the transferor
company to be adjusted against reserve.

The difference
in accounting treatment as above, in compliance with the High Court Order, is
as permitted by paragraph 42 of the AS-14. As the said paragraph 42 of AS-14
requires disclosure of the impact of the amalgamation on all accounts, had the
accounting treatment as per AS-14 been followed, this is given below for
information.

Had the
accounting treatment prescribed in AS-14 been followed, amortisation of
intangible assets would have been higher by Rs.27,990,000 with its
consequential impact on the profit of the Company, General Reserve would have
been lower by Rs.423,622,791, Unamortised Licence Fees would have been higher
by Rs.216,239,509 and Share Premium Account would have been higher by
Rs.667,852,300.

2. Titagarh Wagons Ltd.
(31-3-2010)

From Notes to Accounts :

25. (a) Pursuant to a
Scheme of Amalgamation (the Scheme) sanctioned by the High Court of Calcutta
by order dated September 14, 2009, Titagarh Steels Limited (TSL) and Titagarh
Biotec Private Limited (TBPL) were amalgamated with the Company with effect
from April 1, 2009 (the appointed date). The amalgamation has been accounted
for under the Pooling of Interest Method as prescribed by the Institute of
Chartered Accountants of India (ICAI). TSL was in the business of
manufacturing of steel castings and TBPL was in the process of setting up
biotech business. The transferred companies carried on all their businesses
and activities for the benefit of and in trust for, the Company from the
Appointed Date. Thus, the profit or income accruing or arising to or
expenditure or losses arising or incurred by the transferred companies from
the Appointed Date are treated as the profit or income or expenditure or loss,
as the case may be, of the Company. The Scheme has accordingly been given
effect to in these accounts upon filing of certified copy of the Order of the
High Court at Calcutta on November 27, 2009 (the Effective Date).

(b) In terms of the
Scheme, the following assets and liabilities of TSL and TBPL have been
transferred to and stand vested with the Company at their respective book
values with effect from 1st April 2009:

 

 

(Rs. in lacs)

Particulars

TSL

TBPL

 

 

 

Fixed Assets (Net, including

1,804.35

Nil

Capital work in progress)

 

 

 

 

 

Current Assets, Loans and

 

 

Advances

4,858.09

2.09

 

 

 

Total Assets

6,662.44

2.09

 

 

 

Less
:

 

 

Current Liabilities and

 

 

Provisions

4,033.32

0.28

 

 

 

Loans

914.55

Nil

 

 

 

Total
Liabilities

4,947.87

0.28

 

 

 

Net
Assets

1,714.57

1.81

 

 

 

    c) The Company has issued 3,66,954 equity shares of Rs.10 each aggregating to Rs.36.70 lakhs to the shareholders of TSL on January 16, 2010, while in case of TBPL which was a wholly-owned subsidiary of the Company, all the shares held by the Company in TBPL were cancelled and extinguished.

    d) A sum of Rs.1288.85 lakhs being the difference between the amounts recorded as additional shares of the Company and the total share capital of TSL and TBPL has been adjusted and reflected as general reserve, instead of capital reserve as prescribed under Accounting Standard-14 in terms of the above court order.

    e) To make the accounting policies followed by TSL fall in line with those of the Company, a sum of Rs. 411.13 lakhs as on April 1, 2009 representing the impact of following accounting policy differences has been adjusted against General Reserve which as per Accounting Standard-5 should have been charged to Profit and Loss Account:

Particulars

Amount

 

(Rs. in lacs)

 

 

Depreciation

77.09

 

 

Liquidated damages (Net of Taxes)

334.04

 

 

Total

411.13

 

 

    f) Certain immoveable properties, investments, licences, contracts/agreements which were acquired pursuant to the above Scheme are in the process of registration in the name of the Company.

3    HCL Infosystems Ltd. (30-6-2010)
From Notes to Accounts:
    The Scheme of Amalgamation (‘Scheme’) for merging the wholly-owned subsidiary Natural Technologies Private Limited (NTPL) with the Company u/s.391 to u/s.394 of the Companies Act, 1956 sanctioned by the High Courts of Delhi and Rajasthan vide their respective orders dated 11-8-2008 and 29-5-2009 has come into effect on July 6, 2009 from the appointed date of 1-7-2008. On the scheme becoming effective NTPL stands dissolved without winding up in the previous year.

Pursuant to the Scheme:

The amalgamation of erstwhile NTPL with the Company was accounted for under the ‘pooling of interest method’ in the manner specified in the Scheme and complies with the Accounting Standard notified u/s.211(3C) of the Companies Act, 1956 and the following balances as at July 1, 2008 of erstwhile NTPL was adjusted with the profit and loss account forming part of reserves of the Company

 

(Rs. crores)

 

 

Assets

 

Fixed assets (including Capital

 

Work-in-progress Rs.0.80 crore)

4.09

 

 

Deferred Tax Assets

0.13

 

 

Sundry Debtors

3.34

 

 

Cash & Bank Balance

0.78

 

 

Other Current Assets

2.19

 

 

Loans & Advances

0.03

 

 

Total

10.56

 

 

Liabilities

 

Current Liabilities and Provisions

3.68

 

 

Secured Loan

1.52

 

 

Unsecured Loan

1.34

 

 

Total

6.54

 

 

Net
Assets acquired on

 

amalgamation
(a)

4.02

 

 

Transfer of balances of

 

Amalgamated Company

 

 

 

Securities Premium Account

0.45

 

 

Profit and Loss

0.55

 

 

Revaluation Reserve

2.54

 

 

Total
Reserves and Surplus (b)

3.54

 

 

Less
:

 

Adjustment for cancellation of

 

Company’s investment in Transferor

 

Company (c)

8.41

 

 

Shortfall
arising on Amalgamation

(7.93)

(a)
– (b) – (c) = (d)

 

 

 

Adjusted with :

 

— Revaluation Reserve

5.70

 

 

— Profit and Loss Account

2.23

 

 

Total

7.93

 

 


4. Godrej Consumer Products Ltd. (31-3-2010)
From Notes to Accounts:

    a) A Scheme of Amalgamation (‘the Scheme’) for the amalgamation of Godrej Consumer Biz Ltd. (GCBL) [a 100% subsidiary of Godrej & Boyce Manufacturing Company Ltd. (G&B)] and Godrej Hygiene Care Ltd. (GHCL) [a 100% subsidiary of Godrej Industries Ltd. (GIL)] together called ‘the Transferor Companies’, with Godrej Consumer Products Limited (the Transferee Company), with effect from June 1, 2009, (‘the Appointed Date’) was sanctioned by the High Court of Judicature at Bombay (‘the Court’), vide its Order dated October 8, 2009 and certified copies of the Order of the Court sanctioning the Scheme were filed with the Registrar of Companies, Maharashtra on October 15, 2009 (the ‘Effective Date’).

    b) The amalgamation has been accounted for under the ‘pooling of interests’ method as prescribed by AS-14 — Accounting for Amalgamations and the specific provisions of the Scheme. Accordingly, the Scheme has been given effect to in these accounts and all assets and liabilities of the Transferor Companies stand transferred to and vested in the Transferee Company with effect from the Appointed Date and are recorded by the Transferee Company at their book values as appearing the books of the Transferor Companies.

    c) The value of Net Assets of the Transferor Companies taken over the Transferee Company on Amalgamation are as under :
   

 

 

 

(Rs. in lac)

 

 

 

 

 

Particulars

GHCL

GCBL

Total

 

 

 

 

 

 

Investments in

 

 

 

 

Godrej Sara Lee

 

 

 

 

Limited

4,741.61

14,958.91

19,700.52

 

 

 

 

 

 

 

 

Cash and Bank

 

 

 

 

Balances

1.34

15.02

16.36

 

 

 

 

 

 

Loans and Advances

—

0.30

0.30

 

 

 

 

 

 

Advance Taxes Paid

—

1.03

1.03

 

 

 

 

 

 

Current Liabilities

 

 

 

 

and Provisions

(2.94)

(15.31)

(18.25)

 

 

 

 

 

 

Provision for taxes

—

(1.20)

(1.20)

 

 

 

 

 

 

Net Assets

4,740.01

14,958.74

19,698.76

 

 

 

 

 

 

    d) GCBL and GHCL held 29% and 20%, respectively, in Godrej Saralee Ltd., which is a 49 : 51 unlisted joint venture company between the Godrej Group and Saralee Corporation, USA. As a result of the amalgamation, Godrej Sara Lee Limited has become a joint venture between the Company and Sara Lee Corporation USA.

    e) In accordance with the Scheme of Amalgamation, the Company has issued and allotted 30,296,727 equity shares having a face value of Re.1 each to G&B and 20,939,409 equity shares having a face value of Re.1 each to GIL, being 10 equity shares in the Transferee Company for every 11 equity shares held by them in GCBL an GHCL, respectively, as consideration for the transfer. Consequently, the issued, subscribed and paid up equity shares capital of the Company stands increased to 308,190,044 equity shares having a face value of Re.1 each aggregating Rs.3,081.90 lac.

    f) The excess of book value of the net assets of the Transferor Companies taken over, amounting to Rs.18,455.25 lac, after adjusting the expenses and cost of the Scheme which amounted to Rs.731.15 lac, over the face value of shares issued as consideration to the Members of the Transferor Companies has been credited to the General Reserve as per the Scheme.

    g) Had the Scheme not prescribed the above treatment, the balance in Security Premium Account would have been higher by Rs.19,165.65 lac, investments would have been higher by Rs.731.15 lac, Capital Reserve would have been higher by Rs.51.24 lac, the Profit and Loss Account and the General Reserve would have been lower by Rs.30.50 lac and Rs.18,455.25 lac, respectively.

    h) Since the aforesaid Scheme of amalgamation of GCBL and GHCL with the Company, which is effective from June 1, 2009, has been given effect to in these accounts, the figures for the current year to that extent are not comparable with those of the previous year.

Illustration of an audit report containing large number of qualifications : Mahanagar Telephone Nigam Limited (31-3-2009)

Appeal to Appellate Tribunal : Fees : S. 2(45), S. 5 and S. 253(6) of Income-tax Act, 1961 : A.Y. 2003-04 : Total income determined at negative figure : Fees of Rs.500 alone is payable.

New Page 1

  1. Appeal to Appellate Tribunal : Fees : S. 2(45), S. 5 and S.
    253(6) of Income-tax Act, 1961 : A.Y. 2003-04 : Total income determined at
    negative figure : Fees of Rs.500 alone is payable.


[Gilbs Computer Ltd. v. ITAT, 317 ITR 159 (Bom.)]

For the A.Y. 2003-04 the assesse’s total income was
assessed at a loss of Rs.7,18,78,768. While filing appeal before the Tribunal
u/s.153 of the Income-tax Act, 1961 the assessee paid appeal fees of Rs.500.
The registry of the Tribunal communicated the defect inasmuch as the appeal
fee paid was less by Rs.9,500 and called upon the petitioner to rectify the
defect within 10 days. The petitioner did not pay the additional amount.
Therefore the Tribunal dismissed the petitioner’s appeal as unadmitted.

The Bombay High Court allowed the writ petition filed by
the assessee challenging the order of the Tribunal and held as under :

“(i) The expressions ‘more’ or ‘less’ in S. 253(6) of the
Act have to be given their natural meaning. Negative income cannot be
‘more’. It will always be less. In that event the language of Ss.(6)(a)
would be attracted. If the total income can be considered even to be a loss
then the absence of it will not be covered by either clause (a), (b) or (c)
of Ss.(6). It will be clause (d) of Ss.(6) which will apply.

(ii) The petitioner was not obliged to pay the fee in
excess of Rs.500. The petitioner had been admittedly assessed to loss. The
income computed was less than Rs.1,00,000 and, therefore, clause (a) of S.
253(6) would apply.

(iii) If on the other hand, one took the view that clause
(a), (b) or (c) would not apply as they postulate assessment of a positive
figure, only clause (d) would apply and, even so, the fee payable would be
Rs.500. The petitioner was right in paying court fee of Rs.500.”

 



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Prosecution : Willful attempt to evade tax and false verification : S. 276C and S. 277 : Firm : Partners liability : Failure by prosecution to adduce evidence to show partners had active role in business : Trial Judge acquitting accused : Proper.

New Page 1

21 Prosecution : Willful attempt to evade
tax and false verification : S. 276C and S. 277 of Income-tax Act, 1961 : A.Y.
1981-82 : Firm : Partners liability : Failure by prosecution to adduce evidence
to show partners had active role in business : Trial Judge acquitting accused :
Proper.


[UOI v. Nalinidevi and another, 304 ITR 382 (MP)]

The accused in this case were partners of the assessee firm.
The two accused set up the defence that they being only housewives were not in
charge of the business of the firm. On the basis of the evidence led by the
prosecution, the trial judge found that the two individual members of the firm
were not guilty of any offence and as such they were acquitted.

 

The Madhya Pradesh High Court dismissed the appeal filed by
the Revenue and held as under :

“(i) Every partner of the firm is an agent and thus
vicariously liable, but that liability is restricted only to civil liability
and does not extend to criminal liability. The burden is always upon the
prosecution to prove that the accused person had an active role to play in the
business of the firm.

(ii) As the prosecution had failed to adduce any evidence to show that the
acquitted women had any active role to play in the business of the firm, the
Trial Court had no option but to acquit the accused members of the firm.”

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Prosecution : Delay in filing return and false statement : S. 276CC and S. 277 : No evidence that delay was willful : Acquittal by criminal court : High Court would not interfere merely because another view possible.

New Page 1

20 Prosecution : Delay in filing return and
false statement : S. 276CC and S. 277 of Income-tax Act, 1961 : A.Y. 1981-82 :
No evidence that delay was willful : Acquittal by criminal court : High Court
would not interfere merely because another view possible.


[UOI v. Dinesh, 304 ITR 345 (MP)]

For the A.Y. 1981-82 the assessee accused had filed the
return of income disclosing income of Rs.52,997. Thereafter the assessee filed a
revised return on 16-4-1983. On a complaint filed by the Department for offences
u/s.276CC and u/s.277 of the Income-tax Act, 1961 the Trial Court acquitted the
accused assessee.

 

The Department filed appeal before the Madhya Pradesh High
Court. The case of the prosecution was that in accordance with S. 139 of the
Income-tax Act, 1961 the return was not filed in time, but was filed after a
lapse of almost about 20 months. It was submitted that in both the returns the
income was not shown correctly and, therefore, the accused has committed
offences punishable u/s.276CC and u/s.277 of the Act. It was also submitted that
the Court below took a hyper-technical view of the matter and wrongly acquitted
the accused.

 

The Madhya Pradesh High Court dismissed the appeal and held
as under :

“(i) In the matter of Narayan v. UOI, (1994) 208 ITR
82, this Court has observed that if except the length of delay, there is
nothing on the record and there does not appear to be any willful default,
then the Court would not be unjustified in acquitting the accused. In the said
matter, the appellant-accused was convicted by the lower Court, but the High
Court after finding that there was no willful default acquitted the accused.
The High Court has also observed that mere failure to file the return in time
in itself would not be sufficient, but the burden is upon the Department to
prove that non-action or inaction was a willful default.

(ii) In the present case, the Court below after giving its
anxious consideration to the facts of the case has come to the conclusion that
there was no willful default on the part of the accused. It would be trite to
say that the High Court would not interfere in an acquittal simply because yet
another view is possible.”


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Income or capital receipt : S. 4 of Income-tax Act, 1961 : A.Y. 2004-05 : Assessee built temple of Goddess Adhiparasakthi : Devotees offered gifts to assessee on birthday : Gift amount not income : Not taxable.

New Page 1

Reported :

19. Income or capital
receipt : S. 4 of Income-tax Act, 1961 : A.Y. 2004-05 : Assessee built temple of
Goddess Adhiparasakthi : Devotees offered gifts to assessee on birthday : Gift
amount not income : Not taxable.

[CIT v. Gopala Naicker
Bangaru, 193 Taxman 71 (Mad.)]

As per profile submitted by
the assessee, he was born in a village. During his childhood, Goddess
Adhiparasakthi frequented his dreams to make it known that she wanted a temple
to be built to alleviate the sufferings of humanity and, accordingly, the
assessee had built a temple which was also known as ‘Sakthi peedam’. Out of
love, and affection and veneration, the devotees of the temple used to assemble
in great numbers on the eve of the assessee’s birthday and offer gifts. The
amounts of gifts so received by the assessee were shown as capital receipts in
his balance sheet. The Assessing Officer treated the gifts as having
nexus to his profession as a religious head and assessed the amount as income.
The Tribunal deleted the addition.

On appeal by the Revenue the
Madras High Court upheld the decision of the Tribunal and held as under :

“(i) In the instant case,
the assessee, as a religious head, was not involving himself in any profession
or vocation and also not performing any religious rituals/poojas for his
devotees for some consideration or the other. In fact, he was doing charitable
and spiritual work and made his devotees to follow the same for the benefit of
the mankind.



(ii) The devotees out of natural love,
affection and veneration used to assemble in large numbers on the birthdays of
the assessee and voluntarily made gifts, and by any stretch of imagination, it
could not be said that the amounts received by the assessee by way of gifts
would amount to vocation or profession. It was not the case of the Department
that the devotees were compelled to make gifts on the occasion of the
assessee’s birthday. The amounts/gifts received by the assessee could not be
said to have any direct nexus with any of his activities as a religious
person/head.

(iii) Moreover, in the
assessee’s own case in the A.Y. 1988-89, the Department had accepted the
position that gifts received by him on birthdays and other occasions were not
taxable. Since, there was no change in facts and law in the instant case, the
reasons assigned by the Tribunal were correct and there was no infirmity or
error apparent on the face of record in the impugned order.”


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Educational institution : Exemption u/s. 10(23C(vi) of Income-tax Act, 1961 : A.Ys. 2000-01 to 2007-08 : Tests to be applied similar to S. 10(22) : Generation of surplus not a bar : Surplus to be applied to the educational objects of assessee : No distinc

New Page 1

Reported :

18. Educational institution
: Exemption u/s. 10(23C(vi) of Income-tax Act, 1961 : A.Ys. 2000-01 to 2007-08 :
Tests to be applied similar to S. 10(22) : Generation of surplus not a bar :
Surplus to be applied to the educational objects of assessee : No distinction
between revenue expenditure and capital expenditure.

[Pinegrove International
Charitable Trust v. UOI, 327 ITR 73 (P&H)]

The assessee was running a
school. For the relevant years, the assessee was granted exemption
u/s.10(23C)(vi) of the Income-tax Act, 1961. The exemption was then withdrawn by
the Chief Commissioner on the ground that the profits were substantial and arose
year after year and stating that if substantial profits were earned in one year,
it should be the duty of the institution to lower its fees for the subsequent
year so that such profits were not intentionally generated.

The Punjab and Haryana High
Court allowed the writ petition filed by the assessee and held as under :

“(i) Merely because
profits have resulted from the activity of imparting education that would not
change the character of the institution existing solely for educational
purposes.

(ii) The words ‘not for
the purposes of profit’ accompanying the words ‘existing solely for
educational purposes’ have to be read and interpreted in view of the third
proviso to S. 10(23C)(vi), which prescribes the methodology for the
utilisation and accumulation of income at the hands of the educational
institutions.

(iii) Both on principle
and precedent the capital expenditure is to be deducted from the gross income
of the educational institutions.

(iv) The interpretation of
the Chief Commissioner that there had to be a reasonable profit, only and only
then can an institution be said not to exist solely for the purposes of
profit, was totally a misconception of law.

(v) The Chief Commissioner
failed to keep in view the third proviso while wrongly holding that since
substantial profits were being earned year after year it could not be said
that the surplus was arising incidentally and, therefore, the assessee was not
entitled to exemption.

(vi) The methodology
adopted by the Chief Commissioner while computing surplus in not deducting the
capital expenditure incurred by the assessee from the gross income was
contrary to the third proviso to S. 10(23C)(vi) of the Act. Admittedly, in the
case of the assessee the application of income for the attainment and
achievement of the objects in the last three years, was more than 100%. The
assessee could not be held to be an institution existing for the purpose of
making profit so as not to be entitled to exemption in view of the provisions
of S. 10(23C)(vi) of the Act.”

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Business expenditure : Disallowance u/s.43B of Income-tax Act, 1961 : Luxury tax deferral scheme : Benefit under CBDT Circular Nos. 496 and 674 with reference to sales tax should be given for luxury tax also.

New Page 6

17. Business expenditure :
Disallowance u/s.43B of Income-tax Act, 1961 : Luxury tax deferral scheme :
Benefit under CBDT Circular Nos. 496 and 674 with reference to sales tax should
be given for luxury tax also.


[CIT v. Eastbourne Hotels
(P) Ltd., 233 CTR 86 (HP)]

The assessee had claimed
that in view of the luxury tax deferral scheme the payment of luxury tax be
deemed to be made in the year in which it fell due and accordingly requested not
to make any disallowance of luxury tax u/s.43B of the Income-tax Act, 1961. The
Assessing Officer disallowed the claim. The Tribunal allowed the assessee’s
claim.

On appeal by the Revenue,
the Himachal Pradesh High Court upheld the decision of the Tribunal and held as
under :

“(i) The argument of the
Revenue that the CBDT Circular Nos. 496 and 674 make reference to the Sales
Tax Act only and not to luxury tax and, therefore, do not cover the luxury tax
deferral scheme is wholly without force. Deferral schemes for grant of
incentives whether under the Sales Tax Act or any other Act have the same
effect. The purpose is to encourage the industry. The Circulars issued by the
CBDT relate to the manner in which S. 43B has to be interpreted. This
interpretation has to be consistent for every tax deferral scheme and the
interpretation cannot change from Act to Act.

(ii) The CBDT has not
granted any exemptions from the provisions of S. 43B, but has held that if its
instructions are complied with then it will be deemed that the requirements of
S. 43B has been met. This will be applicable across the board to all Acts and
cannot be limited only to the Sales Tax Acts.

(iii) However, before
taking the benefit of the deferral scheme the assessee must produce before the
Assessing Officer the requisite certificates showing that it is covered under
the deferral scheme.”

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Business expenditure : S. 37(1) of Income-tax Act, 1961 : A.Y. 2004-05 : Assessee a cine artist : Expenditure relating to fans association is deductible business expenditure.

New Page 1

Reported :

16. Business expenditure :
S. 37(1) of Income-tax Act, 1961 : A.Y. 2004-05 : Assessee a cine artist :
Expenditure relating to fans association is deductible business expenditure.

[CIT v. A. Vijayakant,
234 CTR 103 (Mad.)]

The assessee is a popular
cine actor. For the A.Y. 2004-05, the assessee had claimed a deduction of
Rs.20,19,000 towards Rasigar Manrams (fans associations) expenses. The Assessing
Officer rejected the claim. The CIT(A) noticed that for the A.Ys. 2001-02 to
2003-04, 80% of the claim was allowed. The CIT(A) therefore restricted the
disallowance to 20%. The Tribunal upheld the order of the CIT(A).

On appeal by the Revenue,
the Madras High Court upheld the decision of the Tribunal and held as under :

“(i) It is a well-known
fact that popular cine artists promote their Rasigar Manrams for the purpose
of promoting their films among the public at large. For that purpose when it
is claimed that substantial amount was spent towards dress, food, etc., at the
time of release of new films as well as for regular maintenance of the Rasigar
Manram activities, it cannot be held that it was not part of their
professional activities, namely, acting in cine field.

(ii) Therefore, the
perception of the CIT(A), which found favour with the Tribunal, cannot be
faulted.

(iii) The appeal fails and
the same is dismissed.”

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Appeal to High Court : Power and duty : S. 260A of Income-tax Act, 1961 : Where a substantial question of law arises, a party should not be denied to raise that question of law at the time of final hearing on the ground that such question was not framed a

New Page 1

Reported :

15. Appeal to High Court :
Power and duty : S. 260A of Income-tax Act, 1961 : Where a substantial question
of law arises, a party should not be denied to raise that question of law at the
time of final hearing on the ground that such question was not framed at stage
of admission of appeal.

[Ankita Deposites and
Advances (P) Ltd. v. CIT, 193 Taxman 36 (HP)]

In this case, the question
before the Himachal Pradesh High Court was as to whether a party can be
permitted to raise a substantial question of law at the time of final hearing,
which has not been framed earlier.

The High Court held as under
:

“(i) A bare reading of S.
260A clearly shows that an appeal to the High Court u/s.260A can only be filed
if a substantial question of law is involved in the appeal. It is the duty of
the High Court to frame the substantial questions of law at the time of the
admission of the appeal. In terms of Ss.(4) of S. 260A, normally, the appeal
should only be heard on the question of law so formulated and the respondent
would have a right to urge that the question so framed is not a substantial
question of law or the question so framed does not arise in the appeal.

(ii) However, the proviso
to this sub-section clearly lays down that nothing in sub-section shall in any
manner impinge on the right of the Court to hear, for the reasons to be
recorded, the appeal on any other substantial question of law not framed by
it, if it is satisfied that the case involves such a question.

(iii) It is the duty of
the Court to do justice and in case a substantial question of law arises, it
would be extremely unfair not to permit the party to raise the substantial
question of law only on the ground that such substantial question of law was
not framed at the stage of admission of the appeal.”

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AOP : Share of member in AOP : S. 86 r/w S. 40(ba), of Income-tax Act, 1961 : Assessee-company member of AOP : No bar on company member from getting benefits of S. 86.

New Page 1

Reported :

14. AOP : Share of member in
AOP : S. 86 r/w S. 40(ba), of Income-tax Act, 1961 : Assessee-company member of
AOP : No bar on company member from getting benefits of S. 86.

[CIT v. Ideal
Entertainment (P) Ltd., 194 Taxman 81 (Mad.)]

The assessee-company was a
member of an association of persons (AOP). The assessee claimed exemption of
interest received from AOP u/s.86 of the Income-tax Act, 1961. The Assessing
Officer disallowed the claim on the ground that the provisions of S. 86 of the
Income-tax Act, 1961 can be made applicable only to the assessee who is not a
company or co-operative society. On a consideration of S. 86 and comparing the
same with S. 40(ba) the Tribunal allowed the assessee’s claim and held that
there is no bar for the assessee to claim the benefits provided thereunder.

On appeal by the Revenue,
the Madras High Court upheld the decision of the Tribunal and held as under :

“(i) A perusal of S. 86
would clearly show that in the case where the assessee is a member of
association of persons, income-tax was not to be payable by the assessee in
respect of his share in the income of the association or body in the manner
provided u/s.67A of the Act. The exclusion provided under the Section that
other than the company or the co-operative society or a society registered
under the Societies Registration Act, 1860 would be made applicable only to
the association of persons or a body of individuals and not to the member. In
other words, if the association of persons or a body of individuals happened
to be a company or a co-operative society or a society registered under the
Societies Registration Act, 1860 then in such an eventuality the member, who
is also an assessee is not entitled to get the benefits provided u/s.86 of the
Act.

(ii) Further, a reading of
S. 40(ba) of the Act would also make it clear that the share of the assessee
under the income of association of persons shall not be taxable. Hence, a
combined reading of the abovesaid provisions would make it clear that there is
no bar for a private company like the assessee from getting the benefits of S.
86 of the Act.”

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BCAS recognises Challenges of change . . . . helps members stay ahead !

History

The Bombay Chartered Accountants’ Society (BCAS) has entered
its Diamond Jubilee year. Founded by seven visionaries 59 years ago, it is an
institution with a membership of around 8000 members, from the entire length and
breadth of the country.

During these six decades, India has been transformed, from an
impoverished nation after 150 years of the British Raj to being a country which
the whole world looks at as a global player. It is on the threshold of becoming
an economic super power. In the economic meltdown through which the world is
passing today, it is a country that will possibly be the least affected. In
these 60 years, the profession has faced many challenges. The Society’s role has
been to help members meet these challenges and remain ahead. This write up is
not an attempt to trace the Society’s history, for that would require a separate
publication; but the endeavour is to place before you how the Society has been
in sync with the theme of this conference ‘Challenges of change — always ahead.’

BCAS — An educational institution striving for excellence :

BCAS is an educational institution. It has to its credit many
firsts in the field of member education. It held its first seminar on taxation
in the year 1960. The Direct Tax refresher course, where participants heard
speakers on various topics of current significance was organised in 1968 where
400 participants enrolled.

Residential refresher courses :

BCAS is the first organisation that recognised that a course
where members would learn together in an informal atmosphere would not only
enhance learning but would create a bond between members. To meet this
objective, the Society, commencing from 1969, has organised 41 residential
refresher courses (RRC) to date. These have witnessed many new endeavours with a
record 610 participants for the 35th RRC, and a course wherein all papers were
with case studies as the concept. The RRC remains till date one of the most
sought after events.

The concept of learning and bonding has become so popular
that, the Society organises a separate residential course on international
taxation titled ‘International Tax & Finance conference’. With service tax
continuously increasing in its scope, the indirect tax committee also organises
a separate residential refresher course in the area of indirect taxes.

Journal :

The Bombay Chartered Accountant Journal (BCAJ) is the
flagship of the Society. It is a journal respected by every professional. Its
publication commenced in 1969, and is in its 40th year of publication. It has a
circulation of over 12000. It caters to every need of a Chartered Accountant. It
covers the entire gamut of taxation, corporate laws, and economic legislation.
Different features are added to the journal to ensure that it retains its
utility to the professional.

Referencer and Diary :

A chartered accountant has to advise his clients on a number
of laws and regulations. The compliance with these provisions is made by
different due dates. To enable him to discharge his duties, the Society brings
out a Referencer & Diary. It is the most sought after pub-lication and is used
by more than 10000 professionals.

Other publications :

The Society has over 250 publications to its credit, many of
them the first of their kind. When tax audit was introduced in 1984, the Society
published a Tax audit manual which was revised in 2004. Its audit checklist is
extremely popular with users. When transfer pricing came on the scene, it
published a transfer pricing manual which is now revised. As India emerged on
the global scene, it arranged with OECD to make their publications available to
its members. After service tax was introduced in 1994, it published a number of
publications on that subject.

Technology absorption :

The Society is deeply conscious that it is essential to
harness technology to cater to the increasing expectations of members. Paucity
of time and space has made the utilisation of information technology imperative.
The Society maintains a vibrant website. It has recently launched two e-learning
modules. Conscious of the need to have a working knowledge of information
technology, to update knowledge, the Society organises a course on computer
training for its senior members. It has made available to members its journal
for the past years on a CD, with search facility.

Long term duration courses :

It was recognised that in order to enable members to attain
the requisite expertise in emerging areas, knowledge imparted at lectures,
seminars and workshops was inadequate. The Society therefore organised,
structured long duration courses. The subjects covered were, internal audit,
business consultancy, arbitration and conciliation.

The concept of corporate governance required independent
directors on the boards of listed companies. Considering this opportunity, a
long-term course on independent directors was organised. The course was so
popular that a special programme for the armed forces was also arranged.

In the field of international taxation, a long-term course on
Double Tax Avoidance agreements is organised on a regular basis.

The primary objective of the Society has been the spread of
knowledge. Its programmes whenever felt necessary, are arranged also for persons
other than CAs. The Society has organised programmes for the Regional Training
Institute of Direct Taxes where training is imparted to income tax officials.

Realising that the training/knowledge imparted up to the
stage of graduation was insufficient, the Society designed a course titled
‘Professional Accountant’. The course is immensely popular and six such courses
have been conducted.

Research :

The Society has a permanent research committee, which has
also published a number of publications on off-beat subjects. Recently the
committee has decided to arrange a programme to guide chartered accountants
about how to obtain a PhD.

Initiatives for students :

The Society recognised early that students are the future of the profession. It has always strived to cater to their needs. In 1963, it had student observers during seminars, to introduce students to this method of learning. Since 1974 it started publishing a students’ diary. It holds a number of programmes for students, including a crash course to enable them to understand and appreciate the nuances of each subject. The course is organised jointly with the Western India Regional Council of the Institute of Chartered Accountants of India. In June 2008; it launched a students’ forum to make available a platform to students.

Making members better citizens:

The BCAS visionaries were  of the view that  it is not sufficient that a member becomes a competent professional, but it is necessary that he becomes a good citizen and a compassioriate human being. The Human resources development committee runs programmes with a goal to make members part of happier families. It arranges public speaking courses, leadership camps which aspire to make members complete human beings.

Service to general public:

The Society is always in the forefront in rendering service to citizens. Each year it publishes a lucid analysis of the finance bill in four languages, English, Hindi, Gujarati and Marathi. It makes representations to the authorities when any change in legislation is unfair or unjust to the citizens. Whenever administrative actions create hardships for the tax paying public, the Society interacts with the administrators in an attempt to mitigate those hardships. The Society published a booklet on Survey, search and seizure, with an emphasis on the rights of citizens during surveyor search.

Aware that social organisations are not easily able to avail of professional assistance, it runs a charitable trust clinic, where experts address the problems faced by charitable institutions and their trustees.

BCAS Foundation:

The BCAS is aware of the obligations that a professional has towards society, not as a professional, but as a citizen. It therefore started the BCAS foundation, an independent charitable trust. The foundation helped victims of the tsunami disaster. The endeavour is to launch many projects which will be of utility to the public.

Right to Information Act 2005:

The Society supports a clinic which guides the members of the public as to how the Act can be used to solve their problems. It runs a special feature in the journal on the Right to Information Act.

Conclusion:

The Society has always attempted to be an organisation with a difference. Many of its endeavours have been emulated by other organisations. The Society is happy that it has been able to bring into the public domain, a fund of knowledge and its efforts have helped members, students and citizens.

The goal of the Society in the coming years will be to spread an awareness of its activities so that more people can benefit from the same. For achieving its objectives the Society has been ever willing to change. The aim is constant improvement with the ultimate goal of perfection. The Society believes in what Winston Churchill said, “To improve is to change; to be perfect is to change often”.

Exemption — Amount received by employees of Reserve Bank of India opting for Optional Early Retirement scheme was eligible for exemption u/s.10(10C).

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Exemption — Amount received by employees of Reserve Bank of
India opting for Optional Early Retirement scheme was eligible for exemption
u/s.10(10C).


[Chandra Ranganathan and Others v. CIT, (2010) 326 ITR
49 (SC)]

The appeals before the Supreme Court were directed against
the order passed by the High Court in several tax appeal cases where the
question involved was with regards to the deduction available to the appellants
u/s.10(10C) of the Income-tax Act, 1961. The order of the Commissioner of
Income-tax (Appeals)-IV, Chennai, relating to the A.Y. 2004-05, was questioned
before the Income-tax Appellate Tribunal, Chennai Bench, which were
disposed of by the Tribunal upholding the claim for deduction made by the
appellants. The same was the subject-matter of the tax appeal cases before the
High Court, which referred to the order of the Appellate Tribunal on the basis
of letter F. No. 225/74/2005-ITA-II, dated October 20, 2005, of the Central
Board of Direct Taxes so far as the Reserve Bank of India was concerned. The
High Court held that having regard to the above letter of the Central Board of
Direct Taxes, the amount received by the employees of the RBI opting for
Optional Early Retirement Scheme did not qualify for deduction u/s.10(10C) of
the aforesaid Act.

During the course of hearing of the appeals, it was brought
to the notice of the Supreme Court that by the subsequent letter dated May 8,
2009, issued by the Central Board of Direct Taxes, it was indicated that the
matter had been reviewed on the basis of the judgment of the Bombay High Court
dated July 4, 2008, in the case of CIT v. Koodathil Kallyatan Ambujakshan,
(2009) 309 ITR 113 (Bom.); and it was held that amount received by the retiring
employees of the RBI would be eligible for exemption under the aforesaid
provisions of the Income-tax Act. On behalf of the Union of India and the
Commissioner of Income-tax, the respondent herein, it was submitted that in view
of the said Circular, the respondent would allow the benefit of deduction to the
appellants u/s.10(10C) of the Income-tax Act, 1961, as far as the retired
employees of the Reserve Bank of India were concerned.

Having regard to the above, the Supreme Court held that the
appeals had succeeded and were allowed. The impugned order passed by the High
Court was set aside and that of the Tribunal was restored.

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Business expenditure — Differential payment to cane-growers — Matter remanded.

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Business expenditure — Differential payment to cane-growers —
Matter remanded.


[DCIT v. Shri Satpuda Tapi Parisar SSK Ltd., (2010)
326 ITR 42 (SC)]

The Supreme Court after considering the contentions of the
parties at length was of the view that a large number of questions had remained
unanswered in the case and the following questions were required to be
considered by the Department :

Whether the differential payment made by the assessee(s) to
the cane-growers after the close of the financial year or after the balance
sheet date would constitute an expenditure u/s.37 of the Income-tax Act, 1961,
and whether such differential payment would, applying the real income theory,
constitute an expenditure or distribution of profits?

In deciding the above questions, the Assessing Officer will
take into account the manner in which the business works, resolutions of the
State Government, the modalities and the manner in which the S.A.P. and the
S.M.P. are decided, the time difference which will arise on account of the
difference in the accounting years, etc. In a given case, if the assessee has
made provision in its accounts, then the Assessing Officer shall enquire whether
such provision is made out of profits or from gross receipts and whether such
differential payment is relatable to the cost of the sugarcane or whether it is
relatable to the division of profits amongst the members of the society ?

Another point which would also arise for determination by the
Assessing Officer will be on the theory of overriding title in the matter of
accrual or application of income. Therefore, in each of these cases, the
Assessing Officer will decide the question as to whether the obligation is
attached to the income or to its source.

The Supreme Court observed that none of these questions were
examined by the authorities below. These questions were required to be examined
because, in these cases, it was not only concerned with the applicability of S.
40A(2) of the Act, but was primarily required to consider whether the said
differential payments constituted an expense or distribution of profits. The
Supreme Court held that ordinarily it would not have remitted these matters,
particularly when they were for the A.Y. 1992-93, but, for the fact that this
issue was going to arise repeatedly in future. It would also help the
assessee(s) in a way that they would have to re-write their accounts in future
depending upon the outcome of this litigation. Therefore, in the interest of
justice, the Supreme Court remitted the cases to the concerned Commissioner of
Income-tax (Appeals). It was made clear that both parties were at liberty to
amend their pleadings before the Commissioner of Income-tax (Appeals). The
Supreme Court expressed no opinion on the merits of the case. The parties were
at liberty to argue their respective points uninfluenced by any observations
made in the impugned judgments on the applicability of S. 28 or S. 37 of the
Act.

[Note : Decision of the Bombay High Court in CIT v.
Manjara Shetkari Sahakri Karkhana Ltd., (2008) 301 ITR 191 (Bom.) set aside
and matter remanded.]

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Deduction of Tax at source — When 85% of the fish catch is received after valuation in India by the non-resident company, the same is chargeable to tax in India — Tax ought to have been deducted at source on such value.

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Deduction of Tax at source — When 85% of the fish catch is
received after valuation in India by the non-resident company, the same is
chargeable to tax in India — Tax ought to have been deducted at source on such
value.


[Kanchanganga Sea Foods Ltd. v. CIT & ITO & Ors.,
(2010) 325 ITR 540 (SC)]

The appellant M/s. Kanchanganga Sea Foods Limited, a company
incorporated in India, engaged in sale and export of seafood had obtained a
permit to fish in the exclusive economic zone of India. To exploit the fishing
rights, the appellant-company (hereinafter referred to as the ‘assessee’)
entered into an agreement dated March 7, 1990 chartering two fishing vessels,
i.e., two pairs of Bull trawlers, with Eastwide Shipping Co. (HK) Ltd., a
non-resident company incorporated in Hong Kong.

According to terms of the agreement, the Eastwide Shipping
Co. (HK) Ltd., the owner of the fishing trawlers (hereinafter referred to as the
‘non-resident company’) was to provide fishing trawlers to the assessee for an
all inclusive charter fee of US $ 600,000 per vessel per annum. In terms of the
agreement, the assessee was to receive Rs.75,000 or 15% of the gross value of
catch, whichever was more. The charter fee was payable from earning from the
sale of fish and for that purpose, 85% of the gross earning from the sale of
fish was to be paid to the non-resident company.

Necessary permission to remit 85% of the gross earning from
the sale of fish towards charter fee was granted by the Reserve Bank of India.
As per the agreement, the trawlers were to be delivered at the Chennai Port for
commencement of fishing operation.

The trawlers were delivered to the assessee with full
equipment and complements of staff at the Chennai Port. Actual fishing
operations were done outside the territorial waters of India but within the
exclusive economic zone. The voyage commenced and concluded at the Chennai Port.
The catch made at the high seas was brought to Chennai, where the surveyor of
the Fishery Department verified the log books and assessed the value of the
catch over which local taxes were levied and paid. The assessee, after paying
the dues, arranged customs clearance for the export of fish and the trawlers
which were used for fishing, carried the fish to destination chosen by
non-resident company. The trawlers reported back to the Chennai Port after
delivering fishes to the destination and commenced another voyage. The assessee
did not deduct tax from the payments to the non-resident company, nor produced
any clearance certificate during the A.Ys. 1991-92 to 1994-95. Notice u/s.
201(1) of the Income-tax Act was issued to it to show cause as to why it should
not be deemed to be an assessee in default in relation to tax deductible but not
deducted. The assessee filed objection contending that the non-resident company
did not carry out activities or operations in India which had the effect of
resulting in accrual of income in India and hence it was not obliged to make any
deduction. Alternatively, it contended that even if the operation of bringing
the catch to India Port for customs appraisal and export to the non-resident
company resulted in an operation, it was an operation for mere purchase of goods
and, therefore, there was no income liable for assessment. It also contended
that even if 85% of the catch was considered as charter fee to the non-resident
company, it was paid outside India. Accordingly, the plea of the assessee was
that where the entire income is not taxable, there is no obligation to deduct
tax at source. The Income-tax Officer considered the objections raised by the
assessee and finding the same to be untenable, rejected the same.

On appeal by the assessee, the Deputy Commissioner of
Income-tax (Appeals) declined to
interfere and affirmed the order of the Income-tax Officer.

The assessee unsuccessfully preferred appeal before the
Income-tax Appellate Tribunal.

The High Court answered all the questions referred to it
against the assessee and in favour of the Revenue.

The Supreme Court held that from a plain reading of the provisions of S. 5(2), it was evident that total income of a non-resident company shall include all income from whatever source derived, received or deemed to be received in India. It also includes such income which either accrues, arises or is deemed to accrue or arise to a non-resident company in India. The legal fiction created has to be understood in the light of the terms of contract. Here, in the present case, the chartered vessels with the entire catch were brought to the Indian Port, the catch was certified for human consumption, valued, and after customs and port clearance, the non-resident company received 85% of the catch. So long as the catch was not apportioned, the entire catch was the property of the assessee and not of the non-resident company, as the latter did not have any control over the catch. It was after the non-resident company was given share of its 85% of the catch, it did come within its control. It is trite to say that to constitute income the recipient must have control over it. Thus, the non-resident company effectively received the charter fee in India. Therefore, the receipt of 85% of the catch was in India and this being the first receipt in the eye of law and being in India, would be chargeable to tax. According to the Supreme Court, the non-resident company having received the charter fee in the shape of 85% of the fish catch in India, the sale of fish and realisation of the sale consideration of fish by it outside India shall not mean that there was no receipt in India. When 85% of the catch is received after valuation by the non- resident company in India, in sum and substance, it amounts to receipt of value of money. Had it not been so, the value of the catch ought to have been the price of which the non-resident company sold at the destination chosen by it. According to the terms and conditions of the agreement, charter fee was to be paid in terms of money, i.e., U.S. dollar 600,000 per vessel per annum “payable by way of 85% of gross earning from the fish sales”. In view of the above, there was no escape from the conclusion that the income earned by the non-resident company was chargeable to tax u/s.5(2) of the Income-tax Act.

Therefore, the assessee was liable to deduct tax u/s.195 on payment made to non-resident company and admittedly it having not deducted and deposited was rightly held to be in default u/s.201.

Income — S. 94(7) applies to transactions entered into after its insertion vide Finance Act, 2001 w.e.f. April 1, 2002.

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Income — S. 94(7) applies to transactions entered into after
its insertion vide Finance Act, 2001 w.e.f. April 1, 2002.


[CIT v. Walfort Share and Stock Brokers P. Ltd.,
(2010) 326 ITR 1 (SC)]

The assessee, a member of the Bombay Stock Exchange, earned
income mainly from share trading and brokerage. During the financial year
1999-2000, relevant to the A.Y. 2000-01, the Chola Freedom Technology Mutual
Fund came out with an advertisement stating that tax-free dividend income of 40%
could be earned if investments were made before the record date, i.e.,
March 24, 2000. The assessee by virtue of its purchase on March 24, 2000 became
entitled to the dividend on the units at the rate of Rs. 4 per unit and earned a
dividend of Rs. 1,82,12,862.80. As a result of the dividend payout, the NAV of
the said mutual fund which was Rs. 17.23 per unit on March 24, 2000, at which
rate it was purchased, stood reduced to Rs. 13.23 per unit on March 27, 2000,
which was the succeeding working day in the stock exchange. This fall in the NAV
was equal to the amount of the dividend payout. The assessee sold all the units
on March 27, 2000 at the NAV of Rs. 13.23 per unit and collected an amount of Rs.
5,90,55,207.75. The assessee also received an incentive of Rs. 23,76,778 in
respect of the said transaction. Thus, the assessee thereby received back Rs.
7,96,44,847 (Rs. 1,82,12,862.80 + Rs. 5,90,55,207.75 + Rs. 23,76,778) against
the initial payout of Rs. 8,00,00,000. For income-tax purposes, the assessee in
its return, claimed the dividend received of Rs. 1,82,12,862.80 as exempt from
tax u/s.10(33) of the Income-tax Act, 1961 (‘the Act’) and also claimed a
set-off of Rs. 2,09,44,793 as loss incurred in the sale of the units, thereby
seeking to reduce its overall tax liability.

The Assessing Officer in his assessment order dated March 21,
2003, accepted that the dividend income amounting to Rs. 1,82,12,862.80 was
exempt u/s.10(33) of the Act. However, the Assessing Officer disallowed the loss
of Rs. 2,09,44,793 claimed by the assessee, inter alia, on the ground
that a dividend stripping transaction was not a business transaction, and since
such a transaction was primarily for the purpose of tax avoidance, the so-called
loss was an artificial loss created by a pre-designed set of transactions.
Accordingly, the Assessing Officer deducted the incentive income of Rs.
23,76,778 received by the assessee + transaction charges from the loss of Rs.
2,09,44,793 and added back the reduced loss of Rs. 1,82,12,862.80 to the
repurchase price/redemption value amounting to Rs. 5,90,55,207.75.

Being aggrieved by the disallowance of the reduced loss of Rs.
1,82,12,862.80, the assessee filed an appeal before the Commissioner of
Income-tax (Appeals), who by his order dated December 12, 2003, confirmed the
order of the Assessing Officer saying that the loss of Rs. 1,82,12,862.80
incurred by the assessee on the sale of units should be totally ignored and that
the same should not be allowed to be set off or carried forward.

The assessee moved the Tribunal against the order dated
December 12, 2003. The disallowance stood deleted by the Special Bench of the
Tribunal vide its impugned order dated July 15, 2005, by holding that the
assessee was entitled to set off the said loss from the impugned transactions
against its other income chargeable to tax. This view of the Tribunal was
affirmed by the High Court.

The Supreme Court formulated three points which it required
to decide and those were as follows :


(i) Whether ‘return of investment’ or ‘cost recovery’
would fall within the expression ‘expenditure incurred’ in S. 14A.

(ii) Impact of S. 94(7) with effect from April 1, 2002 on
the impugned transactions.

(iii) Reconciliation of S. 14A with S. 94(7) of the Act.


According to the Department, the differential amount between
the purchase and sale price of the units constituted ‘expenditure incurred’ by
the assessee for earning tax-free income, hence, liable to be disallowed
u/s.14A. As a result of the dividend payout, according to the Department, the
NAV of the mutual fund, which was Rs. 17.23 per unit on the record date, fell to
Rs. 13.23 on March 27, 2000 (the next trading date) and, thus, Rs. 4 per unit,
according to the Department, constituted ‘expenditure incurred’ in terms of S.
14A of the Act.

The Supreme Court held that, expenditure, return on
investment, return of investment and cost of acquisition were distinct concepts.
Therefore, one needed to read the words ‘expenditure incurred’ in S. 14A in the
context of the scheme of the Act and, if so read, it was clear that it
disallowed certain expenditure incurred to earn exempt income from being
deducted from other income which was includible in the ‘total income’ for the
purpose of chargeability to tax.

According to the Supreme Court, a return of investment cannot
be construed to mean ‘expenditure’ and if it is construed to mean ‘expenditure’
in the sense of physical spending, still the expenditure was not such as could
be claimed as an ‘allowance’ against the profits of the relevant accounting year
u/s.30 to u/s.37 of the Act and, therefore, S. 14A cannot be invoked.

The Supreme Court further held that the real objection of the Department appeared to be that the assessee was getting tax-free dividend; that at the same time, it was claiming loss on the sale of the units; that the assessee had purposely and in a planned manner entered into a pre-meditated transaction of buying and selling units yielding exempted dividends with full knowledge about the fall in the NAV after the record date and the payment of tax-free dividend and, therefore, the loss on sale was not genuine. According to the Supreme Court, there was no merit in the above argument of the Department. The Supreme Court observed that there were two sets of cases before it. The lead matter covered assessment years before insertion of S. 94(7) vide the Finance Act, 2001 with effect from April 1, 2002. With regard to such cases, the Supreme Court stated that on the facts it was established that there was a ‘sale’. The sale price was received by the assessee. That, the assessee did receive dividend. The fact that the dividend received was tax- free was the position recognised u/s.10(33) of the Act. The assessee had made use of the said provision of the Act. That such use cannot be called ‘abuse of law’. Even assuming that the transaction was pre-planned, there was nothing to impeach the genuineness of the transaction. With regard to the ruling in McDowell and Co. Ltd. v. CTO, (1985) 154 ITR 148 (SC), the Supreme Court observed that in its later decision in Union of India v. Azadi Bachao Andolan, (2003) 263 ITR 706, it has been held that a citizen is free to carry on its business within the four corners of the law. That, mere tax planning, without any motive to evade taxes through colourable devices is not frowned upon even by the judgment of this Court in McDowell and Co. Ltd.’s case (supra). Hence, in the cases arising before April 1, 2002, losses pertaining to exempted income could not be disallowed. However, after April 1, 2002, such losses to the extent of dividend received by the assessee could be ignored by the Assessing Officer in view of S. 94(7).

The next question which the Supreme Court needed to decide was about reconciliation of S. 14A and S. 94(7). According to the Supreme Court, the two operated in different fields. S. 14A deals with disallowance of expenditure incurred in earning tax-free income against the profits of the accounting year u/s.30 to u/s.37 of the Act. On the other hand, S. 94(7) refers to disallowance of the loss on the acquisition of an asset which situation is not there in the cases falling u/s.14A. U/s.94(7), the dividend goes to reduce the loss. S. 14A applies to the cases where the assessee incurs expenditure to earn tax-free income, but where there is no acquisition of an asset. In the cases falling u/s.94(7), there is acquisition of an asset and existence of the loss which arises at a profit of time subsequent to the purchase of units and receipt of exempt income. It occurs only when the sale takes place. S. 14A comes in when there is a claim for deduction of expenditure, whereas S. 94(7) comes in when there is a claim for allowance for the business loss. One must keep in mind the conceptual difference between loss, expenditure, cost of acquisition, etc., while interpreting the scheme of the Act.

Income or capital — Compensation received for sterilisation of the profit-earning source, not in the ordinary course of business, was a capital receipt.

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Income or capital — Compensation received for sterilisation
of the profit-earning source, not in the ordinary course of business, was a
capital receipt.


[CIT v. Saurashtra Cement Ltd., (2010) 325 ITR 422
(SC)]

The assessee, engaged in the manufacture of
cement, etc., entered into an agreement with M/s. Walchandnagar Industries
Limited, Mumbai, (hereinafter referred to as ‘the supplier’) on September 1,
1967 for purchase of additional cement plant from them for a total consideration
of Rs. 1,70,00,000. As per the terms of contract, the amount of consideration
was to be paid by the assessee in four instalments.

The agreement contained a condition with regard to the manner
in which the machinery was to be delivered and the consequences of delay in
delivery.

As per clause 6 of the agreement, in the event of delay
caused in delivery of the machinery, the assessee was to be compensated at the
rate of 0.5% of the price of the respective portion of the machinery, for delay
of each month by way of liquidated damages by the supplier, without proof of
actual loss. However, the total amount of damages was not to exceed 5% of the
total price of the plant and machinery.

The supplier defaulted and failed to supply the plant and
machinery on the scheduled time and, therefore, as per the terms of contract,
the assessee received an amount of Rs. 8,50,000 from the supplier by way of
liquidated damages.

During the course of assessment proceedings for the relevant
assessment year, a question arose whether the said amount received by the
assessee as damages was a capital or a revenue receipt. The Assessing Officer
negated the claim of the assessee that the said amount should be treated
as a capital receipt. Accordingly, he included the said amount in the total
income of the assessee. Aggrieved, the assessee filed an appeal before the
Commissioner of Income-tax (Appeals), but without any success. The assessee
carried the matter further in an appeal to the Tribunal.

According to the Tribunal, the payment of liquidated damages
to the assessee by the supplier was intimately linked with the supply of
machinery, i.e., a fixed asset on capital account, which could be said to
be connected with the source of income or profit-making apparatus rather than a
receipt in course of profit-earning process and, therefore, it could not be
treated as part of receipt relating to a normal business activity of the
assessee. The Tribunal also observed that the said receipt had no connection
with loss or profit, because the very source of income, viz., the
machinery was yet to be installed. Accordingly, the Tribunal allowed the appeal
and deleted the addition made on
this account.

Being dissatisfied with the decision of the Tribunal, as
stated above, at the instance of the Revenue, the Tribunal referred the
questions of law on the above issue for the opinion of the High Court. The
reference having been answered against the Revenue and in favour of the
assessee, the Revenue filed an appeal before the Supreme Court.

The Supreme Court noted that It was clear from clause No. 6
of the agreement dated September 1, 1967, that the liquidated damages were to be
calculated at 0.5% of the price of the respective machinery and equipment to
which the items were delivered late, for each month of delay in delivery
completion, without proof of the actual damages the assessee would have suffered
on account of the delay. The delay in supply could be for the whole plant or a
part thereof but the determination of damages was not based upon the calculation
made in respect of loss of profit on account of supply of a particular part of
the plant. The Supreme Court observed that it was evident that the damages to
the assessee were directly and intimately linked with the procurement of a
capital asset, i.e., the cement plant, which would obviously lead to
delay in coming into existence of the profit-making apparatus, rather than a
receipt in the course of profit-earning process. The Supreme Court held that the
compensation paid for the delay in procurement of capital asset amounted to
sterilisation of the capital asset of the assessee as the supplier had failed to
supply the plant within time as stipulated in the agreement and clause No. 6
thereof came into play. The aforestated amount received by the assessee
toward compensation for sterilisation of the profit-earning source, not in the
ordinary course of their business, was a capital receipt in the hands of the
assessee. The Supreme Court therefore was in agreement with the opinion recorded
by the High Court that the amount of Rs. 8,50,000 received by the assessee from
the suppliers of the plant was in the nature of a capital receipt.

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Depreciation — Manufacture of tea — In cases where Rule 8 applies, the income which is brought to tax as ‘business income’ is only 40% of the composite income and consequently proportionate depreciation is required to be taken into account because that is

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  1. Depreciation — Manufacture of tea — In cases where Rule 8
    applies, the income which is brought to tax as ‘business income’ is only 40%
    of the composite income and consequently proportionate depreciation is
    required to be taken into account because that is the depreciation ‘actually
    allowed’.

[CIT v. Doom Dooma India Ltd., (2009) 310 ITR 392
(SC)]

The respondent-assessee was in the business of growing and
manufacturing of tea. The assessee filed its return of income for the
assessment years 1988-89 to 1991-92. The Assessing Officer completed the
assessments determining total income at a figure higher than what was
reflected in the returns. The assessee filed an appeal before the Commissioner
of Income-tax (Appeals). The assessee raised additional grounds before the
Commissioner of Income-tax (Appeals) at the time of hearing of the appeal,
inter alia, stating that the Assessing Officer had erred in determining the
opening ‘written down value’ of the block of assets without following the
provisions of S. 43(6)(b) of the 1961 Act. According to the assessee, for
arriving at the opening ‘written down value’ of the block of assets, the
Assessing Officer erred in deducting 100% of the depreciation for the
preceding year calculated at the prescribed rate from the opening ‘written
down value’. However, the assessee claimed that only 40% of the depreciation
allowed at the prescribed rate ought to have been deducted and not 100% as
done by the Assessing Officer. The assessee sought a direction from the
Commissioner of Income-tax (Appeals) to the Assessing Officer to determine the
‘written down value’ in accordance with the provisions of S. 43(6)(b) by
deducting only 40% of the depreciation computed at the prescribed rate, being
the depreciation actually allowed. Though the additional ground was allowed to
be raised, the argument of the assessee came to be rejected by the
Commissioner of Income-tax (Appeals).

Aggrieved by the decision, the assessee carried the matter
in appeal to the Tribunal. By its decision the Tribunal, following the
decision of Calcutta High Court in the case of CIT v. Suman Tea and
Plywood Industries P. Ltd. [1993] 204 ITR 719, held that since 40% of the
assessee’s composite income is chargeable u/s.28 of the 1961 Act, for the
purposes of com-puting the “written down value” of depreciable assets used in
the tea business, only 40%, instead of 100% of depreciation allowable at the
prescribed rate shall be deducted in the case of the assessee. This view of
the Tribunal was affirmed by the impugned judgment of the High Court.

On an appeal, the Supreme Court observed that the key word
in S. 43(6)(b) of the 1961 Act is ‘actually’ and in this context referred to
its decision in Madeva Upendra Sinai v. Union of India, [1975] 98 ITR
209 (SC) in which the meaning of the words ‘actually allowed’ in S. 43(6)(b)
was clearly laid down to mean — “limited to depreciation actually taken into
account or granted and given effect to, i.e., debited by Income-tax
officer against the incomings of the business in computing taxable income of
the assessee”.

The Supreme Court also referred to its decision in the case
of CIT v. Nandlal Bhandari Mills Ltd., [1966] 60 ITR 173 (SC), which
judgment was in the context of composite income and, the question, inter
alia, which arose was whether depreciation ‘actually allowed’ would mean
depreciation deducted in arriving at the taxable income or the depreciation
deducted in arriving at the world income (composite income). In that case, it
was held that the depreciation deducted in arriving at the taxable income
alone could be taken into account and not the depreciation taken into account
for arriving at the world income (composite income).

According to the Supreme Court, the above referred
judgments were squarely applicable to the present case and therefore, there
was no infirmity in the impugned judgment of the High Court. The Supreme Court
held that, in cases where Rule 8 applied, the income which is brought tax as
‘business income’ is only 40% of the composite income and consequently
proportionate depreciation is required to be taken into account because that
is the depreciation ‘actually allowed’.

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New industrial undertaking in backward areas — Deduction u/s.80HH — In the absence of particulars of outsourcing activity deduction cannot be allowed.

New Page 1

  1. New industrial undertaking in backward areas — Deduction
    u/s.80HH — In the absence of particulars of outsourcing activity deduction
    cannot be allowed.

[CIT v. R. Pratap, (2009) 310 ITR 405 (SC)]

The Supreme Court was concerned with the case of an
assessee who claimed to be a processor of cashew kernels. The Supreme Court
noted that the said processing consisted of various stages like drying
followed by heating followed by decorticating which resulted in emergence of
the kernel covered by the skin which was ultimately sold. The Supreme Court
observed that if an assessee claims that he is the processor who has
outsourced some of its activities to its sister concern then the nature of the
activity undertaken by the industrial undertaking has got to be demonstrated
by the assessee who claims deduction u/s.80HH(1). The Supreme Court further
observed that the object underlying the enactment of S. 80HH(1) is to
encourage setting up of new industrial undertakings in backward areas. The
Supreme Court noted that in the present case, the assessee who had claimed
deduction had not given any particulars regarding the activity undertaken by
it, the activity outsourced by it to its sister concern, whether those sister
concerns were located in or outside the backward areas, etc. There was no
claim made by the assessee that its sister concerns were its job workers. No
details had been given as to whether after the process stands undertaken by
its sister concerns, whether or not, the material came back to the assessee
for further activities before export. There was no averment that the assessee
was the principal manufacturer. In the circumstances, the Supreme Court held
that the assessee was not entitled to claim the benefit of S. 80HH in the
assessment year in question. The Supreme Court however clarified that the
Department had given the benefit of 20% of the profits vis-à-vis the
number of bags processed in the assessee’s own factory situated/located in the
backward area and to that extent the findings given by the Assessing Officer
as well as by the Commissioner of Income-tax (Appeals) remained undisturbed.



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Industrial undertaking — Deduction u/s. 80-I — To determine whether manufacturing is carried out in the industrial undertaking, assessee should place all the relevant material before the Tribunal which is the highest fact finding authority — Whether the a

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  1. Industrial undertaking — Deduction u/s. 80-I — To determine
    whether manufacturing is carried out in the industrial undertaking, assessee
    should place all the relevant material before the Tribunal which is the
    highest fact finding authority — Whether the activity of supply of ammonia gas
    to heavy water plant and return of the same after extracting deuterium
    amounted to manufacture — Matter remanded.

[Krishak Bharati Co-op. Ltd. v. Jt. CIT, (2009) 310
ITR 400 (SC)]

The appellant, a multi-state co-operative society engaged
in the business of manufacturing urea and ammonia at its plant at Hazira, used
to supply ammonia gas through pipe connections from its plant at Hazira
directly to the heavy water plant (HWP) of the Heavy Water Board (HWB),
which is a Department of Atomic Energy. The HWP was located next to the
appellant’s plant. In fact, it was in the precincts of the appellant’s plant.

On September 14, 1994, an agreement came to be executed
between the appellant and HWB. Under that agreement, the appellant was
entitled to be reimbursed the cost of ammonia manufactured by it and supplied
to the Board and in addition thereto it was also entitled to receive service
charges and incentives from HWB.

In respect of the assessment year 1993-94, the Commissioner
of Income-tax (Appeals) held that since the receipt of service charges was not
directly connected or linked with the manufacturing activity carried out in
the industrial undertaking of the assessee, the service charges received by
the assessee from the said activity of producing heavy water cannot be
considered as profit derived from its industrial undertaking so as to qualify
for deduction u/s.80-I of the Act.

This view of the Commissioner of Income-tax (Appeals) was
affirmed by the judgment of the Tribunal as well as by that of the Delhi High
Court.

The Supreme Court at the outset, noted the brief process of
manufacturing heavy water. Heavy water is employed as a coolant in pressurised
heavy water nuclear reactors. Synthesis gas is produced at the ammonia plant
of the appellant. It contains deuterium. Synthesis gas containing deuterium is
taken to heavy water plant, where deuterium is extracted in extraction towers
and the balance synthesis gas is returned to the ammonia plant of the
appellant. The Supreme Court observed that the appellant’s plant which is
known as ammonia plant from which synthesis gas flows to HWP at Hazira owned
by the Department of Atomic Energy and which is known as Hazira Ammonia
Extension Plant (‘HAEP’). HAEP is an extension of the ammonia plant. According
to the Supreme Court this aspect was important for deciding the appeal before
it as it indicated the inseverability between the two plants.

The Supreme Court further observed that unfortunately, in
this case, the appellant herein had failed to place before the Tribunal, which
is the highest fact finding authority under the Act, the relevant contracts
and other data. In fact, the appellant had failed to produce the relevant
contracts and the connected data before the Tribunal. The Supreme Court
therefore, held that there was no fault with the impugned judgment of the High
Court. Normally, it would have dismissed this civil appeal for lack of due
diligence. However, looking to the importance of the matter and in view of
special features of the contract, Supreme Court decided to entertain the civil
appeal by grant of special leave. The Supreme Court noted that in this case,
the appellant had placed reliance only on an agreement dated September 14,
1994, for operation and maintenance of heavy water plant at Hazira. They had
failed to produce the contracts dated August 5, 1986, and July 11, 1990.
According to the Supreme Court the exact meaning of the manufacturing carried
out in the industrial undertaking of the appellant required in-depth
examination.

The Supreme Court held that as the appellant had failed to
produce relevant data before the authorities below it was permitted to do so,
subject to the payment cost of Rs.25,000 as a condition precedent to the
hearing of the appeal by the Tribunal.

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Green Shoots ?

Editorial

As we finish another audit and tax return filing season, and
have a little time to relax after Diwali (scrutiny assessments permitting), we
get a little time to ponder on some broader issues of how the Indian economy and
business are faring, and their impact on our practices. It is now a little over
a year since the financial crisis struck, impacting economies and businesses
worldwide. Is the worst now behind us and can we expect better times?

If one reads reports of GDP growth, many economies worldwide
(including the USA and Europe) are now showing signs of positive growth, though
slow. Most economists seem to be of the view that measures taken by Governments
and Central Banks have had an impact of arresting the negative growth. Banks
which were in trouble, have been bailed out by infusion of fresh funds,
restoring public confidence in the financial system. Insurance companies with
worldwide operations indicate that credit insurance claims, which had peaked
towards the end of 2008 and early 2009, have abated to lower levels, though
still higher than the level prevalent before the start of the financial crisis.
Generally, the consensus seems to be that the bottom has been reached, and that
we can now expect a recovery, though perhaps gradual.

What we must however remember is that this recovery has been
based on money being pumped in by Governments by following an easy money policy.
Governments realise that an easy money policy has consequences in the form of
unsustainable deficits, higher inflation and bubbles in various markets, such as
stock markets or property markets. Cheap borrowing rates encourage investment in
stocks, properties or other assets, in the hope that the return from such assets
will exceed the borrowing cost. In India, the interest rates on savings were
lower than the consumer inflation rate, due to lower lending rates. We have seen
property markets starting to recover from the lows, and stock markets almost
doubling to nearly reach their historic highs. These inflated values seem to
have been fuelled by rising liquidity due to infusion of Government funds into
the economy, as well as inflow of foreign funds into an economy which was seeing
positive growth in spite of the slowdown.

The Reserve Bank of India has just announced an end to this
easy money policy, with a view to controlling inflation. This is bound to have
an impact, on interest rates on savings and lending, which are bound to rise, on
stock markets, which will see stocks being replaced by bonds in investment
portfolios leading to fall in stock values, and real estate prices, where
builders will find it difficult to hold on to unsold stocks of real estate with
higher borrowing costs. We may therefore witness an end to the high stock market
and real estate prices. One only hopes that the decline in both these sectors is
gradual, and does not cause major upheavals and pain that an abrupt fall would
trigger off.

Fortunately, India is still seen as an attractive investment
destination, notwithstanding the infrastructural, bureaucratic and taxation
barriers to growth. Therefore, the inflow of foreign funds should cushion the
economy to some extent from the impact of the end of the easy money policy.
However, we need to keep in mind the fact that many of our businesses are now
dependent on foreign markets for their growth, and these businesses would
continue to feel the impact of the worldwide slow growth. Our expectations need
to be tempered to understand that while we will surely witness economic and
business growth, such growth will be measured and steady, and will not be as
rapid and frenzied as witnessed during the boom preceding the financial crisis.

Our profession continues to enjoy a good reputation in India, notwithstanding
the battering that its public perception took in India over the last one year.
Given the economic scenario, one can therefore expect reasonable professional
growth. One hopes that the fall in standards of quality and integrity of the
profession that the recent scandals have pointed to, are arrested and reversed.
The important lesson that all of us need to keep in mind is that while earning
well from one’s profession is essential, such earning should not be at the cost
of relaxation of one’s professional or ethical standards. One can look forward
to enough professional work even while maintaining one’s professional and
ethical standards. With our increasing professional competence, worldwide
opportunities today beckon us. We need to gear up and be capable of grasping
these opportunities and growing in a sustainable and satisfying manner. The
current lull should be effectively utilised to hone or diversify our skillsets,
based on our individual perception of our professional drawbacks.

Gautam Nayak

 

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The Challenge of Change — Always Ahead

Editorial

Ever since we took up the study of chartered accountancy, it
has been ingrained in us that constant professional change is something that we
have to necessarily live with and adapt to. No other profession is perhaps
subjected to so many changes happening at such frequent intervals in the subject
matter of its practice. All of us have got accustomed to and have adapted to the
annual wholesale changes in the tax laws. However, today in India, we are at a
stage where every sphere of our practice is in a state of flux, where change is
happening at a much greater pace, requiring us not only to learn new laws and
skills, but also to unlearn a part of what we have learnt in the past.


In auditing, our core area of practice, we not only have
various auditing standards to comply with, but totally new accounting standards
and practices of IFRS to understand over the next couple of years. As if that
were not sufficient, a Companies Bill has been introduced to replace the 52-year
old Companies Act that we are familiar with.

In internal auditing, we have a new set of standards being
put in place, which we need to adapt to and comply with. Our income tax law has
always seen new taxes or new provisions every year — we are threatened by
wholesale changes in the form of the new Direct Taxes Code. Fortunately, that is
not likely to happen in the immediate future. Our service tax law is ever
changing with new services and new provisions added every year — along with the
recently introduced VAT law and Central Excise, this is now likely to be
encompassed within a totally new goods and services tax, in a couple of years.

The amount of knowledge that we would be required to acquire
over the next two or three years makes us think that perhaps we are once again
studying for our CA course !

The recent downswing and turmoil in the world economy and the
Indian economy throws up its own challenges. There is of course the challenge of
ensuring growth in one’s professional career, in spite of severe downturns in
the business cycle. More significantly, the recent business failures have raised
questions internationally, regarding the relevance of auditing as practised
today, and various accounting concepts, such as mark-to-market. We are yet to
embrace some of those concepts in India, and even before we do so, they may
undergo significant changes or be discarded internationally !

Why, even the manner in which we practise has to undergo a
change. The increasing strength of global firms, the increased expectations of
clients due to globalisation, the increased competition for talented people due
to entry of global businesses in India, increasing computerisation and e-filing
— all these are challenges which one has to face.

Each one of us has to clearly now sit down, think, choose and
chalk out our own growth strategy. Should one consider joining a large firm
drawing a good remuneration ? Should one network with other similar minded
firms, with each firm focussing on a niche area of practice ? Or should one
merge with other similar minded firms ? Should one convert the partnership firm
into a limited liability partnership ? Should one continue on one’s own with a
focussed approach of concentrating either on a few areas of practice or with a
few clients ? Or should one join industry ?

We are fortunate today to have so many choices of change.
Each alternative has its own risks and rewards. Based on one’s own perception of
levels of acceptable risk and desired rewards, each one of us has to make a
choice. Not making any change by ignoring the massive changes happening all
around us is not an option at all — that will only result in our professional
stagnation or decline.

We need to look at the challenges or threats that we face as
opportunities. Many of us may not have learnt certain laws in the past, such as
sales tax or VAT, excise duty, etc. The introduction of new laws facilitates our
learning of these laws from their inception, and provides us an opportunity of
offering services in newer areas of practice. The introduction of service tax in
1994 is a classic example — so many of us have learnt that law and are today
focussed on that area of practice for our growth.

The Journal, as always, seeks to support you in your efforts
to meet the challenge of change. In this issue, under the painstaking efforts of
the past editor of the Journal and Chairman of the Diamond Jubilee Celebration
Committee, K. C. Narang, we bring you special articles contributed by eminent
chartered accountants and other professionals from various spheres of life, to
help you understand and prepare for changes happening or likely to happen in
different spheres of our practice.

We hope this will facilitate your making the right choices in
time to meet the challenges of change, and ensure your rapid professional
development and growth.


Gautam Nayak

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Deficiency in service by company/dealer supplying LPG cylinders and regulators : Consumer Protection Act 1986 S. 2(1)(g).

New Page 17 Deficiency in service by company/dealer supplying LPG cylinders and
regulators : Consumer Protection Act 1986 S. 2(1)(g).

 

Death caused due to leakage from LPG cylinder/regulator. The
NCDRC held that it was duty of Indian Oil Corporation (IOC) to provide technical
facilities to its consumers and periodically examine the cylinder or the
regulator to find out its defects.

 

As the Indian oil company also did not ask its dealer to get
the regulator and cylinder examined by any expert, the dealer and Indian Oil
Corporation were held jointly and severally liable to pay compensation to the
complainant.

[ Regional Manager IOC Ltd., Bhopal v. Rakesh Kumar
Prajapati & Ors., AIR 2008 (NOC) 1988 (NCC)]



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Reopening of a completed assessment

1. Issue for consideration :

    1.1 S. 147 of the Income-tax Act, 1961 permits reassessment of income, where the Assessing Officer has reason to believe that any income chargeable to tax has escaped assessment for any assessment year so however no reassessment will ensue where there was no failure on the part of the assessee to disclose fully and truly the material facts necessary for assessment. No reopening is possible once it is shown that a mind is applied by the AO to the facts of the case unless the reopening is sought to be made in consequence of the possession of information obtained subsequent to an assessment.

    1.2 Very often substantial details are collected and inquiries are made by the AO but assessment orders are passed without reference to such details and inquiries, allowing a deduction or exemption. The factual question that arises in such cases is whether there has been an application of mind by the Assessing Officer during the assessment proceedings to the issue involved, and whether the deduction, exemption or non-taxation was after due deliberation, in which case reassessment proceedings cannot be initiated. The issue gets added dimensions where the assessee is able to show that he has filed details in response to the AO’s inquiry but the AO claims that he had not noticed the same in the myriad of details furnished with him.

    1.3 The issues that have arisen before the courts in such cases are whether, in a case where a regular order of assessment is passed u/s.143(3) without much discussion on a particular issue, there was an application of mind by the Assessing Officer; whether there was disclosure of material facts by the assessee and whether permitting reopening in such cases would amount to giving premium to an authority exercising quasi-judicial function to take benefit of its own wrong. While the full bench of the Delhi High Court has taken the view that no reassessment proceedings are permissible in such cases, the division bench of the Allahabad High Court, recently, has taken a contrary view.

2. Kelvinator’s case :

    2.1 The issue came up before the Full Bench of the Delhi High Court in the case of CIT v. Kelvinator of India Ltd., 256 ITR 1.

    2.2 In this case, the assessment of the assessee was completed u/s.143(3). Subsequently, it was noticed by the Assessing Officer that as indicated in the accounts and tax audit report, certain prior period expenditure and certain disallowable expenditure had been wrongly allowed as deductions. He therefore issued a notice for reassessment u/s.147.

    2.3 The assessee challenged the reassessment proceedings in appeal. The Commissioner (Appeals) allowed the assessee’s appeal holding that the assessee had disclosed all the facts, that no new fact or material was available with the Assessing Officer, and that it was a mere change of opinion on the part of the Assessing Officer. The Tribunal upheld the order of the Commissioner (Appeals).

    2.4 Before the Delhi High Court, on behalf of the department, it was argued that the change of opinion was relevant only for the purposes of clause (b) of S. 147, and that initiation of reassessment proceedings was permissible when it was found that the Assessing Officer had passed an order of assessment without any application of mind. According to the department, such application of mind could be found out from the order of assessment itself inasmuch as, if the order of assessment did not contain any discussion on the particular issue, the same may be held to have been rendered without any application of mind.

    2.5 On behalf of the assessee, it was argued before the Delhi High Court that the expression ‘reason to believe’ contained in S. 147 denoted that the reassessment must be based on a change of fact or subsequent information or new law. According to the assessee, income escaping assessment must be founded upon or in consequence of any information which must come into the possession of the Assessing Officer after completion of the original assessment.

    2.6 The Delhi High Court, after considering the various decisions cited before it, observed that it was not in dispute that the Assessing Officer did not have the jurisdiction to review his own order. His jurisdiction was confined only to rectification of mistakes as contained in S. 154. The power of rectification of mistakes could be exercised only when the mistake was apparent, and a mistake could not be rectified where it was a mere possible view or where the issues were debatable. Thus, where the Assessing Officer had considered the matter in detail and the view taken was a possible view, the order could not be changed by way of exercising the jurisdiction of rectification of mistake.

    2.7 The Delhi High Court further noted that it was a well settled principle of law that what could not be done directly could not be done indirectly. If the Assessing Officer did not have the power of review, he could not be permitted to achieve the object by taking recourse to initiating a proceeding of reassessment.

    2.8 According to the Delhi High Court, when a regular order of assessment is passed in terms of S. 143(3), a presumption can be raised that such an order has been passed on application of mind. In terms of S. 114(e) of the Indian Evidence Act, judicial and official acts are presumed to have been regularly performed. If it be held that an order which has been passed purportedly without application of mind would itself confer jurisdiction upon the Assessing Officer to reopen the proceeding without anything further, this would amount to giving a premium to an authority exercising quasi-judicial function to take benefit of its own wrong.

    2.9 The Delhi High Court therefore held that since the material was before the Assessing Officer at the time of assessment, the reassessment proceedings were invalid.

3. EMA India’s case :

    3.1 The issue again recently came up before the full bench of the Allahabad High Court in the case of EMA India Ltd. v. ACIT, (unreported — copy of order available on www.itatonline.org).

    3.2 In this case also, the assessment proceedings were completed u/s.143(3), and reassessment proceedings were initiated u/s.147 to disallow prior period expenditure and to tax certain interest which were disclosed in the balance sheet, profit and loss account, tax audit report, and other documents submitted before the Assessing Officer in the earlier proceedings.

3.3 The assessee challenged the reassessment proceedings in a writ petition before the High Court. Before the Allahabad High Court, it was submitted on behalf of the assessee that the initiation of proceedings and issue of notice were based on mere change of opinion and were totally without jurisdiction. It was submitted that the action of the Assessing Officer amounted to review of the earlier assessment order, and that even though the Assessing Officer had noticed such items, he did not assess these items nor add the same to the income during the assessment proceedings. Reliance was placed by the assessee on the full bench decision of the Delhi High Court in Kelvinator’s case (supra).

3.4 On behalf of the department, it was submitted that the initiation of reassessment proceedings was permissible when it was found that certain items of income, though chargeable to tax, had escaped the notice of the Assessing Officer, and no discussion of chargeability to tax of such items of income was made in the assessment order.

3.5 According to the Allahabad High Court, where the assessment order had been passed and certain items of income are not at all discussed and it escaped the notice of the assessing Officer as a result of which the reassessment proceedings were initiated in respect of those items of income, in the circumstances it could not be said that it would amount to review. Since the Assessing Officer did not form any view or any opinion with regard to the items of income which escaped its notice in the original assessment order, it would not amount to review of the order or change of opinion. According to the Allahabad High Court, there could be no change of opinion when no opinion was formed by the Assessing Officer.

3.6 The Allahabad High Court was of review that initiation of reassessment proceedings was permissible where it was found that the Assessing Officer had passed an order of assessment without any application of mind and such application of mind could be found out from the order of assessment itself, inasmuch as, in the event the order of assessment did not contain any discussion on a particular issue, the same may be held to have been rendered without any application of mind. According to the Allahabad High Court, in view of Explanation 1 to S. 147, mere production of account books or other evidence from which material evidence could, with due diligence have been discovered by the assessing authority would not necessarily amount to disclosure. This aspect, according to the Allahabad High Court, had not been considered by the Delhi High Court in Kelvinator’s case.

3.7 The Allahabad High Court therefore held that the reassessment proceedings were valid.

Observations:

4.1 Some controversies do not lead to ‘closements’ soon. The issue being discussed here is an example of one such controversy. Even the attempt in the proposed Direct Tax Code for resolving the controversy in favour of smooth reopening will surely raise new controversies. The issue is fiercely con-tested by the tax payers, in spite of amendments, as they perceive the whole exercise of reassessment as unjust weilding of power by those in the power. One finds a lot of merit in this when one notices the ease with which completed cases are sought to be reopened in large numbers.

4.2 The sting is acutely painful in cases where the reopening is made after expiry of four years, in spite of the fact that there is no failure on the part of the assessee to disclose fully and truly the material facts necessary for assessment. Even in such cases the reopening is sought to be justified on the pretext that the AO had not applied his mind to the material disclosed, though it was produced. The action is sought to be explained by resorting to Explanation 1 to S. 147 and in many cases by relying on Explanation 2 to the said section.

4.3 Fortunately for the tax payers the courts have, by and large, frustrated such attempts of the Revenue in cases where disclosure is found to be evident and also in cases where the material has been furnished in response to an inquiry by the AO. The courts have not given great credence to the Revenue’s contention, often made, that the assessment order is silent on the relevant aspect under contest. The courts have advanced the cause of the tax payers even in cases involving reopening within four years on being convinced that material facts necessary for assessment were disclosed. The courts have also taken a unanimous view that the amendments of 1989 have not materially altered the available law on the subject and that a change of opinion can not lead to a valid reopening even post 1989.

4.4 The Courts have been consistent in holding that the law does not permit a review of an order, not even in the name of reassessment. A thing which can not be done directly can certainly not be done indirectly by resorting to the provisions of re-assessment. It is this principle that has been reiterated by the Full Bench of the Delhi High Court by stating that permitting an AO to reopen a completed case in given circumstances amounted to giving a premium to an authority exercising quasi-judicial function to take benefit of its own wrong.

4.5 Whether this position stated in paragraph 4.4 has been changed by insertion of Explanation 1 and 2. The Courts do not think so. Even after the said insertion the courts are more or less consistent, in holding that a change of opinion can not lead to reopening of a completed assessment and further that in cases where the assessee has not failed in disclosing truly and fully the material facts necessary for assessment, reopening is not possible irrespective of the time of reopening.

4.6 The Punjab & Haryana High Court, in the case of Hari Iron Trading Co. v. CIT, 263 ITR 437, observed that the taxpayer had no control over the actions of an AO and that he was not in a position to direct the framing of an order in a manner that would record fully and truly all that had actually transpired during the course of assessment and in such circumstances it was appropriate to assume that the order had been passed with due diligence unless it was otherwise proved by the AO. It is normally seen that an assessment order rarely records the findings of the inquiry by AO where he is satisfied with the assessee’s explanation furnished in response to his inquiry.

4.7 The Bombay High Court, consistently follow-ing the full bench decision of the Delhi High Court, has held that once an assessment order is passed u/s.143(3) and the assessee has not been found to have failed in disclosing material facts, no reopening was sustainable. Asian Paints Ltd. v. DCIT & Ors., 308 ITR 195, Idea Cellular Ltd. v. DCIT, 301 ITR 407 and GT v. Eicher Ltd., 294 ITR 310. The same is the ratio of the decisions of several High Courts and Tribunals including the latest one by the Tribunal in the case of Vardhman Industries, ITA No. 501/ Jd/2008 dated 14-9-2009 wherein the jodhpur Bench held that even within four years it was not possible to reopen an assessment where the material facts were found to have been disclosed by the assessee. It appears that in all cases of assessments completed after scrutiny, a reopening can follow only on the basis of an information received subsequent to assessment.

4.8 Even the Allahabad High Court in the case of Foramer v. CIT & Ors., 247 ITR 436 had held that no reopening was possible on a mere change of opinion in cases where there was no failure to disclose material facts by an assessee, a decision which was later on approved by the Supreme Court. Had this decision been noted by the court in EVA’s case, the outcome could have been different. It is interesting to note that the full bench of the Delhi High Court in coming to the conclusion in assessee’s favour had concurred with the abovementioned decision of the Allahabad High Court in Foramer’s case.

4.9 The twin decisions of the Gujarat High Court in the cases of Praful Chunilal Patel, 236 ITR 732 and Garden Silk Mills, 237 ITR 668, heavily relied upon by the Allahabad High Court in EVA’s case, were not even followed by the same Gujarat high court and importantly the full bench in Kelvinator’s case had specifically dissented from these decisions of the Gujarat High Court. Like Delhi, the Bombay High Court has refused to follow the said decisions of the Gujarat High Court.

4.10 CBDT Circular No. 549 dated 31-10-1989, while explaining the implication of the scheme of reassessment, specifically clarified vide para 7.2, that the new scheme does not bring about a material change in the existing law providing that no reopening would sustain in cases of change of opinion not involving any failure on the part of the assessee to disclose material facts. It is this circular which has helped information of a definitive judicial consen-sus in the era after amendment of 1989. It is need-less to note that the circulars of the Board are binding on its officers in administering the provisions of the Income-tax Act.

4.11 S. 114 of the Indian  Evidence  Act vide clause provides that due care has been taken by a public officer in performing his duty. Therefore on completion of assessment, it can be presumed that the AO has examined the material produced before him. Frankly, Explanation 1 is an unintended but serious reflection on the state of affairs in the Revenue department, indicating that orders as a rule are passed without due diligence, unless otherwise proved.

4.12 Article 14 has been favourably relied upon by the courts to support the contention that permitting an AO to review his order results in violation of the Constitution which guarantees protection against such administrative actions of the executive.

4.13 A point which emerges from the controversy is that the issue is debatable, and the language adopted by the law is capable of two interpretations. If that is so, a view that is favourable to the assessee should be accepted.

4.14 The decision of the Supreme Court, in the case of Indian Newspaper, relied upon by the Allahabad high court in EVA’s case, clearly supported the view that the reopening of an assessment was not possible for reviewing an order.

4.15 The decision in Kelvinator’s case was delivered by the full bench of the high court. The law of precedent required that the division bench of the high court, of two judges, in EVA’s case should have followed the decision of a larger bench instead of following decisions which were specifically dissented by the full bench. The decision in the case of Shyam Bansal, 296 ITR 95 (All.), again relied upon in EVA’s case did not consider the decision of the full bench and in any case the Revenue in that case was in possession of some information obtained post assessment. The binding force of the decision of the full bench in Kelvinator’s case was specifically considered in the case of KLM Royal Dutch Airlines 292 ITR 49 (Delhi) wherein the Court, in the context of the very same issue, had considered the validity of a decision delivered by the division bench in the case of Consolidated Photo and Finvest Ltd. 281 ITR 394 (Del.) wherein the division bench had failed to follow the decision of the full bench in Kelvinator’s case. The Court in KLM Royal Dutch Airlines’ case held that the decision of the full bench in Kelvinator’s case had to be followed by the division bench of the Court. This position in law of precedent has been reiterated by the Bombay High Court in the case of Eicher Ltd., 294 ITR 310.

Rectification of mistake — No finding on the decision cited by the appellant.

New Page 1

8 Rectification of mistake — No finding on
the decision cited by the appellant.


The appellant had filed appeal before the CESTAT. In the
written submission filed before the Tribunal the appellant had relied on two
Tribunal decisions in its favour. The appeal was heard ex parte. The
Tribunal by referring to a judgment of the Supreme Court in the case of CCE,
Ahmedabad v. Ramesh Food Products, 2004(174) ELT 310 (SC) disposed of the
appeal. No reference was made to the judgments of the Tribunal which were relied
upon by the appellant. The appellant, therefore, filed an application for
rectification, pointing out that the appellant had relied upon two judgments of
the Tribunal in his submissions. The Tribunal, however, disposed of his appeal
without considering those judgments. The Tribunal again dismissed the
rectification application. On further appeal the High Court observed that the
procedure that has been followed by the Tribunal is not in accordance with law.
If in the opinion of the Tribunal, the two judgments of the Tribunal on which
the appellant was relying, were not relevant, the Tribunal could have said so in
its judgment. The course adopted by the Tribunal, of even not referring to the
judgments of the Tribunal or which the appellant was relying, is not proper. It
was for the Tribunal to point out, after considering the judgments of the
Tribunal on which the appellant was relying, why those judgments were not relied
and how, according to the Tribunal, the matter is covered by the judgment of the
Supreme Court. In view of the above, the appeal was allowed by remanding the
matter back to the Tribunal.

[ Stanlek Engineering P. Ltd. v. Commissioner of C. Ex.
Mumbai, 2008 (229) ELT 61 (Bom.)]

 


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Fraud and Audit

Article

Preamble :



After the Enron debacle, auditing all over the world has come
under the scanner. The age-old saying that ‘an auditor is a watchdog and not a
blood hound’ is being re-examined, if not questioned. Legislation which seeks to
lay a greater emphasis on detection and reporting of fraud by auditors has been
introduced all over the globe. In this context, the article examines an
auditor’s duty as regards detection and reporting of fraud. It examines the
causative factors that led to Enron’s bankruptcy and some of the subsequent
legislation in India and ICAI’s pronouncements affecting an auditor’s duty and
responsibility towards the issue of fraud. For this purpose, the relevant
clauses in the Companies (Auditors Report) Order, 2003 (CARO), the Auditing and
Assurance Standard (AAS) 4, and certain observations made in a recent High Court
judgment in Maharashtra (Note 3) have been considered. To get an
international flavour, the article also examines the findings of the O’Malley
Report (Note 1) on audit effectiveness. To make this study more interesting, the
new enhanced role of the auditor is examined with the help of a case study.

Comparison of auditing scenarios before and after the turn of the
millennium :

In the last decade, two things have impacted the auditors’
role a great deal : (a) The rapidly evolving IT environment, and (b) the Enron
debacle in 2001. E-commerce and computerisation in all walks of life, for all
the conveniences offered, have made business practices and business models more
complex. New business models have sprung up as commerce transcends not only
distances, but also time zones, currencies, and countries. Data volumes are huge
and products with incredible technical specifications are introduced every other
day. Consequently, the audit scenarios in this rapidly changing IT environment
have become far more challenging. Amidst this, the Enron bankruptcy (as well as
the fall of several other corporate giants during the 2001-02 period), brought
the auditor’s role under the scanner. Panic buttons were pressed all over the
world and new legislation and statutory pronouncements enhancing the role of
auditors were announced. The Sarbanes-Oxley Act came into force in 2002 with
revolutionary reporting and disclosure requirements in audited accounts. For the
first time the CEO and CFO were obligatorily required to attest the financial
statements and also comment on existence of fraud. World over, questions were
raised about the performance of the auditors. Undoubtedly, the auditor’s role
was questioned. Auditing practices, and auditing standards were revisited to
make auditors address the issue of fraud, thereby emphasising the need for
greater audit effectiveness. In order to understand the auditor’s role from the
point of view of detection and reporting of fraud, it would be useful to conduct
a simple case study.

Case Study of a ‘Van Sales’ — business model :

Consider a business model applying the ‘Van Sales’ method of
selling Fast Moving Consumer Goods (FMCG). This model was conceived by a company
with a view to reach out to geographically far-flung untapped areas of potential
demand. The model required deployment of a fleet of multiple trailer vans
stacked with FMCGs like soaps, toothpastes, gels, creams, biscuits, etc. The van
crew would consist of a driver and a sales representative given a specific
route, (which could be hundreds of kilometres long in the country), to find
retailers, shops and other buying entities to sell the products. Both cash and
credit sales were permissible within policy norms. These sales operations were
monitored through palm-top computers and small portable printers provided to
salesmen in the vans. Each palm-top was linked to the main central server at the
head office. The salesmen made efforts to maximise their sales by approaching
retailers/shops and buying outlets spotted all along the route. The sales
deliveries, invoices and collection receipts were raised at the remote locations
by the salesmen using the palm-top computers and printers provided. The palm-top
sales system had well-designed controls built in to monitor credit limits, sales
returns, discounts, and promotion/festival/season offers. Each van would return
to the main warehouse to replenish its stocks and deposit the collections after
a tour was completed. In addition, all the vans were required to report, all
together, once in a year at one central place to facilitate stock verification,
which was carried out by the management. In such a business model, how does the
auditor perceive his role and what kind of audit procedures does he apply ?

Conventionally, an auditor would apply the following
procedures :

(a) Review and vouchsafe sales, receivables and inventory
data furnished to him at the head office, through the central server,

(b) Carry out tests of the sales application software for
evaluation of controls,

(c) Apply substantive tests to ensure compliance with
rates, discounts, etc., and terms and conditions in sales policies,

(d) Apply substantive tests to ensure that collections
deposited at the warehouse by the van crew were deposited into the bank,

(e) Observe the annual stock verification procedure of
stocks in vans, and,

(f) Debtors’ scrutiny and call for confirmations from
debtors.


Would the foregoing tests be enough for him to express an opinion on the correctness of the sales, collections, and debtors? A couple of decades ago, the foregoing audit plan would have been considered adequate. Unless some serious indication or sign of fraud came up in his routine audit, or was brought to his notice, the thought of a possible fraud or misuse would not even have crossed an auditor’s mind. In other words, he would not be specifically hunting for such a sign or indicator of fraud, nor would he even consider discussing with his team the possibility that any process or control could be exposed or circumvented to commit fraud. However, in the current auditing scenario, the above procedures would not be adequate. An auditor has a duty to consider the overall business model with ‘professional scepticism’ to understand its vulnerability and then apply appropriate audit procedures to maximise his chances that any sign or indicator will be spotted. For example, in the above case study, the auditor would have to consider the business model and its control systems with professional scepticism. If he does this, he will immediately realise that a business of this kind is fraught with several significant risks of revenue loss in myriad ways.

Huge geographical distances within which the van stocks move, virtually unmonitored and unchecked, along with sales to parties with unknown credentials expose the business model to risks of stock shortages, pilferage of cash or stocks, fictitious sales, unaccounted sales returns, teeming and lading of collections, abuse or misuse of vans for personal purposes or parallel business, etc. Countless other kinds of misuse could take place. While drafting his audit plan, the auditor cannot be completely impervious to these possibilities and merely carry out the tests stated above, on data given to him. He has to think of and apply various customised tests to address all the business risks envisaged. If he does not do this, fraud will occur and devastate a business as happened in Enron’s case. The failure of the auditors of Enron to detect irregularities and/or their apparent will-ingness to support some questionable transactions, permitted wrongful accounting practices and diluted or misleading disclosures and eventually brought Enron to bankruptcy. Corporate governance was at its nadir and exposed that audit effectiveness was very low. It would be immensely useful to study some of the findings in the Enron investigation.

Insights from Enron bankruptcy:

There is a very comprehensive report tabled on February 1, 2002 by Enron’s Special Investigative Committee (Note 2), which had a mandate to examine in detail certain transactions as regards their nature, what went wrong, why they took place and who was responsible. This report provided not only valuable information about the possible causative factors which led to Enron’s bankruptcy, but also insights of immense value to auditors, such as issues relating to accounting practices, corporate governance, audit effectiveness, management over-sight and public disclosures. Much of the subsequent legislation such as the Sarbanes-Oxley Act, 2002, and other acts and auditing standards around the world were based on the revelations in this report. Some of the major revelations are summarised below as they are relevant to the subject matter of this article:

1.    The auditors’ and legal advisors’ role. The report revealed that the legal advisors of Enron and their auditors had actually reviewed these transactions and had even cleared them. The report did not actually go to the extent of stating that the auditors had participated in the wrongdoing. However, a reader can draw his own conclusions about this aspect from the meaningful disclosures about the enormous fees paid to them during the relevant period. Auditors billed US$5.7 million for advice for these transactions alone, above and beyond the regular audit fees. At the minimum, there was gross negligence on the part of the auditors.

2.    Corporate Governance failure. The report clearly indicated that the Board failed to stop or deter transactions of conflicting interest to Enron. The Chief Financial Officer (CFO) and the Chief Accounting Officer (CAO) had dual and conflicting interests in the suspected transactions. The Board was aware, at least about the CFO’s interest, yet it failed to exercise sufficient checks and controls to ensure that all dealings were above board, fair and equitable to Enron interests.
 

3.    Ineffectiveness of audit procedures to spot malicious ‘off-balance sheet’ transactions. Auditors ignored the implications of transactions with entities referred to as ‘Special Purpose Vehicles’ (SPVs) which were created to enable Enron to camouflage its losses and debts and remove them from Enron’s balance sheet. SPVs with whom such transactions were effected were adroitly portrayed as external independent entities (which they were not), so that it was possible to conceal Enron’s losses and debts, without the necessity of disclosing these in Enron’ sown financial statements. These SPVs were, in fact, entities owned and controlled by Enron’s own employees.

4.    Ineffectiveness of audit procedures to spot book entries. The report pointed out that the management resorted to ‘complex structuring of transactions that lacked fundamental economic substance’. In simple words – book entries were created without basis and in contravention of accounting principles, possibly like ‘hawala’ entries commonly referred to in India.

5.    Misleading Disclosures. The disclosures in the reports were ‘obtuse, and did not com-municate the essence of the transactions’. The disclosures were made to ‘downplay the significance of related-party transactions, and in some respects, to disguise their substance and import’.

If one considers the possible business risks in the above case study and the Enron fraud there are a lot of similarities. In the above case study, the overall business risk could be quite high. The SPVs in the above case study could be fictitious retailers and creative book entries could be fictitious sales, the creative accounting treatment could be use of teeming and lading practices and perpetrating other sales, collection and inventory accounting manipulations. The conventional audit plan would not necessarily expose these frauds.

Thus, concerns of audit effectiveness were raised in India too, and the auditor’s role and CARO and ICAI’s auditing standards have been revised. The relevant clauses of these pronouncements have been examined below:

1.    Auditing Assurance Standard –  AAS 4 :

This is a specific auditing and assurance standard pronounced by the ICAI (effective from April 1, 2003), relating to an auditor’s duty as regards ‘fraud and error’ in financial statements. This standard states that the primary responsibility for the prevention and detection of fraud and error rests with both (1) those charged with governance, and (2)    the management of an entity. The standard also spelt out the auditor’s enhanced responsibility and laid down expectations of a far more penetrative audit than ever before in the past. The salient features of this AAS 4 are:

(a)    An attitude of professional skepticism. No longer can an auditor rely merely on any management representation. In effect, he must obtain evidence that either agrees with, or, brings into question the reliability of management representations. An auditor must adopt, necessarily, an attitude of professional sk ticism that will enable him to identify and properly evaluate matters that increase the risk of a material misstatement in the financial statements resulting from fraud or error. He now has to examine and question the management’s influence over the control environment, industry conditions, and operating characteristics and financial stability.

(b)    Importance of teamwork in conducting an audit. The standard also expresses the importance of teamwork. In planning the audit, the auditor should discuss with other members of the audit team, the susceptibility of the entity to material misstatements in the financial statements resulting from fraud or error.

(c)    Perform additional, extended orcommensurate audit procedures where fraud is suspected. When the auditor encounters circumstances that may indicate that there is a material misstatement in the financial statements resulting from fraud or error, the auditor should perform procedures to determine whether the financial statements are materially misstated.

(d)    Reporting obligations When the auditor identifies a misstatement resulting from fraud, or a suspected fraud, or error, the auditor should consider the auditor’s responsibility to communicate that information to management, those charged with governance and, in some circumstances, when so required by the laws and regulations, to regulatory and enforcement authorities also.

(e)    Where an auditor has obtained evidence that fraud exists, even materiality is not a point for consideration for communicating this matter to the appropriate level of the management timely.

Thus as per AAS 4, an auditor has to virtually move heaven and earth to satisfy him-self while carrying out an audit, that no serious red flags exist. If they do exist, he has to necessarily apply appropriate procedures to confirm his suspicions or dispel his doubts, about the existence of fraud. In case there is evidence of fraud, then, even materiality is not a factor for consideration – the matter of fraud has to be communicated to the appropriate level of management on a timely basis and he has to even consider reporting it to those charged with corporate governance.

CARO also casts a sigmficant responsibility on the auditor which has been considered next.

2.    Clauses of CARO relating to reporting of fraud by auditors:

Clauses 4(iv) and 4(xxi) of CARO are very important for auditors, especially with regard to their duty towards fraud. 4(iv) requires an auditor to report whether there are adequate internal control procedures commensurate with the size of the company and the nature of its business, for the purchase of inventory and fixed assets and for the sale of goods. What is significant is that the auditor is expected to report whether there is a continuing failure to correct major weaknesses in internal control. The key phrase is ‘continuing failure’. The continuing failure could stem from incompetence or fraud, but either way the auditor cannot ignore the possibility of existence of fraud. If he reports such a continuing failure but not a fraud, and if fraud is discovered later, the auditor may find himself in an unenviable situation to escape the responsibility for not carrying out appropriate audit procedures and also perhaps for not reporting the fraud. Clause 4(xxi) is even more serious, in that, it actually casts a direct responsibility on the auditor to report whether any fraud on or by the company has been noticed or reported during the year; if the answer is affirmative, the nature of the fraud and the amount involved have to be indicated. Here too, it is pertinent to note that materiality is not a factor for consideration by the auditor. If a fraud has been noticed or even reported, he has no choice but to report its nature and the amount involved. Furthermore, by virtue of being an auditor, and the very definition of audit as explained later, his duty does not end merely in mentioning that a fraud was noticed or reported; as an auditor his role automatically requires him to carry out an investigation and apply such other checks and verifications so as to enable him to be satisfied that the fraud is not isolated and that it does not have any other implications on the financial information he is expressing an opinion on.

Thus, CARO clearly spells out the duty of the auditor towards fraud detection and reporting. In the recent past, an auditor’s duty towards fraud detection was further accentuated by the High Court in a recent judgment given below.

3. Sales Tax Practitioners’ Association (STPA) of Maharashtra v. the State of Maharashtra (Note 3):
This case is also very relevant to this article because it examines the definition of audit and concludes that detection of fraud is of primary importance in an audit. While considering the petition of the STP (refer note 3 for details) the High Court examined the very definition of audit. After considering certain definitions, it concluded that the word audit has a specific connotation in the matter of examination, investigation and auditing of. accounts, where detection of fraud is of primary importance. One of the definitions of audit referred to is that of R A Irish in his book ‘Practical Auditing’. It says that an audit may be said to be a skilled examination of such books, accounts and vouchers as will enable the auditor to verify the balance sheet. The main objects of an audit are: (a) to certify the correctness of the financial position as shown in the balance sheet and the accompanying revenue statements, (b) the detection of errors and (c) the detection of fraud – the detection of fraud is generally regarded as being of primary importance. The High Court also observed ‘The object and purpose of compulsory audit is to facilitate the prevention of evasion of taxes, administrative convenience …. “. It is a specialised job which can be undertaken only by a person professionally competent and trained to audit. Thus, auditors are expected to possess skills which could act as even a deterrent for tax evasion fraud. However, the High Court, also accentuated the risks accompanying the privileges: “The Chartered Accountant, by his very privileged status exposes himself to the consequences of civil liability for negligence, liability for professional misconduct in disciplinary proceedings under the Chartered Accountants Act, 1949, and sometimes to criminal liability under the Penal Code.”

Thus the above judgment clearly emphasises that an auditor’s role includes fraud and error detection and detection of fraud is of primary importance and that the auditor is exposed to severe penal consequences for non-performance of his duty.

4.    Insights from the O’Malley Report:

Thus far, this article has reviewed the auditor’s role within the domain of the Indian legislation and the ICAI’s pronouncements. It would be useful to examine some views from the international arena too. In this regard, there can be nothing better than the O’Malley Panel Report (Note 1). The Panel made some important revelations about the auditor’s role towards fraud. The Panel recommended that auditors should perform some ‘forensic-type’ procedures on every audit to enhance the prospects of detecting material financial statement fraud. Audit work would be based and directed to detect and find the possibility of dishonesty and collusion, overriding of controls and falsification of documents. Auditors would be required, during this phase, in some cases on a surprise basis, to perform substantive tests directed at the possibility of fraud. The Panel recommendation also calls for auditors to examine non-standard entries, and to analyse certain opening financial statement balances to assess, with the benefit of hindsight, how certain accounting estimates and judgments or other matters were resolved. The intent of this recommendation is twofold: to enhance the likelihood that auditors will be able to detect material fraud, and to establish implicitly a deterrent to fraud. This can be achieved by greater audit effectiveness which would pose a threat to perpetrators in successful concealment of fraud. The Panel also advocated stronger standard setting for auditors. It observed that the Auditing Standards Board should make auditing and quality control standards more specific and definitive to help auditors enhance their professional judgment. The Panel recommended that audit firms should review, and where appropriate, enhance their audit methodologies, guidance, and training materials; and peer reviewers should ‘close the loop’ by reviewing those materials and their implementation on audit engagements and then reporting their findings.

Audit firms should put more emphasis on the performance of high-quality audits in communications from top management, performance evaluations, training, and compensation and promotion decisions.

The auditor’s enhanced role towards fraud:

In the past, the issue of fraud was a ‘once in a blue moon’ phenomenon for auditors. There was no compulsion for an auditor to keep an eye open for red flags or warning bells, or even to under-take extended audit procedures in areas where potential red flags were noticed. Therefore, the actual reporting of fraud in any report ‘was rare. Furthermore, auditors had limited digital tools and techniques, nor any specialised training to be able to conduct interviews, mathematical data pattern analysis, nor did they have trained investigators to carry out field inquiries. The scenario changed completely after the Enron debacle and the advances in IT. Society’s expectations increased and auditors have started using sophisticated software, digital tools and have done further research and training to address the issue of fraud. Risk-based auditing plans and fraud risk detection is now a component of all audit plans.

Considering all the  foregoing, consider the case study of the van sales business once again. Is the auditor concerned about all the business risks envisaged – stock shortages, pilferage of cash or stocks, fictitious sales, unaccounted sales returns, teeming and lading of collections, abuse or mis-use of vans for personal purposes or parallel business, etc. ? Yes, the auditor must necessarily recognise these risks, and based on the issues brought out in AAS 4, CARO, O’Malley Report and the High Court judgment, an auditor cannot complete his audit of this business merely on the conventional audit plan detailed earlier. In order to really provide a meaningful opinion on the van sales operating results, an auditor would have to supplement the conventional audit plan with at least the following :

1.    Process study and Gap Assessment: The control environment of the entire business model has to be studied and examined by the auditor. Complete process walk through study of the van sales process has to be carried out by the auditor to identify vulnerabilities and gaps in the controls. An overall gap assessment of unaddressed risks must be conducted. In the case study illustrated, an auditor would have to study all the built-in controls in each of the processes on a typical route of a sales van. For example, he must study all the processes such as loading the van, scheduling the route, visiting the retailers, raising invoices, and issuing collection receipts, accepting sales returns and submitting an account, at the end of the day.

2.    Teamwork: Have a brainstorm session for designing appropriate audit tests and procedures with all the members of the team to address the risks, corresponding controls in place and gaps identified in step 1 earlier.

3.    Testing of controls: Based on steps 1 and 2 above, and other appropriate audit tests to address the risks would have to be applied including surprise tests at warehouse, visits to some retailers, and covert observation of van sales operations by having observers on the route.

4.    Additional IT tests of palm-top computer/ printer controls for sales invoicing and issuance of cash receipts to address the issue of fictitious documents.

The above is not an exhaustive list – it is merely an indication of the penetrative approach which an auditor must adopt. Depending upon his findings, he may need to report errors/fraud or control weaknesses in CARO. As per the CARO reporting requirement if these weaknesses have been continuing persistently without being addressed by the management, it may stem from fraud and therefore needs appropriate tests and verifications. The auditor needs to decide at what level of management he needs to report the issue of fraud, and perhaps to the audit committee as well. In such a case, as per the O’Malley Panel, forensic-type procedures may also be necessary, which may include multi-dimensional trend analysis of sales and collections, examination of palm top logs for changes, deletions, alterations, warehouse stock discrepancies, etc.

Conclusion:

While the duty of detecting and preventing fraud lies primarily with the management, the auditor’s role is not insulated from this issue. Auditors cannot be a substitute for the enforcement of high standards of conduct by management, but, auditors can be an important factor in promoting high standards’. Auditors must possess the discipline, fortitude and ability to stand up to management or to an audit committee or board of directors. They need to be able to say, “No, that’s not right!” where deemed essential. The O’Malley Panel called on all individual professional auditors to heed this message’: “Only quality audits serve the public interest, and the public is the auditor’s most important client.”

GAPs in GAAP – Discount rate for employee benefits (Proposed amendments to IAS 19)

Accounting Standards

IAS 19 Employee Benefits have required pension obligations to
be discounted at rates based on high quality corporate bond rates. However, in
countries with no deep market in such bonds the rate on government debt is to be
used.

One of the effects of the current financial crisis has been a
significant widening of the spread between yields on government bonds and those
on high quality corporate bonds. In particular, the current market results in
otherwise identical obligations being measured at very different rates due
solely to the presence or absence of a deep corporate bond market. In light of
this, the IASB published an exposure draft aiming to remove this lack of
comparability. The proposal will require the use of corporate bond rates in all
circumstances. The intention of the amendment of IAS 19 seems to be to require
use of a consistent reference in choosing the rate for discounting employee
benefit obligations regardless of whether there is a deep market in high quality
corporate bonds in the country concerned. The Board envisages that there will be
improved comparability between reporting entities due to a reduction in the
range of rates used.

Should the Board eliminate the requirement to use government
bond rates to determine the discount rate for employee benefit obligations when
there is no deep market in high quality corporate bonds ?

Since market interest rates differ considerably from country
to country or from currency zone to currency zone, consistency in application is
primarily important among plans operated in the same country or currency zone.
The financial crisis has not only widened the spread between government bond
rate and the rate on high quality corporate bonds, it has also widened the range
of corporate bond rates generally considered to be of high quality. In
particular, now that we see evidence of the spread between government bond rate
and corporate bond rate narrowing again, the range of applied corporate bond
rates within a jurisdiction is a significantly bigger concern than the spread
between government bond rate and corporate bond rate.

Generally, government bond rates are more reliably
determinable and show a significantly narrower range than high quality corporate
bond rates. In countries or currency zones where there is no or no deep market
for high quality corporate bonds the range of applied discount rates may be even
wider. The proposed change may actually decrease comparability among entities
within a jurisdiction (such as India) that would have previously applied a
discount rate determined by reference to government bond rates, as the range of
available rates for high quality corporate bonds tends to be much wider than
that of government bond rates.

This is aggravated by the fact that the current IAS 19, as
well as the proposed amendment, do not contain any further guidance regarding
the meaning of the phrase ‘high quality corporate bond rate’. So even if the
Board proceeds with this ED despite the concerns, more detailed guidance is
needed on what constitutes ‘high quality’. This would avoid the risk of
continued significant variability in discount rates selected, even within those
jurisdictions having a deep market for high quality corporate bonds.

The Board reminds its constituencies that it intends to
review the accounting for employee benefits more broadly in due course and notes
that these proposals are not meant to pre-empt that. Perhaps more ominously, the
Board notes that “The Board has not yet considered whether the measurement of
employee benefit obligations could be improved more generally and, in
particular, the Board has not yet considered whether the yield on high quality
corporate bonds is the most appropriate discount rate for postemployment benefit
obligations.”

Rather than proceeding with this ‘quick fix’, it is
recommended that the Board works expeditiously on its comprehensive review of
IAS 19, including the choice of discount rate. This will avoid a disruption of
financial information for those entities operating in jurisdictions that
currently use government bond rates to discount defined benefit obligations. In
those jurisdictions where entities currently use government bond rates due to
the absence of a deep market for high quality corporate bonds, users are
accustomed to this practice, the discount rate can be determined reliably and is
applied consistently by entities in that jurisdiction. The ED would lead to a
considerable widening of the range of discount rates applied and a move from a
‘level 1 fair value’ discount rate to a ‘level 3 fair value’ discount rate.

One would generally support proposals to improve
comparability and consistency. However, it appears inappropriate to have
consistency without having considered whether corporate bond rate or government
bond rate is appropriate to use. This quick fix proposed change only for
purposes of consistency does not match well with numerous accounting options
under IFRS — particularly one that needs mention is the manner in which
actuarial gains and losses are recognised in IFRS. Besides, for reasons
mentioned above, it is highly questionable if consistency would be achieved by
the proposed amendments.

The author would therefore recommend status quo and no haphazard changes to
IAS 19 discount rate at this stage.

levitra

Back to basics — Audit

Article

What is Audit :


Audit is an independent examination of financial information
of any entity when such an examination is conducted with a view to expressing an
opinion thereon. Audit is supposed to provide credibility to the accounts
presented. Audits are conducted for different purposes. Internal or management
audit objective is to aid management or owner of an entity to ascertain specific
aspect of an entity or may be for overall comfort of the management.

Evolution of Audit :

Previously business of an enterprise was run by owners
themselves. But with the increase in scale and complexity of operations,
ownership and management of the business was separated. In earlier days business
was conducted with own resources, without the help of funds borrowed
from outsiders. Now the proportion of borrowed funds utilised in the business
has increased and is in multiples of own fund. As a result, there are different
stakeholders for an enterprise, such as shareholders, lenders, employees, etc.
All the stakeholders are interested in protecting their own interest. With the
emphasis on governance, audit has gained much more importance. Audit is no more
conducted merely for statutory compliance. Expectations from audit by the
management, independent directors, investors and regulators have increased.

A change in nature and scale of operations has also resulted
into a change in the manner of record keeping. Enterprises have shifted from
manual records to computerised system of book keeping. Most of the records are
now kept in computerised format. Certain important controls are built in the
computerised system itself. With the opening up of the economy, exposure of
domestic businesses to the world market has increased. It has given rise to
substantial foreign currency transactions, various types of financial
products/instruments and different way of addressing the fund requirement. As a
result, accounting has also become much more complex. To deal with some of the
complexity, number of accounting standards have been introduced/revised which
are mandatory.

The new challenges have obviously brought a change in the
audit approach as well. To bring uniformity in audit and to maintain its
quality, various standard auditing practices have been prescribed by The
Institute of Chartered Accountants of India (ICAI). In all, there are more than
35 Auditing and Assurance Standards which have been issued by ICAI. With a view
to converge them with the International Standards, recently they have been
renumbered and are now called Engagement & Quality Control Standards. These
auditing standards are guide to an auditor for conducting an audit in an
effective manner. It also provides elaborate procedures and tools for conduct of
audit.

In spite of this, worldwide many enterprises are suddenly
folding and many of them have gone into liquidation. When such an event happens,
role of the auditor is always questioned and in many cases auditors are found to
have committed lapses in their work. The question which arises is whether all
these auditing standards and using modern techniques have improved quality of
audit ? I believe that it has not yielded expected results as the basics of
the audit are either forgotten or not applied properly. In the subsequent
paragraphs, I have discussed certain basics which should not be forgotten in the
new era. In my view, these basics need to be applied along with the modern
techniques of ‘audit’ to improve quality of audit.

Basics of Audit :

1. Cut-off procedure and checking :


Cut-off is a process by which one accounting period is
separated from another. It is important to have proper check of cut-off
documents to make sure that there is no over or understatement of revenue or
expenses. In the computerised environment it is difficult to check ‘cut-off’
procedures. It is important to understand the accounting software used and
control in the system by which no new transactions can be entered after the
cut-off date. It is important to check certain physical records such as
invoices, purchase orders, receipts and issue notes with the entry in the
computer software. To meet the stricter time deadline, one should not compromise
checking of ‘cut-off’ procedures.

2. Control in the Computerised

Environment :

One should not blindly rely on the accounting software used
in the preparation of financial statements. In-built checks and balances in the
accounting software should be examined and it is necessary to confirm that they
meet the internal control norms. It is also necessary to ascertain other
software packages which interact with the accounting software and one must
ensure that there is no possibility of unauthorised intervention. It is also
important to keep record of changes made in the accounting system and their
implication. In case there is a weakness noticed in the computer system, manual
controls exercised to overcome the same should be verified. In manual record
keeping any changes made in the records are apparent, while in case of
computerised system it is not so. It is important to check the history file
created by the system to ascertain changes made in the record.

There is a general feeling that computer-generated statements
will not have any totalling error and will capture all the relevant items. Many
times this results into an error. It is therefore important to confirm that
relevant fields are properly captured in totalling. Simple technique like hash
total will ensure that relevant items are properly considered.

3. Prudence :


With the emphasis of fair value accounting in the modern world, accounting prudence is forgotten. The importance of prudence is highlighted only when something goes wrong. One should always keep in mind prudence even at the time of fair value accounting. In other words, when one is calculating fair value of assets or liabilities, prudence should be giVen importance and in the shadow of fair value, assets should not be overvalued or liabilities should not be undervalued. One should remain conservative in recognising revenue and in case of uncertainty, should follow the principle of postponing the revenue till the time certainty of its recovery is established. At the same time probable loss or expense should be recognised in the financial statements and should not be reversed till the time probability exists of its materialising. As India is preparing for conversion of its accounting standards to International Financial Reporting Standards (IFRS), it is also moving towards fair value accounting and in this journey it is important to keep the principle of prudence alive. With the recent financial crisis the world is facing, a debate has already started in the United States and Europe about blind acceptance of fair value accounting.

4. Substance over Form:
This concept is quite important in current scenario. With the advent of various structured products in the financial market, it is important to understand the intrinsic nature of a product. Without this understanding, there can be fatal error in accounting. In-depth understanding of the product is required before one judges its accounting treatment. Many times, implication of certain clauses in such agreements are not known even to the management of the company and in the process they are not aware of risks the organisation is exposed to. It is the duty of the auditors to go into the important terms and conditions of such products and if necessary, make management aware of the substance and its implication. In a situation where audit firm does not have internal expertise in understanding such products, one should not shy away from taking help of another fellow member or an expert. Many frauds happen when substance is different than form. Auditors need to keep in mind that form of instrument should not over-shadow its substance. An audit team needs to have proper training, so that such instances can be detected to make appropriate adjustments in accounting.

5. Professional Judgment:
With so many quality control (auditing) standards and importance given to documentation, audit is becoming a rule-based exercise and many times lacks proper application of mind. Here, I am not trying to undermine importance of documentation. It is important to have proper documentation to prove that proper audit was conducted and to avoid charge of negligence. At the same time, professional judgment is also important, which is gained by experience. Professional judgment is an art and is an important element of any audit.

An experienced auditor is aware of the need to develop a rapport with key personnel of the organisation without compromising independence. It is important to have constructive conversation with key employees in departments other than finance. Many times such interaction gives important clues to something wrong happening in the accounting. A Latin meaning of the word ‘Audit’ is ‘he hears’ and this quality of hearing others is important part of audit. The acquisition of technical knowledge and skill, no matter how extensive, will take one so far and no further. Good auditors are those who have developed their intuitive skills in a manner that technical knowledge can be applied in a given situation. Professional judgment is also to be applied in ascertaining that audit findings are material enough to affect true and fairness of the financial statements presented. For materiality, one should not merely go by percentage of profit or sales, but should apply his professional judgment for correct reporting on the financial statements.

Substantive Tests:

Substantive test is one of the important audit tests performed. It is a test of transactions and balances, and other procedures such as an analytical review, which provides audit evidence as to the completeness, accuracy and validity of financial information contained in the accounting records. The nature, extent and timing of the tests are determined by the degree of reliance which the auditor can place on the internal and operational controls.

Successful of audit depends upon proper selection of samples. Nowadays, substantive tests are conducted in a routine manner. Samples are chosen on the basis of random number selections. What is missing is proper designing of substantive tests. There should be intelligent selection of samples based on the review of main ledger accounts and after conducting analytical review. One should also remember that vouching has its place in audit, though this method of audit testing is time-consuming. By vouching the auditor goes behind the accounting records and traces the entries to their source. Where the internal controls system is weak, vouching may not be effective as the information may have been purposely entered and may be contrary to the facts. In case of a reasonable internal control in place, vouching should be carried out of key operational areas.

Before I conclude I would strongly recommend that the auditor should ensure that the business carried on by the auditee is authorised by its objects clause and the various authorities within the company operate within their sanctioned prescribed limits.

Conclusion

The challenge is to have a blend of basic and modern techniques for an effective audit. Basics of audit should not be forgotten whilst implementing modern audit techniques and approach.

Practical Insights into Accounting for change in Ownership Interest in a Subsidiary under IND AS

The business combination and consolidation principles as discussed under Ind AS-103 (Business combinations) and Ind AS-27 (Consolidated and Separate Financial Statements) provide elaborate guidance on different arrangements between shareholders that lead to change in ownership interest. Such a change in ownership interest may alter the existing control conclusion (i.e., that lead to an investor obtaining or losing control over an investee) or that may not alter the existing control conclusion. In this article, we focus on the guidance provided under Ind AS on such transactions between shareholders, sharing our perspectives on the accounting for such arrangements.

There could be mainly four scenarios for change in ownership interest over an investee, where the change in ownership interest in the investee leads to:

(1)    dilution of ownership interest that leads to loss of control over a subsidiary;
(2)    dilution of ownership interest, but the control over a subsidiary is retained;
(3)    acquisition of additional ownership interest in an existing subsidiary; and
(4)    acquiring control over the investee that is not a subsidiary at the time of acquisition.

Scenario 2 and 3 as mentioned above relate to dilution of existing interest and acquisition of additional interest, respectively, that does not change the control conclusion i.e., the investee would be classified as a subsidiary before and after the change in ownership interest. As the accounting principles for such transactions are common, we shall combine the scenario 2 and scenario 3 for the purpose of this discussion.

The accounting for change in ownership interest in an investee that is not classified as a subsidiary, associate or joint venture in accordance with Ind AS shall be accounted based on guidance provided under the Ind AS-32 and Ind AS- 39 relating to financial instruments and is beyond the discussion under this article.

Let us consider each of the above scenarios.

Dilution leading to loss of control

Dilution and loss of control

The dilution of ownership interest in a subsidiary may be in the nature of absolute change or a relative change in ownership interest and takes various forms such as:

— the parent selling all or part of its ownership interest in its subsidiary;
— the subsidiary issues shares to third parties, thereby reducing the parent’s ownership interest in the subsidiary.

Such a dilution may lead to loss of control over the subsidiary. However, sometimes the loss of control may not involve change in ownership interest (absolute or relative), but may be effected

through contractual arrangements, such as:

— a contractual agreement that gave control of the subsidiary to the parent expires; or

— substantive participating rights are granted to other parties.

Accounting for loss of control

When a parent loses control of a subsidiary, broadly the following steps are involved in accounting for the loss of control over a subsidiary, whereby the parent:

—  de-recognises the assets (including any good-will) and liabilities of the subsidiary at their carrying amounts in the consolidated financial statements at the date when control is lost;

— de-recognises the carrying amount of any non-controlling interests (NCI) in the subsidiary in the consolidated financial statements at the date when control is lost (including any components of other comprehensive income attributable to them);

— recognises the fair value of the consideration received, if any, from the transaction, event or circumstances that resulted in the loss of control;

— recognises any investment retained in the former subsidiary at its fair value at the date when control is lost;

— reclassifies to profit or loss (or transfers directly to retained earnings if required in accordance with other Ind AS) gain or loss previously recognised in other comprehensive income (OCI); and

— recognises any resulting difference as a gain or loss in profit or loss attributable to the parent.

Based on the above broad steps, there is a two-fold impact for the loss of control in the profit or loss account (i) reclassification of amounts accumulated in the OCI; (ii) loss or gain due to loss of control over subsidiary.

Reclassification from OCI to profit or loss

The amounts accumulated in OCI are transferred to profit or loss account as on losing control, components of other comprehensive income related to the subsidiary’s assets and liabilities are accounted for on the same basis as would be required if the individual assets and liabilities had been disposed of directly.

Loss or gain due to loss of control

If the loss of control is pursuant to sale of all of the parent’s investment in the former subsidiary, then the loss or gain would only comprise of loss or gain on sale of subsidiary.

However, if the parent retains some or all of its investment in the former subsidiary after losing control (i.e., a non-controlling interest), then such investments would be measured at its fair value as at the date of losing control and the impact would be recognised as part of loss or gain in profit or loss account. In such a case, the loss or gain due to loss of control would comprise of two elements i.e.,

—  loss or profit on disposal of subsidiary; and

—  loss or gain on remeasurement of investments to the extent retained at the time of losing control.

Illustration
The above principles can be explained with the help of the following example:

— Company A owns 60% of the shares in Company B.

— On 1 April 2010 A disposes of a 20% interest in B for cash of Rs. 200 and loses control over B.

—  The fair value of the remaining 40% (i.e., 60 – 20) investment is determined to be Rs. 400.

— At the date that A disposes of a 20% interest in B, the carrying amount of the net assets of B is Rs. 875.

— Before allocation to NCI, the OCI included foreign currency translation reserve (FCTR) of Rs. 50 and available-for-sale revaluation reserve (AFS reserve) of Rs. 100 relating to the subsidiary.

— The amount of NCI in the consolidated financial statements of A on 1 April 2010 is Rs. 350. The carrying amount of NCI includes an amount of Rs. 20 and Rs. 40 relating to NCI’s share (i.e., 40%) in the FCTR and AFS reserve, respectively.

A shall record the following entry to reflect its loss of control over B at 1st April 2010:

The 165 recognised in profit or loss comprises:

— the increase in the fair value of the retained 40% investment of Rs. 50 [400 – (875 x 40%)];

— the gain on the disposal of the 20% interest of Rs. 25 [200 – (875 x 20%)],

— the reclassification adjustments for transfer from OCI of Rs. 90 (30 + 60).

The remaining interest of 40% represents the cost on initial recognition of that investment and the subsequent accounting for the said investment would be as per Ind AS-28 (Investment in Associates) or Ind AS-39 (Financial Instruments: Recognition and Measurement), depending upon whether the investee qualifies as an associate.

Change in ownership interest while retaining control

After a parent has obtained control of a subsidiary, it may change its ownership interest in that subsidiary without losing control. This can happen, for example, through the parent buying shares from, or selling shares to, the NCI or through the subsidiary issuing new shares or reacquiring its shares.

Transactions that result in changes in ownership interests while retaining control are accounted for as transactions with equity holders in their capacity as equity holders. As a result, no gain or loss on such changes is recognised in profit or loss; instead it is recognised in equity. Also, no change in the carrying amounts of assets (including goodwill) or liabilities is recognised as a result of such transactions. This approach is consistent with NCI being a component of equity.

The interests of the parent and NCI in the subsidiary are adjusted to reflect the relative change in their interests in the subsidiary’s equity. Any difference between the amount by which NCI are adjusted and the fair value of the consideration paid or received is recognised directly in equity. Similar principles also apply when a subsidiary issues new shares and the ownership interests change due to that issuance.

Broadly, the following steps are involved in accounting for such transactions:

— Calculate the amount of adjustment required in NCI

— Recognise the difference between the adjustment to NCI and consideration, in equity. Illustrations:

The above principles can be explained with the help of the following examples:

Illustration 1: Subsidiary issues fresh shares leading to change in relative interest

— Company B has 100 ordinary shares outstanding and the carrying amount of its equity (net assets) is Rs. 100. S has no other comprehensive income.

—  Company A owns 90% of B, i.e., 90 shares.

— B issues 20 new ordinary shares to a third party for Rs. 40 in cash, as a result of which B’s net assets increase to Rs. 140;

— A’s ownership interest in B reduces from 90% to 75% (A now owns 90 shares out of 120 issued); and

— NCI in B increase from Rs. 10 (100 x 10%) to Rs. 35 (140 x 25%).

Company A records the following entry in its consolidated financial statements to recognise the increase in NCI in B arising from the issue of shares as follows:

Illustration 2: Purchase of additional interest from NCI

— Company A acquired 80% of Company B in a business combination several years ago. A sub-sequently purchases an additional 10% interest in B from third parties for Rs. 300;

—  The carrying value of B’s net assets, NCI and parent’s share of equity was Rs. 1000, Rs. 200 and Rs. 800, respectively.

Consequent to the additional purchase of 10% interest in B, the NCI shall adjusted by Rs. 100 for the 10% interest and the difference between the consideration paid (i.e., Rs. 300) and the adjustment to NCI (i.e., Rs. 100) shall be recognised in equity.

Illustration 3: Sale of interest

— Company A acquired 80% of Company B in a business combination several years ago. A subsequently sells a 20% interest in S for Rs. 300, but retains control of B.

— The carrying value of B’s net assets, NCI and parent’s share of equity was Rs. 1000, Rs. 200 and Rs. 800, respectively.

Consequent to the sale of 20% interest in B, the NCI shall be adjusted (i.e., increase) by Rs. 200 for the 20% interest and the difference between the consideration received (i.e., Rs. 300) and the adjustment to NCI (i.e. difference of Rs. 100) shall be recognised in equity.

Acquisition control over the investee that is not a subsidiary at the time of acquisition

The fourth scenario discussed above is in relation to acquisition of shares in an investee resulting in the investor acquiring control over the investee. Such transactions are covered within Ind AS-103 (Business Combinations) to the extent the investee constitutes a business. If the investee does not constitute a business, then the accounting should be in line with the other applicable Ind ASs. We will cover these in subsequent articles.

Summary

Overall, the implementation of the above guidance would involve exercise of judgment as the accounting for change in ownership interest is dependent on whether the control conclusion has changed. In case the change in ownership interest leads to:

— gaining control over an investee that constitutes a business, then such arrangements are recognised as business combinations as per Ind AS-103;

—  losing of control over an existing subsidiary, then any profit or loss on change of ownership (including fair value movements of retained interest) is recognised as part of profit or loss; and

— any change in absolute or relative interest that does not change the control conclusion in case of a subsidiary, is recognised in equity.

Suit by grandfather on behalf of minor — Next friend can be any person — Civil Procedure Code, Order 32 Rule 2.

[Iqbal Ahmad Khan v. Master Mahmood Raza Khan Sherwani, AIR 201 All. 136]

The plaintiff was a minor and filed the suit through his grandfather. An application had been moved by the defendant before the Trial Court that the suit was not maintainable on the ground that it had not been filed through the next friend and, therefore, it was not maintainable under Order XXXII, Rule 2 of the Code of Civil Procedure.

The Court observed that the father was not alive though the mother was alive, but the suit had been filed through the grandfather. Under Order XXXII, Rule 2 of the Code of Civil Procedure, the word used is ‘next friend’. The ‘next friend’ is not confined to the natural guardian only. The Patna High Court in the case of Narain Singh v. Sapurna Kuer and Ors., AIR 1968 Pat. 318 had observed that a next friend can be any person, not necessarily any of the guardians enumerated in section 4 of the Hindu Minority and Guardianship Act, 1956. Therefore, the suit filed by the minor through grandfather cannot be said to be not maintainable.

Right to Information — Disclosure of order sheet noting and note sheets of public authority — Right to Information Act S. 8(j).

[Arun Luthra v. Chattisgrah State Information Commission & Ors., AIR 2011 Chhatisgarh 128]

On an application filed seeking disclosure of order sheets and note sheets of public authority relat-ing to matter of encroachment, the State Chief Information Commissioner had directed the Public Information Officer of the Raipur Development Authority to supply the information in the form of order sheets.

The petitioner filed the petition challenging the le-gality of the order. The Court observed that as far as clause 8(j) of the Act is concerned, it would not come in the way of disclosure of information of the nature, which has been directed by the Chief Information Commissioner. The exemption from disclosure of the information under clause 8(j) of the Act is in relation to those categories of information, which are personal, the disclosure of which has no relationship to any public activity or interest or which would cause unwarranted invasion of the privacy of the individual. The disclosure of order sheets and note sheets of a public authority with regard to various actions taken by it, cannot be said to be a matter relating to personal information of the petitioner, having no relation to any public activity or interest. Moreover, it cannot be said that the disclosure of note sheets of the public functionary with regard to whatsoever activity it has undertaken in its capacity as such, would cause unwarranted invasion of the privacy of the petitioner. In any case, such exemption is not absolute, because even assuming that the information is personal in nature, disclosure of such, would be permissible, if the Information Officer is satisfied that the larger public interest justifies the disclosure of such information. The Court held that the disclosure of the order sheets or note sheets of the Development Authority with regard to steps, if any, taken after the order of the Court, would not be in any manner, a matter relating to disclosure of personal information of the category as stated under clause 8(j) of the Act.

The Court further observed that as far as violation of section 11 of the Act is concerned, the contents of note sheets and order sheets maintained by public authority, cannot be said to be information supplied by a third party to the Public Information Officer as confidential. From the fact there was no material disclosed to the Court to show that any confidential information given by the petitioner to the Development Authority was sought to be disclosed under the order impugned. In the order, the Chief Information Commissioner had not directed the Public Information Officer to disclose any information disclosed by the petitioner and treated by the Development Authority as confidential. There was no information sought by the respondent which is of the nature as contemplated u/s.11 of the Act, though the order of the Chief Information Commissioner is merely confined to disclosure of order sheets and note sheets after the order of the Court.

The provisions of section 3 of the Act state that subject to the provisions of the Act, all citizens shall have the right to information. If the same is read along with section 6 of the Act, it would be clear that in order to seek dis-closure of information, an information seeker is neither required to disclose invasion of any of his rights, nor any legal injury much less state reasons as to why he is seeking such information. The right is only subject to the provisions of the Act. Therefore, whatever may be the motive of the respondent and whether or not, any of his rights are affected, there is an obligation to provide information by the Information Officer, which of course, would be subject to other provisions of the Act.

Stamp Duty — Gift deed — Market value not relevant : Stamp Act, 1899.

[Sumit Gupta v. State of UP and Ors., AIR 2011 All. 135]

The instrument in question was a deed of gift dated 11 -2-2009 executed by one Ramesh Chand Lohia in favour of his grandson in respect of a property of Rs.61 lakh in value, as disclosed in the gift deed. However, on the objection of Sub-Registrar its value was enhanced to Rs.61 lakh for the purposes of stamp duty and on the said value stamp duty of Rs.4,27,100 was duly paid.

The matter was referred u/s.33/47-A of the (Indian) Stamp Act, 1899 for determination of the market value and the deficiency in payment of stamp duty was determined.

The said order was challenged and upheld in ap-peal. The important aspect involved in the petition was whether the authorities under the Act are competent u/s.47-A of the Act to determine the market value of the property referred to in the gift deed in question for the purposes of levy of stamp duty.

The Court observed that a gift deed is chargeable to stamp duty under Article 33 of Schedule 1-B of the Act. It provides that a gift is chargeable to stamp duty as a conveyance provided under Article 23 Clause (a) for a consideration equal to the value of the property.

In the said Article words used are ‘value of the property’ as distinguished from the ‘market value’, meaning thereby that for the purposes of determining stamp duty on a gift deed, market value is not required to be mentioned/determined. The disclosure of the value of the property in the gift is sufficient for the purposes of payment of stamp duty.

Thus, there is a clear departure in the language used in Article 33 of the Schedule 1-B of the Act and section 47-A of the Act. Section 47-A of the Act uses the expression in ‘market value’, whereas for levying stamp duty on a gift deed Article 33 of Schedule 1-B of the Act uses the expression ‘value of the property’.

The Legislature in its wisdom has differently used the words ‘value of the property’ and ‘market value’ in the Act. It is not without purpose. ‘Market value’ refers to the value of the property prevailing in the market on which the prospective purchaser is ready and willing to purchase and seller is ready and willing to sell the property in the ordinary course of business. Therefore, market value is a bilateral transaction depended upon the will of two persons. On the other hand, ‘value’ simply connotes the estimated monetary worth of the property in the eyes of the seller and is in the nature of a unilateral act.

Therefore, the market value is not at all relevant for levying stamp duty on a gift deed and the provisions of section 47-A of the Act does not come into play which necessitate determination of market value.

Rights of daughter to ancestral property — Overriding effect of Act — Hindu Succession Act section 4(1)(a) and 6.

[Smt. Gulabbai Chhaganlal & Ors. v. Smt. Kamalabai Lakhan & Ors., AIR 2011 MP 156]

The appellant No. 1 was the wife while appellants No. 2 and 3 and respondents No. 1, 2, 3, 4 and 6 were sons and daughter of the deceased. The appellants filed a suit on 7-11-2001 for permanent injunction, wherein it was alleged that the property shown in Schedule of the plaint was recorded in the Revenue record in the name of the appellants and respondents No. 3 and 4 (sons).

It was alleged that as per family personal law, daughters (respondent No. 1 and 2) had no right in ancestral property. It was alleged that daughters were claiming their rights illegally. Undisputedly, the appellants and respondents were members of one family and were legal representatives of de-ceased Shri Chhaganlal. The suit was dismissed.

The Court observed that the right which was be-ing claimed by the appellants was based on family customs. As per Clause (a) of s.s (1) of section 4 of the Hindu Succession Act, 1956 any text, rule or interpretation of Hindu Law or any custom or usage as part of that law in force immediately before commencement of this Act, shall cease to have effect with respect to any matter for which provision is made in that Act. After coming into force of the Hindu Succession Act, any custom or usage as part of that law prevailing in the family automatically ceased to have effect. Apart from this, the appellants had failed to establish any rule prevailing in the family, which denied rights of daughter in the ancestral property. In view of the above, the appeal was dismissed.

Dishonour of cheque — Cheque presented after expiry of six months from date of issuance — Complaint not maintainable — Negotiable Instruments Act, S. 138.

[Prabhakar Sinha v. The State of Bihar & Anr., AIR 2011 (NOC) 367 (Pat.)]

The complainant gave Rs.50,000 as friendly loan to the petitioner vide cheque dated 7-9-2004 for an amount of Rs.20,000 drawn on ICICI Bank, Dhanbad Branch and he gave Rs.30,000 in cash to the petitioner. It was further disclosed that the petitioner subsequently on 4-2-2005 issued a cheque of Rs.50,000 dated 4-1-2005 drawn on Bank of Baroda, Patna Branch. However, at the time of handing over the cheque, it was requested by the petitioner to present the same after a fortnight. As appears from the complaint-petition that in the meanwhile the petitioner was kidnapped and he was released after a week and as such the complainant kept the presentation of the cheque in abeyance. Subsequently, the petitioner periodically requested the complainant not to present the cheque. After confirmation given by the petitioner that there was sufficient amount in his account, the cheque was presented in Bank. However, on 16-7-2005, the cheque was returned to the complainant unpaid due to the reason of insufficient funds in account of the petitioner. The complainant again contacted the petitioner, who promised to deposit sufficient amount in his account by 25-7-2005. Accordingly, the complain-ant again produced the cheque on 26-7-2005 for its encashment, but the same again bounced back. The complainant received such intimation on 6-8-2005. The complainant further disclosed that on 25-8- 2005, the complainant got a legal notice issued to the petitioner and despite that the petitioner did not clear the due amount. The learned Sub- Divisional Judicial Magistrate, Patna, by its order dated 19-12- 2005, took cognizance of offence u/s.420 of the Indian Penal Code and section 138 of the Negotiable Instruments Act. The petitioner challenged the said order before the High Court, wherein the Court held that since the cheque itself was presented after expiry of six months from the date of issuance, section 138 of the Negotiable Instruments Act will not attract. The Magistrate committed an error in passing the impugned order of the cognizance moreso when the facts disclosed in the complaint-petition do not make a case for either application of section 420 of the Penal Code or section 138 of the Negotiable Instruments Act. The impugned order of cognizance was therefore quashed.

SA 330 – The Auditor’s Responses to Assessed Risks

While planning an audit of financial statements, the auditor identifies risks of material misstatement both at the financial statement level and at the assertion level. The objective of the auditor is to obtain sufficient and appropriate audit evidence to address this risk and he does so by designing and implementing appropriate responses to such risks. How the auditor designs these responses will be influenced by the auditor’s assessment of the risk of material misstatement at the assertion level for each class of transactions, account balances and disclosures including:

  • the likelihood of material misstatement due to the particular characteristics of the relevant class of transactions, account balances, or disclosures (i.e., inherent risk); and

  • the existence and operation of relevant controls (i.e., control risk), thereby requiring the auditor to obtain audit evidence to determine whether the controls are operating effectively and whether reliance can be placed on their operating effectiveness in determining the nature, timing and extent of substantive procedures.

Let us break the auditor’s responses to assessed risks into two parts and look at each one of them independently and in conjunction, bearing in mind the auditor’s objectives while performing an audit of financial statements:

1)    Overall response to the risks identified at financial statement level
2)    Audit procedures which are responsive to assessed risks of material misstatements at the assertion level.

Overall response to the risks identified at financial statement level

Guilelessly put, risk of material misstatements at the financial statement level is the risk that the financial statements as a whole may not reflect a true and fair view. Risk of material misstatement as we know is a function of inherent risk and control risk. To address this risk, the auditor may include the following responses while planning the audit of financial statement:

  • Incorporating additional elements of unpredictability in the selection of further audit procedures to be performed (like varying the timing of audit procedures, selecting items for testing that have lower amounts or are otherwise outside customary selection parameters, etc.)

  • Making generic changes to the nature, timing or extent of audit procedures, for example: performing substantive procedures at the period end instead of at an interim date; or modifying the nature of audit procedures to obtain more persuasive audit evidence.

  • Emphasising to the audit team the need to maintain professional skepticism.

  • Assigning more experienced staff or those with special skill sets or using experts and providing increased levels of supervision

The auditor’s assessment of the financial statement level risks, and thereby his overall responses, are affected by his understanding of the control environment. An effective control environment may allow him to have more confidence in internal controls and the reliability of audit evidence generated internally within the entity. The overall response by an auditor to the financial statement risks generally has a noteworthy bearing on the auditor’s general approach towards an audit. Hence it is important that these responses are evaluated and implemented by the auditor in the planning stage of an audit.

Audit procedures which are responsive to assessed risks of material misstatements at the assertion level

The nature, timing and extent of audit procedures are based on the assessment of risk of material misstatement at the assertion level of financial statement captions by the auditor and the auditors’ approach to address a specific risk may vary. For example:

  • He may choose to perform only test of operating effectiveness of controls if he feels that he may achieve an effective response to the risk of material misstatement for a particular assertion.

  • He may choose to perform only substantive procedures if he concludes that there are no effective controls relevant to that particular assertion.

  • He may choose to have a combined approach using both test of controls and substantive procedures.

The design of further audit procedures to be performed by the auditor is generally based on:

1)    The auditor’s assessment of inherent risk and control risk assigned to an assertion, and
2)    Persuasiveness of audit evidence required to address the degree of risk identified.

Let us consider a case study to understand the above concepts.

Case study

Addressing risks at the financial statement level

Background

KKM and Company (‘KKM’) is a financial institution operating in a highly regulated environment. Based on the following scenarios, let us examine the approach that the auditors of KKM, M/s. ALB and Associates would need to adopt to address the risk of material misstatement at financial statement level.

1.    Based on the experience obtained during the past audits, management inquiries conducted and the results obtained while evaluating the design and implementation of higher level controls, the auditors have assessed the control environment to be effective.

2.    The engagement team is comparatively new and is undertaking the audit of this company for the very first time.

3.    The management of the company is well aware of the audit procedures performed by the audit team on a year on year basis. They are ready with all the information required by the audit team at the commencement of the audit. All the information required to be given to the auditors is entirely reviewed by the management to identify any errors and changes and any identified changes are duly incorporated in the information sent to auditors for audit.

4.    As per the policy in place at ALB and Associates, based on the risk grading assigned to KKM while performing the engagement acceptance formalities, the audit team is required to have at least two managers reviewing the work done by the engagement team. However, the engagement partner is of the belief that one manager is sufficient to review the audit.

Evaluation

As per SA 330, the auditor is required to address the risk of material misstatement at financial statement level. He may do so by changing the nature, timing and extent of his audit procedures.

1.    In this scenario, the auditor has concluded that the control environment of the entity is effective. Based on the efficacy of the control environment and existence and operation of internal controls, the reliability of the audit evidence generated internally by the entity increases. This may help the auditor to reduce the nature, timing and extent of audit procedures to be performed by him. Such a reliance on internal controls may help him to place less emphasis on substantive procedures and elect to have a controls based approach towards audit. Such an approach would also help the auditor save time and resources.

2.    In such a scenario where the engagement team is relatively new to the client, the engagement manager/ partner need to ensure that the team is appropriately trained and guided to apply professional skepticism during the course of the audit. The audit team may also find it useful to engage the work of experts wherever required. The audit team should also be made to attend trainings on audit methodology and procedures so as to equip them with the requisite knowledge about the client and the industry. The audit team should familiarise themselves with the client and the industry in which it operates by perusing the previous year’s work papers to obtain an understanding of the issues which were identified in the prior year audit as well as to address any carried forward issues from the previous year’s audit.

3.    In the current scenario, the audit team has been performing identical audit procedures over a period of time due to which the client is well aware of these procedures. In such a scenario, the audit team should include surprise procedures so as to eliminate the consistency of audit procedures so as to incorporate an element of unpredictability in the procedures applied. This surprise element will also help the audit team to address the fraud risk, if any, for certain classes of transactions. For example the audit team may perform a surprise visit for one of the branches of the company for verification of cash balances, select certain low value debtors or debtors with credit balances for balance circularisation etc.

4.    The engagement partner is deviating from the policy followed by the firm while performing the audit of this entity. In the given scenario, based on the risk grade assigned to the entity, at least two managers are to be assigned to this engagement. Hence the engagement partner should increase the number of managers on the job to two. This would increase the supervision on engagement, thus also helping the auditors to address the risk of material misstatement at the financial statement level.

Closing Remarks

Assessing risk lies at the core of the audit process and this article has introduced and explained some of the terminology used by SA 330, giving guidance to auditors on how to respond to assessed risks. In general, tests of control are short, quick audit tests, whereas substantive procedures will require more detailed audit work. SA 330 requires that, irrespective of the assessed risks of material misstatement, the auditor would need to design and perform substantive procedures for each class of transactions, account balance and disclosures. We will discuss the concept of assessing risks at the assertion level in our next article.

25. [2015-TIOL-2086-CESTAT-DEL] Commissioner of Service Tax, Delhi vs. M/s Bagai Construction.

25. [2015-TIOL-2086-CESTAT-DEL] Commissioner of Service Tax, Delhi vs. M/s Bagai Construction.

The taxable event for the levy of service tax is the date of rendition of service. Thus the rate prevalent at the time of provision of service would be the applicable rate irrespective of the rate prevalent at the time of receipt of payment.

Facts:

Assessee paid service tax under works contract service at the rate of 2.06% which was the rate prevalent prior to 01/03/2008 for the payments received after the said date. Although the rate applicable at the time of receipt of payment was 4.12% it was contended that the payments received related to the services rendered prior to 01/03/2008 therefore the old rate should apply.

Held:

Relying on the decision of the Delhi High Court in the case of Vistar Construction P. Ltd vs. Union of India & Ors [2013-TIOL-73-HC-DEL-ST] wherein the Court held that the rate of tax applicable on the date on which the services were rendered would be the one that would be relevant and not the rate of tax on the date on which payments were received. The Tribunal decided the matter in favour of the Assessee.

[Note: Readers may note that the issue pertains to the period prior to the introduction of the Point of Taxation Rules, 2011. However, section 67A of the Finance Act, 1994 provides that the rate of service tax, value of taxable service and rate of exchange will be as applicable at the time when the taxable service has been provided or agreed to be provided. Therefore the taxable event being the provision of the service provided or agreed to be provided, the ratio of the aforesaid judgment may be applied.

20. 2015 (39) STR 972 (Ker.) Dileep Kumar V. S. vs. Union of India

20. 2015 (39) STR 972 (Ker.) Dileep Kumar V. S. vs. Union of India

If the assessee has alternate remedy to file appeal before the Tribunal, writ is maintainable even if there is a provision of mandatory pre-deposit before filing appeal.

Facts:

The petitioner’s demand was confirmed by adjudicating authority and first appellate authority without expressly considering the issue of jurisdiction as directed by the Hon’ble High Court. Further, the appellate authority did not consider the plea of limitation. Accordingly, the petitioner filed the writ.

Held:

The petitioner had an effective alternate remedy to file appeal before appellate tribunal after payment of mandatory pre-deposit. The condition of mandatory pre-deposit for filing appeal was not so onerous to deprive the petitioner of an effective right of appeal. Comparing the present and erstwhile provisions of pre-deposit, only 10% of confirmed tax demand needed to be deposited which is fairly reasonable and imposes a lighter burden on the assessees. The writ therefore was dismissed.

Hindu Law – Joint family property – Partition – Members suing for partition not bound to bring into hotchpot all family property

7. Hindu Law – Joint family property – Partition – Members suing for partition not bound to bring into hotchpot all family property:

Dhapibai vs. Tejubai    AIR 2013 MP 149

The defendant No.1 and 2 Tejubai and Supdibai are the real sisters of plaintiff No.1 Dhapubai. The property under dispute is the agriculture lands of late Bhilya father of Plaintiff No. 1 and defendant. As per allegations made, plaintiff No. 1 being the youngest daughter, after her marriage with the plaintiff No. 2, both continued to reside and live with Bhilya. The couple looked after Bhilya and managed his affairs including cultivation over the land in dispute. It was alleged that Bhilya died intestate in the year 2001, therefore his interest would devolve exclusively upon the plaintiffs as per custom and usage and not upon other surviving members of the family. It was further alleged that defendants were trying to interfere in the possession over the land in dispute therefore, the suit for permanent injunction.

Defendants denied the claim of plaintiffs that they exclusively succeeded to the Bhilyas interest in the agricultural land in dispute as per custom or usage. They also denied existence of any such usage and custom. They claimed that upon the death of Bhilya, his daughters jointly succeeded and each and equal share. They also filed a counter claim claiming 1/4th share in the land in dispute.

The Trial Judge, on due consideration of evidence found no merit and substance in the case set up by the plaintiffs. On the other hand, the trial court found that defendants were able to establish their counter claim, accordingly while dismissing plaintiffs suit, a partition decree was passed in favour of respondents.

The lower appellate court continued the dismissal of the suit while affirming the decree of partition passed in favour of respondents. Hence, the second appeal.

Referring to section 332 of Mulla’s Hindu Law (21st Edition), it was submitted that a member suing for partition is bound to bring into hotchpot all family property in order that there may be complete and final partition between coparceners. In this connection, it was submitted by the plaintiff that since the defendants did not include the residential house of Bhilya in their counter claim therefore, it was liable to be dismissed and courts below erred in allowing the counter claim. The submission ignores the fact that a partition may be partial either in respect of property or in respect of the person making it. It is open to the members of joint family to make a division and severance of interest in respect of a part of the joint estate section 325 of Mullas Hindu Law. The appeal was dismissed.

Companies Act, 2013 – Accounts and Audit Provisions

The existing Companies Act was enacted in 1956 with the object to consolidate the law relating to corporate sector and to regulate its activities. This Act is in force for the last over 56 years and has been amended several times. In view of changes in national and international economic environment and growth of our economy, the Government has decided to replace the Companies Act, 1956, by a new legislation. Originally Companies Bill, 2009 was introduced in the Lok Sabha in August, 2009 and was referred to Parliamentary Standing Committee. The Government received several suggestions from various stakeholders. After due consideration of various recommendations, a fresh Companies Bill, 2011 was introduced in the Lok Sabha and again referred to the Parliamentary Standing Committee. Lok Sabha has passed this Bill as Companies Bill, 2012 on 18th December, 2012. Now the Rajya Sabha has also passed the Bill in August, 2013. The President has given his assent on 29th august, 2013. Thus the Companies Act, 2013, has now been enacted and will come into force from the date to be notified by the Government. It may be noted that out of 470 Sections, 98 Sections have come into force with effect from 12-09-2013 by a notification issued by the Government. Sections 128 to 133 and 138 to 148 of this Act deal with Accounts, Audit and Auditors. These provisions will have far reaching implications for the Audit Profession. In this article some important provisions contained in the Companies Act, 2013 are discussed.

1.    Maintenance of Accounts

1.1 New section 128 of the Companies act, 2013 (New Act) provides for books of accounts to be maintained by the company. This section is similar to the existing section 209 of the Companies Act, 1956. The new section provides that every company shall prepare and keep at its registered office and at its branches such books of account and other relevant papers as may be prescribed. The company can maintain such books and records in the electronic mode. It is clarified in the section that the books of account should be kept on accrual basis and according to the double entry system. The section also provides that the company shall retain the books of accounts with the relevant vouchers and relevant other financial records for a period of 8 financial years. Recently, the government has issued some Draft rules framed under the New Act for public comments. Draft rules 9.1 and 9.2 deal with procedure for maintenance of accounts by Companies.

1.2 It may be noted that for the first time new section 2(41) defines the term “Financial Year” to mean the period ending on 31st March of every year. Therefore, every company will now be required to maintain accounts from 1st April to 31st March which is the accounting year to be adopted for Income tax purpose. There is only one exception to this rule in the case of a holding company or subsidiary company incorporated outside India which is required to maintain its accounts for a financial year which is different from April to March. In such a case, different financial year can be adopted by getting approval of the National Company Law Tribunal (Tribunal). Further, if any existing company is adopting different financial year it will have to fall in line with the new provision within a period of two years from the date on which the new Companies Act comes into force.

2. Financial Statements

2.1 New Section 129 provides for preparation of financial statements.

The term ‘Financial Statement’ is defined in the new section 2(40) to include balance sheet, profit and loss account/income and expenditure account, cash flow statement, statement of changes in equity and any explanatory note annexed to the above. Section 2(40) has come into force from 12-09-2013. New section 129 corresponds to existing section 210. It provides that the financial statements shall give a true and fair view of the state of affairs of the company and shall comply with the accounting standards notified under new section 133. It is also provided that the financial statements shall be prepared in the form provided in new schedule III.

2.2 It may be noted that in the new schedule III the provisions for preparation of balance sheet and statement of profit and loss have been given which are on the same lines as in the existing schedule VI. Further, in the new Schedule III detailed instructions have been given for preparation of consolidated financial statements as consolidation of accounts of subsidiary companies is now made mandatory in section 129.

2.3 It may be noted that for the first time a provision has been made in the new section 129(3) that if a company has one or more subsidiaries it will have to prepare a consolidated financial statement of the company and of all the subsidiaries in the form provided in the new schedule III. The company has also to attach along with its financial statement, a separate statement containing the salient features of the financials of the subsidiary companies in such form as may be prescribed by the rules. It is also provided that if the company has interest in any associate company or a joint venture the accounts of that associate company as well as joint venture shall be consolidated. For this purpose “associate company” has been defined in new section 2(6) to mean a company in which the reporting company has significant influence i.e. it has control of atleast 20% of the total share capital of the company or has control on the business decisions under an agreement. The Central Government has power to exempt any class of companies from complying with any of the requirements of this section and the rules made under the section.

2.4 New section 136 provides for right of members to get copies ofaudited financial statements, auditors’ report, Board Report etc. at least 21 days before the date of AGM. In the case of a listed company it will be sufficient if a statement containing the salient features of such documents in the prescribed form is sent to the members at least 21 days before the AGM. Further, new section 137 provides for filing of the financial statement etc. with ROC. These provisions are similar to existing sections 219 and 220.

2.5 Draft Rules 9.3 and 9.4 provide for procedure to be followed and the Forms for compliance with Section 129.

3.    Reopening of Accounts

3.1 New sections 130 and 131 provide for the manner in which a company can reopen or recast its books of account or financial statements. This is a new provision made in the company legislation for the first time. At present, the Government has taken the view that the accounts once adopted by the members of the company at the AGM cannot be reopened or recast.

3.2    New section 130 provides that if it is found that (i) the accounts for a particular year were prepared in a fraudulent manner or (ii) the affairs of the company were mismanaged during the relevant period casting a doubt on the reliability of financial statements, an application will have to be made by the Central Government, the Income tax Authorities, the SEBI, any other statutory regulatory body or authority or any concerned party to a competent Court or Tribunal. On receipt of the order of the Court/Tribunal the company will have to reopen its accounts or recast its financial statements in conformity with the order. The accounts so revised or recast shall be considered as final.

3.3 New section 131 provides for voluntary revision of financial statements or Director’s Report. Under this section, if it appears to the directors that (i) financial statement or (ii) report of the Board of Directors for a particular financial year does not comply with the provisions of the new sections 129 or 134, they can revise the financial statement or director’s report in respect of any of the three preceding financial years. For this purpose the directors have make an application to the Tribunal in the prescribed manner and obtain its order. Before giving such an order the Tribunal has to give notice of hearing to the Central Government and the Income tax Authorities. It is also provided that such revised financial statement or report of directors shall not be prepared more than once in any financial years. Further, detailed reasons for such revision will have to be disclosed by the directors in their report to the members in the relevant financial year in which revision is made.

3.4 The Central Government has been authorised to make Rules about the procedure for such voluntary revision of financial statements and director’s report. These Rules will also provide for reporting requirements applicable to the auditors of the company. Draft rules 9.5 to 9.8 provide for the procedure to be followed by the Company for this purpose.

4.    Accounting and Auditing Standards

4.1 New Sections 132, 133 and 143(10) provide for issue of Accounting and Auditing Standards. Existing Sections 210A and 211(3A) to (3C) deal with notification of Accounting Standards on the advice of National Advisory Committee on Accounting Standards (NACS). It may be noted that NACAS is now replaced by a new authority called National Financial Reporting Authority (NFRA) with very wide powers.

4.2 New Section 132 provides for constitution of NFRA, its functions and powers. Briefly stated these provisions are as under.

(i)    The Central Government will constitute NFRA consisting of a chair person, who shall be a person of eminence and having expertise in accounting, auditing, finance or law and such other full-time or part-time members, not exceeding 15, as may be prescribed.

(ii)    Terms and conditions and the manner of appointment of chairperson and members of NFRA and other related matters shall also be prescribed.

4.3 New Section 133 provides that the Central Government will prescribe the Standards of Accounting or any addendum to such standards as recommended by the Institute of Chartered Accountant of India (ICAI) in consultation with and after examination of recommendations made by NFRA. These Accounting Standards will be binding on the companies as well as their auditors. New section 143(10) provides that the Central Government will prescribe standards of Auditing or any addendum to such standards in a similar manner. It is also provided that until such auditing standards are notified by the Government, the existing Auditing Standards issued by ICAI will be binding on the auditors. It may be noted that new Section 133 has come into force from 12-09-2013. However, Section 132 providing for constitution of NFRA has not yet come into force. In such an event it is difficult to understand how powers u/s. 133 will be exercised by the government under this Section. Further, it is not clear as to what is the position of NACAs at present. Draft Rule 9.9 provides that the existing accounting standards made under the Companies Act, 1956, shall continue till the new standards are framed.

5.    The functions of NFRA:

5.1 New Section 132 provides for functions of NFRA as under:-

(a)    to recommend to the Central Government about formation of Accounting Standards and Auditing Standards for adoption by Companies and their auditors.

(b)    to monitor and enforce the compliance with the accounting and auditing standards in such manner as is prescribed in the Rules.

(c)    to oversee the quality of service of the profession associated with ensuring compliance with such standards.

(d)    to suggest measures required for improvement in the quality of service by the professionals (i.e. chartered accountants, Cost accountants and company secretary) and such other related mat-ters as may be prescribed.

(e)    to perform such other functions relating to the above matters as may be prescribed by the Rules.

5.2 The powers which NFRA can exercise are as under.

(a)    Power to investigate, either on its own or on a reference made by the Central Government, in cases of such bodies corporate or persons, as may be prescribed, into the matters of performance or other misconduct committed by a Chartered Accountant or a Firm of Chartered Accountants. Once NFRA initiates this investigation, ICAI will have no authority to initiate or continue any proceedings in such matters.

(b)    NFRA shall have the same powers as vested in a civil Court under Code of Civil Procedure, 1908. In other words it can issue summons, enforce attendance, inspect books and other records, examine witness etc.

(c)    If any professional or other misconduct is proved, NFRA can impose penalty as under.

•    In the case of an Individual CA. minimum penalty of Rs. 1 lakh which may extend to 5 times of the fees received by the Individual.

•    In the case of a C.A. Firm, minimum penalty of Rs. 10 lakh which may extend to 10 times the fees received by the Firm.

•    NFRA can debar any Chartered Accountant or a CA Firm from practice for a minimum period of six months or for such higher period not exceeding 10 years.

5.3 Any person/firm aggrieved by any order of NFRA can file appeal before the Appellate Authority. The Central Government has been empowered to appoint such Appellate Authority consisting of the chairperson and not more than two other members. The qualifications of those constituting the Appellate Authority and all other related matters will be prescribed by the Rules.

5.4 The above provisions in new section 132 will over ride any provisions contained in any other statute. This will mean that the council of ICAI will not be able to exercise its powers relating to disciplinary action against auditors of companies. Even powers to formulate auditing standards, ensure quality of audit etc. are now vested in NFRA. To this extent the autonomy conferred on ICAI under the C.A. Act, 1949, is partially taken away.

6.    Rotation of Auditors

6.1 ICAI had successfully objected to the introduction of the system of Rotation of Auditors for the last six decades. Several commissions and Parliamentary Committees had agreed that rotation of auditors is not in the interest of the Accounting Profession and the corporate sector. In spite of this, provision for rotation of auditors has now been introduced by enactment of new section 139 in the New Act.

6.2 Appointment of Auditors:

The provisions of new section 139 dealing with appointment of auditors can be briefly stated as under.

(i)    After incorporation of a company, the first auditors (Individual or Firm of CA) should be appointed by the Board of Directors within 30 days. If the Board does not make such appointment, an extraordinary general meeting of members will have to be called within 90 days for appointment of auditors. The first auditors shall hold office upto the conclusion of first AGM.

(ii)    At the first AGM, the auditors will have to be appointed for a period of 5 years i.e. from conclusion of the AGM to the conclusion of the sixth AGM. This appointment will have to be ratified by the members every year at each AGM during this period of 5 years.

(iii)    Before appointment, the auditors will have to give their consent in writing along with a certificate in accordance with the prescribed conditions. The auditor has also to give a certificate that the criteria for his appointment given in new section 141 is satisfied.

(iv)    After such appointment, the company will have to file a notice with ROC within 15 days and also inform the auditors.

(v)    Draft Rules 10.1 and 10.2 provide for the procedure for selection of Auditors and conditions of their appointment.

6.3 Procedure for Rotation of Auditors:

(i)    The system of Rotation of Auditors has been introduced in the case of Auditors of listed companies and other class of companies (specified companies) as may be prescribed by rules. This is provided in new section 139(2) as under.

(a)    If the auditor is an Individual, he cannot be auditor of such a company for more than 5 consecutive years.

(b)    If a firm/LLP is auditor, it cannot be auditor of such a company for more than two terms of 5 consecutive years (i.e. 10 years)

(c)    In the case of an Individual who has been auditor for one term of 5 years, he cannot be reappointed by the company for the next 5 years. In the case of a firm/LLP who has been auditors of such a company for 10 years cannot be reappointed by the company for the next 5 years. It may be noted that any firm/LLP which has one or more partners who are also partners in the outgoing audit firm/LLP cannot be appointed as auditors during this 5 year period.

(d)    After the Companies Act, 2013, comes in force, every existing listed or specified company will have to comply with the above provisions relating to Rotation of Auditors within 3 years from such commencement. From the wording of second proviso to Section 139(2) it is not clear whether, for the purpose of Rotation, the period prior to the New Act coming into force should be counted for calculating the period of 10 years. Draft Rule 10.4(4)(i) states that for the purpose of Rotation the period for which the Auditor has been holding office as Auditor prior to the commencement of the New Act shall be taken into account in calculating the period of 5 or 10 consecutive years.

(e)    Thus, if an Auditor (Individual) was Auditor of any specified Company for 5 consecutive years or a Firm has been Auditors of such a Company for 10 consecutive years prior to the New Act coming into force, such Auditors will be subject to the new provisions for Rotation. As stated in Para 9.2 below, the provisions relating to Rotation will also apply to Branch Auditors.

(f)    The Central Government can make Rules to prescribe the manner in which companies shall rotate their auditors. It may be noted that Draft Rule 10.1 to 10.4 provide for procedure for Rotation of Auditors.

(g)    It may be noted that Draft Rule 10.3 provides that theabove provisions for Appointment and Rotation of Auditors will apply, besides listed Companies, to all public and private companies, other than one-person Company or small Companies.

(ii)    New section 139(3) provides that the members of any company can resolve at any AGM that the audit firm/LLP appointed by it shall rotate the audit partner and his team at such internals as specified in their resolution.

(iii) It may be noted that section 139 specifically provides that the term ‘Firm’ shall include a Limited Liability Partnership (LLP). Section 141 also states that a body corporate will not include a LLP. In other words, any company can appoint LLP wherein majority of the partners are practicing chartered accountants, as auditors of the company.

(iv)    In the case of Government companies, the C & AG has been given power to appoint auditors within the specified time limit. Provisions have also been made for filling up casual vacancy in the office of the auditors in Government companies as well as private sector companies. There are also provisions to deal with contingencies where retiring auditors are not be reappointed. It is also provided that in the cases of private sector companies where Audit Committees are constituted, the appointment of auditors can only be made by the Board/

AGM after consideration of the recommendation of the audit committee. These procedures are on similar lines as provided in the existing Companies Act with minor modifications

6.3 Since the C.A. Act permits Chartered Accountants to form LLP for professional practice and the new Companies Act permits such LLP to render service as auditors of companies, it is necessary to suggest to the Government for amendment of section 47 of the Income tax Act. At present, section 47 (xiiib) provides for exemption from capital gains tax when a company is converted into LLP, subject to certain conditions. There is no similar exemption given on conversion of firm into LLP. Unless this exemption is given by amending section 47 of the Income tax Act, it will be difficult for existing C.A. firms to convert into LLP for rendering audit service. Let us hope that council of ICAI will make suitable representation to the Central Government for amendment of Income tax Act.

7.    Removal of Auditors

7.1 New Section 140 provides for Removal, Resignation etc. of Auditors. The procedure given in this section is more or less similar to the existing procedure in section 225 with the following difference.

(i)    Under new section 140 an auditor can be removed from his office before the expiry of his term only after obtaining the previous approval of the Central Government and after passing a Special Resolution by the Members. For this purpose the company will have to comply with the prescribed rules.

(ii)    If an auditor resigns from his office, he is required to file, within 30 days, a statement in the prescribed form with the company and ROC.

In the case of a Government company, this form is also required to be filed with C& AG.
In this statement the auditor has give reasons and other facts relevant for his resignation. For failure to comply with this requirement, the auditor is punishable with a minimum fine of Rs. 50,000/- which may extend upto Rs. 5 lakh.

(iii)    If the auditor is found to have, directly or indirectly, acted in a fraudulent manner or abetted or colluded in any fraud by the company or any of its officers, the Tribunal can, on its own or on an application by the company, Central Government or any concerned person, direct the company to change the auditors. In the case of such an application by the Central Govern-ment for change of Auditors, the Tribunal can, within 15 days, pass an order that the auditor shall not function as such and the Central Government will be able to appoint another auditor. The auditor who is removed by the Tribunal cannot be appointed as an auditor of that company for 5 years. Further, under the new section 447 the auditor who is guilty of fraud will be punishable with imprisonment for a minimum term of six months which may extent to 10 years and shall also be liable to pay a minimum fine of an amount involved in the fraud which may extend to 3 times the said amount. If the fraud involves public interest the minimum period of imprisonment will be 3 years.

7.2 Draft Rules 10.5 and 10.6 provide for procedure for removal and resignation of an Auditor.

8.    Eligibility and Qualification of Auditors

8.1 New section 141 deals with eligibility, qualifications and disqualifications of Auditors. This section is similar to the existing section 226 with the following modifications.

(i)    A firm of Chartered Accountants can be appointed as auditors of a company only if ma-jority of its partners are partners practicing in India.

(ii)    As stated earlier, a LLP can be appointed as auditors of a company. However, in such a case only those partners of LLP who are chartered accountants in practice can be authorised to act and sign on behalf of the LLP.

(iii)    It is provided that no Individual or Firm of chartered accountants can be appointed as auditors of a company if the Individual, his partner or partner of the firm or any relative of such persons hold any shares in the company, its holding or subsidiary or associate company. However, a relative of such persons can hold shares of the F.V of Rs. 1,000/- or such higher amount prescribed by the rules. Draft Rule 10.7(2) increases this limit from Rs. 1,000/- to Rs.1 Lakh. Similarly, the limit for indebtedness to the Company, its subsidiary etc. is also fixed

(iv)    A person whose relative is a director or is in employment of the company as a director or key managerial personnel cannot be appointed as auditor.

(v)    A person who is associated with any entity which is engaged in consulting and specialized services as specified in the new section 144 cannot be appointed as auditor.

8.2 Draft Rule 10.7 provides for circumstances under which an Auditor will be disqualified.

9. Powers and Duties of Auditors

9.1 New section 143 provides for powers and duties of Auditors. This section is similar to existing section 227. In the Auditor’s Report on the financial statements, apart from the existing reporting requirements, the auditor has to state (i) the observations or comments on the financial transactions or matters which have any adverse effect on the functioning of the company and (ii) whether the company has adequate internal financial controls system in place and the operating effectiveness of such controls. The Central Government is also authorized to expand the requirements of reporting by the Auditor. Draft Rule 10.8 states that the Audit Report shall now state the views of the Auditors in respect of (a) whether the Company has disclosed the effect of any pending litigations on its financial position in its financial statement, (b) whether the company has made provision for foreseeable losses on long term contracts, including derivative contracts and (c) whether there has been delay in depositing money into the Investor Education and Protection Fund by the Company.

9.2 New section 143(8) provides for appointment of Branch Auditors.

This section is similar to the existing section 228. At present if the statutory auditor is not to conduct the audit of the branch members can appoint branch auditors at AGM or authorise the Board of Directors to make such appointment. New section provides that the Branch Auditors will have to be appointed by the members in AGM as provided in new section 139. From this provision it is evident that the Branch Auditors will have to be appointed for a consecutive period of 5 years. Similarly, it appears that the Branch Auditors will be subject to the system of Rotation of Auditors u/s. 139(2) in the audit of a listed company or a specified company as stated to above.

9.3 As stated earlier, the auditors will have to comply with the Auditing Standards while conducting Audit of any company as provided in new section 143(10).

9.4 It is also provided in section 143 that if an auditor, during the course of audit, has reason to believe that an offence involving fraud is being committed by the officers/employees against the company, the auditor will have to report to the Central Government in the prescribed manner. If the auditor fails to comply with this reporting requirement, without reasonable cause, he shall be punishable with minimum fine of Rs. 1 lakh which may extend to Rs. 25 lakh. Draft Rule 10.10 provides for procedure for reporting such frauds by the auditors. From this it is evident that under this Section only Matrial Fraud is to be reported. It is also clarified in Rule 10.10(2) that for this purpose materiality shall mean (a) Frauds that happening frequently or (b) Frauds where the amount involved or likely to be involved are not less than 5% of the net profit or 2% of turnover of the preceding financial year of the Company.

9.6 It may be noted that a Chartered Accountant having at least 10 years experience in Company matters can now be appointed as a Company Liquidator as provided in new Section 275. Under this Section, it is provided that when a Company is being wound up by the Tribunal, it can appoint a professional i.e. Chartered Accountant, Advocate, Company Secretary, Cost Accountant or such professional whose name is on the Panel maintained by the Central Government in the prescribed manner as a liquidator. Such liquidator has to perform duties of Liquidator as provided in the Act.

10. Auditor not to render non-audit services

10.1 New section 144 provides that Auditor of a company shall render only such other services to the company as may be approved by the Board of Directors or the Audit Committee. However, it is specifically provided that the auditor shall not render, directly or indirectly, other services such as (a) accounting and book keeping services, (b) internal audit, (c) design and implementation of any financial information system (d) actuarial services, (e) investment advisory services, (f) investment banking services, (g) rendering of outsourced financial services, (h) management services and (i) any other kind of services as may be prescribed.

10.2 It may be noted that this is a new provision and there is no restriction of this type in the existing Companies Act. Therefore, if any auditor is rendering any such non-audit service to the company before the new Act comes into force, he will have to comply with this provision of new section 144 before the end of the financial year after the new Act comes into force.

10.3 It is also provided in this section that the prohibited non-audit services cannot be rendered by the following associates of the auditor.

(i)    If the auditor is an Individual :- The Individual himself, his relative any person connected or associated with him, or any entity in which the Individual has significant influence or control or whose name or trade mark/brand is used by the Individual.

(ii)    If the auditor is a firm or LLP:- Such firm/LLP either itself or through its partner or through its parent, subsidiary or associate or through any entity in which the firm/LLP or its partner has significant influence or control or whose name, trade mark or brand is used by the firm/LLP or any of its partners.

10.4 From the above it appears that under this section the auditor can render non-audit service such as tax audit, direct or indirect tax advice, company law advice, tax or company law representation before appropriate authorities, FEMA matters and other related services.

11.    Cost Auditors:

New Section 148 provides for appointment of Cost Auditors by Board of Directors of Companies engaged in the business of manufacture of such goods as may be notified by the Government. The procedure for appointment and reporting by the Cost Auditor is similar to the existing procedure. Draft Rule 10.11 provides for procedure for fixing remuneration of Cost Auditor.

12.    Penalty Provisions

New section 147 provides for punishment for contra-vention of the provisions of new sections 139 to 146. These penalty provisions are as under.

(i)    If a company contravenes any of the provisions of new sections 139 to 146 it shall be liable to pay minimum fine of Rs. 25,000/- which may extend to Rs. 5 lakh. Further, every officer who is in default shall be punishable with imprisonment upto one year and minimum fine of Rs. 10,000/- which may extend to Rs. one lac or with both.

(ii)    If an auditor of a company contravenes any of the provisions of sections 139 and 143 to 145, the auditor shall be punishable with minimum fine of Rs. 25,000/- which may extend to Rs. 5 lakh. If it is found that the auditor has contravened those provisions knowingly or willfully with the intention to deceive the company, its share holders, creditors or tax authorities, he shall be punishable with imprisonment for a term upto one year and with a minimum fine of Rs. one lakh which may extend upto Rs. 25 lakh.

(iii)    If any auditor is convicted of an offence as stated in (ii) above, he shall be liable to (a) refund the remuneration received by him to the company and (b) pay for damages to the company, statutory bodies/authorities or to any other persons for loss arising out of incorrect or misleading statements of particulars made in his audit report.

(iv)    In the case of audit of a company which is conducted by an audit firm, if it is proved that any partner or partners of the audit firm have acted in a fraudulent manner or abetted or colluded in any fraud by the company, its
Directors or officers, the civil or criminal liability, as provided in this Act or any other law, for such act shall be joint and several of the firm and each of its partners.

(v)    New section 148 provides for audit of cost records in specified companies. This section is more or less similar to existing section 233B with some modifications. It may be noted that the above penalty provisions contained in new section 147 are applicable to the company as well as the Cost Auditor in the same manner as stated above.

13.    To Sum Up

13.1 The above provisions relating to accounts and audit contained in the Companies Act, 2013 will have far reaching impact on the companies and auditors. It appears that these provisions are being made with a view to curb the present day tendency on the part of some companies to manipulate accounts with a view to benefit those in management or with a view to reduce tax. Some of these provisions are very harsh and they are likely to affect the development of the corporate sector and the profession of Chartered Accountants.

13.2 The New Act will curtail the autonomy of the Institute of Chartered Accountants of India to issue Accounting Standards and Auditing Standards. These standards will now be notified by the Government in consultation with NFRA. This is a new national authority to be appointed by the Government with very wide powers. This National Authority will be able to take disciplinary action against erring auditors and award punishment to them. Therefore, the autonomy of ICAI to take disciplinary action against its members will be curtailed to this extent. It appears that the Central Government is now loosing the confidence reposed in the Council of ICAI for the last over 6 decades and started transferring this important function of regulating the C.A. profession to other Government controlled Agencies. It is surprising that the Council of ICAI has not taken general membership into confidence and no public protest has been made when such legislation was being made by the Parliament.

13.3 Considering the responsibilities being placed on the auditors it appears that small and medium size audit firms will find it difficult to continue in audit practice. No such audit firm will be able to undertake such responsibilities with threat of litigation in the event of unintended and genuine mistakes. The provisions relating to restrictions on number of years one can continue to remain auditor of a company and restriction on rendering other services will also impact the ability of such small and medium size firms to continue in audit practice. Let us hope that the provisions for removal of auditors, awarding punishment and other harsh provisions will be implemented by the Government and other authorities in a reasonable, sympathetic and fair manner.

Quantum of Exclusion of Export Profit From Book Profit— MAT

Closements

Introduction :


1.1 U/s.115JB, Minimum
Alternative Tax (MAT) is payable by a company, if the Income-tax payable on the
total income as computed under the Income-tax Act (the Act) in respect of any
assessment year is less than the specified percentage of its book profit. In
such an event, the book profit is deemed to be the total income of the company,
on which the tax is payable at the rate of specified percentage. S. 115JB was
introduced by the Finance Act, 2000 with effect from 1-4-2001 to replace the
earlier version of MAT contained in S. 115JA. Initially, the specified
percentage was 7.5%, which is gradually increased and presently the same is 18%
as per the last amendment made by the Finance Act, 2010 with effect from
1-4-2010.

1.2 For the purpose of
determining the MAT liability, every company is required to prepare its profit &
loss account for the relevant previous year in accordance with the provisions of
Parts II and III of Schedule VI to the Companies’ Act, 1956. There are some
other provisions also in this respect with which we are not concerned in this
write-up.

1.3 Explanation 1 to S.
115JB defines the book profit (hereinafter referred to as the said Explanation).
Under the said Explanation, the book profit means the net profit as shown in the
profit & loss account for the relevant previous year, which is to be increased
by certain specified items (upward adjustments) and the profit so increased is
required to be reduced by certain specified items (downward adjustments), if
such items are debited to profit & loss account.

1.4 One of the downward
adjustments is contained in Clause (iv) of the said Explanation which deals with
the exclusion of export profit eligible for
deduction u/s.80HHC(3)/(3A). The said Clause reads as under :

“the amount of profits
eligible for deduction u/s.80HHC, computed under clause (a) or clause (b) or
clause (c) of Ss.(3) or Ss.(3A), as the case may be of that Section, and
subject to the conditions specified in that Section;”

1.5 S. 80HHC provides for
deduction of export profit while computing the total income as provided in the
Section. Earlier, quantum of such deduction was 100% of the export profit.
However, the Government decided to phase out this deduction with a view to
provide a sunset clause for this incentive available to exporters. For this
purpose, the Finance Bill, 2000 introduced Ss.(1B) with effect from 1-4-2000,
which provided restriction on the extent of deduction available u/s.80HHC(1).
Accordingly, the quantum of deduction u/s.80HHC in respect of export profit
available u/s.80HHC(1) was to be reduced to specified percentage every year,
with effect from A.Y. 2001-02 and was to be completely phased out by the A.Y.
2004-05. In the A.Y. 2001-02, such deduction was to be restricted to 80% of the
deduction of export profit determined u/s.80HHC(1) and for the A.Y. 2002-03 the
same was to be restricted to 70% and so on (this restricted amount of deduction
hereinafter referred to as the reduced export profit). Ss.(1B) also provided
that no deduction shall be allowed u/s.80HHC from the A.Y. 2005-06.

1.6 The Circular No. 794,
dated 9-8-2000 [162 CTR (St.) 9], while explaining the provisions of the Finance
Bill 2000, in para 43.5, clarifying the impact of new MAT provisions, pointed
out that the export profit u/s.10A/10B/80HHC/80HHD, etc. are kept outside the
purview of these provisions, as these are being phased out. In the context of S.
115JB similar clarification was also found in the Memorandum explaining the
provisions of the Finance Bill, 2000, as well as in the speech of the Finance
Minister.

1.7 In view of the
provisions for phasing out deduction available u/s.80HHC and the provision for
excluding export profit from the book profit made in Clause (iv) of the said
Explanation for the purpose of levy of MAT, the issue was under debate as to
whether the entire amount of export profit should be excluded from the book
profit or only reduced export profit should be excluded in view of the
provisions contained in S. 80HHC(1B). To clarify the issue, if the export profit
determined u/s.80HHC(3) is Rs.100, then for the purpose of computation of book
profit for the A.Y. 2001-02, the amount to be excluded by way of export profit
should be Rs.100 (i.e., entire export profit) or Rs.80 (i.e.,
reduced export profit). This issue was decided against the assessee by the
Bombay High Court in the case of Ajanta Pharma Ltd.

1.8 Recently, the Apex Court
had on an occasion to consider the issue referred to in para 1.7 above in the
same case of Ajanta Pharma Ltd. and the issue is now finally settled. Though, S.
80HHC is effectively no more operative from A.Y. 2005-06, in a large number of
pending cases, this issue is relevant and therefore, it is thought fit to
consider the same in this column.


CIT
v.
Ajanta Pharma Ltd., 318 ITR 252 (Bom)


2.1 The issue referred to in para 1.7 above, came up before the Bombay High Court in the above case in the context of A.Y. 2001-02. The brief facts in the above case were that the assessee company was assessed u/s.115JB for the A.Y. 2001-02. While computing the book profit, the assessee claimed that the entire export profit computed u/s.80HHC(3) should be deducted and not the reduced export profit as provided u/s.80HHC(1B). The Assessing Officer restricted the deduction to 80%, being the amount of reduced export profit. The First Appellant Authority as well as the Appellate Tribunal accepted the contention of the assessee and took the view that for such purposes, the entire export profit is eligible for deduction. Accordingly, at the instance of Revenue, the issue referred to in para 1.7 above came up for consideration before the Bombay High Court.

2.2 On behalf of the Revenue, it was, inter alia, contended that while computing book profit u/s. 115JB,?only reduced export profit as provided u/s. 80HHC(1B) should be excluded from the book profit and not the amount of entire export profit. As per the Memorandum explaining the Finance Bill, 2000, the reason to introduce S. 115JB was to simplify the MAT provisions. Considering the language of Clause (iv) of the said Explanation, the export profit eligible for deduction should be equal to the amount of actual deduction allowed u/s.80HHC while computing the total income of the assessee under the normal provisions of the Act. If this is not done, an absurdity will be created to the extent that while full deduction is not allowed in respect of export profit u/s.80HHC, for the purpose of S. 115JB, the full amount of export profit will be excluded. This was never the intention of the Legislature while interpreting the provisions of law. An interpretation that results in an absurd situation is to be avoided. It was alternatively contended that even if one takes a view that eligible export profit is referable to only S. 80HHC(3) without applying the restriction contained in Ss.(1B), one has to bear in mind the expression ‘subject to the conditions specified in that Section’ contained in Clause (iv) of the said Explanation (hereinafter referred to as the said conditions). Accordingly, the restriction contained in Ss.(1B), being a condition for allowing deduction u/s.80HHC, has to be considered while determining the quantum of export profit to be excluded from the book profit u/s.115JB. It was also contended that the Finance Minister’s speech and the Memorandum explaining the provisions of the Finance Bill cannot by itself be used to interpret literal meaning of Act.

2.3 On the other hand, on behalf of the assessee-company, various contentions were raised, which, inter alia, include : Considering the expression, ‘eligible for deduction u/s.80HHC’ used in the said Clause (iv), the entire export profit requires to be excluded from the book profit that being the amount eligible for deduction u/s.80HHC. The provision for exclusion of export profit contained in Clause (iv) of the said Explanation is to ensure that the export profits are not subjected to MAT. In the past also, in different provisions made in the Act for the levy of MAT, the export profits have been kept outside the purview of MAT. Therefore, the policy adopted by the Legislature of encouraging/boosting export was considered to be of such importance that the Legislature wished to forego taxes thereon, including MAT. Referring to the dictionary meaning of the expression ‘eligible’, it was contended that it would be beyond any doubt that the word ‘eligible’ has to be read to mean type or class or nature of profit (i.e., qualitative description of profits) and can never take within its ambit, a particular proportion or quantum thereof. The amount quantified for deduction u/s.80HHC(1B) is only a subclass or part of the type/class or nature of profit eligible and hence, the same cannot be considered for this purpose. In short, it was pointed out that Clause of the said Explanation refers to entire export profit and not reduced export profit. It was submitted that the quantum set out u/s.80HHC(1B), is not a condition and the same only provides the extent of deduction available u/s.80HHC(1). This is also supported by the language of S. 80HHC(1), which specifically allows ‘a deduction to the extent of profits referred to in Ss.(1B)’. It was also contended that if two views are possible of interpretation of the said Clause (iv), then the view in favour of the taxpayer ought to be adopted.

2.4 To decide the issue on hand, at the outset, the Court first noted the following settled position with regard to interpretation of a taxing statute [pages 258/259]:

“With the above background, let us now consider the provisions. What the Legislature ought to have done or what language or words or expression ought to have been used, is not for the Courts to consider.?The duty of the Court, in the event, where literal interpretation would defeat the intent of the Legislature or lead to an absurdity or the like would be to ascertain the Parliamentary intent, by applying the rules of statutory interpretation as followed in our jurisdiction. A word of caution, it is only in the event when the literal interpretation would lead to an absurdity or defeat the object or intent of the legislation and not otherwise. The principle of all fiscal legislation is that if the person sought to be taxed comes within the letter of the law he must be taxed, however, great the hardship may appear to the judicial mind to be. On the other hand, if the State, seeking to recover tax, cannot bring the subject within the letter of the law, the subject is free, however, apparently within the spirit of the law the case might?otherwise?appear?to?be.?The?taxing?statutes cannot be interpreted on any presumptions or assumptions. The Court must look squarely at the words of the statute and interpret them. It must interpret a taxing statute in the light of what is clearly expressed; it cannot imply anything which is not expressed, it cannot import provisions in the statutes so as to supply any assumed deficiency [CST v. Modi Sugar Mills Ltd., AIR 1961 SC 1047; (1961) 12 STC 182].”

2.5 The Court, then, proceeded to decide the issue and referred to the provisions of S. 80HHC, as well as S. 115JB, as applicable to the case under consideration. The Court also referred to the earlier version of MAT contained u/s.115J as well as u/s.115JA. After tracing the history of the provisions relating to MAT, the Court stated as under (page 261)?:

“Insofar as MAT companies are concerned, that reduction of export profit while computing the book profits was not available when S. 115J was introduced from April 1, 1988. The benefit was given subsequently from April 1, 1989. Similarly the reduction was not available in the case of S. 115JA which was introduced with effect from April 1, 1997. The benefit was extended only from April 1, 1998. This intent of the Legislature must be considered while interpreting the provisions. The other aspect would be that if Ss.(1B) is not read while computing the book profits and which contains the sunset clause it would mean that even after April 1, 2005, MAT companies could claim deduction of export profits, while computing book profits which would be an absurdity.”

2.6 Proceeding further, referring to the judgment of the Apex Court in the case of K. P. Varghese (131 ITR 597), the Court noted that in that judgment it was observed that it is well-recognised rule of construction that the statutory provisions must be so construed if possible that absurdity and mischief may be avoided. If the situation arises where the construction suggested by the Revenue would lead to wholly unreasonable and unjust result, which could never have been intended by the Legislature, then it must be avoided. The Court also noted that this judgment also supports the rule of interpretation that the speech made by the mover of the Bill explaining the reason for the introduction of the Bill can certainly be referred to for the purpose of ascertaining the mischief sought to be remedied by the legislation and the object and the purposes for which the legislation was enacted. Therefore, the Finance Minister’s speech can be relied upon by the Court for the purposes of ascertaining what was the reason for introducing that clause. The Court also referred to various judgments of the Apex Court dealing with principles of statutory interpretation and in particular, dealing with principles of interpretation of taxing statute.

2.7 After referring to the judicial pronouncements with regard to principles of statutory interpretation, the Court stated as under (Page 266):

“The principles elucidated earlier of statutory construction can now be considered for interpreting the provisions of S. 115JB vis-à-vis S. 80HHC. Does a literal reading of S. 80HHC read with S. 115JB(2), Explanation 1(iv), lead to an absurdity and/or does not make clear Parliamentary intent considering the law as it stood before S. 115JB was introduced. In S. 115J and S. 115JA the expression used were ‘profits eligible for deduction u/s.80HHC.’ S. 115JB also uses the expression ‘profits eligible for deduction.’ There really can be no difficulty in understanding what this means. Only those profits which are eligible and computed in terms of Ss.(3) or Ss.(3A) and quantified in terms of Ss.(1B). The computation whether under Ss.(3) or Ss.(3A) are for the purpose of Ss.(1) or Ss.(1A). S. 80HHC(1) permits a deduction to the extent of profits referred to in Ss.(1B). The only question is whether the expression in clause(a), (b) or (c) of Ss.(3) consequent on introduction of Ss.(1B) to S. 80HHC will have a meaning different from the meaning than what was originally understood, considering clause (iv) to Explanation 1 of S. 115JB.”

2.8 Referring to the argument made on behalf of the assessee that for the above purposes, provisions contained in Ss.(1B) should be ignored, the Court stated as under (Page 267):

“…….If the construction sought to be given by the counsel for the assessee is accepted it would make Ss.(1B) irrelevant for the purpose of S. 115JB. Ss.(1B) provides for deduction in terms set out therein. Ss.(3) sets out the method of computation of profits. The computation of profits is, therefore, for the purpose of working out the deduction of profits available u/s. 80HHC(1B). Earlier it was in terms of Ss.(1). Now, S. 80HHC(1) in term refers to Ss.(1B) . All the provisions are interrelated and cannot be read de hors one another. If Ss.(1B) is not read in Ss.(1), then the expression ‘no deduction shall be allowed in respect of the assessment beginning on the first day of April, 2005, and any subsequent year’, shall be rendered otiose.”

2.9 The Court also considered the argument made on behalf of the assessee that the provisions of Ss.(1B) is not a condition, but in the nature of computation and stated that even if we accept this proposition and proceed on that finding, nevertheless it is impossible of reading S. 80HHC(3) or (3A) independent of S. 80HHC(1B). The Court also noted that basically the argument of the assessee is based on the Memorandum explaining the provisions of the Finance Bill, 2000. However, at the same time, in the Notes on Clauses, it is clearly stated that the profits will be reduced by certain adjustments which are eligible for deduction u/s.80HHC. The profits eligible for deduction are Reduced export profits in terms of S. 80HHC(1B). According to the Court, there is nothing in the Finance Minister’s speech of February 29, 2000 to hold otherwise. Noting the argument made on behalf of the assessee that if two views are possible, the view favourable to the taxpayer should be adopted, the Court stated that the question is whether there are two views possible in this case. According to the Court, no two views are possible, but the only view is that the MAT companies are entitled to the same deduction of export profits u/s.80HHC, as any other company involved in export in terms of S. 80HHC(1B). Once that be the case, this argument is also devoid to merit.

2.10 The Court finally concluded as under (page 268):

“……To our mind, the language is clear. The literal meaning does not in any way defeat the object of the Section and/or lead to any absurdity. The object of S. 115JB is to allow even MAT companies to avail of the benefit of deduction. If we consider the assessee’s arguments that MAT companies are entitled to full deduction of export profits, it will lead to anomaly, whereby the companies which are paying tax on total income under the normal rules, for them the deduction of export profits will be lesser than what MAT companies are entitled to. Is this a possible view? When S. 115J was originally introduced, MAT companies were not entitled to deduction of profits u/s.80HHC while working out the book profits…….”

“……Can it now be argued that MAT compa-nies considering S. 115JB(2), Explanation 1(iv) are entitled to be placed in a better position than the other companies entitled to the export deduction under 80HHC, though earlier they constituted one class? No rule of construction nor the language of the S. 80HHC read with S. 115JB, in our opinion, will permit such construction. If such construction is not possible, then both the classes of companies will be entitled to the same deduction. This would contemplate that both would be entitled to deductions of profits in terms of S. 80HHC(1B). So read, it would be a harmonious construction…..”

Ajanta Pharma Limited v. CIT, 327 ITR 305 (SC):

3.1 The above-referred judgment of the Bombay High Court came up for consideration before the Apex Court at the instance of the assessee. To consider the issue, the Court referred to the facts of the case and noted that the following question of law is raised in the Civil Appeal:

“whether for determining the ‘book profits’ in terms of S. 115JB, the net profits as shown in the profit and loss account have to be reduced by the amount of profits eligible for deduction u/s.80HHC or by the amount of deduction u/s. 80HHC?”

3.2 To decide the question, the Court noted the provisions of S. 115JB and S. 80HHC as applicable to the case of the assessee. After referring to relevant provisions, the Court also noted and analysed in brief, the earlier provisions relating to MAT contained in S. 115JA. The Court, then, stated that from these provisions it is clear that S. 115JA is a self-contained code and will apply not-withstanding any other provisions in the Act. The Court then stated that S. 115JB, though structured differently, stood inserted to provide for payment of advance tax by MAT Companies. S. 115JB is the successor to S. 115JA. In essence, it is the same as S. 115JA with certain differences. Accordingly, S. 115JB continues to remain a self-contained code.

3.3 Referring to the object for which S. 80HHC was enacted, the Court noted that the Section provides for tax incentive to exporters. At one point of time, S. 80HHC(1) laid down that an amount equal to an amount of deduction claimed should be debited to profit & loss ac-count and credited to reserve account to be utilised for business purposes. Ss.(1) of 80HHC is concerned with eligibility, whereas Ss.(3) is concerned5 with computation of quantum of deduction. Prior to amendment made by the Finance Act, 2000, the exporters were allowed 100% deduction in respect of the export profit. Thereafter, the same has been reduced in a phasewise manner, as provided in Ss.(1B). The Court also noted that the deduction is available in respect of eligible goods and the same is not available to all assessable entities. Referring to S. 80AB, the Court noted that computation of deduction is geared to an amount of income, whereas the quantification of deduction u/s.80HHC(3) is geared to export turnover and not to the income. On the other hand, S. 115JB refers to levy of MAT on deemed income. This shows that the S. 80HHC and S. 115JB operate in different spheres.

3.4 Dealing with S. 80HHC, the Court further stated that S. 80HHC(1) refers to ‘eligibility’, whereas S. 80HHC(3) refers to computation of tax incentive. According to the Court, S. 80HHC(1B) deals with ‘extent of deduction’ and not with the eligibility.

3.5 The Court then referred to the argument raised on behalf of the Revenue, with regard to applicability of other conditions of S. 80HHC incorporated in Clause (iv) of the said Explanation and noted that based on this, the Revenue contends that the quantum of export profit for this purpose should be subject to Ss.(1B) of 80HHC. The Court then pointed out that according to the Revenue, both ‘eligibility’ as well as ‘deductibility’ of the profit have got to be considered together while applying the said Clause (iv). Rejecting this contention, the Court stated that if the dichotomy between ‘eligibility’ of profit and ‘deductibility’ of profit is not kept in mind, S. 115JB will cease to be a self-contained code. According to the Court, for the purposes of S. 80HHC(3)/(3A), the conditions are only that the relief should be certified by a chartered accountant. Such condition is not a qualifying condition, but it is a compliance condition. Therefore, one cannot rely upon the last sentence of the said Clause (iv) to obliterate the difference between ‘eligibility’ and ‘deductibility’ of profits as contended on behalf of the Revenue.

3.6 Comparing the relevant provisions of S. 115JB and S. 80HHC, the Court concluded as under (page 310):

“As earlier stated, S. 115JB is a self-contained code. It taxes deemed income. It begins with a non obstante clause. S. 115JB refers to computation of ‘book profits’ which have to be computed by making upward and downward adjustments. In the downward adjustment, vide clause (iv) it seeks to exclude ‘eligible’ profits derived from exports. On the other hand, u/s. 80HHC(1B) it is extent of deduction which matters. The word ‘thereof’ in each of the items u/s.80HHC(1B) is important. Thus, an assessee earns Rs.100 crores then for the A.Y. 2001-02, the extent of deduction is 80% thereof and so on which means that the principle of proportionality is brought in to scale down the tax incentive in phased manner. However, for the purposes of computation of book profits which computation is different from normal computation under the 1961 Act/computation under Chapter VI -A. We need to keep in mind the upward and downward adjustments and if so read, it becomes clear that clause (iv) covers full export profits of 100% as ‘eligible profits’ and that the same cannot be reduced to 80% by relying on S. 80HHC(1B). Thus, for computing ‘book profits’ the downward adjustment, in the above example, would be Rs.100 crores and not Rs. *90 crores. The idea being to exclude ‘export profits’ from computation of book profits u/s.115JB which imposes MAT on deemed income. The above reasoning also gets support from the Memorandum of the Explanation to the Finance Bill, 2000.”

* In the given example, this should be Rs.80 crores.

Conclusion:

4.1 In view of the above judgment of the Apex Court, it is settled that for the purpose of excluding the export profit from the book profit while applying the MAT provisions, the entire export profit will be excluded and not the reduced export profit. Primarily, the decision of the Court seems to have been rested on the finding that both provisions (S. 80HHC & S. 115JB) operate in different spheres, S. 115JB is a self-contained code, S. 80HHC(1) deals with the ‘eligibility’, whereas S. 80HHC(3) deals with computation of quantum of deduction, S. 80HHC(1B) deals with the extent of deduction and not with the eligibility, there is dif-ference between the ‘eligibility’ and ‘deductibility’ of profits and the view also gets support from the Memorandum explaining the Finance Bill, 2000.

4.2 Interestingly, in the above judgment, the arguments raised on behalf of the assessee, as well as the view expressed by the Bombay High Court on such argument and the reasons given by the High Court for reaching the conclusion are neither referred to nor dealt with. It appears that perhaps the same arguments must have been raised by the assessee before the Apex Court, which were raised before the High Court.

4.3 On a careful reading of both the judgments, one may notice that the Apex Court has taken a view that while determining the amount of export profit for exclusion from the book profit, provisions of S. 80HHC(1B) are not to be taken in the account, whereas the Bombay High Court had taken exactly contrary view. One of the reasons given by the High Court for taking such a view was that if, while computing the book profit, Ss.1(B) is not to be read with Ss.(1) of S. 80HHC, then there would an absurdity as in such an event, MAT companies would claim deduction of export profit even after 1-4-2005 (refer para 2.5 and para 2.8 above). This reason is also to be treated as impliedly overruled as otherwise, an interesting academic issue may arise as to whether on account of the view taken by the Apex Court, whether MAT companies can attempt to claim the benefit of Clause (iv) of the said Explanation even after A.Y. 2004-05.

4.4 After giving judgment in the case of Ajanta Pharma Ltd., the Bombay High Court in the case of Al-Kabeer Exports Ltd. (233 CTR 443) has also taken a view that the export profit for exclusion from the book profit under the said Clause (iv) has to be computed strictly in accordance with the provisions of S. 80HHC and not on the basis of adjusted Book Profit. For this, the High Court had also placed reliance on it’s judgment in the case of Ajanta Pharma Ltd. referred to in para 2 above. Prior to this, the Special Bench of the Tribunal in the case of Syncom Formulations (I). Ltd. [106 ITD 193 (Mum.)] had taken a view that for such purpose, the determination of export profit should be based on the adjusted book profit and not on the basis of regular provision of the Act as applicable to the computation of profits and gains of business. The judgment of the High Court in the case of Ajanta Pharma Ltd. also gave an impression that it has overruled the decision of Special Bench in the case of Syncom Formulations (I) Ltd. (supra). Now, in view of the judgment of the Apex Court reversing the judg-ment of the Bombay High Court, even the view taken by the Bombay High Court in the case of Al-Kabeer Exports Ltd. may not be regarded as good law and in that context, the view taken by the Special Bench of ITAT in the case of Syncom Farmulations (I) Ltd. (supra) gets support from the judgment of the Apex Court.

Cryptic order of the AO dropping penalty proceedings Revision u/s.263

closements

Introduction :


1.1 Various orders are passed by the Assessing Officer (AO)
under different provisions of the Income-tax Act, 1961 (the Act). Since the
Department has no right of appeal against such orders passed before the first
appellate authority, there is an inbuilt mechanism in the Act to supervise and
monitor the correctness of such orders to safeguard the interest of the Revenue.
Accordingly, a power of revision is vested with the Commissioner of Income-tax
(CIT) to revise, etc. such orders passed by the AO as provided in that Section.

1.2 U/s.263, if the CIT considers that the order passed by
the AO is erroneous in so far as it is prejudicial to the interest of the
Revenue, he may pass such orders thereon as the circumstances of the case
justify, including an order enhancing or modifying the assessment, or cancelling
the assessment and directing a fresh assessment, of course, after providing
opportunity of being heard to the assessee. Such order, under this Section, can
be passed within a time limit provided in the Section. Certain other relevant
terms are also defined in the Section, with which we are not concerned in this
write-up.

1.3 For the purpose of exercising jurisdiction u/s. 263, two
cumulative conditions are required to be satisfied, namely, (i) that the order
of the AO is erroneous, and (ii) that it is prejudicial to the interest of the
Revenue as held by the Apex Court in the case of Malabar Industrial Company
Limited (243 ITR 83). It is further held that the phrase ‘prejudicial to the
interest of the Revenue’ is of wide import and is not confined to loss of tax.
At the same time, the phrase has to be read in conjunction with erroneous order
passed by the AO. Every loss of revenue as a consequence of an order of the AO
cannot be termed as prejudicial to the interest of the Revenue, e.g.,
when the AO has adopted one of the courses permissible in law and it has
resulted in loss of revenue, or where two views are possible and the AO has
adopted one view with which the CIT does not agree, it cannot be treated as an
erroneous order prejudicial to the interest of the Revenue unless the view taken
by the AO is unsustainable in law.

1.4 Once penalty proceedings are initiated against the
assessee under the provisions of Act, in response to the same, various
explanations, etc. are filed by the assessee to show that the case is not fit
for imposing such penalty. After considering the same, the AO decides as to
whether penalty should be levied or not. When the AO decides not to levy the
penalty and passes an order dropping the penalty proceedings without mentioning
reasons for the same in the order, it was under consideration as to whether the
order passed by the AO dropping the penalty proceedings attracts and justifies
the revision by the CIT u/s.263 merely because reasons for dropping the penalty
proceedings are not mentioned in such order.

1.5 Recently the Apex Court had an occasion to consider the
issue referred to in Para 1.4 above in the case of Toyota Motor Corporation.
Though the judgment of the Court is very short, it is felt that it has
far-reaching consequences in the actual day-to-day practice and therefore, it is
thought fit to consider the same in this column.


CIT v. Toyota Motor Corporation, 218 CTR 628 (Del.) :


2.1 In the above case, the financial years involved were
1988-89 to 1997-98. The facts are not available in the judgment. It seems that
the penalty proceedings u/s.271C for non-deduction of tax were initiated. It
also seems that the matter of liability to deduct tax and the fact of
non-deduction of tax were not in dispute at that stage. It also seems that the
assessee had explained his case and had shown his bona fides for the same
and after considering the same, the AO had decided not to levy the penalty and
the following order dated 9-7-1999 was passed :

“The penalty proceedings initiated in this case u/s.271C
r/w S. 274 of the IT Act, 1961 are hereby dropped.”


2.2 The CIT initiated the proceedings u/s.263 to revise the
above order passed by the AO and after hearing the assessee, took the view that
the AO did not verify several issues and facts as mentioned in the order passed
by him, nor did the AO carry out necessary investigations to come to the
conclusion that penalty is not leviable. Based on this, the CIT treated the
order of the AO as erroneous and prejudicial to the interest of the Revenue and
set aside the same with a direction to pass fresh order after making necessary
enquiries, etc. and after giving opportunity of hearing to the assessee.

2.3 When the order of the CIT passed u/s.263 came up for
consideration before the Tribunal, it was held that the AO had carried out due
verification of relevant facts and the assessee has also shown its bona fides
and its reasonable belief in not deducting tax at the appropriate stage. The
penalty proceedings were not dropped casually by the AO, but the same was done
after verification of full facts disclosed by the assessee in reply.
Accordingly, the order passed u/s.263 was set aside.

2.4 At the instance of the Revenue, the matter came up before
the High Court, for which the following substantial question of law was framed :

“Whether AO could have passed an order u/s. 271C of the IT
Act, 1961 without giving any reasons whatsoever ?”


2.5 For deciding the above question, and after noting the
reasons given by the Tribunal for deciding the issue in favour of the assessee,
the Court observed as under (page 630) :


“We are unable to appreciate this reasoning given by the Tribunal simply because that the AO him-self did not say any such thing in his order. There is no doubt that the proceedings before the AO are quasi-judicial proceedings and a decision taken by the AO in this regard must be supported by reasons. Otherwise, every order, such as the one passed by the AO, could result in a theoretical possibility that it may be revised by the CIT u/ s.263 of the Act. Such a situation is clearly impermissible.”

2.6 The Court, then, stated that it is necessary for the parties to know the reasons for the conclusion arrived at by the authorities. The order of the AO should be self-contained order giving the relevant facts and the reasons for his conclusion. The Court finally decided the issue against the assessee and held as under (page 630) :

“We find that the order passed by the AO is cryptic, to say the least, and it cannot be sustained. The Tribunal cannot substitute its own reasoning to justify the order passed by the AO when the AO himself did not give any reason in the order passed by him.

Under the circumstances, we answer the question in the affirmative, in favour of the Revenue and against the assessee and remand the matter back to the file of the AO to decide the issue afresh in terms of the order passed by the CIT u/ s.263 of the Act.”

Toyota Motors Corporation v. CIT, 218 CTR 539 (SC) :

3.1 The above-referred judgment of the Delhi High Court came up for consideration before the Apex Court. Somehow, the Apex Court has not dealt with the issue in detail and dismissed the appeal.

3.2 While deciding the issue against the assessee, the Court observed as under :
“We are not inclined to interfere with the impugned order of the High Court. The High Court has held that the AO had disposed the proceedings stating the penalty proceedings initiated in this case u/s.271C r/w S. 274 of the IT Act, 1961 are hereby dropped. According to the High Court, there was no basis indicated for dropping the proceedings. The Tribunal referred to certain aspects and held that the initiation of proceedings u/ s. 263 of the IT Act, 1961 (in short, the ‘IT Act’) was impermissible when considered in the background of the materials purportedly placed by the assessee before the AO. What the High Court has done is to require the AO to pass a reasoned order. The High Court was of the view that the Tribunal could not have substituted its own reasoning which were required to be recorded by the AO. According to the assessee all relevant aspects were placed for consideration and if the officer did not record reasons, the assessee cannot be faulted.

We do not think it necessary to interfere at this stage. It goes without saying that when the matter be taken up by the AO on remand, it shall be his duty to take into account all the relevant aspects including the materials, if any, already placed by the assessee, and pass a reasoned order.”

Conclusion:

4.1 From the above judgment of the Apex Court, it seems that even an order passed by the AO dropping the penalty proceedings should be with reasons. The AO has to record the reasons for which penalty proceedings are dropped.

4.2 Unfortunately, the Apex Court did not appreciate the contention of the assessee that all relevant aspects were placed before the AO for consideration and if the AO did not record reasons, the assessee cannot be faulted.

4.3 In response to show-cause notice for levy of penalty, the only thing the assessee can do is to offer explanation and make out a case for non-levy of penalty. However, it is difficult to understand as to how the assessee can ensure that while dropping the penalty proceedings, the AO should incorporate reasons also in the order? It seems that it is this position which must have led the Tribunal to decide the issue in favour of the assessee after verifying the factual position that the order was passed by the AO after making necessary verifications, etc. Unfortunately, this factual position has neither been appreciated by the High Court, nor by the Apex Court. In both these judgments, there is not even a discussion on this practical as well as legal difficulty faced by the assessee.

4.4 In practice, we understand that in most cases, orders for dropping the penalty proceedings are cryptic and without reasons and the same are, more or less, on the same line as in the above case. Considering the constraints of the administration and the AO in particular, it is necessary to accept the position that if the assessee has given proper explanation and shown his bona fides to the satisfaction of the AO, penalty matters should be treated as concluded even if the reasons for such satisfactions are ‘not formally mentioned in the order passed by the AO. Therefore, the above judgment of the Apex Court, to that extent, requires reconsideration. Till this happens, perhaps, the CITs while exercising. their jurisdiction u/ s.263 should consider this in the interest of justice.

Potential Voting Rights — Impact on Consolidated Financial Statements

Consolidated Financial Statements shall be prepared by an entity if it has control over another entity. ‘Control’ under IFRS, being power to govern the financial and operating policies, covers within its purview even those entities that have been excluded under Indian GAAP. This article attempts to analyse the meaning and scope of the term — Potential Voting Rights — when determining control.

India, in the year 2011, joins the global accounting revolution : International Financial Reporting Standards (IFRS). It’s being defined as a revolution by many, because significant conceptual level changes are envisaged. One such concept that is evidenced in the piece that follows is substance over form. Recognising the core substance of the transaction over its legal form will indisputably bring an evolution in financial decision making.

It’s not that Indian GAAP does not recognise the importance of substance over form, but its true application will happen only under IFRS. One such instance is consideration of potential voting rights to determine existence of ‘control’ for the purpose of consolidation.

What is Potential Voting Rights ?

    An entity may own securities that are convertible into ordinary shares or other similar instruments that have the potential, if exercised or converted, to give the entity voting power or reduce another party’s voting power over the financial and operating policies of another entity.

    Some of the key instruments that are considered to have potential voting rights are as under :

    1. Equity share warrants

    2. Share call options

    3. Convertible preference shares

    4. Convertible debts

Defining control :

    Under IFRS, International Accounting Standard (IAS) 27 Consolidated and Separate Financial Statements defines Control as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.

    As per Indian GAAP — Accounting Standard (AS) 21 Consolidated Financial Statements, Control means

    (i) the ownership, directly or indirectly through subsidiary(ies), of more than one-half of the voting power of an enterprise; or

    (ii) control of the composition of the board of directors in the case of a company or of the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities

    The above definition is in line with that given under the Companies Act, 1956.

    As per S. 4(1) of the Companies Act, 1956, a company shall be deemed to be a subsidiary of another if, but only if, :

    (i) that other controls the composition of its Board of directors; or

    (ii) that other :

  •      where the first-mentioned company is an existing company in respect of which the holders of preference shares issued before the commencement of this Act have the same voting rights in all respects as the holders of equity shares, exercises or controls more than half of the total voting power of such company;

  •      where the first-mentioned company is any other company, holds more than half in nominal value of its equity share capital; or

    (iii) the first-mentioned company is a subsidiary of any company which is that other’s subsidiary.

    Here, the expression ‘nominal value of its equity share capital’ means paid-up value of the equity shares and not its face value. The meaning is clear when it is read in conjunction with S. 87(1)(b) of the Companies Act, 1956 which provides that the voting rights in respect of a member holding equity shares in a company shall be in proportion to his share of the total paid-up value of equity shares of the company.

Exclusion of Potential Voting Rights under Indian GAAP :

    From the above definition, it can be seen that the Companies Act, 1956 considers nominal value of equity share capital and not potential shares/voting rights.

    Although AS 21 does not specifically exclude potential voting rights, Explanation to paragraph 4 of AS 23 Accounting for Investments in Associates in Consolidated Financial Statements states that the effects of potential voting rights are not to be considered for the purpose of determining control.

    Based on the above analysis and in light of law prevailing over standards, potential voting rights are not considered for determining control under Indian GAAP.

    However, the scope of IAS 27 is much wider as it considers the effects of potential voting rights.

Determining whether potential voting rights exist :

    In assessing whether potential voting rights contribute to control, the entity examines all facts and circumstances (including the terms of exercise of the potential voting rights and any other contractual arrangements whether considered individually or in combination) that affect potential voting rights, except the intention of the management and the financial ability to exercise or convert. The intention of the management and the financial ability of an entity to exercise or convert does not affect the existence of power.

    Example : An entity holding 35% voting rights in another entity, but having options to acquire another 20% voting interest, would effectively have 55% current and potential voting interests. This may lead to consolidation as per IAS 27.

Currently exercisable or convertible:

An entity has control when it currently has the ability to exercise that power, regardless of whether control is actively demonstrated or is passive in nature. The existence and effect of only those potential voting rights that are currently exercisable or convertible, including potential voting rights held by another entity, are considered when assessing whether an entity has the power to govern the financial and operating policies of another entity. Potential voting rights are not currently exercisable or convertible when they cannot be exercised or converted until a future date or until the occurrence of a future event.

Example: Company H issues Foreign Currency Convertible Bonds (FCCB) with the condition that they are redeemable or convertible only after a period of 3 years. In this case, potential voting rights shall be assumed to exist only after completion of the 3 year lock-in period.

When potential voting rights exist, the proportions of profit or loss and changes in equity allocated to the parent and minority interests are determined on the basis of present ownership and do not reflect the effects of potential voting rights. That is, potential ownership may necessitate consolidated financial reporting, but income or loss allocation is still to be based on actual, not potential, ownership percentages.

Can one subsidiary have  two parents?

Potential voting rights are capable of changing an entity’s voting power over another entity – if the potential voting rights are exercised or converted, then the relative ownership of the ordinary shares carrying voting rights changes. Consequently, the existence of control is determined only after considering the existence and effect of potential voting rights. The definition of control in IAS 27 permits only one entity to have control of another entity. Therefore, when two or more entities each holding significant voting rights, both actual and potential, the factors are reassessed to determine which entity has control.

Whereas, under Indian GAAP, Explanation to paragraph 10 of AS 21 Consolidated Financial Statements states that both the entities should consolidate the financial statements of the controlled entity.

Potential voting rights held  by others:

Thus, an entity will not be able to conclude that it controls another entity after considering the potential voting rights held by it without considering the potential voting rights held by other parties. Consequently, an entity considers all potential voting rights held by it and by other parties that are currently exercisable or convertible when determining whether it controls another entity.

As can be seen above, Company B holds 45 lakhs current and 15 lakhs potential voting rights in Company O. Thus, company B holds in all 60 lakhs voting rights. Company D, in turn, holds SS lakhs current voting rights in Company O. However, this fact alone shall not lead to a conclusion that company B is the controlling entity. Company B must also consider the potential voting rights held by company D, if any.

Can non-convertible Preference Share Holders have potential voting rights?

A combined impact of IFRSs and legislations like the Companies Act may give rise to unique circumstances. For instance, in the Indian scenario, non convertible preference shares may have a role to play in determining control, as described below.

As per S. 87(2)(b) of the Companies Act, 1956, every member of a company limited by shares and holding any preference share capital therein shall, in respect of such capital, be entitled to vote on every resolution placed before the company at any meeting, if the dividend due on such capital or any part of such dividend has remained unpaid:

i) in the case of cumulative preference shares, in respect of an aggregate period of not less than two years preceding the date of commencement of the meeting; and

ii) in the case of non-cumulative preference shares, either in respect of a period of not less than two years ending with the expiry of the financial year immediately preceding the commencement of the meeting or in respect of an aggregate period of not less than three years comprised in the six years ending with the expiry of the financial year aforesaid.

As per S. 87(2)(c) of the Companies Act, 1956, where the holder of any preference share has a right to vote on any resolution in accordance with the provisions of this sub-section, his voting right on a poll, as the holder of such share, shall, subject to the pro-visions of S. 89 and Ss.(2) of S. 92, be in the same proportion as the capital paid-up in respect of the preference share bears to the total paid-up equity capital of the company.

Also, one must not forget that a security will be considered to have potential voting rights only if it is currently exercisable or convertible. As the cumulative/non-cumulative preference shares will have right to exercise voting power only on default by the company, as mentioned above, the shares shall be considered for the purpose of ‘control’ only when they are entitled to vote. In short, the cumulative/ non-cumulative preference shareholders shall not be considered to be having potential voting rights till they actually are eligible to vote.

Takeaways:

As defined above, ‘Control’ is the power to govern financial and operating policies of an entity. Voting rights cannot be considered in isolation to determine control. There are several other factors, not having been touched upon by this article, which may deserve consideration to zero in on the entity that has power to govern policies.

To conclude,  there are three important takeaways:

1. An entity has control when it currently has the ability to exercise that power

2. An entity shall consider all potential voting rights held by it and by other parties that are currently exercisable or convertible while determining whether it controls another entity

3. Income or loss allocation between parent and minority interests is still to be based on actual, not potential, ownership percentages.

The complementary nature of relationship between the legal profession and the CA profession in the past and the future 135

Article

I have stopped accepting invitations to give lecturers or
write papers. At the age of 76 and after a reasonably successful career, I can
possibly afford such a luxury. However, when Gautam Nayak, the Editor of the BCA
Journal asked me to write an article for the special issue of the Journal on the
occasion of the Diamond Jubilee of the Bombay Chartered Accountants’ Society, I
was tempted to accept the invitation, firstly being a fond reader of the
Journal, but really because of the subject on which I was asked to write.


During my long professional career spanning over five
decades, the nature of specialised work done by me has always brought me in
close contact with the accountancy profession, so much so that today I can claim
to have more personal friends in the accountancy profession as compared to the
legal profession. Possibly, this well-known fact has earned me the privilege of
being invited by the Society to write this article on the complementary nature
of relationship between the two professions in the past and in the future, as I
see it.

As G. P. Kapadia, who is acknowledged to be the father of the
CA profession in India, fondly put it, the legal profession and the CA
profession are sister professions which complement each other. I firmly believe
that neither can survive, exist or successfully practise without the active
help, support and co-operation of the other. Moreover, it is noticed that a
practising lawyer with accountancy qualifications or a practising chartered
accountant with legal qualifications has always been more successful as compared
to the others in the profession. The reasons are obvious.

Present scenario :

Presently, the sphere of work of CA firms has extended far
beyond the normal accounts, audit and taxation functions, and needs constant
legal inputs. Similarly, the work of law firms has increased as a result of
increasing mergers, acquisitions, trans-border transactions and complicated
financial structuring, needing constant support from CA firms. Consequently,
during the recent years CA firms and law firms have been working in closer
coordination with each other than ever before.

Both law and accountancy are venerable professions with old
and ingrained traditions. There are many similarities between the practice of
law and the practice of accountancy, particularly with respect to business and
corporate lawyers. Both accountants and lawyers play an integral role in the
smooth operation of trade, commerce and industry. Both are crucial to the
development and execution of the transactions that fuel industry and business
and thrive on reputation built after years of practice and expertise. On the
lighter side, both also have a relatively equal capacity to wreck havoc on the
financial sector in case they turn a blind eye to the fraudulent activities of a
client.

Dynamic changes in laws and the manner in which transactions
are entered into also play a vital role. Cross-border transactions have
necessitated the importance of international taxation and interpretation of
double taxation avoidance agreements/treaties. For such interpretation, lawyers
and accountants both have to advise their clients on the best way to solve any
problem, which may evolve during such transactions or better still, for carrying
out the most effective tax planning.

These days one sees at least three different trends in
working of a CA firm. Most of the CA firms have what is popularly known as ‘best
friend relationship’ with one or more law firms and all legal issues are dealt
with in consultation with lawyers. One also comes across CA firms who have
qualified legal personnel on their rolls or law firms who have qualified CAs
working for them. Though this is possible only at a junior level, it helps the
concerned firm to offer to its client services covering the other field. The
third trend which one notices these days (and which may in some cases prove
risky) is that even without qualified legal persons on its roll, some CA firms
offer extended services to the clients like purchase or sale of ownership
premises or drafting of documents like wills or trusts.

The scope of work of CA firms is no longer restricted to
accountancy, audit and taxation. Presently, CA firms render diverse other
services, which to some extent encroach legal field. No one can object to a CA
firm venturing to do legal work. However, it could lead to serious consequences
if CAs were to undertake drafting of complicated legal documents like wills or
trusts, which needs not just deep knowledge of law, but also expertise in
drafting, and which cannot be done merely by following precedents. The same
holds true also for lawyers who advise clients on complex taxation provisions
while drafting these complicated legal documents.

Recently, I came across a will containing some complicated
provisions, which was drafted by a senior Chartered Accountant. On the first
reading of the will, it was clear that the draftsman had followed some good
English precedent and used the normal legal terminology. However, on further
consideration I found some major flaws in drafting, which could have created
misunderstanding amongst the beneficiaries and possibly led to long-drawn
litigation. Luckily, the will was brought to me by the testator for
interpretation of some provisions and was suitably revised.

Future possibility :

In view of the current complementary nature in relationship
between two professions, future can only bring convergence.

Given the similarity and the interdependence between the two
professions, the need is for establishment of multidisciplinary firms so long as
separate firms are constituted for non-exclusive areas. In the context of
globalisation of services, establishment of firms formed by tie-up between
lawyers and chartered accountants would provide professionals from both the
professions a level playing field and strengthen the scope of services that can
be provided by them.

A major obstacle in the way of establishing such a multi-disciplinary firm is clause 2 of Chapter III Part IV of Bar Council of India Rules, 1975 which provides that, an advocate shall not enter into a partnership or any other arrangement for sharing remuneration with any person or legal practitioner who is not an advocate. The Chartered Accountants Act, 1949 provided similar regulation, which was later amended by the Chartered Accountants (Amendment) Act, 2006. The amended Act now makes an enabling provision permitting partnership with any person whose qualifications are recognised by the Central Government or the Council for purpose of permitting such partnership. Another hurdle to such establishment is S. 11 of the Companies Act, 1956, which restricts the maximum number of partners to twenty, which is to be done away with soon.

The future – as I see it – shows a distinct possibility of multidiscipline partnerships, with the necessary changes in the Chartered Accountants Act and the Advocates Act and blessings of the Institute of Chartered Accountants of India and the Bar Council of India. One can visualise a partnership or LLP with top lawyers like Soli Dastur being in partnership with Y. H. Malegam or Bansi Mehta.

While some of the big international CA firms had tried to set up in-house legal cells, the experiment does not seem to have worked well so far. I do not see a day far when even multinational muitidiscipline partnerships (or LLPs) will enter the field. Imagine Deloittes or E&Ys of the world joining hands with AZBs or Amarchands of India to form a multidiscipline organisation. Whatever is said and done, one thing is certain that the two professions will always continue to have very close relationship, complementing and supplementing each other.

Windows Phone 7

Computer Interface

This month’s tech update is about the recently announced
Windows Phone 7. In December 2009 itself Microsoft had announced its intention
to release this version (and the latest offering from Microsoft’s stable) by
November 2010. Needless to say, this was one of the most eagerly awaited
announcement of this quarter. This write-up merely summarises some of the
stories on this new software.

Behind the scenes story :

For the uninitiated, Windows Phone 7 Series is Microsoft’s
reboot of its mobile platform previously named Windows Mobile. Even though
Windows Mobile had the first-mover advantage as the smart phone operating system
of choice, the platform last year suffered significant losses in its market
share. Apple’s iPhone and Google’s Android platform ate into Microsoft territory
by offering better user experience, a more robust platform and offering phone
apps.

The development team at Microsoft was clear that they would
be rethinking a lot of things and that there would be a sea change in the
approach to the development process itself. They revamped just about every
aspect of building the phone software, ranging from how they perceived customers
to how they would go about engineering for the product. An obvious course,
considering that they were attempting to regain their mobile groove by offering
a brand new user interface integrating applications and multimedia into ‘Hubs’
(i.e., software experiences organised into main categories or menus) as well as
a tidier platform for third-party developers to create and serve apps.

For development the plan was that, Windows Phone 7 Series
would employ the Silverlight and XNA programming environments. Silverlight would
serve as the coding toolkit for ‘rich Internet applications.’ (As Microsoft’s
alternative to Adobe Flash, this is not surprising, and potentially gives
Windows Phone 7 an edge over phones that don’t support Flash or Silverlight —
namely, the iPhone). XNA, on the other hand, refers to a set of programming
tools that makes it easier for game designers to develop games for multiple
Microsoft platforms, including Windows XP, Xbox 360, Windows Vista and Windows
7.

Simply put, it meant that most mobile apps would be made with
Silverlight, while more graphics-intensive 3D games would most likely be
developed with XNA. The objective was that Microsoft would make the tools
friction-free for developers and to enable them to get in as easily as possible.

The user interface (UI) while similar to iPhone was intended
to be different from any other smart phone in the market. The phones would
support the same touch gestures seen on the iPhone: pinch or double tap to zoom,
and swipe in a certain direction to pan. For hardware, each Windows Phone 7
Series phone would include seven standard physical buttons for controlling
power, volume, screen, camera, back, start and search.

Comparison of some innovative and unique features :

With the lucrative mobile ecosystem getting crowded, the
existing players are battling hard to retain their market share (in some cases
to remain relevant). Up to 2009, developments were not as fast-paced as they are
today. In fact, while Microsoft took the lead over the other mobile/ phone
operating systems, iPhone and Google Android devices took a few years to refine
their user interface and features, giving them plenty of time to get ahead of
Microsoft’s ailing Windows Mobile OS.

Once they got in to the fray, the only way out for Microsoft
was to come up with a totally new user interface i.e., Windows Phone 7 OS, that
too without the luxury of time. Add to this, Microsoft had to build the system
from scratch and that it could ill-afford significant delays in release, the
likelihood that they would leave out several features that we now take for
granted on our smart phones was pretty high. Nonetheless, Microsoft brought in a
few interesting new elements to the table with Windows Phone 7, elements that
they thought would be preferred over the usability of an iPhone or an Android
phone.

All this has generated quite a bit of chatter on the pros and
cons of some of the features, the more popular topics of discussion are as
discussed below :

  • Microsoft’s new mobile OS doesn’t have copy/paste capabilities :

    Some of you may recall, the first, the second, and even the third iPhone did not initially have copy/paste functionality as well — but that was over a year ago (copy/paste for the iPhone arrived later as a software update). Interestingly, Android had this capability from day one. Besides this, both iPhone and Android have office apps that work a lot better than Microsoft’s. On Windows Phone 7, office work is impossible due to lack of Copy & Paste.

    Microsoft reportedly revealed during a Q & A session at its MIX10 conference that it believes that people don’t need copy-and-paste on their phones. Instead, the new OS offers new functionality the company believes people actually want. For example, the new Microsoft handsets will identify addresses and phone numbers, and you will reportedly be able to send this information to different applications such as the phone or your contacts manager.

    Notwithstanding, the exclusion of copy/paste in Windows Phone 7 doesn’t earn the new OS any gold stars for functionality.

  • Second on the list of missing Windows Phone 7 features is true multitasking :

    Windows Phone 7 does not allow third-party apps to run in the background, but pauses them until you return to the app. Apparently, multitasking was something that Android had from day one, and that was later introduced for the iPhone. This puts the OS in the same situation the iPhone was over a year ago, when only Apple’s apps could run in the background.

    It is interesting to note that one of the most highly criticised points against the iPhone is its inability to multitask, which prevents you from using more than one third-party application at a time. You can’t for example, use Blip.fm, while reading something on your Kindle or New York Times app. Apple’s solution to this problem was to create a push notification system where the content provider pushes information to your phone, instead of having applications on your phone you can call the content provider to get it. One reason critics are able to live with Apple’s strategy is that the iPhone can switch between applications fairly quickly, and most developers make sure their iPhone apps can open up from where you left off. So the downtime between closing and opening different apps, and finding the content you need, isn’t that significant on the iPhone.

    If Windows Phone 7 apps aren’t as equally fast and smart as their iPhone counterparts, Microsoft could end up being heavily criticised for its no multitasking-push notification system.

        The third debated feature oversight for Windows Phone 7 is the lack of Adobe Flash, Silverlight, or HTML5 support in the browser:
    Steve Jobs squashed any ideas of running Flash on an iPhone, so Android is the only one left in this round. It took Google and Adobe over a year to come up with Adobe Flash support for Android, but now the latest generation of Android phones has the feature. If Microsoft really wanted to have an edge over the iPhone and fight Android, it could have at least supported its own Flash-competing technology, Silverlight, on Windows Phone 7 devices. It is surprising considering that Silverlight was supposedly part of the original plan.

        Android and iPhone have equivalent of hubs:
    Android has notifications. iPhone has folders. While Windows Phone 7’s hubs are touted to be dysfunctional because it only notifies you with Microsoft messages. In effect, there are no notifications for third-party apps that you use, because those third-party apps cannot multitask. The apps are frozen, or tombstoned, and can’t notify you of anything. The moot question is “So what, then, is the point of the tiled hub interface if you can’t get notifications from the things you want (rather than what Microsoft wants)?”

    For the benefit of the readers, I have compiled a small list of what’s missing and what’s new.

    Features available in either iPhone or Android phone (but not available in Windows Phone 7):

        Copy and paste
        Multitasking
        Flash support
        HTML 5 support
        Unified inbox
        Threaded email
        Visual voice mail
        Video calling
        Universal search
        Limited removable storage
      Not enough applications (Microsoft 1000 plus as against over 3 lakh offered by iPhone and about a lakh by Android)

    Features available in Windows Phone 7 (but not available in either iPhone or Android phone):
        Limited removable storage
        Facebook integration
        Microsoft office support
        Widget tiles on home screen
        X-box live integration
        Panorama view of hub content
        Animated transitions
        Unlimited music download from Zune, unlimited video download from U-verse
        XNA game developer platform

    While it is too premature to say whether Microsoft was right or wrong, Windows Phone 7 has (may be rightly) received a lot of flak from reviewers for not having some features that many owners take for granted on their current smart phones. The next write-up will have more on the story as it unfolds (Windows Phone 7 is scheduled for launch on 7th November).

Chairman’s Foreword

Chairman

The theme of this conference and the Diamond Jubilee issue of
the Journal is :

‘Challenges of change — always ahead.’

It exemplifies what Peter Drucker once said :

“One cannot manage change, one can only be ahead of it”.

Bombay Chartered Accountants’ Society — BCAS — in its
existence has always been anticipating change. It has been innovating its
educational programmes to arm its members to be always ahead — to meet the
‘challenges of change’. Change also demands that we continuously rewrite our
rules whilst retaining our values. BCAS initiatives also :



  • attempt to bridge the gap between expectations and realities.



  • pursue excellence through curiosity and creativity. Hence, the motto on BCAS’s
    journal is ‘curiosity to creativity’.



  •  aim to create opportunities for the accounting fraternity to learn and
    re-learn.


Six days after the birth of our Institute, seven visionaries
established this organisation to chisel talent to meet the needs of trade and
industry and has since then been evolving and innovating. The Society is an
adjunct to the Institute. It is there to support the Institute in achieving its
objective of being ‘partner in nation building.’

It was Leo Tolstoy who said, “Faith is the force of life”.


It is the faith that the founders of BCAS had in the
accounting fraternity of this metropolis (great city) that continues to inspire
us. It was their dream — nay — vision to make BCAS an institution that disperses
knowledge and trains chartered accountants to serve the ever changing needs of
society. It is this vision which was articulated into a ‘vision statement’ by
the Narayan Varma committee in the year 2002; which in concrete terms guides the
present and will guide the future activities of the Society. It is rightly
said :

“Great leaders institutionalise.”

In order to achieve our objectives we seek not only the
co-operation of our fraternity, but also the co-operation of sister professions
which we have received in abundance. We take this opportunity to express our
gratitude for their contribution.

Questions arise :


What makes BCAS what it is today ?; and

What prevents BCAS — an oasis of intellectuals — from
becoming irrelevant like some institutions ?

The answer lies in the fact that BCAS has been fortunate in
always having leaders who perceived the need for change, has responded to the
environment and delivered change. This is what makes BCAS vibrant and
challenging. It continues to challenge the old and the young alike — challenges
them to contribute both to their personal growth and the growth of BCAS.
Individuals do not come to lead and leave. They continue to serve and face
challenges of change to keep BCAS always ahead. It is because of this
that the BCAS is an epitome of excellence in the art of being always ahead.
Our leaders consider it a privilege to be part of it and serve it.

It was Eric Hoffer who said :

“The future always belongs to those who earn it, and the only
way to predict the future is to have the power to shape it.”

It is also said ‘everything is possible for those who
believe’ and I say that the founders of BCAS believed and the leaders of BCAS
today believe in its contribution to the growth and shaping of our profession.

I believe that my fraternity has the vision to both predict
and shape its future and to be a part of the exciting times that the trade and
industry is going through and beholds for the future. I also believe that in all
this along with our Institute, BCAS has the ‘wherewithal’ to contribute.

In an environment where Indian businesses are expanding
beyond our territorial waters and foreign investors consider India as an
opportunity, we professionals need to hone our skills to meet the needs of both
these challenges. In honing the skills of my fraternity BCAS has played a
crucial role by being ‘always ahead’.



  • It was ahead of others, as mentioned earlier, when it was established just six
    days after the birth of our Institute; to impart skills.



  • It was again ahead when in late eighties it encouraged the study of
    international tax.



  • It is again ahead today when it conducts programmes on ‘business consultancy,’
    ‘alternative dispute resolution,’ ‘internal audit’ and ‘corporate governance’.



To respond to ‘challenges of change’ we need to examine the
change that has happened and is happening in both the social and economic
environments. A few illustrative changes are :

  • live-in relationships are accepted and are also being judicially recognised.

  • divorce and adultery are not shunned but are accepted as ‘freedom of choice.’

  • single motherhood  is accepted.

  • gays and lesbians live openly and are no longer shy of their affiliations.

  • every centre of power, big or small, is suspect of conspiracy and corruption.

  • individuals and organisations blatantly use authority without accountability.

  • business failures because of un-ethical practices – sub-prime is the latest which has shaken some of the world’s largest financial institutions.

  • laws are violated  with  virtual  immunity.

  • reported instances of our professionals involved in unethical practices.

  • professionals are accused of being collaborators in fostering corruption.

  •  society existing at flash point – riots, dharnas and agitations based on religion, language, caste, creed and even on admission to educational institutions virtually taking place every day.

  • society today approves, accepts, tolerates and at times even applauds corruption – the change in character.

Our tolerance or acceptance of the above changes over a period has increased.

If one were to analyse these they represent different facets of the same animal corruption. In factual terms it is conflict between:

1.    standards of behaviour with practicality, for ex-ample, business considers tax as a cost and we support and contribute to this thinking whereas the excessive use of tax havens has been held to be not only immoral but against law. Professionals in U.5.A. have been fined for encouraging use of tax havens .

2. being lawful  and practical.

In this environment we professionals are challenged to retain our professionalism. Society conveniently forgets that we professionals also emanate from the same environment but expects professionals to live in an oasis.

Let us not forget that Arthur Anderson went down with Enron because there was loss of values. Whenever, wherever a seam occurs the first question is :

‘Where was the auditor ?’

In other words, we are challenged by the dangerous play of convergence of commitment to principles with convenience. I repeat and question:

Is it the time to rewrite our rules without changing our values?

BCAS believes that a professional without ‘values’ is not a true professional. BCAS attempts to inculcate values through its study circle and articles in the Journal. It is not shy of discussing the multiheaded monster’ corruption’ which is becoming the scourge of Indian psyche.

Friends, this conference is a symbol of BCAS’s commitment to excellence in serving the accounting fraternity and to create opportunities to learn. The symphony of professional thoughts which is going to be presented today will be a treat to our ears and will at the same time be ‘thought-provoking’. The special issue of the Journal also aims to achieve the same objective. The credit for this goes to the cast and the crew of this conference and our learned contributors who have diligently toiled to give us ‘thoughts to think’. A review of the papers and articles exhibits the mastery which the authors have over the subjects. They have made complicated, confounding and confusing issues simple. They have dealt with the issues with luminous clarity. Their level of excellence, I am sure, will be a source of inspiration to the younger members of our fraternity.

I would conclude by saying  :

‘BCAS is a journey and not a destination and pray that this journey will – nay – shall continue.’


TDS and S. 40(a)(ia) of the Income-tax Act, 1961

1.0 Facts :

    1.1 ABC Ltd. credits on 1st October, 2009 the account of Mr. X, a resident, with Rs.55,000 being commission on sales payable to him. ABC Ltd. deducts tax at source @ 5% being oblivious of the actual rate applicable. This results in a short deduction of tax of Rs.2,750.

    1.2 ABC Ltd. also credits on the same day the account of Mr. Y, a resident, with Rs.55,000 being commission on sales payable to him. The company deducts tax at source @ 15%. This results in an excess deduction of tax of Rs.2,750.

    1.3 The company has made accounting entries in accordance with the above facts, and cleared the accounts of Mr. X and Mr. Y before 31st December, 2009. Thus, the balances in these accounts are reduced to nil. It is believed that in neither account any further credit will arise till 31st March, 2010.

    1.4 The company uploads its quarterly TDS statement with the above information.

    1.5 When the CFO of the company is informed that commission paid to Mr. X is likely to be disallowed u/s.40(a)(ia) on account of short deduction of tax thereon, he argues that there is no overall short deduction when payments to Mr. X and Mr. Y are considered together.

    1.6 The company seeks your opinion about the allowability of deduction in respect of commission paid to Mr. X. The company also seeks your views on whether the company is liable to pay interest u/s.201 in respect of this short deduction of tax.

2.0 Opinion :

    2.1 Let us first see how S. 40(a)(ia) when read with the substantive part S. 194A would work. For a better comprehension, substantive parts of S. 40(a)(ia) and S. 194A are reproduced below :

    40(a)(ia) : “any interest, commission or brokerage, rent, royalty, fees for professional services or fees for technical services payable to a resident, or amounts payable to a contractor or sub-contractor, being resident, for carrying out any work (including supply of labour for carrying out any work), on which tax is deductible at source under Chapter XVII-B and such tax has not been deducted or, after deduction, has not been paid”.

    194A : “(1) Any person, not being an individual or a Hindu undivided family, who is responsible for paying to a resident any income by way of interest other than income by way of interest on securities, shall, at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rates in force :

    2.1.1 The following features of S. 40(a)(ia) when r.w. the substantive part of S. 194A stand out in order that the provisions of S. 40(a)(ia) may apply.

    (i) Tax on interest is deductible in respect of every credit or payment of interest if the amount of credit or payment exceeds or is likely to exceed the specified amount in a financial year. Thus, the liability is fastened to credit or payment, as the case may be.

    (ii) Tax on specified incomes should be deductible under Chapter XVII-B.

    (iii) Such tax should not have been deducted;

    or

    (iii) after deduction, such tax should not have been paid before the specified dates.

    2.1.2 It is admitted that tax in this case is deductible since income is a specified income and that the full tax has not been deducted. Further, when taxes deducted from payments made to Mr. X and Mr. Y are taken together, there is no shortfall.

    2.2 The following issues arise out of the facts and the queries :

    (i) Whether full tax at source should be deducted and paid on a specified income in order that no disallowance u/s.40(a)(ia) may be made.

    (ii) Whether some tax deduced at source and paid to the Treasury on a specified income can make S. 40(a)(ia) inapplicable making thereby the entire underlying income eligible for deduction.

    (iii) Is it possible that the amount of disallowance u/s.40(a)(ia) is restricted to the amount which bears to the amount of expenditure the same proportion as the amount of tax not deducted bears to the amount of full tax ? In other words, can the amount of disallowance be decided by the formula :
   

    (iv) Whether an excess tax deduction in one case can be adjusted against shortfall arising in another case so as to avoid disallowance u/s.40(a)(ia) and interest.

    2.2.1.1 As regards the first issue, a view can be taken that a small shortfall may make the entire underlying expenditure disallowable u/s.40(a)(ia). The reason for holding this view is that S. 40(a)(ia) applies when a tax in respect of a specified income is deductible and such tax has been either not deducted or not paid. Therefore, in this case, Rs.5,500 was the tax deductible from the payment made to Mr. X, and therefore, such tax should have been deducted and paid if one wants to avoid disallowance under these provisions. Since such tax was not deducted and paid, S. 40(a)(ia), prima facie, becomes applicable making the entire underlying expenditure disallowable.

2.2.1.2 Another view can also be taken that if some as against the full tax is deducted from credits or payments of specified incomes, full allowance for the underlying expenditure should be made. The reason for holding this view is that, as seen above, S. 40(a)(ia) will primarily apply if there is a tax deductible in respect of a specified income and such tax has not been deducted, meaning thereby, that full of such tax should not have been deducted. In other words, in order that this case may fall in S. 40(a)(ia), the amount not deducted should be Rs.S,SOO,no more and no less. In case a part deduction of tax has been made, as in the case of payment to Mr. X, no disallowance u/s.40(a)(ia) can be made.

2.2.1.3 I must admit that the views expressed in paragraphs 2.2.1.1 and 2.2.1.2 are unreasonable and outrageously extreme. A person, who deducts some tax from a specified income and another person who does not deduct any tax at all from a similar income, cannot be treated on par. If the views expressed in paragraph 2.2.1.1 are accepted, both these persons suffer full disallowance whereas the offence of the first person is certainly mitigated by the fact he has made some deduction of tax at source. For similar reasons, the views expressed in paragraph 2.2.1.2 can also not be accepted as these views put on par persons who have fully complied with the law, with persons who have shown no compliance at all. It would be absurd to say that two persons, one of whom has made the full payment of tax at source of Rs.5500 and the other person who has made no payment at all, will both enjoy full allowance of the underlying expenditure.

2.2.2 Therefore, the better view is that disallowance of the expenditure is restricted to the amount which bears to the amount of expenditure the same prociate that any amount is mathematically a sum of several amounts and any amount can be broken up into several sub-amounts. For example, a thousand is also a summation of eight hundreds and two hundreds, and likewise. Thus, a view can be taken, when Rs.2,7S0 is deducted in the case of Mr.X, that the underlying expenditure in respect thereof is Rs.27,SOO. Viewed thus, there is full deduction of tax @ 10% from Rs.27,500. The remaining Rs.27,500 of the expenditure is the amount in respect of which the default has been committed. It is this last amount which will suffer disallowance.

2.3.1 We shall now deal with issue No. 4 : whether excess deduction in one case can be adjusted against the shortfall arising on account of short deduction in anether case. In this particular case, since the information with excess and short deduction of tax has been uploaded, inter account adjustment between the two accounts is not possible unless this information is revised and reuploaded. The obligation on a person is to deduct proper tax in respect of an expenditure. Though expenditures incurred in favour of Mr. X and Mr. Y have a similar nature, they represent different expenditures, and there is admittedly a default committed in respect of payment made to Mr. X. Therefore, the excess deduction of tax in the case of payment to Mr. Y will not be available for adjustment against the shortfall of tax in the case of Mr. X.

2.3.2 However, inter account adjustment between Mr. X and Mr. Y would have been possible before uploading the information in the quarterly statement by debiting Mr. X’s account in whose case short tax was deducted and crediting Mr. Y’s account in whose case an excess tax was deducted and thereby a net short payment of commission was made. The company would, thereafter, recover Rs.2,750 from Mr. X and pay it over to Mr. Y. Or else, if the company is unable to recover such amount from Mr. X, the company could write it off and claim it as a commercial loss. It should be remembered that such tax borne by the company is not ‘a tax levied on the profits or gains ,of any business or profession’, and therefore S. 40(a)(ii) operating as a disallowance of expenditure by way of income-tax, will not apply.

Needless to say that if inter account adjustment is carried out between the accounts of Mr. X and Mr. Y, the TDS certificates should be issued accordingly.

3.0 Conclusion:

The amount to be disallowed in this case should be Rs. 27,500, that is, on a proportionate basis. No inter account adjustment is possible once the information is uploaded; unless the information is revised. TDS certificates should be issued in accordance with the information uploaded.

Understanding Islamic Finance

Article

“All that we had borrowed up to 1985 or 1986 was around $ 5
billion and we have paid about $ 16 billion, yet we are still being told that we
owe about $ 28 billion. That $ 28 billion came about because of the injustice in
the foreign creditors’ interest rates. If you ask me what the worst thing in the
world is, I will say it is compounded interest”.


—Former
President Obasanjo of Nigeria
after the G8 summit in Okinawa in 2000.


First the big question :

How is Islamic finance different from conventional finance ?
It looks the same; the result is often the same. What is the difference ?

Let’s take a real world comparison. Let’s take $ 10,000 for
instance and compare what a conventional bank can do with this and what an
Islamic bank can do.

First — The conventional bank :

The conventional bank finds a creditworthy customer and lends
at 5% interest. The bank is not particularly concerned about what happens to
this money other than that it gets repaid. The customer on the other hand has
already found a borrower willing to pay 7%. The borrower runs a small credit
co-operative for students and lends at 10%. One of these students is
enterprising enough to lend to his unemployed brother at 15% who has just
discovered the power of compounding interest and lends to street vendors at 25%.
We can go on. But you get the idea. There are poor people today paying upwards
of 40%.

The problem with artificial wealth creation based on interest
and the fact that you do not need actual cash to lend money means that the
original $ 10,000 could keep passing hands until we pump out over $ 100,000 of
artificial wealth. So how much actual cash is there ? Only $ 10,000. With
interest, we managed to turn $ 10,000 into much more. So are we surprised when
billions of dollars vanish into thin air ?

Second — The Islamic bank :

The Islamic bank only invests in actual assets and services.
It might buy machinery, lease out a car, or invest in a small business. But
throughout, the transaction is always tied to a real asset or service.

That is the difference between Islamic finance and
conventional finance. The difference between buying something real and borrowing
and lending something fleeting. What conventional finance enables is the ability
to sell money when there is no money; to sell assets before there are underlying
assets and to allow debts to grow unchecked while borrowers become more
desperate.

Interest creates an artificial money supply that is not
backed by real assets. The result is increased inflation, heightened volatility,
richer rich, and poorer poor.

It seems unbelievable but sadly it is typical. Developing
countries start off with relatively small loans and remain saddled with huge
amounts of growing debt for generations. This could be Nigeria, or any other
poor country. To give just one other example, during the years leading up to the
1997 Asian collapse, Indonesia’s foreign debt as a percentage of GDP was over
60%. So Nigeria is certainly not an isolated example.

UNICEF estimates that over one-half million children under
the age of 5 die each year around the world as a result of the debt crisis. But
as we have seen, it is not the debt that is the problem; it is the compounding
interest.

Nick the homebuyer :

In 2009, Nick lost his job, his house and all the money he
had spent paying off his mortgage. Let us consider that Nick availed a
Diminishing Musharakah (Partnership) facility with the bank.

Under a Diminishing Musharakah, the bank’s equity decreases
throughout the tenure of the financing, while the client’s ownership keeps
increasing throughout a series of equity purchases. Eventually, the client
becomes the sole owner.

Nick, having lost his job, would still have an equity stake
in an actual property that he could monetize.

Assume he purchased a $ 220,000 house and put down $ 20,000,
financing the remaining $ 200,000 from the Islamic bank. The finance is to last
20 years and the bank sets a 5% profit rate. For the sake of simplicity we will
make it 20 annual instalments. (Refer Table)

Year

Home buyer’s

Bank’s

Rent

Home
buyer’s

 

equity

ownership

 

payment

 

 

 

 

 

1

$10,000

$190,000

$10,000

$20,000

2

$10,000

$180,000

$9,500

$19,500

3

$10,000

$170,000

$9,000

$19,000

4

$10,000

$160,000

$8,500

$18,500

18

$10,000

$20,000

$1,500

$11,500

19

$10,000

$10,000

$1,000

$11,000

20

$10,000

$0

$500

$10,500

In the second column of the Table we have the homebuyer’s equity purchase, which is how much the buyer pays every year for buying the property’s actual equity. It is his way of increasing ownership in the property while diminishing the bank’s ownership as shown in the third column of the Table. The fourth column of the Table called rent is what the homebuyer pays the bank for the portion of the property he does not yet own, a number that keeps decreasing as the bank’s share keeps decreasing. The final column shows what the homebuyer pays in total every year.

At no time does the homebuyer pay any interest. And certainly at no time does any payment compound. The homebuyer pays for just two things: the house in incremental payments, and the rent for the portion of the house he does not yet own. Call it Islamic finance, ethical finance, or conventional finance; when banks take real ownership of an asset, what can only truly be called real risk, economics do not fall apart like a house of cards.

So how could Islamic finance have helped former President Obasanjo of Nigeria?

Using the $ 5 billion from their initial borrowing, Islamic banks could provide $ 5 billion of financing for infrastructure, literacy, healthcare and sanitation programmes to name a few.

An Islamic bank could have arranged for the $ 4 billion construction of a natural gas pipeline delivered to Nigeria for $ 5 billion using an Istisna financing.

Or taken an equity stake in a highway project and shared in profits and losses using a Musharakah partnership.

The next time one wonders whether Islamic banking is just dressed-up conventional banking, see if one finds a single major consumer bank that co-owns actual properties with their customers. An Islamic bank takes direct ownership of actual assets, whether for a long period such as in a lease or equity partnership, or for a short period, such as in a sale trade.

Simply put, Islamic finance permits equity, trade, and leasing, but forbids debt.

Principles guiding Islamic banks:

Islamic banking transactions must be:

  •     Interest free

  •     Risk shared

  •     Asset or service backed, and

  •     Contractual certain

  •     Ethical

The Islamic ban on interest is not new. For centuries banned by Christians and Jews, Islamic Law prohibits paying or earning interest irrespective of whether it is a soft development loan or a monthly consumption loan.

The Bible contains the following verse:

“If you lend to one of my people among you who is needy, do not be like the money-lender; charge him no interest.”
— Exodus 22:25-27

In March 2009, the Vatican came out with the following statement : “The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.”

Today, Islamic finance is no longer a niche market. With global assets estimated at USD 1 trillion, asset growth has kept steady in most countries at over 15% per annum. Apart from Muslim countries, Islamic finance has penetrated into countries like Singapore, China, Australia, Thailand, Canada, United Kingdom, France, Korea, Japan, Switzerland, and Luxembourg.

Conventional banks with extensive Islamic banking operations include Citigroup, HSBC, Deutsche Bank, UBS, ABN-Amro, and Standard Chartered.

Standardised accounting and product standards promulgated by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) provide regulated standards and common bases for global convergence. Islamic market indices like the Dow Jones Islamic Market Index comprise 69 country indices including India’s.

India is on the threshold of launching key Islamic finance initiatives with the Reserve Bank of India considering landmark policy changes. Companies like TATA AIG, Bajaj Allianz, and Taurus have already started to tap this segment of the market by offering Islamic-friendly products. With over 160 million Muslims in India, and with its strong position in global capital markets, India stands poised to become a major Islamic finance hub in the coming years.

Reminiscences about the profession

Article

The word ‘Reminiscences’ suggests remoteness in time unlike,
its synonyms ‘Recollections’ and ‘Remembrances’ which entail sequential
recalling of facts rather than disparate incidents. This subtle distinction
allows the latitude for selectivity, when penning ‘reminiscences’.


Reminiscences could be hazardous, but I agreed to write in
appreciation of BCAS’ role as a thought leader in our profession, and their
exemplary functioning, which reminds me of the hope expressed by Hon. C. D. Deshmukh, the first Finance
Minister of India in his speech inaugurating the ICAI that “this structure shall
house all that is noble and dignified in the profession of Chartered
Accountants”.

This narrative cannot begin without acknowledging a deep debt
of gratitude to two benefactors, Mr. V. D. Chowgule, and the Hinduja family, who
respectively facilitated my entry into Articles in London (1966) and passage
into industry (2002) gently, swiftly and with future prospects that could hardly
have been bettered.

Entry via UK :

An entry to ICAI membership in 1971 as a UK CA, under a
facility open up to mid 90s, and paradoxically shut during my own presidency,
gave me relief from examinations, and seemed almost providentially designed by
ICAI founding fathers, to set the duller lot free from the severer struggles
with Indian legislation, bestowing on me large leisure to brood over coming to
terms with Mumbai’s ground reality, on return from PW London Office.

Early ’70s :

On joining a large firm in India (1972), my first impressions
were of contrasts, difficult to reconcile. Firms with quality clientele to match
today’s multinational LLPs, but squeezed by an oppressive tax regime, worked in
rudimentary environments with non-existent creature comforts, the serene
antithesis of the later-day CA offices modelled after five-star lounges.
Unctuous peons donning traditional round black topis served feeble beverages —
reverentially to ‘Saabs’, obsequiously to ‘Seths’, deferentially to visiting
clients, and indifferently to other inmates.

CAs rode the high tide of sought-after tax expertise,
following doomed attempts by the business community to find cheer in the tax
regime then extant under the FERA-cum-Licence Raj, except through the most
abstruse tax planning, on a scale now hardly credible even to modern tax
planners.

The finest minds upon graduation craved Articles, enchanted
by the premium CA qualification. Some of the gems who trained during those
years, including under me, are today leaders of many sectors in India and
abroad, too numerous to recount.

Managers were deemed successful if staff rooms were empty
(there was no hot-desking then). It was seen as a sign of success (billable
hours was the main saleable product, as it is today) if the little ones were
ticking up chargeable hours in client offices, while the big ones turned
disputation into argument in tax offices, and escalated these before tax
Tribunals, — the latter appellate forum already under relentless surrender to
the rival black-gowned profession.

Seeds of slide :

Members of our profession were imperceptibly but irreversibly
consigning themselves to meaner and less rewarding rungs on the ladder of
representational work. When the enduring tale of our profession is eventually
written, the scribes shall have the unenviable task of scripting a durable
record of the price we paid for neglecting the two engines that could have
navigated us to greater prosperity and good fortune — presentation skills, and
language skills. The neglect of these skills virtually handed on a platter to
MBAs and other disciplines, traditional preserves, over which CAs could easily
have retained hegemony.

Inherent tragedy :

The inherent tragedy of the CA in India is that — the CA Act
keeps members from doing that which is not prescribed, whereas the Advocates Act
keeps non-members from doing whatever the black-gowned profession does. So the
CA Act shackles CAs while the Advocates Act shackles competition.

Extensions of accounting like costing, management accounting
and financial management had by 70s been popularised, covered by authoritative
ICAI pronouncements, and become common enough to be put to general account. The
concept of accounting had changed, from one of maintenance of books and tracking
asset changes, to complex resource allocations and forward looking measurements
that support decisions for the efficient maximisation of profit. These
specialisms were subsumed by management consultancy, which turned esoteric, and
gradually the more lucrative work was captured by brand names, mostly non-CAs,
able to win predatorily priced assignments, and function with impunity outside
any regulatory framework whatsoever.

Gradually, all perceived ‘value added’ domains moved away
from the core attest function.

Auditing :

Audits had progressed, beyond the’ post factum technique of validating profit or loss and asset changes, to prescriptive regulator-driven reporting regimes, notably the requirements of October 1973 obliging verifications of capacities, turnover, production and stock quantities categorised by licensed sublimits, to be published in Annual Reports; and MAOCARO 1975 (forerunner of current CARO) requiring explicit subjective judgmental statements that broke new ground, augmenting responsibility and chargeable hours to perform extra work, without commensurate rise in fees, because clients saw little benefit to their businesses from that work. Astute, information-hungry bureaucracy had spotted an ideal intermediary to cater to regulator needs at no cost. So, over the years MAOCARO items elongated like the legendary Hanuman tail. One benefit that flowed to the membership from MAOCARO was a formal resuscitation of Internal Audit.

ICAI formed an Audit Committee on 17th September 1982, the date, I entered the Council. The ICAI President retiring on that day had lectured me on book keeping two decades back at college. I wondered if his farewell symbolised departure of quality from those hallowed premises, but was reassured to observe the elders that stayed on in the Council. They were learned men, rather serious, looking as though they would never surrender to any form of mirth, except maybe a twitch of a smile, if elected President.

Accent was as much on redistribution of work as on creation of new work; ‘Tax Audit’ was a notable milestone in creation of new work. Curiously though, the more comprehending minds among the then seniors, were, at least initially, not enthused by this source of perennial new work – it was seen as too risky.

The pet themes in rationing audits were ‘rotation’ which was rumoured tri-annually, and ‘ceiling’ which was mooted more recurrently. The latter was eventually enacted at 20 audits per partner and the former dumped, not because this was a triumph of self preservation by the old guard, but because many rotationists had done so well over the decade, as to see life differently. In the first draft of the new Companies Bill, the proposed ceiling on large audits was misprinted as 2 instead of 20 per partner. The first copies arrived as I was hosting a dinner for a former ICAI President. He had just declined a dessert that I had offered to order. Together we noticed the unexpected steep diminution in the ceiling on large audits at 2 per partner, without realising it was a misprint. He lightened the gloom by announcing that he would change his mind, and have the dessert after all, as this might be among the last occasions that it would be on offer. Obviously I had been wrong about elders not having a sense of humour – they did!

The big scramble in audit was for empanelment to win audits of nationalised banks, insurance companies and PSUs. The appearance of a senior bureaucrat with dispensing powers at any gathering could metamorphose ‘service’ into ‘servility’. This may have been the first dent in a system which had earlier taught members to aspire, but not to grovel.

Hopes about uplifting audit as a deterrent to corporate quixotry, through a convergence of statistical sampling and unprecedented advances in information technology, died early . Technology and sampling were used to boost margins by justifying drastic reductions in work and costs, by many, but almost institutionalised by a large international organisation that collapsed some years ago causing much misery. Given the disability that an auditor can neither issue summons, nor examine on oath, nor disclose the most horrendous client sins except in a court proceeding, auditing is probably destined to veer towards forensic investigations with statutory support. Some international firms have made commendable progress in this, without formal backing.

The Licence Raj also required numerous attestations – there was a boom in what was referred in vernacular as ‘certificate work’. Agents scouted impecunious young CAs even deep into the mofussil to entice ‘certifications’ of illusory end users and fictitious consumptions of the costliest imports.

Fleeing  the  shackles:

Fault lay not with the hapless membership, but in the stagnant economy and archaic regulatory shackles that offered little opportunity, except perhaps through emigration. Thousands went west, and as many gravitated to the Gulf. They did well, and did their country and calling proud.

The Council contained competent and clean professionals. But in a closed economy, an unseemly proportion of time was drained on volumes of disciplinary cases punishing puny sins – no more than tiny ads, minor indirect solicitations, and acceptance of minuscule audits without prior NOCs, mainly by members struggling for the economic necessities of life. Large established wrongdoers, including CAs outside professional practices, were seldom booked.

Tax:

Before the blossoming of other specialisms, the absorption with taxation as a discipline was near total. When established CAs of that era crossed fifty years of age, it would not have been uncommon to see their interest in the finer points of fiscal interpretations sublimated to become the principal passion of existence, replacing all other zests. 1985 broke the tax spell and ushered in Financial Services which were already waiting in the wings to come centre stage.

Finance:

The risks assumed by financial institutions in ex-tending term loans soon brought forth a new breed of CAs to help borrowers satisfy the information needs of lenders. This work quickly extended to an appraisal of justifications for projects before committing funds. The ICAI published the Back-ground Material on Project Evaluation in 1988, but well before that, entrepreneurs increasingly saw CAs as facilitators and procurers of much-needed finance, rather than number crunchers peering at small print, while big picture concerns went unnoticed. The evolution of a learned but backward looking timid lot into a dynamic pack not lacking commercial nous, became agreeably evident.

Industry :

An important lesson the profession was learning; was, that sectors outside traditional audit, especially industry sector, would value as advisors only those professionals who were providers of solutions, not those who stopped short of a solution after finding the root of a problem, howsoever painstakingly researched that finding of the problem root may be. For many of us brought up in the traditional mould, this may have been a bitter pill to swallow. But it is important to bear in mind that if the perceptions of society about us professionals do not coincide with our self perception, then it is we professionals who become irrelevant, not society, nor those who hold the purse strings that generally influence the perceptions of society.

Standards    – ASB,  IASB & IFRS

The Council did take worthy initiatives in line with world trends. Accounting Standards Board was set up in 1977. But contrary to popular impression, our thrust, at least initially, was not market-driven. I was Chairman of ASB for some years, thereafter on Steering Committees of International Accounting Standards (IAS) and finally India’s nominee on the main Board of IAS for a full Term. I worked closely with Sir David Tweedie, later IASB Chairman, and luminaries from US, Europe and Japan. International Standard Setter meetings occurred in exotic places in the world, and at times went on for nearly a week. The scholarship and erudition round the table was so profound as to be intimidating. But the humility was amazing. I once complimented Jim Lisenring, Vice-Chairman of US FASB, that his oration on the subtler aspects of financial instruments was the most brilliant piece I ever heard; and he shot back “that proves you have not been around in the world enough”. Incidentally the divide on debatable issues between the two sides of the Atlantic was at least as wide as between the two sides of the Pacific. The Board included such experienced individuals as could elucidate the most intractable technical problems with astounding clarity using examples of transactions in a small shop. Belying the irrepressibly drab image of beancounters, some delegates regaled us with the wittiest after-dinner speeches.

Installation of IFRS, including in US corporations, may well represent the single biggest opportunity for ICAI members during the next decade.

Capital markets and Bank NPAs:

For much of our formative years, my generation was awed by an authority known as the Controller of Capital Issues that obliged industry to seek our pricey attestation on intricate application forms, designed to obstruct rather than facilitate, the issue of capital or bonus shares. This controller vanished overnight, a little before the new SEBI-sponsored arrangements were fully in place, leaving an interregnum during which a number of adventurous souls including CAs had more than their share of fun.

In one of his famous plays Shakespeare has written an oft-quoted line “let us kill all lawyers”. He was terribly wrong, not only because he exaggerated the foibles and banalities of the calling he named, but because he had never met merchant bankers before he wrote that line. Had he met merchant bankers, he may not have dished out this dire prescription to others.

One of the Managing Directors at Bear Stearns (which folded up later) led the Financial Analysts in the IASB in discussing many issues including derivatives, hedge instruments, options, off-balance sheet items, etc. She would sometimes ask me how she had come through, and I would reassure her that she had not exhibited the characteristics implicit in the sounds of her firm name i.e., ‘neither ‘Bear’ nor ‘Ste(a)rn(s)’. Uncannily though, I had then, and still have today, an instinct against some of the new fangled financial instruments, and particularly their accounting.

I have a foreboding of worse disasters to come, because the malaise is no longer confined to bankers and capital market intermediaries, but includes modern CFOs, some belonging to our own profession. So obsessed are the CFOs with ‘selling’ bankable balance sheets to Analysts and Investors and presenting their Business to audiences from an external perspective, that, an in-depth expertise in specialist areas like Risks including Tax risks, and Regulatory requirements, have become for them the least important areas of their work. This folly is compounded by the cordial assent which these incorrect priorities now seem to receive, even from the more comprehending minds, in Industry and Profession.

If I were asked to muse in retrospect, on who should be regarded as the biggest offender against financial discipline, I would not accuse the business community. On the contrary, given the spate of acquisitions abroad, the Indian businessman must be seen as a defender, not offender, by those who care about the Indian Economy.

Pre-liberalisation era curbed genuine entrepreneurship, denying the scarce foreign exchange to the worthy enterprise, while at times releasing it for the not so deserving. One instance may suffice to illustrate incondite loans in foreign exchange.

A consortium of nationalised banks had lent a humongous sum in US dollars to a project spear-headed from India with some foreign individuals as stakeholders. The project was located in an island in the Indian Ocean. Costs and Interests escalated and were additionally funded. The Banking consortium sent me to investigate. With the benefit of hindsight, it would appear this was done by the lead banker, more to allay the disquiet among some bankers in the consortium, than to ascertain what went on. I turned out to be a bad choice for them. In a show of excessive confidentiality, instead of the easier route via Bahrain, I was flown east-ward and then back on a long flight across the Indian Ocean westward. I think it was intended that I have a whale of a time for a week, and return home with a tutored report. My total rejection of any alcoholic stimulant on the island and a punctilious application of mind to Books and Records soon soured the pitch. As a professional, and as a human being, I was grieved to see an instance of how the scarce resources of a poor country seemed to have been applied by those appointed to guard those resources. On return, unsurprisingly I was cold shouldered, and received only superficial acknowledgement, with just one exception. One bank official had the courage to openly support my findings, and when these ran into a dead end, the grace to orally share his suspicion that the report had been dumped. This outstanding officer later rose to be Chairman of one of the oldest nationalised banks, partially reinforcing my faith in the survival of virtue in an ocean of compromise.

Tenure in Council:

I was re-elected five times to the ICAI Council over 16 years 1982-1998.

In 1994 I became Vice-President solely because, the councillors disenchanted with me were marginally less than the number disenchanted with the other contestant who was actually a far more deserving candidate than I was.

Jack of all:

Every few years, Council resolutions expanded the list of what could be includible as permissible work to be performed by CAs. Like troops attempting to hold more ground than what their supply lines could sustain, the spread became thinnest at the core. Adjacent competencies waxed, while traditional proficiencies may have waned.

Sadly, members in industry gradually saw our Institute activities as somewhat less relevant, and in later years, one was never certain how much of the participation at seminars, was spurred by mandatory CPE.

Weaning away:

Meanwhile tribes that were initially tiny, like Company Secretaries, Internal Auditors, and Financial Analysts made considerable headway. They cultivated, inter alia, better relationships with key officials in Ministries of immense relevance to the Professions. ICAI was more established, but may have been perceived as somewhat insular by those whose opinion mattered most, during critical phases of growth and development. There was a joke that our policy towards competition appeared to be to, first disregard, thereafter ban our members joining those bodies, and after such banning had conferred upon those bodies the halo of martyrdom that ensured their survival, consider mutual exemptions from examinable subjects.

Change:

Elections had always been an undercurrent in the Council, and with exponential growth in the number of members, elective merit loomed larger. Elected councillors, could be seen as outstanding CAs who happened to have good PR, or perceived as outstanding PR persons who happened to be CAs. Fortunately, sufficient numbers of CAs of great merit still obtain on the Council. Only time can tell how many of the challenges that came along – whether it be the electronic age, the growing role of rival disciplines, or more vitallythe avalanche of Foreign Service Suppliers post 1993 – were proactively met with foresight by those at the helm including me.

New Order:

A New Order evolved in which professional services organisations, some of whom are integral parts of international networks, endeavour to offer advice using a multidisciplinary business-focussed approach.

To view the New Order as unwelcome would be an exercise in misinformation and prejudice. The change heralded much that was good and some of it exceptionally good. First of all, the New Order destroyed oligarchies that had existed earlier. Equality of opportunity is a principle far better served by the New Order in the first decade of the 21st century than was ever served during the preceding half century. Equally importantly, aspiring talented CAs unable to flourish in their own practice can now join the very large establishments more easily than they could ever have become part of the erstwhile oligarchies. Besides, it is only the New Order that has made it possible for large numbers of CAs to receive pecuniary rewards far higher than those ever expected in the past. Moreover, under the current new dispensations, the large residue is annually shared locally with remarkable fairness, and reportedly with an equity that contrasts favourably with the skewed slopes for profit sharing ordained in the past. Finally and happily, the local top brass of all the new large CA establishments in India are overwhelmingly members of ICAI.

Shangri-la :

These reminiscences could hardly be complete without a kind word for those who encouraged my drift in a turbulent upheaval from profession to industry. But for this, I would have missed out on the most rewarding and happiest working years 2002 onwards, which at this moment of writing seem to grow richer by the day. From 1966 to 2002, for 36 years, I deprecated my role in Kipling’s words – “those who report on deeds performed by others are not equal to those that perform deeds worthy of being reported”. Now I am performing the deeds, and the uniquely benign Promoter Family I closely work for, have afforded me roles, in exciting realms of modern international business and wealth creation.

Deductibility of ‘set-on’ amount under Payment of Bonus Act

Controversies

1. Issue for consideration :


1.1 The Payment of Bonus Act, 1965 requires an employer,
running a factory or an establishment where twenty or more workers are employed,
to pay to the employees such amount or amounts by way of bonus as prescribed
under the said Act, subject to a maximum amount prescribed therein. The amount
payable is calculated with reference to the allocable surplus to be computed in
accordance with the provisions of the Act and the rules framed thereunder.

1.2 The Act inter alia provides for setting aside an
amount, out of the allocable surplus, that is found to be in excess of the
maximum amount payable towards bonus for an year, subject to a maximum of twenty
per cent of the salary, wages, etc. Such a provision, prescribed u/s.15 of the
Act, is allowed for meeting the shortfall, if any, in any of the four years
including the fourth year. The amount so provided for becomes free at the expiry
of the four years, provided there was no shortfall in any of the said years. S.
28 of the said Act provides for punishment with fine and imprisonment for
non-compliance of the provisions of the Act.

1.3 The excess so set aside is known as ‘set-on’ amount for
which a provision is made in the books of account by debiting the profit & loss
account of the year. The issue has arisen about the deductibility of this
provision of set-on amount. The Gauhati High Court has held that the set-on
amount is allowable as deduction while several High Courts including the Bombay
High Court recently held that such an amount is not deductible.

2. India Carbon Ltd.’s case :


2.1 In India Carbon Ltd. v. CIT, 180 ITR 117 (Gau.),
the question in the reference arose as to whether bonus amounts set apart
(called ‘set-on’ amount) debited to the profit & loss account of the company
could be deducted from the income of the company or not for A.Y. 1976-77. The
assessee a company claimed deduction of two amounts, Rs.8,56,241 as bonus paid,
and Rs.7,36,915 the amount deposited in ‘set-on’ account. The former was claimed
u/s.36(1)(ii) and the latter u/s.37 of the Income-tax Act, 1961. The ITO allowed
the deduction of Rs.8,56,241 but rejected the claim for Rs.7,36,915. The
Appellate Authority allowed deduction for both the payments. The Tribunal
however overturned the decision of the Appellate Authority and rejected the
claim for deduction of the set-on amount of Rs.7,36,915. The Tribunal was not
impressed with the contention of the company that it regularly adopted the
mercantile method of accounting and the deduction in the past assessment years
was allowed to the company.

2.2 Being aggrieved by the order of the Tribunal, the company
referred the following questions for consideration of the Gauhati High Court
under Ss.(1) of S. 256, :

(i) “Whether, on the facts and in the circumstances of the
case, the Tribunal was justified in reversing the order of the AAC and
disallowing the statutory liability of bonus set-on computed according to the
provisions of the Payment of Bonus Act, 1965 ?

(ii) Whether, on the facts and in the circumstances of the
case, the Tribunal was justified in disregarding and rejecting the method of
accounting regularly employed by the appellant company ?

(iii) Whether, on the facts and in the circumstances of the
case, the Tribunal was justified in holding that bonus set-on cannot be
regarded as a liability of the year in which the computed amount should be
carried forward for being set-on in the manner prescribed under the Payment of
Bonus Act, 1965 ?”

2.3 The company contended that the set-on amount is not
prohibited to be deducted u/s. 40(a)(ii) and, therefore, such amounts were
expenditure for the business; the assessee could not utilise the amount
irretrievably and it was commercially expedient to provide for such set-on.

2.4 In reply the Revenue argued that the amount in question
was a reserve fund; the amount stood deposited in the account books of the
assessee and could be utilised by the assessee and, therefore, was not an
expenditure; such an amount, to be paid in future, could not be allowed either
u/s.28 or u/s.30 to u/s.36 or u/s.37 of the Income-tax Act.

2.5 The Gauhati High Court noted the following amongst other
things :

  • The
    Government of India in 1961 to obtain industrial peace, appointed a committee
    called the Tripartite Commission and on acceptance of the committee’s report
    on 6-12-1964, with modifications, the Government of India promulgated on
    29-5-1965, an Ordinance which was replaced by the Act No. 21 of 1965 called
    the Payment of Bonus Act, 1965, to regulate the bonus payments in the country
    with some exceptions.
     


  • The
    Act contained 40 Sections, 4 Schedules and the Rules. They provided together
    for ascertainment of gross profits, available surplus and allocable surplus
    and set out the sums to be deducted from gross profits besides the manner of
    calculation of taxes. The Act also provided for eligibility of workmen for
    bonus and for a minimum bonus to be paid and defined the limit of maximum
    bonus. Rules were provided explaining how the number of working days was to be
    reckoned.
     


  • The
    Act inter alia vide S. 15 provided for how amounts were to be carried
    forward (referred to as ‘set-on’) and when the set-on amount was to be
    utilised with the help of the Fourth Schedule. The utilised amount was called
    the ‘set-off’ amount. Register was prescribed to show the set-on and set-off
    amounts.


2.6 The Court further noted that what constituted ‘expenditure’ was a many splendoured controversy; its meaning had gained many facets and dimensions over the years in fiscal statutes and in its trail had brought to surface many fresh controversies. It referred to the decision of the Supreme Court in Indian Molasses Co. (P.) Ltd. v. CIT, 37 ITR 66, to notice that an ‘expenditure’ was that which was paid out and paid away; an amount which passed out irretrievably from the hands of the assessee was ‘expenditure’. Referring to CIT v. Malayalam Plantations Ltd., 53 ITR 140 (SC), the Court noted that the expenditure was wider in meaning and scope than when used to mean expenditure for earning profits; not all that was spent in a business could be construed as expenditure. ‘Commercial expediency’ and ‘reasonableness of expenditure’ were considered relevant for allowing a deduction, as was held in CIT v. Walchand & Co. (P.) Ltd., 65 ITR 381 (SC), and these aspects were to be looked at from the point of view of business. In Shree Sajjan Mills Ltd. v. 156 ITR 585 (SC), the Gauhati High Court noted, that contribution to the gratuity fund created for the benefit of employees in an irrevocable trust, was allowed to be deducted.

2.7 The three cases where the issue was considered under the Payment of Bonus Act, against the assessee’s claim for deduction, were noted by the Court:

  •     In Malwa Vanaspati & Chemical Co. Ltd. v. CIT, 154 ITR 655 (MP), it was held that S. 15 created a liability which was not a subsisting liability and, therefore, such amounts were held in reserve for meeting a future liability which contingent in nature, more so where the assessee did not deposit the amount with the Bonus Act authority.

  •     In Rayalaseema Mills Ltd. v. CIT, 155 ITR 19 (AP), it was held that set-on was not covered by S. 28 and S. 37 of the Income-tax Act and therefore, not an expenditure and the set-on amount was carried forward for a limited period for four years which was not the same as amounts paid to a third party, and, therefore, not loss, not a trading liability and not an expenditure.

  •     In P. K. Mohammed Pvt. Ltd. v. CIT, 162 ITR 587 (Ker.) the set-on amount was construed to be deposits made under the compulsion of a statute to satisfy a contingent liability to be paid in future.

2.8 The Gauhati High Court also noted that in three other cases, the Madras High Court had examined the issue of deductibility of an amount set aside for payment of bonus to workers independent of the Payment of Bonus Act. In CIT v. Somasundaram Mills (P.) Ltd., 95 ITR 365 (Mad.), CIT v. Anamallais Bus Transports (P.) Ltd., 99 ITR 445 (Mad.) and again in 118 ITR 739 (Mad.), it was held that the amount set aside as such for payment of bonus represented a contingent liability and could not be allowed as expenditure; the workmen did not have a right in such amounts.

2.9 The Court referred to the rule that required the statutory maintenance of registers and the columns therein. It noted that the Register ‘B’ showed set-on and set-off; that the amounts shown in columns, 3, 4 and 5 of the Fourth Schedule were amounts which were to be paid or have been paid to the employees; columns 2 to 5 in Form ‘B’ showed the amounts paid or to be paid. The Court observed that these columns, coupled with the language of S. 15 of the Act, indicated that the set-on amount could not be used or utilised by the assessee for business purposes and the amount deposited was held for the benefit of workmen; the use of words ‘utilised for the purpose of payment of bonus’ in S. 15 made this clear.

2.10 The Court posed itself a question, the answer thereto was considered crucial for deciding the issue whether a set-on amount was deductible or not. “In case such amounts were used by the assessee and the amounts were lost in the business, could a businessman be heard to contend that amounts were lost in business, there was nothing left to be paid to workmen and that as such he might be absolved from paying the bonus to workmen?”

2.11 The Court answered that the assessee could not utilise the set-on amount for business; that on making the deposit the assessee was divested of the right to invest or utilise the amount for business; the columns shown in the Fourth Schedule, Form B and the language used in the Schedule and in S. 15 of the Act indicated that the set-on amount, after it was deposited, could not be utilised; the amount was to be paid in four years. The Court was not impressed by the contention that the assessee could utilise the amount in business as the amounts set on were akin to the funds in an irrevocable trust such as referred to in Shree Sajjan Mills Ltd. v. CIT (supra) and the assessee was not an owner of the funds. The issue of deduction when viewed from the point of business as was done in CIT v. Walchand and Co. (P.) Ltd. (supra), would lead to an inevitable answer in favour of allowance of claim of the assessee.

2.12 The set-on amount could not be utilised by the assessee and had to be deposited perforce under the statute, and in that view of the matter such amount was an expenditure allowable for deduction. The Court observed that the company would be liable for punishment for fine and imprisonment u/s.28 of the Act for contravention where it utilised or used the amount. The set-on amount for the aforesaid reasons was an expenditure incurred by the assessee, and, therefore, had to be deducted.

    3. Ingersoll-Rand’s case:

3.1 In Ingersoll-Rand (India) Ltd. v. CIT, 320 ITR 513 (Bom.), the question that had been referred for consideration of the High Court at the instance of the assessee read as?: “Whether, on the facts and in the circumstances of the case, the Tribunal was right in law in holding that the set-on liability u/s.15 of the Payment of Bonus Act, amounting to Rs.24,73,865 was not allowable as a deduction in computing the total income of the assessee for the year under reference?”

3.2 The Court in the beginning took notice of the fact that S. 15(1) of the Payment of Bonus Act laid down that where for any accounting year the allocable surplus exceeded the amount of maximum bonus payable to the employees in the establishment u/s.11, then the excess should, subject to a limit of twenty per cent of the total salary or wage of the employees employed in the establishment in that accounting year, be carried forward for being set on in the succeeding accounting year and so on up to and inclusive of the fourth accounting year to be utilised for the purpose of payment of bonus.

3.3 The Court also noted that the issue of deduc-tion of set-on bonus was already considered by several High Courts and particularly, in favour of the Revenue by the Madhya Pradesh High Court in the case of Malwa Vanaspati & Chemical Co. Ltd. v. CIT, 154 ITR 655, the Andhra Pradesh High Court in Rayalaseema Mills Ltd. v. CIT, 155 ITR 19 and the Kerala High Court in P. K. Mohammed (P) Ltd. v. CIT, 162 ITR 587. It also took note of the contrary view taken by the Gauhati High Court in India Carbon Ltd. v. CIT, 180 ITR 117. The Court noted that amongst the High Courts, there were two different views, though the majority of the High Courts have taken a view that the sum in question was not an allowable deduction.

3.4 The Bombay High Court observed that in India Carbon’s case (supra) the Gauhati High Court proceeded to hold that; the assessee could not utilise the amount for business; that on making deposit it was divested of the right to invest or utilise the amount for business; the amount had to be paid in future in the course of a cycle of four years; the amount if utilised would be in contravention of the Act and punishable. On this basis it held that the amount deposited under the provisions of the Act, which could not be utilised for the purposes of business, amounted to expenditure allowable.

3.5 Attention of the Court, on behalf of the company, was drawn to the judgment of the Supreme Court in Bharat Earth Movers v. CIT, 245 ITR 428 (SC), to contend that considering the ratio of that judgment, the allocable surplus would be an allowable deduction. In that case, the company had floated a scheme for its employees for encashment of leave and created a fund by making a provision for meeting such liability under a leave reserve account which was maintained so as to provide for encashment and payment of leave and vacation leave was paid from the leave reserve. On the basis of facts, the Court held that the provision made by the appellant company for meeting the liability incurred by it and the leave encashment scheme was entitled to deduction.

3.6 The Court relying on the precedents in favour of the Revenue held that an amount set on u/s.15 of the Payment of Bonus Act was not an accrued liability, but only a provision to meet a future liability, if any, and therefore, being a contingent liability, it was not allowable as deduction. It observed that; what the assessee was required by statute to do was to keep a reserve with itself, of what was known as allocable surplus to meet a future shortfall, if any, for a period of four years; the shortfall could not be estimated with reasonable certainty, though statutorily the liability had to be incurred; the extent of the liability also could not be estimated with reasonable certainty as if there were profits to meet the bonus liability the reserve would not be expended; only in the event there were no sufficient profits would the allocable surplus be utilised to meet the liability; the amount was merely a reserve fund which the Payment of Bonus Act mandated; after the expiry of four succeeding accounting years if the amount was not utilised the assessee was free to make use of the amount; the amount to be adjusted for the subsequent year, depended therefore on the shortfall which could not be anticipated with reasonable certainty; the amount was not deducted in the hands of the assessee unless it was utilised; the deduction claimed was not an accrued liability, but only a provision u/s.15(1) of the Payment of Bonus Act to meet a future liability, if any; the Tribunal was right in law in holding that the set-on liability u/s.15 of the Payment of Bonus Act was not allowable as a deduction in computing the total income of the assessee for the year under reference.

3.7 The judgment in Bharat Earth Movers (supra) case was found by the Bombay High Court to be clearly distinguishable and, therefore, not applicable.

    4. Observations:

4.1 S. 15 of the Payment of Bonus Act reads as under:

    1) “Set-on and set-off of allocable surplus — (1) Where for any accounting year, the allocable surplus exceeds the amount of maximum bonus payable to the employees in the establishment u/s.11, then, the excess shall, subject to a limit of twenty per cent of the total salary or wage of the employees employed in the establishment in that accounting year, be carried forward for being set on in the succeeding accounting year and so on up to and inclusive of the fourth accounting year to be utilised for the purpose of payment of bonus in the manner illustrated in the Fourth Schedule.

    2) Where for any accounting year, there is no available surplus or the allocable surplus in respect of that year falls short of the amount of minimum bonus payable to the employees in the establishment u/s.10, and there is no amount or sufficient amount carried forward and set on U/ss.(1) which could be utilised for the purpose of payment of the minimum bonus, then, such minimum amount or the deficiency, as the case may be, shall be carried forward for being set off in the succeeding accounting year and so on up to and inclusive of the fourth accounting year in the manner illustrated in the Fourth Schedule.

    3) The principle of set-on and set-off as illustrated in the Fourth Schedule shall apply to all other cases not covered by Ss.(1) or Ss.(2) for the purpose of payment of bonus under this Act.

    4) Where in any accounting year any amount has been carried forward and set on or set off under this Section, then, in calculating bonus for the succeeding accounting year, the amount of set-on or set-off carried forward from the earliest accounting year shall first be taken into account.”

4.2 S. 28 provides for penalty for violation of any of the provisions of the Act. It reads as:

“If any person —

    a) contravenes any of the provisions of this Act or any rule made thereunder; or

    b) to whom a direction is given or a requisition is made under this Act fails to comply with the direction or requisition, he shall be punishable with imprisonment for a term which may extend to six months, or with fine which may extend to one thousand rupees, or with both.”

4.3 The primary thing that emerges out of the provisions of the Act is that the setting aside of the prescribed amount of ‘set-on’ is a statutory requirement and non-compliance thereof attracts the stringent punishment. Also emerges is the fact that the Income-tax Act does not provide for any express disallowance of the amount of ‘set-on’ un-less a view is taken that it is hit by S. 43B. It is also clear that such amount is not free for utilisation at the whims and fancies of the establishment which is rather duty bound to utilise the said amount for meeting the shortfall of any of the four years. Specific formula are provided by the Act for scientifically calculating the ‘set-on’ amount with the precision. There is nothing uncertain about the quantum of the provision. There is every possibility that the liability might emerge as had that not been anticipated, the law would not make any provision for such ‘set-on’. The sum is set aside for the labour welfare under a statutory stipulation.

4.4 The establishment is made presently liable for setting aside an amount not out of the profit, but out of the allocable surplus under a provision of law and under the mercantile system of accounting, it falls for allowance u/s.37 of the Income-tax Act. The establishment is divested of the set-on amount on creating a provision as per statute and on provision ceases to be the owner of the funds and holds thereafter as trustee or a custodian of the funds. The employees have an overriding title for the pre-scribed period of four years and the set-on money cannot be frittered away at the sweet will of the employer during the said period of four years.

4.5 For allowance of a deduction, actual parting of funds is not necessary and in any case, settlement by accounts is also an expenditure. The Supreme Court in the case of Metal Box Ltd., 73 ITR 53 held that an accrued but undischarged liability is allowable and a discounted value of a contingent liability in given circumstances be sometimes an expenditure. The Calcutta High Court in case of Electric Lamp Mfg. (India) Ltd., 165 ITR 115 (Cal.) held that a provision of a statutory liability on actuarial valuation is allowable as a deduction.

4.6 It may be true that the payment as also the quantum thereof is not certain, that fact alone should not deter the allowance of the claim for deduction. In the event the amount or part thereof was found to be not payable, the same nonetheless will be liable for taxation u/s.41 of the Act. No income escapes taxation by allowing the claim. In fact the Andhra Pradesh High Court in Rayalaseema Mills Ltd. v. CIT, 155 ITR 19 (AP) was pleased to hold that the obligation for setting on was statutory, but was confined only to the four succeeding accounting years, whereafter the assessee was free to make such use of the amount, if any, remaining, as it thinks fit. The Court accordingly confirmed that for the period of four years, the assessee was prevented from using the said funds at his will leading to a reasonable inference that the liability cannot at least be construed to be contingent and the funds set aside were not free. The said decision also noted the fact that the set-on amount could be utilised for payments in case of the need and only after the expiry of the four year period that the funds will be a part of the general revenue. The better view appears to be in favour of allowance of a set-on amount more importantly in view of provisions of S. 41 of the Act which ensures that no expenditure, that is not incurred finally, escapes taxation.

Reminiscences of the profession in the Society

Article

In this article for the Special Issue on the occasion of the
Diamond Jubilee of the Bombay Chartered Accountants’ Society, I have been asked
to write my reminiscences of the profession in the Society. I passed in 1951 and
became a member of the Society, introduced by Ambalal S. Thakkar. I have tried
to cover my experiences, enjoyable moments and the travails undergone by me
during the long period of 57 years. I have also made observations about the
state of the profession from time to time and the manner in which it has changed
during the half century.


My most vivid recollection is of the Study Circle meetings,
which used to be held in the office of M/s. Shah & Co., Chartered Accountants as
the Society did not have its own office and the meetings used to be attended by
stalwarts like late S. P. Mehta, Senior Advocate and Chartered Accountants like
Sarvashri Ambalal Thakkar, Narandas Shah, Dhirubhai Bhatt, the first President
of the Society and others. The discussions were very useful and knowledgeable
for a beginner like me.

In those days, the important meetings were felicitation of
the President of the Institute, which were normally held at Radio Club in
informal atmosphere and constituted important source of information about the
Institute and its activities. The other annual feature was the talk on the
Budget by late N. A. Palkhivala. These meetings were held at the Greens Hotel,
which is now no more there. The attendance by the members was large but can-not
be compared to the meetings held in later years at the Brabourne Stadium by
Forum of Free Enterprise.

I also remember the first conference held by the Society at
Taj, which was attended by many senior members of the profession and many
subjects of professional interest were discussed at the conference. The meetings
were also addressed, amongst others by R. P. Dalal, who was earlier the member
of the Income Tax Appellate Tribunal and who humorously introduced himself as
out-standing member of the Tribunal after retirement from the Tribunal. The main
characteristic of the Study Circle and Lecture meetings was the informal
atmosphere in which they were held.

But the more notable feature of the Society was that normally
the President was selected by the Committee of the past Presidents taking into
consideration the erudition and leadership qualities of the person and was
respected by the members except on one or two occasions. This healthy tradition
is continued till today. There was scope for aspiring members of the Society to
work in honorary capacity as Committee members, Secretary and Treasurer and also
without being members of the Committee. The seeds of democracy and
responsibility as good professionals were sown by the members during their work
for the Society.

Another landmark stage was reached when the Society hired the
Office of Circle Literaire for its Study Circle and lecture meetings usually
held on Wednesdays. It was not necessary to know a single word of the French
language to attend the meetings there ! ‘60, Forbes Street’ became the famous
address of BCA Society for a number of years. The larger space gave a boost to
the Study Circle and lecture meetings and the publication of the Journal of the
Society, which was issued in cyclostyled form and which was the precursor of the
present ‘The Bombay Chartered Accountant Journal’ of the Society. One cannot
forget the services of Shyam Argade, as the editor of the Journal for a number
of years. The Study Circle and Lecture meetings gave opportunity, encouragement
and confidence to the new members to participate in the meetings. The meetings
of the Managing Committee were usually followed by dinner of the Committee
members and Past Presidents, which was frequently held at Ripon Club, Opp.
Bombay University.

But the real contribution of the Society to the profession
was by its leading role in representation to the authorities concerned on tax
matters and other professional problems relating to the Companies Act,
Partnership Act, etc. and the educational programmes like Seminars, Residential
Refresher Course, Workshops, etc., I remember the stormy meeting held at the
Greens Hotel to oppose tooth and nail the introduction of Rule to certify Income
Tax Return of the clients, a move fraught with danger to the professional filing
his clients’ Tax Returns.

One of the interesting features of the social activities was
the annual picnic of the members to Mahableshwar and Matheran, Lonavala, Pune,
Malavali Fort, etc. The present generation will not be able to believe that one
of the courses organised by the Society was at Mahableshwar for a charge of Rs.6
per day including boarding. Likewise, the annual social held more or less
regularly every year provided musical programmes including veteran Music
Directors like Naushad, not to mention the Qawali programme of Shakila Banoo
Bhopali on the boat cruise. A memorable event in one of these programmes was the
failure of the brakes of the car on ‘Ghat Road’ of Homi Banaji, one of the
amiable members and President of the Society. Likewise, the distinguished
gallery of the Presidents included personalities like late S. V. Ghatalia, S. N.
Desai, and E. C. Pavri besides the trinity of Shri Dinubhai, Shri Ambalal and
Shri Narandas.

The Society was the first to organise a Residential Refresher Course at Matheran under the Presidentship of P. N. Shah, which was inaugurated by S. P. Mehta whom the Society had accepted as the Hon. Member. The faculty included Bansi Mehta and I had the opportunity to write my first paper at the RRC on the evergreen subject of depreciation, which never depreciated in its value. Since then the Society has organised the course every year and is one of the most popular programmes, for which the enrolment is full within hours of the commencement and faster than some of the listed companies’ issues. This pioneering activity was followed by other professional bodies including Western Indian Regional Council of Chartered Accounts, Chamber of Tax Consultants and All India Federation of Tax Practitioners. It was in one of such programmes that I had contributed a paper on Public Trusts, which was repeated in sub-sequent courses and became a monograph on the subject, of which revised editions were brought out from time to time, the later ones being with Shariq Contractor and Gautam Nayak.

I had the good fortune to work as Treasurer and Secretary, and finally the President of the Society in the year 1963-64 along with R. J. Damanwala as Secretary, who was very meticulous about various activities. These positions gave me the basic training of presiding over the meetings of the members and various committees, the number of which was not very large at that time.

The growth and development of the Society compelled it to acquire the larger office at Dol-Bin-Shir. The bigger office but with a smaller lift gave boost to the meetings and library activity. One interesting feature of this office was that the office of that witty, principled Chartered Accountant, late Jal Dastur was in the same building involving greater participation by him. With the holding of Residential Refresher Courses at Bangalore, Pune, Aurangabad, Goa, Jaipur, Agra, Mount Abu and Indore, the Society became an All India Society which brought in new talent from younger members like Pinakin D. Desai, Kishor Karia and seniors like Y. H. Malegam, M. L. Bhakta, K. H. Kaji and others. The special invitees or the chief guests included the President of the Institute and persons from academic field like Prof. Rege of Bombay University. The scope of the subjects was extended to Indirect Taxes, Company Law, Computers, etc., so that the RRC became the hallmark of the Society. Another first was the RRC held at Dubai, which was participated by many local members also and meetings with Government officials and fol-lowed in the evening by Harbour visit, socials and dinners in Desert Safari.

The annual budget lectures were given by S. P. Mehta for a number of years and after his demise, are being given by Soli Dastur, Senior Advocate, whose popularity is evidenced by the fact that even the Birla Hall proved too small, compelling the Society to shift the venue to the architecturally beautiful hall of Swaminarayan Sanstha with a ca-pacity of more than 2000 persons. This was followed by annual half-day meeting on the Finance Act, after it was passed in Parliament. The mile-stone programme was the Silver and the Golden Jubilee conferences, the last being inaugurated by the President of the Institute and valedictory address by Shri Chidambaram, the present Finance Minister.

The next milestone in the Society’s history was the acquisition of new office premises at Churchgate Chambers, ‘A’ Road, Mumbai, further expanded by two premises in the same building. The larger office gave a further boost to the activities of the Society led by Narayan Varma, past President of the Society, with originality and number of new ideas for the growth of the Society and vision. The Society adopted the vision with the implementation of the goals set therein as its foundation. On his initiative the Society started educational programmes with the first such programme for management training jointly with Jamnalal Bajaj Institute. The success of this programme led to the launching of several new courses one after the other, namely, Professional Accountant, Internal Audit, Corporate Directors, Arbitration, etc. and also enhanced the value of the Chartered Accountants by giving them certificate for the training, approved by the University of Mumbai.

Shri Varma also gave a thrust to the activities of the BCA Foundation, a public trust established for help to the Chartered Accountants and the stu-dents, by very large collection for the Tsunami victims, by helping them to restore the schools in Tamil Nadu and development of computer programmes. Last but not the least, on account of his interest and enthusiasm, the foundation also devoted itself to the activities under the Right to Information Act, which proved to be a very pow-erful instrument in the hands of the people.

The publication activity received a big fillip with issue of marathon tax audit manual by five joint authors, Narayan Varma, Kishor Karia, Dilip Lakhani, Sunil Kothare and myself which helped the Chartered Accountants engaged in the task of carrying out tax audit. Likewise, many other publications were brought out on the subject of various aspects of Income Tax law, Accounting Standards, Auditing’ Standards, Service Tax, International Taxation, Computers, FEMA, Indirect Taxes, etc. The fantastic utility of more than fifty publications, revised from time to time enhanced the image of the Society as educational body.

The pre-budget and post-budget representations assumed great importance and were even followed by visits to Delhi for meeting with the Chairman and members of the CBDT and officials of the Finance Ministry. Similar representations were made on Company Law, Indirect Taxes, etc. The Society was recognised for appearance before the various committees appointed by the Government for ‘simplification’ and rationalisation, like the Choksi Committee, the Committee for Rationalisation of Tax Laws, the Kelkar Committee, Vanchoo Committee, etc.

The Society also organised Press Conferences when very serious problems were involved in Tax Laws and also participated in T. V. programmes after the presentation of the Finance Bill. The can-cerous corruption did not escape the attention of the Society, resulting in appointment of a small group comprising representatives of other professional bodies to provide machinery for fighting corruption, but unfortunately, due to inherent limi-tations, the group could not make much headway.

With the liberalisation and opening of the economy to international trade, FEMA and International Taxation became very important and Study Circles and other groups made special study of the subject with a view to equip the members to deal with issues arising therefrom and the need of foreign companies for attending to their work in India. Transfer pricing was not ignored and Conferences and special programmes were annually held to discuss the various issues.

The latest development in the field of education is to develop several modules on different subjects like Service Tax, TDS, etc., for the distant education programme and though, it may face teething trouble, it will succeed ultimately in its goal of educating Chartered Accountants as well as others. The idea has been picked up by other professional bodies also.

The role of the Society for the professional development has to be considered in the context of co-ordination and rapport with the Institute of Chartered Accountants of India, our official body governing the profession. In the early 50s the Society was asked to consider whether it was necessary to continue and expand the Society and whether it was duplicating the work of the Institute. However, the majority of the members did not subscribe to this view, as they considered that the Society is performing useful role to supplement the activities of the Institute and not to supplant the official organisation, some of whose Presidents and Council members also were actively involved with the Society. Hence, every new President and Vice-President was invited to visit the Society for be stowing felicitations and discussing the professional problems with them. In addition, in some cases the President of the Institute also inaugurated the technical programmes or gave talks on current issues like Accounting & Auditing Standards. Thus, the rapport of the Society with the parent body has been excellent throughout the years.

The clinics started by the Society for guidance of members and the public for Charitable Trusts, Accounts and Audit, and Right to Information have been doing excellent work in the education of professional as well as others who attend the clinics and take advantage thereof to solve their difficulties. The other way of public education is to bring out booklets for exposition of the changes brought in by the Budget within three days in not only English but also Hindi and Gujarati languages, so that more than 40,000 copies are circulated to professionals as well as members of the public. likewise, the education of students is not overlooked by starting revisional classes for them and lower subscription for journal of the Society and attending other programmes at concessional rates.

The last lap of expansion has been acquiring the present premises at New Marine lines, equipped with facilities for library, computers, Conference Hall for about 100 persons over an area of about 2500 sq. ft.

I have been associated with the Society in different capacities as member of the Managing Committee and Core Group and Invitee as past President over more than 50 years and have been member of the various committees including Taxation, International Taxation, and Accounting & Auditing. life is an unending educational process, so that I continue to contribute to the activities of the Society by participating in its Seminars, Conferences, Brains Trust, RRC, etc. I had therefore, the opportunity to overview the growth and development of the Society from seven members to more than 8,000 members today. There is difference in professional life in the 50s and 60s of the last century when the laws and the practice were very simple, though effective. But today with the increasingly important role of the Chartered Accountant in the core subjects of Taxation and Auditing and the new fields of International Accounting & Auditing Standards, IFRS and International Taxation, FEMA, audits of Public Sector Companies, Banks and Insurance, with greater expectation by the C&AG and the new pastures of Government Accounting, Local Bodies and the whole gamut of Indirect Taxation covering Excise & Customs Duties, Modvat and Service Tax – the list is endless and the ever-increasing need for continuing professional education is amply served by the Bombay Chartered Accountants’ Society.

In view of the knowledge required on several fronts, the need of the hour is specialisation and bigger firms rendering services in all directions under one roof. This has witnessed even the amalgamation and mergers of the big eight firms into big four firms today and merger of other middling firms to cope with the need of the professional services, raising a question whether there is scope for proprietary or small firms of two or three members. But my observation of the small firms in U.S. and even European countries leads me to conclude that even the smaller firms have the scope for practising with the advantage of greater personal attention and intimate rapport with the clients and specialisation by the firms and partners only in some subjects. Time alone will show whether this prediction will turn out to be right or wrong.

Risk Management

Article

Introduction :


1.1 Over the years, risk and its management have been the
focus of human activity. Risk coexists with change, and it has been a facet of
human life whether it is culture, race, religion, personal life, political,
economic or social activities . . . . risk is an inseparable part of all human
endeavour.

1.2 However, depending on the prevailing attitudes and the
ground situation, in terms of the environment, setting, context and background,
risk has had a lesser or greater importance depending on the role it had to
play. In times of prosperity, growth and wellbeing, risk was and still often is
the farthest from human thought. That it applies equally to the modern world is
evidenced by the severe turbulence and swings and the consequent losses
witnessed in the stock market in the recent past when risk was not top of the
mind for the players in the financial market.

1.3 The current heightened interest and importance of risk
assessment is due to the unique situation that the world is in. Unlike in the
past, in times of the industrial revolution, which had its fair share of risks,
the modern world in the era of Information and Communication technology is a
globalised and networked world where the forces of disintermediation,
virtualisation, convergence, knowledge management and empowerment are at play.
The scope, scale and speed of operations in modern times are far beyond what was
even thought of in the past, the shortened fuse wire of decisions and the
worldwide impact of local actions and reactions are extremely difficult to
predict.

1.4 This transformation has on the one hand magnified
rewards, but on the other hand, has also enhanced risk. Enhanced risk is the
price we pay in this modern globalised world.

Concept of risk :

2.1 The concept of risk has been attempted to be captured in
many ways, but the basic definition still is relevant.

2.2 Webster’s defines risk as — possibility of loss
or injury (peril), someone or something that creates
or suggests a hazard, the chance of loss or the perils of the subject matter of
an insurance contract, the chance that an investment will lose value.

2.3 The word entered the English Language circa 1661 from the
French word ‘risqué’ and the Italian word ‘risco’.

2.4 Risk is imbedded when there is an event with more than
one possible outcome, that is, resulting in either desirable or undesirable
consequences. Each outcome has a probability of occurrence depending on the
circumstances. It is thus a potential event and not the loss itself.

2.5 In fact what may be perfectly normal and beneficial to
one in a given set of circumstances may be fraught with danger and risk to
another in the same or different setting. Thus we have the probability of early
bird catching the worm, and the possibility of early worm getting caught, but
the decision whether to be early or late depends on whether you are the ‘bird’
or the ‘worm’.

Attitude to risk :

2.6 Risk, hence, is a word of many meanings. It means
different things to different people. This perception of risk as a source of
‘threat or peril’, or as a ‘challenge and an opportunity’, depends on one’s
attitude to life and risk — that of a ‘risk averter’ or a ‘risk taker’. Risk
comes in all sizes and shapes from getting caught in rain without an umbrella
and catching pneumonia, — sickness- facing life-threatening situations like
natural calamities and of course normal and abnormal business risks involving
loss of money and reputation.

Types of risk :

3.1 An organisation faces many types of risks. These risks
range from strategy and directional risks at the one end to risks in day-to-day
operations at the other.

3.2 If one were to look at the enterprise as a whole, one is
faced with strategic risks that cover strategic issues, business
decisions and the business environment. Macro issues like political, economic,
social situation and competitor activity often affect and influence these risks.
Operational risks deal with operational issues including manufacturing
and service provision, execution, people issues, administration, communications,
etc. At a different level there are other external risks that exist in
the business environment that relate to markets, availability of finance and
changing value of money – forex. A chart showing an overview of these risks is
given in Appendix 1.

3.3 There are thus many ways of classifying risks — according
to their type or even as Systematic Risk and Unsystematic Risk.

3.4 Systematic risk covers interest rate, reinvestment rate,
purchasing power, market exchange rate and political risk, whereas unsystematic
risk covers business, financial, default, credit, liquidity and event risks.

3.5 Apart from these, risk can be physical, psychological,
social/economic, legal and even risk involving confidentiality.

4. Risk — its importance :


Risk has been with us since the beginning of time. Why is it that addressing, comprehending, analysing and managing it has become so important today? The most important reason for the increased importance of risk is that we have started appreciating the fact that uncertainty and its resultant negative impact on business is increasing with globalisation. Risk is becoming more important than ever before, because changes are rapid and all pervasive that it requires preparedness and quick reflexes to launch pre-emptive moves to counter emerging, altered, scenarios. At the same time both stakes and expectations are increasing. A time has’ come when Gandhiji’s words of wisdom, “there is enough for every man’s need, but not for every man’s greed” are palpable today.

Contributing factors – Some  examples:

5.1  Legislation is  becoming tougher:

  • Legislation is now more  extensive  – from compensation to environmental laws, third-party liability to PIL’s, and laws granting compensation for corporate wrongs are becoming stricter.

  • Legislation is more stringent – Corporate Governance – clause 49 of the listing agreement and SEBI rules are continuously reviewed and often amended. In the U.S.A. it is the Sarbanes-Oxley Act.

  • Labour  Laws :

Risk assessment is necessary to avert legal liability – esp. in areas of health and safety.

5.2 Insurance is more expensive and difficult to obtain:

  • Insurance  is no longer  cheaply  available.

  • Open-ended  cover  is not widely available.

  • Insurance companies expect and require clients to manage risks on their own and do not offer a blanket cover.

  • Insurer does not compensate full loss even if the claim is accepted.

  • Insurance payouts are slow and difficult to obtain.

  • Many risks are not covered, such as intangibles like loss of goodwill, reputation and brand equity.

  • Insurance ultimately is reactive and not a proactive way of mitigating risk.

5.3 Customer – Attitudes:

  • Clients want to pass on risks to suppliers and service providers and want to de-risk their own business.

  • Business is more aware of consumer awareness and this has led to claims and litigation.

  • Shareholders are more aware of risks – affecting business value and therefore increased risk reflects in lower stock values.

5.4  Public awareness:

People and the society at large expect higher standards of probity in corporate behaviour, which means that companies have to manage ‘corruption risk’.

6. Response  Management’s attitude:

  • Professional and pro active managements promote risk management.

  • Managements are wiser, from past incidents and want risk management practices in place.

  • With the advent of Global Corporation, risk has become internationalised. Corporations face global concerns and short fuse wire of decisions have a greater impact on corporate bottom lines.

  • Privatisation – high-risk infrastructure sectors are also now in the private domain leading to greater understanding and provisioning for related business risks.


The source of risk:

7.1 Risk arises due to imperfect knowledge stemming from lack of complete or perfect information about certain facts and events on the one hand and the uncertainty and unpredictability of results of specific inputs and actions, on the other. Risk is contextual and its impact varies depending on the underlying situation and ground realities obtaining in a given situation. It also increases if you are dealing with third-party assets.

7.2 Risk is also determined by actions and moves of the associate and/or adversary, for example, in a zero sum or similar game. The well-known game Prisoner’s Dilemma is an example.

Prisoners’ dilemma:

The game known as the Prisoner’s Dilemma got its name from the following hypothetical situation : imagine two criminals arrested under the suspicion of having committed a crime together. However, the police do not have sufficient proof in order to have them convicted. The two prisoners are isolated from each other, and the police visit each of them and offer a deal: the one who offers’ evidence against the other one will be freed. If none of them accepts the offer, they are in fact cooperating against the police, and both of them will get only a small punishment because of lack of proof. They both gain. However, if one of them betrays the other one by confessing to the police, the defector will gain more since he is freed; the one who remained silent, on the other hand, will receive the full punishment, since he did not help the police, and there is sufficient proof. If both betray, both will be punished, but less severely than if they had refused to talk. The dilemma resides in the fact that each prisoner has a choice between only two options, but cannot make a good decision without knowing what the other one will do. The problem with the prisoner’s dilemma is that if both decision-makers were purely rational, they would never cooperate. Indeed, rational decision-making means that you make the decision which is best for you whatever the other actor chooses. Suppose the other one would defect, then it is rational to defect yourself: you won’t gain anything, but if you do not defect you will be stuck with a loss by way of being punished when the other goes scot-free. Suppose the other one would cooperate, then you will gain anyway, but you will gain more if you do not cooperate, so here too the rational choice is to defect. The problem is that if both . actors are rational, both will decide to defect, and none of them will gain anything. However, if both would ‘irrationally’ decide to cooperate, both would gain by being let off with minimum penalty. Thus this well-known game representing the Prisoner’s Dilemma – “If both prisoners cooperate (do not blame each other) they both benefit each being let off. However if one blames the other and the other cooperates (does not blame the first), then the blamer is let off and the one who cooperates gets arrested for a long term and vice versa. If both blame each other, both suffer a sentence but for a shorter term. Though logically it is best to cooperate, since the prisoner is not sure if the other one willget greedy, they settle blaming the other, just to be on the safe side and minimise potential risk/loss.

7.3 While risk arising from deficient information can be mitigated and reduced by gaining more information albeit at a cost, the risk arising from uncertain outcomes can only be controlled to some extent either by developing better mechanism at predicting the outcomes or better still by controlling the outcomes as much as possible.

7.4 Risk as we have seen, originates from vulnerabilities and threats and results in an adverse impact when it occurs. It is a function of threats, vulnerabilities and their impact. Vulnerabilities produce weaknesses that increase risk. Threats are external adverse factors that have a chance of occurrence. The Greater the threat, the greater the risk. The impact is adverse consequences and damages that can flow from the materialising of the threat. The greater the impact, the higher the risk. Thus minimising the chance of the threat materialising, reducing vulnerabilities and minimising the damage or impact helps to mitigate risks.

7.5 If one addresses risk with preconceived notions about its probable causes, it can lead to disastrous results as the real threat often lies else-where. What is required is clear perspective, correct approach and quick response.

7.6 Both predictive and responsive courses of action have an associated cost. The manager has to develop a strategy that ensures that the returns always exceed the cost of risk mitigation. The right way to tackle, deal with and manage risk is to adopt strategic risk management. In the absence of satisfactory definition of Risk Management …. for practical purposes, the emphasis of risk management tends to be on risk awareness, assessment and mitigation. However, strategic risk management involves :

  • The process by which executive management, under board supervision, identifies the risk arising from the business and establishes the priorities for control The Cadbury Report, 1992.

  • Basically altering in a desirable manner where something missing in the system may cause a probable damage or manage its conse-quences.

7.7 The road map to risk management can be summarised as :

  • Risk awareness – Management must be aware of the hazards and their impact on the business, and how they could be avoided, prevented and reduced.
  • Risk analysis and  assessment.
  • Assessment – Monitor threats, assess vulnerabilities, and estimate impact.
  •  
  • Prioritisation – Analysis into acceptable, unacceptable and tolerable – Middle of the road risks.
  • Planning  for the  future.
  • Prevention  of occurrence.
  • Strengthening the system against vulnerabilities.
  • Minimising damage.

7.8 Requirements for successful risk management?

  • Availability of appropriate facilities and equipment.
  • Availability of appropriate systems and procedures, including monitoring and auditing performance.
  • Availability of appropriate organisation, existence of sufficient level of competence, with suitable communication and training arrangements.
  • Availability of appropriate arrangements for detecting and handling emergency situations.
  • Availability of a system of active and continuous system of review of risk throughout the organisation.

7.9 Tools used for effective risk management, are:

  • Control
  • Insurance
  • Loss prevention
  • Technological  innovation
  • Learning,  information,  distribution
  • Robustness.

8.    The Mantra for success in risk management thus seems to be to ‘bear, share and insure’. Bear what you can yourself, given your risk appetite. Share risk within the industry by creating risk sharing, using averting mechanisms and finally insure what cannot be controlled and pass on the risk to insurers. Lastly, ‘monitoring and planning’ for the future involves a continuous process to adopt a ‘Plan, Do, Check and Act cycle’, in order to de-risk your business to the extent possible.

9.1 Managing risks the proactive way thus involves:

  • Having strategy that is : creating and putting in place proper ownership structure, carrying on your business on sound premises based on risk policies which minimise exposure to uncertainties.

  • Managing people is another way of managing risk. This involves:

»    Setting  standards  from the top

»    Quick adaptation  to change

»    Balance and experience – multitasking employees, and

»    Allocate responsibility for risk management.

  • Manage processes: this is the nuts and bolts of risk management and involves developing and putting in place sound policies, best practices, adequate procedures, easy to implement guidelines, sufficient documentation, drills, safer solutions, isolation of threats and active protection of assets.

  • Spreading the risk by: outsouring processes, sharing risk, using hedging option, swaps and derivatives. Risk can also be spread by insuring for loss of profit.

  • Finally having a disaster recovery plan and business continuity plan to minimise the effects of the damage caused due to the adverse impact of threats materialising into reality – for example – strikes, lock-outs and natural calamities.

9.2 In short, Continuous Risk Management (CRM) is a structured plan. CRM provides a disciplined environment for proactive decision making to:

  • Assess continually what could go wrong (risks)
  • Determine which risks are most important to deal with
  • Implement strategies to deal with those risks
  • Measure and assure effectiveness of the implemented strategies.

9.3    For CRM refer Appendix 2

The  effective  use and  implementation of CRM results in a paradigm shift in the way businesses plan, implement and operate.

Risk and the Accountant:

10.1 We have examined risks and risk management as applicable to business and industry in general. Let us now consider the risks that accountants face at the professional, strategic, operational as well as at micro level. Risk has been with the profession since its advent, because accountants certify either ‘correctness’ or ‘true and fair’ state of affairs.

10.2 The accounting profession has passed through turbulent times post Enron and World – Com abroad and our own GTBs and cooperative banking seams in India, and has reached a stage of crossroads. The message is loud and clear, the profession has to improve if the financial system and trust and faith in the profession are to survive. All concerned stakeholders – the government, the key players, the profession itself has moved with alacrity to rectify the situation. New accounting and audit standards have been adopted, the world is moving towards one set of uniform financial reporting standards. A lot has been done; a lot needs to be done. It is in this context we need to look at risk from the perspective of accountants and auditors.

10.3 Accountants play the role of score keeping and reporting. Reporting involves providing information to managements for decision making and to other stakeholders for investment, rewards, taxes, etc. From an accountant’s perspective risk is closely associated with governance, compliance and performance. Every organisation in its attempt to achieve its business objectives needs governance, compliance with laws and measurement of performance – that is profit.

10.4 The issue we will examine is : what is the role and relevance of accounting and the accounting professional, whether as an accountant or as an auditor, in the context of risk and what are the risks an accountant faces.

10.5 The accounting professional’s role in risk is on one side as the person in charge of the accounting and reporting process – the chief financial officer (CFO), and on the other side as a professional, independent auditor or internal auditor who expresses opinion on the financial statements and internal controls, etc. respectively. This is brought out in Fg.1 below.

10.6 The CFO, post SOX in the US and clause 49 and other corporate governance initiatives in India, is responsible for maintaining proper records and accounting for transactions, selection and application of proper accounting standards, computation and extraction of financial statements, true and fair reporting of the profit/loss and the state of affairs and also ensuring safeguarding of assets, control over operations and vouching for the verification and veracity of records. The CFO has thus become ‘owner’ responsible for accounting and reporting function. His liability is thus now two-fold. One of due care to the best of his skill and ability to his employer, and the second of proper service (that is not deficient) to the stakeholders. Failure to do his job using due care, diligence and professional expertise would attract action and liability.

11.    Risk as Score  Keeper:

The accountant as a score keeper maintains records of financial transactions. Books of accounts and accounting and financial records provide the basis for all decision making within the organisation. It is an analysis of this data using various tools and techniques that helps organisations take decisions. Decisions that are strategic like export or not, expand or shut down, diversify or continue, decisions that are operational like working in the second shift, increasing the work force, double the productions, hold stocks, as well as day-to-day decisions like accept an order, increase the price in the local market, etc.

The information provided by the CFO has to be correct, accurate, timely and relevant. In this role as a management accountant providing inputs he is part of the decision-making team.

Risk as reporter:

12.1 Financial statements provide key information to stakeholders. It is the business scorecard that gives vital information about net worth, assets and liabilities, profitability, growth, stability, liquidity, solvency, gearing and turnover.

12.2 The information provided by the accountant – CFO – who is a critical member of the management team is expected to be independent (unbiased), transparent, true and fair – that fairly represents the position of the business from the stakeholders’ perspective. In this role, the accountant faces the risk of application of wrong principles and standards, wrong accounting estimates, errors, mistakes and frauds, inaccurate particulars, window dressing and creative accounting – that is – unfair presentation, off-balance sheet items, unaccounted transactions, unprovided liabilities,watered capital, issues of capital versus revenue, deferment of revenue expenses, under-provisioning or over provisioning for expenses and liabilities, the list is endless.

12.3 Any lapse in the discharge of this responsibility can involve civil, criminal and professional action.

Risk in Audit and Assurance:

13.1 The risk in this role is twofold. The first as an internal auditor having organisational independence and the other as the independent external/ statutory auditor.

Internal Auditor:

13.2 As an internal auditor, the accountant deals with reporting on: existence and effectiveness of controls, adherence to policies and procedures, safeguarding of assets, compliance with laws and regulations, existence of appropriate and adequate documentation and MIS, fraud and error, deviations from established and prescribed procedures and at times on proper utilisation of physical and human resources.

13.3 The risks faced by the accountant as internal auditor arise from the sheer volume and complexity  of transactions and  are:

  • failure to detect lapses and weak in procedures
  • failure to identify areas  of fraud
  • failure to detect  frauds
  • maintain his independence whilst being an employee of, the company.

External Auditor:

13.4 As an external auditor the professional accountant deals with financial statement reporting, fair presentation of the position of its assets and liabilities, and true and fair reporting of its profit and loss for the period. This involves verifying the books of accounts, with supporting evidence, proper application of accounting principles and standards, verifying existence and efficacy of controls and following the set of professional audit and assurance standards developed over the years. All this enables him to express an opinion on the financial statements prepared and submitted by the management.

13.5 The external auditor can do precious little to address risks inherent in a business activity. He is not an insurer of results, but what he can and must do to the best of his professional ability is to address the risk of detection of misreporting.

He needs to display independence and professional competence, use the concepts of materiality, prudence and professional skepticism, whilst dealing with error and fraud to provide sufficient assurance to the users of financial statements that the financial statements are ‘true and fair’.

13.6 The days of the Kingston Cotton Mills’ case where the auditor was not responsible for reporting frauds and other delinquent acts of managements are gone.

13.7 A professional accountant owes a duty of care to the person who has engaged him for the work of auditing and reporting, arising out of the contract and terms of engagement and the governing laws and regulation.

13.8 The liabilities of professionals especially ‘auditors’ who do not discharge their responsibilities are broadly divided into four types. These are:

  • civil liability for negligence,
  •  statutory liabilities under the Companies Act, 1956 and other statutes,
  • liability under  the  Indian Penal Code
  • liability for professional misconduct under the Chartered Accountants Act, 1949.

14.    Auditors were not considered to owe a duty of care to third parties or individuals belonging to a group in the absence of a direct contractual relationship even if these third parties had relied on his report. The decision in the cases of De Savory vis Holden Howard & Co, (TLR) 11-1-60 and Candler vIs Crane Christmas & Co Court of Appeal, 1951 Z. K. B. 164, absolved the auditor from such responsibility. However, the dissenting judgment of Lord Denning in Candler vis Crane Christmas & Co is worth perusing. He observes :

“The accountant, who certifies the accounts of his client, is always called upon to express his personal opinion whether the accounts exhibit true and correct view of his client’s affairs, and he is required to do this not so much for the satisfaction of his own client, but more for the guidance of shareholders, investors, revenue authorities and others who may have to rely on the accounts in serious matters of business. If we should decide this case in favour of the accountants, there will be no reason why accountants should ever verify the word of the one man in a one-man company because there will be no one to complain about it. The one man who gives them wrong information willnot complain if they do not verify it. He wants their backing for the misleading information he gives them and he can only get it if they accept his word without verification. It is just what he wants so as to gain his own ends. And the persons who are misled cannot complain because the accountants owe no duty to them. If such be the law, I think it is to be regretted for it means that the Accountants’ Certificate, which should be a safeguard, becomes a snare for those who rely on it. I do not myself think that it is the law. In my opinion, accountants owe a duty of care not only to their clients, but also to all those whom they know will rely on their accounts in the transactions for which these accounts are prepared.”

This liability of owing a duty to third parties was established by the decision of Hedley Byrne and Co Ltd. vis Heller and Partners. (1964) Act 465.

15.    I would refer to two Indian cases:

1.    The decision of the Bombay High Court in Trisure’s case No. 1377 of 1978, dated 211 24 October 1985 re-emphasised that an auditor need not proceed with suspicions unless the circumstances are such as to arouse suspicions in a professional man of reasonable competence. The judgment also upholds the use of sampling for testing internal controls and use of sampling to complete the audit where controls are found satisfactory .

2.    The observation of Justice P. T. Raman Nair in the decision in the case of “The Official Liquidator, Palai Central Bank Ltd. vis Joseph and Other, (App. No. 247 of 1963 in BCP No. 11 of 1960) are relevant:

“So far as the 8th respondent, the auditor for 1946 onwards is concerned, very lengthy arguments have been addressed regarding the duties of a familiar bloodhound as opposed to watchdog lines. But this much I suppose one would not deny and counsel for the 8th respondent has not been disposed to deny it namely, that even the tamest of watch-dog has duty not to connive with the thief.

16.1 Let us consider the present situation in which chartered accountants and auditors are viewed by the public and stakeholders as service providers. Service provided includes accounting, audit & assurance, taxation, consultancy, investment advisory, valuation and/or many other services including at times opinions and management consultancy. The issue is: Is there any exposure under the consumer protection laws for other similarly-placed professional service providers – for example – doctors and lawyers who have been recently exposed? The decision of the National Consumer Disputes Redressal Commission and later the Supreme Court of India in the case of Indian Medical Association v. V.P. Shantha, (AIR 1996 SC 550) has held that the services rendered by the medical practitioner is included and covered under the definition of ‘services’ in S. 2(1)(0) of the Consumer Protection Act, 1986. This covers not only the treating doctors but also the consultants.

This reflects the view that the watchdog bodies of the profession are not perceived to be adequate to provide justice to consumers. In its judgment dated August 6, 2007, in the case of D. K. Gandhi v. M. Mathias, the National Consumer Redressal Commission made it clear that all professionals, including lawyers, should come under the ambit of the Consumer Protection Act. If doctors can come under the fold of the Act, lawyers and all other providers of services like chartered accountants, architects and property dealers will come under the Consumer Protection Act too. This case marks a departure from the established law that professionals can be penalised only by the established Discipline procedures under the law governing the profession. Thus in the changed environment claims for deficient services will not be restricted to be dealt with by the disciplinary committee or an in-house forum of the Institute, but could be agitated before and decided upon in other fora like the consumer forum and Civil and Criminal Courts.

16.2 The accounting is changing and facing challenges like fair value accounting, inflation, intangibles, growing dependence on information systems, ERP, and last but not the least, convergence with International Financial Reporting Standards – IFRS. All these challenges are areas of risk.

The  current  financial  crisis :

17.1 The current financial crisis beginning with the sub-prime crises in US, followed by economic meltdown, reckless investment and products, right up to the recent string of bankruptcies, near-collapse situation in the United States and the last minute bail-out has brought to fore immense risks in the world of finance.

17.2 What has caused this current crisis? Is it bad economics? Bad mathematics? Bad logic? Poor judgment? Is it a failure of rating agencies, failure of merchant bankers, investment analysts and consultants, failure of banks and financial institutions in their due diligence and homework and failure of auditors in expressing their opinion ? Failure of monitoring and regulatory bodies and government agencies, failure of Boards in their oversight? Failure in record keeping and reporting . . .. probably it is all of this in some measure. I suspect all have failed.

17.3 What would be the fallout and impact of the ongoing crises like the turbulence in the forex market and where derivative products have been sold by leading banks to mature corporates and investors with neither displaying the maturity, the seriousness, the understanding and the capacity of going through such transactions? Can this be called ‘risk’ management? The conclusion is in the negative.

18.    A person can always be wiser in hindsight. But one fact that comes out glaringly out of this is that every situation, every strategy, every move, every operation, every action, every transaction, every receipt and payment, every contract, every assurance, every deal, every agreement, every statement, every acceptance …. has a financial footprint that the accountant captures, records and reports and the auditor verifies, vets, vouches, audits, comments and expresses an opinion on. Does that mean that all this is too onerous and that accountants should hide behind disclaimers, subject tos, not withstandings, ifs and buts, and the law as it stands? Professional accountants, be they CFOs, accountants or auditors, need to understand the situation and the task before them, and equip themselves to go forth and discharge their role. To quote William Shedd

“A ship in harbour is safe, but that is not what ships are built for.”

This is the challenge.

19.    I repeat the way forward for accountants to counter this risk is to equip themselves with knowledge through continuing professional education, improve assurance function supported by peer review, and above all maintain independence coupled with professional skepticism and adherence to ethical standards. The need of the hour then is to convert vulnerabilities and weakness into strengths and threats into opportunities to manage change. Let us accept the challenges of change.

Appendix    1

Overview of different  types  of risks faced by an Enterprise :

(A) Strategic risks:

  • Strategy and business environment risk
  • Event risk, group risk, legal risk
  • Regulatory  risk, competition  risk
  • Management  risk, organisation  risk
  • Human  resources  management  risk
  • Capital  inadequacy  risk
  • Disaster  risk/Force  majeure
  • External  credit  rating

(B)    Operational risks: Manufacturing/Service Risks

  • Manufacturing failure
  • Service failure
  • Project management risk
  • Compliance risk
  • Accounting/Taxation  risk

Risks in  Operations

  • Audit compliance  risk
  • Booking  error
  • Business  process  design
  • Customer  relationship  management
  • Counter  party  failure
  • Confidentiality  risk
  • Distribution  channel
  • Documentation  risk
  • Execution  risk
  • Information  communication  risk
  • Information  security  risk
  • Methodology  error
  • Model error
  • Money laundering
  • Product  complexity
  • Settlement  error
  • Security risks
  • Training gaps
  • Volume risks


Risks in  Human Resources

  • Fraud
  • Keyman
  • Human  error
  • Training gaps
  • Negligence

Risks in Communications

  • Communication  interface  risk
  • Connectivity  failure
  • System  customisation risk
  • Telecom failure
  • Third-party/vendor failure for non-IT outsourcing

(C)    Market Risks:

  • Commodity risk
  • Country risk
  • Equity position  risk
  • Limits risk
  • Price volatility

(D)    Credit Risks:

  • Counter party risk
  • Credit appraisal
  • Credit investigation
  • Exposure  risk
  • Monitoring  gaps
  • Recovery  risk
  • Sector  downturns
  • Security realisation  risk

(E)    Finance Risks

 Liquidity Risk

  • Funding risk
  • Market conditions
  • Time risk

Interest Rate Risk

  • Basis risk
  • Prepayment risk
  • Re-pricing  risk
  • Yield curve risk

Forex  Risk

  • FX rate
  • Gap  risk
  • Settlement risk

Appendix    2

Continuous Risk Management (CRM)

1.    CRM requires formulation of :

  • Develop Risk Management Plan
  • Perform risk assessment during systems analysis sub-process
  • Establish an initial set of risks (simplest technique is brainstorming)
  • RM plan and risk profile evaluated and base-lined in evaluation sub-process.

2. Implementation  of CRM plan requires:

  • Implement risk management process defined in the plan
  • Implement risk tracking  system
  • Use risk management continuously to control and mitigate risks
  • Use risk assessment to identify and analyse risks.

Warren Buffet. Is this statement valid ?

Article

In his annual Chairman’s letter to shareholders of Berkshire
Hathaway Inc for year 2001, Warren Buffet set out his perspective on financial
derivatives — particularly credit derivatives1, and concluded that “We try to
be alert to any sort of megacatastrophe risk, and that posture may make us
unduly apprehensive about the burgeoning quantities of long-term derivatives
contracts and the massive amount of uncollateralised receivables that are
growing alongside. In our view, derivatives are financial weapons of mass
destruction, carrying dangers that, while now latent, are potentially lethal”.


The 2008 US Financial Crisis :

An overview :

Indeed, Warren Buffet’s words of wisdom in his 2001 letter to
shareholders seem almost prophetic in the wake of the catastrophic financial
meltdown that is redefining the landscape of global finance at the speed that
perhaps makes Hurricane Ike look like a minor high tide. The historic US
government takeover2 of twin mortgage buyers — Fannie Mae3 and Freddie Mac4 on 7
September, 2008, bankruptcy of the 158 years’ old Lehman Brothers5, acquisition
of the 94 years’ old Merrill Lynch6 by Bank of America on 15 September, 2008, US
Fed and US government $ 85 billion loan bailout of American International Group7
(AIG) on 16 September, 2008, and scrambling for capital or other survival kits
by the remaining two independent investment banks and financial brokerages in
the US market, namely, Goldman Sachs and Morgan Stanley, all in a matter of two
weeks, is unprecedented in the US — the sacred land of capitalism, where
nationalising private investors’ losses through taxpayers’ bailouts has been
sacrilege, ever since the establishment of the US Fed system after the Great
Depression in the 1930s.

And yet even this did little to stave off the financial storm
whose end is nowhere in sight. Much like the stages of a scenario of systemic
financial meltdown associated with this severe economic recession that Professor
Nouriel Roubini of the Stern School of Business at New York University outlined
in February 20088 : “A vicious circle of losses, capital reduction,
credit contraction, forced liquidation and fire sales of assets at below
fundamental prices could ensue leading to a cascading and mounting cycle of
losses and further credit contraction. In illiquid market actual market prices
are lower than the lower fundamental value that they then have given the credit
problems in the economy. Market prices include a large illiquidity discount on
top of the discount due to the credit and fundamental problems of the underlying
assets that back the distressed financial assets. Capital losses then lead to
margin calls and further reduction of risk taking by a variety of financial
institutions that are then forced to mark to market their positions. Such a
forced fire sale of assets in illiquid markets leads to further losses that
further contract credit and trigger further margin calls and disintermediation
of credit. The triggering event for the next round of this cascade is the
downgrade of the monolines and the ensuing sharp drop in equity markets; both
will trigger margin calls and further credit disintermedia-tion . . . . . A
near-global economic recession could ensue as the financial and credit losses
and the credit crunch spread around the world. Panic, fire sales, cascading fall
in asset prices will exacerbate the financial and real economic distress as a
number of large and systemically important financial institutions go bankrupt.”


US Treasury Secretary Henry Paulson watched aghast on 17
September 2008 as his dramatic actions of rescuing Fannie Mae, Freddie Mac, and
AIG were met by worldwide stock market panic while inter-bank lending remained
stubbornly frozen. Running out of alternatives, on 21 September 2008 the Bush
administration led by Henry Paulson sent a draft of proposed legislation to the
US Congress asking for $ 700 billion in taxpayer money to get bad mortgage
assets off the books of troubled US financial institutions in a bid to end the
U.S. economy’s worst financial nightmare since the Great Depression. As a
measure of its relative size, this mother of all financial bailouts in modern
history, at $ 700 billion is approx 7.2% of the current outstanding US national
debt of $ 9.67 trillion9, about 24% of the 2008 US government budget outlay of
$ 2.93 trillion10, a tad over 5% of US GDP at $ 13.67 trillion (2007 est)11,
nearly 64% of India’s GDP at $ 1.09 trillion (2007 est)12, and 1.29% of World
GDP at $ 54.31 trillion (2007 est). Ironically, Henry Paulson, who previously
ran the world’s most powerful investment bank Goldman Sachs as its
free-marketeering former chairman now finds himself leading a nationalisation
programme that would make both Fidel Castro and Hugo Chavez blush ! Can the
government really take on the notorious financial instruments tied to sub-prime
mortgages, whose unfathomable loss of value has made the US credit crisis
self-perpetuating, and bury them in a vault funded by the taxpayer ? Time will
tell.

The on or off-balance sheet obligations of Fannie Mae and
Freddie Mac, the two independent government-sponsored enterprises (GSEs) is just
over $ 5 trillion. Together, Fannie Mae and Freddie Mac own or guarantee about
half of the $ 12 trillion of mortgages in the U.S.13 The government accounts for
these GSEs as if they are unconnected to its balance sheet. Notably, their
obligations at over $ 5 trillion exceed 50% of current US national debt14. The
net exposure to US taxpayers is difficult to determine at the time of the
takeover and depends on several factors, such as declines in housing prices and
losses on mortgage assets in the future. Over 98% of Fannie’s loans were paying
timely during 200815. Both Fannie and Freddie had positive net worth as of the
date of the takeover, meaning the value of their assets exceeded their
liabilities16.

As Domnic Rushe17 points out, two things seem to be clear :
First, the economic influence of American presidents is severely limited.
Secondly, US financial markets have become so complex and reliant on highly
technical trading instruments that even some of the country’s best-known
economists declared themselves bewildered by the head-spinning turn of events.
“As an economist, I am supposed to have something intelligent to say about the
current financial crisis”, said Professor Steven Levitt, the author of
Freakonomics, a best-selling guide on the way markets work. “To be honest,
however, I haven’t the foggiest idea what this all means”18.

Corruption — The scourge of India

Article

Corruption is the lack of integrity. This could be lack of
financial integrity, moral integrity or intellectual integrity. When we talk
about corruption in our country we are generally referring mostly to the lack of
financial integrity.


The world bank defines corruption as ‘the use of public
office for private gain’. In this sense only the holders of public office can be
corrupt. The Prevention of Corruption Act, 1983 also defines corruption only in
the context of cases of public servants who hold public office. Corruption in
the private sector is legally considered to be cheating u/s.420 IPC or criminal
breach of trust. Corruption exists in the private sector and the public sector.
It is the root and cause of suffering practically in all spheres of our life
today. Corruption is therefore a scourge of India.

The word scourge is defined by the Oxford Dictionary as
follows : ‘scourge’ as a noun means : a whip for flogging or a person or thing
regarded as the cause of suffering. As a verb it means flog with a whip :
afflict greatly, punish. In short, ‘scourge’ is an act of causing suffering and
inflicting punishment. Our country is being punished by corruption by way of
lack of progress.

When Ms. Indira Gandhi was asked about the problem of
corruption, she qualified that it was a global phenomenon and avoided a direct
reply. Even if we look at corruption as a global phenomenon which is seen in
every society and country, the level of corruption varies from country to
country.

The latest report of Transparency International has focussed
on the sad fact that even the programmes for ‘aam admi’ and those who are
involved in these programmes are prone to corruption.

The Transparency International India Centre for Media Studies
conducted Indian corruption study 2007, a national survey of graft patterns
affecting BPL — ‘below poverty line’ households, categorised the States into
four levels to explain the extent and level of corruption — alarming, very high,
high and moderate. While levels of corruption were deemed alarming in Assam,
Bihar, Jammu & Kashmir, Madhya Pradesh, Uttar Pradesh, Goa, & Nagaland, it was
very high in TN, Rajasthan, Meghalaya and Sikkim. It was deemed high in
Chhattisgarh, Delhi, Gujarat, Jharkhand, Kerala, Orissa, Arunachal Pradesh,
Manipur. If it is any consolation, corruption levels were moderate in the Union
Terrorities of Chandigarh and Puducherry and the nine States Andhra Pradesh,
Haryana, Himachal Pradesh, Maharashtra, Punjab, Uttaranchal, WB, Mizoram and
Tripura. The survey covered 22,728 randomly selected BPL households across the
States between 2007 and January 2008.

The Below Poverty Line (BPL) households in India paid Rs.883
crore as bribe to avail basic needs during the last one year, according to
Transparency International India (TII) — CMS corruption study 2007. The Police
Department tops the chart with total bribe paid by the BPL households to the
tune of Rs.215 crore, while land records and service comes second at Rs.123.4
crore and housing comes third with a total bribe of Rs.156.6 crore.

The press report gives the details :

Corruption is not new to India, but what is shocking is
that the situation is getting worse, if a global watchdog is to be believed.
India has this year been ranked worse than China on a corruption scale devised
by Transparency International, compared to the last year when the two
countries were on par.

In a report that was released simultaneously in cities
worldwide, the organisation said the marginal slide could have had something
to do with television images of currency notes being displayed in the
Parliament during the recent debate on the trust vote.

India is ranked 85 on the corruption perception index-2008,
while China is ranked 72. Last year both the countries were ranked 72. The
index is prepared on the basis of surveys conducted in 180 countries by 13
international agencies that are associated with the organisation.


The index puts India’s integrity score at 3.4 as against 3.5
in 2007. China on the other hand has a marginally higher integrity score 3.6
this year, while Pakistan with a 2.5 integrity score has been ranked at 134 in
the list and Sri Lanka is ranked at 92 with integrity score of 3.2.

Corruption in our country is a vicious cycle starting with
political corruption, leading to bureaucratic corruption, resulting in
criminalisation of politics.

The question is whether India can continue to live with this
level of corruption. Corruption is anti economic development, anti-nation and
anti-poor. Can something be done to eliminate corruption or at least drastically
reduce the level of corruption in our day-to-day life ?

There is a silver lining that even our worst politicians so
far have not come out openly and said that corruption is good.

Information technology and communication has recorded a
healthy development in recent times. The availability of camera mobile phones
and 24X7 news channels always on the look out for sensational news has increased
significantly.

The most important tools of combating corruption are the
judiciary, the Election Commission and the media.

On the issue of remedial measures we can begin with banning all political candidates against whom criminal charges have been framed in courts from contesting elections, we can certainly stop ‘law-breakers becoming law-makers’. The media and photo camera phones can be used to catch the corrupt and punish them. The RTI Act can be used to expose corruption. I believe the use of RTI Act and use of technology will bring in greater transparency in government and semi-government organisations. Other measures would involve the following:

  • Inculcating value-based education.
  •  Educating the citizens of their rights.
  • Increased use of our judicial system and institutions like the Election Commission and the Ombudsman.

Corruption challenges us, let us confront corruption rather than accept corruption.

TDS on exempt incomes (especially agricultural income)

It is obvious that the TDS provisions are going to be expanded day by day even in the direct Tax Code era. In the process to recover more and more tax through this mode of recovery, in many cases tax is also deducted from incomes which are expressly exempt. Many cases are wandering the corridors of various courts of law on this ground. This is also reflected in the decided cases. It seems that the issue gets complicated with the increase of TDS coverage. It will be interesting to go through the law and the judge-made law on the issue.

Questions to be answered :

    To understand the intricacies of the issue we need to address the following questions :

    (1) To what incomes/payments TDS provisions especially S. 194I is applicable ? The question assumes importance because the words in the Explanation to S. 194I are :

    (i) ‘rent’ means any payment, by whatever name called, under any lease, sub-lease, tenancy or any other agreement or arrangement for the use of (either separately or together) any :

    (a) land; or . . . .

    This has created doubts about whether the land here includes agricultural land rent.

    (2) What is the nature of the Rent income received from Agricultural land ?

    (3) Whether the exempt income is covered under the TDS provisions ?

    (4) Whether tax treatment in the hands of the payer is relevant ?

Analysis of the questions :

1. What is agricultural land ?

    1.1 Agricultural land is not defined under the Income-tax Act. Hence we will have to rely on allied laws and interpretations by courts.

    1.2 Under The Bombay Tenancy and Agricultural Lands Act 1960, (BTAL) in clause (a) of S. 2(8) ‘land’ means :

        “(a) land which is used for agricultural purposes or which is so used but is left fallow, and includes the sites of farm buildings appurtenant to such land; . . . . .”

    1.3 Under the Income-tax Act, 1961, various Courts have interpreted agricultural land.

    The Delhi High Court said :

    “In order to come within the category of agricultural land, it must not only be capable of being used for agricultural purposes but should have been actually used as such at some point of time. A temporary non-user for agricultural purposes will not affect the character of the land but a permanent abandonment of user for agricultural purposes will affect the character of the land as agricultural land.”

    [Shri Shankar Lal v. CIT, (1974) 94 ITR 433, Delhi High Court.]

    The Kerala High Court states :

    ” ‘Agricultural land’, as we understand it, is land on which a prudent owner will undertake any of the processes of farming in its widest sense. The fact that a particular area is being used for agriculture may indicate that the land is agricultural in character. But a current user is by no means conclusive.”

    [Venugopala Varma Rajah v. CED, (1967) 64 ITR 358 (Ker.)]

    2.0 What is the nature of the rent income received from agricultural land ?

    2.1 The following discussion confirms that Rent received for renting out the agricultural land, and any such income derived from the said land is an agricultural income.

    2.2 Agricultural income is defined under the Income-ax Act, 1961 in clauses (a), (b) and (c) of S. 2(1A).

    Clause (a) of S. 2(1A) reads as :

“any rent or revenue derived from land which is situated in India and is used for agricultural purposes;”

    2.3 It is obvious that the rent derived from agricultural land is an agricultural income as per S. 2(1A) of the Income-tax Act, 1961.

    The Patna High Court has stated :

    “Rent is obviously an agricultural income which the landlord makes by reason of his having a proprietary interest in the land which he lets out to the tenant and the tenant pays it as a part of the consideration for the use and occupation of the land which he enjoys. The source of the income is the landlord’s superior interest in the agricultural land and, consequently, it is an agricultural income.”

    [Srimati Lakshmi Daiji v. CIT, (1944) 12 ITR 309 (PAT)]

    2.4 This is also confirmed by various Courts including the Supreme Court :

    (i) CIT v. Haroocharai Tea Co., (1978) 111 ITR 495 (Gau.)

    (ii) CIT v. Janab Haji Muhammad Sadak Khoyee Sahib, (1935) 3 ITR 1 (Mad.)

    (iii) CIT v. Raja Benoy Kumar Sahas Roy, (1957) 32 ITR 466 (SC)

    3.0 To what payments TDS provisions, especially S. 194I, are applicable ?

    3.1 TDS provisions are contained in Chapter XVII of the Income-tax Act, 1961 and cast a responsibility on the person responsible for payments. The incomes from which TDS is to be deducted and person responsible for paying are defined in S. 204 of the Act, which reads as follows :

“204. For the purposes of the foregoing provisions of this Chapter and S. 285, the expression ‘person responsible for paying’ means :

(i) in the case of payments of income chargeable under the head ‘Salaries’, other than payments by the Central Government or the Government of a State, the employer himself or, if the employer is a company, the company itself, including the principal officer thereof;

(ii) in the case of payments of income chargeable under the head ‘Interest on securities’, other than payments made by or on behalf of the Central Government or the Government of a State, the local authority, corporation or company, including the principal officer thereof;

(iia) in the case of any sum payable to a non-resident Indian, being any sum representing consideration for the transfer by him of any foreign exchange asset, which is not a short-term capital asset, the authorised dealer responsible for remitting such sum to the non-resident Indian or for crediting such sum to his Non-resident (External) Account maintained in accordance with the Foreign Exchange Regulation Act, 1973 (46 of 1973), and any rules made thereunder;

iii) in the case of credit, or as the case may be, payment of any other sum chargeable under the provisions of this Act, the payer himself, or if the payer is a company, the company itself including the principal officer thereof … “

3.2 It is obvious from the section itself that TDS is to be deducted from income chargeable under the Act. The portion in bold letters and underlined clearly shows this without any ambiguity.

3.3 The next question naturally comes is what is chargeable income under the Act.

3.4 Charge of income is stated in S. 4 of the Act and it states that tax shall be charged on the total income of the previous year of every person. Total income is defined in S. 2(45) and S. 5 of the Act. Hence income chargeable has to be decided as per S. 2(45) and S. 5 of the Act.

3.5 S. 2(45) defines ‘Total income’ and reads as under:

“total income means the total amount of income referred to in 5.5, computed in the manner laid down in this Act;”

S. 5 with  the heading reads:

“Scope  of total  income.

5. (1) Subject to the provisions of this Act, the total income of any previous year of a person who is a resident includes all income from whatever source derived which ….. “

Bombay High Court has interpreted the highlighted words .’Subject to’ in S. 5 as follows:

“The expression ‘subject to’ used in the opening portion of both Ss.(I) and Ss.(2) of S. 5 has to be read keeping in mind that S. 5 is intended to explain the scope of total income. Therefore, what the use of the said expression shows is that in considering what is total income u/s.5, one has to exclude such income as is excluded from the scope of total income by reason of any other provision of the IT Act and not that the other provisions of the IT Act override the provisions of S. 5.

[CIT v.  F. Y. Khambaty, (1986) 159 ITR 203 (Bom.)]

3.6 Hence, it is obvious that the TDS provisions are not independent of other provisions of the Act and whether the income is chargeable to tax under the Act or not has to be considered while deducting TDS.

4.0 Whether the exempt incomes, especially the Agricultural Rent income, is covered under the TDS provisions?

4.1 Rent of Agricultural land is an agricultural income as explained in Point Nos. 2.0 to 2.04 supra. Agricultural Income is exempt from income tax and is not to be included even in the total income.

4.2 Chapter In of the Act deals with incomes which do not form part of total income. Relevant S. 10(1) reads with its heading as:

“Incomes  not included in total income.

10. In computing the total income of a previous year of any person, any income falling within any of the following clauses shall not be included

(1) agricultural income;”

4.3 It is obvious that in computing the total in-come under the Act, incomes which are exempt u/ s.10 have to be excluded. Consequently they have to be excluded while applying the TDS provisions also. Hence, TDS is not to be deducted on payment of incomes exempted and excluded from the scope of total income under the Act.

4.4 Agricultural Rent is an agricultural income and clearly excluded from the scope of total income u/s.10(1) of the Act.

4.5 Even the parliament has given powers to tax agricultural income to the States only and not to the Union (Central Government).

“Reading entry 82 of the Union List and entry 46 of State List of the Seventh Schedule of the Constitution, it is clear that the Parliament is not competent to tax agricultural income. The expression ‘agricultural income’ occurring in the said entries has to be understood in the manner and in the sense defined in clause (lA) of S. 2.”

[J. Raghottama Reddy v. ITO, (1987)35 Taxman 298 (AP).]

4.6 It is obvious that Rent of Agricultural land is completely out of the purview of not only TDS provisions but even income-tax.

4.7 In another case before the Andhra Pradesh High Court in Andhra Pradesh Forest Development Corporation Ltd. v. ACIT & Anr., (2005) 272 lTR 245 the question was whether items of sale viz. bamboo, eucalyptus and pepper are forest produce or non-forest produce and that the petitioner is under an obligation to collect tax at the time of effecting sales.

The Court held that in order to attract the provisions of S. 206C it has to be examined whether items sold are forest produce or not – Legislature intends to apply this provision in respect of timber and other produce obtained from forest and not any produce and that if the produce i.e. bamboo, eucalyptus and pepper are forest produce, then only the provisions of S. 206C would be applicable and not otherwise.

4.8 Considering other incomes, various courts have taken a clear view that incomes which are not includible in total income (exempt) are clearly out of the TDS net.

4.9 High Court of Rajasthan had an occasion to test applicability of TDS provisions to interest paid to a non-resident in CIT v. Manager, State Bank of India, 13 DTR (Raj.) 294.

In this case during a survey conducted on the assessee bank, it was found that TDS was not deducted on interest paid to NRIs on deposits in In-dian rupees.

The AO did not accept the contention of the bank and levied penalty and ClT confirmed the same. But the Tribunal set aside the ClT’s order. In appeal to the High Court, the revenue contended that interest paid on TDRISTDR doesn’t fall u/s.10(15)(iv) (fa) of the IT Act, hence deduction was not admissible, and learned Tribunal has committed error in accepting appeals on this ground whereas the assessee contended that as per provisions of S. 10(15)(iv)(fa), interest income was exempt from taxable income. The provisions of S. 10(15)(iv)(fa), as it then stood were:

“(fa) by a scheduled bank to a non-resident or to a person who is not ordinarily resident within the meaning of Ss.(6) of S. 6 on deposits in foreign currency where the acceptance of such deposits by the bank is approved by the RB!.”

Relying on the observations of the Apex Court in the case of Transmission Corporation of A.P. Ltd. & Anr. v. CIT, (1999) 239 ITR 587 (SC) which has held that tax is to be deducted at source only on the sum on which income tax is leviable, and which income could be assessed to tax under the Act, the High Court held that STDR – Interest on TDR/STDR paid to non-resident Indians being exempt u/ s. 10(15)(iv)(fa), there was no question of deduction of tax at source.

4.10 Before the Gauhati High Court in Sing Killing v. ITO & Ors., 255 ITR 444, the question was – when the transactions entered into by the petitioner in respect of the forest lease situated in Sixth Schedule area and income arising therefrom is exempt from payment of income-tax u/s.10(26) whether collection of income-tax at source under the provisions of S. 206C was applicable.

Petitioner, a member of Scheduled Tribe, was granted a lease of a forest area specified in Sixth Schedule area. The ITO also granted a certificate to the petitioner certifying that he is not liable to pay income-tax u/s.10(26).

The Court held that, Entitlement of the petitioner to the benefit of S. 10(26) in respect of transactions arising out of the lease is not in doubt, S. 206C was not therefore applicable. If the income itself is exempted, any deduction/collection, on account of income-tax, at source, would be beyond the powers conferred by the provisions of the Act.

4.11 In a case to decide disallowance u/sAO(a)(ia) in case of legal fees paid in UK in connection with legal proceedings in UK it was held that where the provisions of Article 15 of the DTAA, between India and UK were applicable, payment of fees for legal consultancy services to UK-based firm of solicitors was taxable in UK and was not exigible to tax in India. Therefore, the assessee (tax deductor) was under no obligation to deduct tax at source from the payment so made. IMP Power Ltd. v. ITO Mumbai E Bench, (2007) 107 TTJ 522.

4.12 In a case before Karnataka High Court in Hyderabad Industries Ltd. v. ITO & Anr., 188 ITR 749 the issue was whether S. 10(6A) has nothing to do with deduction of tax at source and it is attracted only for purposes of computing the total income of a foreign company. In other words, the contention was that, in case the foreign company has to face an assessment proceeding, then only S. 10(6A) will be attracted.

The Court held that, “the construction sought to be placed by the Revenue (to deduct tax) is based on a distinction, which has no substance in it. It is not understandable as to why, a benefit which will not be included in the total income of a person, should be considered as ‘income’ for the purpose of deduction of tax at source at all. Purpose of deduction of tax at source is not to collect a sum which is not a tax levied under the Act; it is to facilitate the collection of the tax lawfully leviable under the Act. The interpretation put on those provisions by the Revenue would result in collection of certain amounts by the State, which is not a tax qualitatively. Such an interpretation of the taxing statute is impermissible. Tax paid on behalf of foreign company, therefore, will not form part of its income.”

“S. 10(6A) nowhere confines its operation to an assessment proceedings; there is no exclusion of its operation from other proceedings under the Act. Language of S. 10 is quite simple and clear. It governs the computation of the total income of the person covered by it; a benefit, which is not includible in the total income of a person, necessarily implies that the said benefit is not the ‘income’ of the person.”

4.13 Transmission  Corporation of A.P. Ltd. & Anr. v. CIT, (1999) 239 ITR 587 (SC).

In this case the Apex Court had to decide whether the TDS provisions are applicable to Gross Receipt vis-a-vis Income Receipt in case of payments made to non-residents.

The Court observed in Para 8 that, “the scheme of Ss.(l), Ss.(2) and Ss.(3) of S. 195 and S. 197 leaves no doubt that the expression ‘any other sum chargeable under the provisions of this Act’ would mean ‘sum’ on which income-tax is leviable. In other words, the said sum is chargeable to tax and could be assessed to tax under the Act.

Consideration would be – whether payment of a sum to non-resident is chargeable to tax under the provisions of the Act or not? That sum may be income or income hidden or otherwise embedded therein. If so, tax is required to be deducted on the said sum – what would be the income is to be computed on the basis of various provisions of the Act including provisions for computation of the business income, if the payment is trade receipt.

However, what is to be deducted is income-tax payable thereon at the rates in force. Under the Act, total income for the previous year would become chargeable to tax u/s.4. Ss.(2) of 5.4 inter alia, provides that in respect of income chargeable u/s.(1), income-tax shall be deducted at source where it is so deductible under any provision of the Act …. “

4.14 While deciding the applicability of the TDS provisions it is necessary to look into the fact whether the income is exempt from being included in the total income. There is a difference between income not chargeable to tax and not includible in the total income (agricultural income) and income which forms part of total income but which is made taxfree. The Apex ,Court observed in – CIT v. Williamson Financial Services & Ors., (2008) 297 ITR v. 17 (SC) that – Agricultural income not being chargeable to tax does not fall under various computation provisions ….. There is a vital difference between income not chargeable to tax and not includible in the total income (agricultural income) and income which forms part of total income but which is made tax-free ….

4.15 Further CBDT has issued Circular No. 736 dated 30-1-1996 to deal with incomes received by certain defense funds and clearly states that “….no tax may be deducted at source u/s.194-I, since the income of these organisations is exempt from tax u/s.10(23AA) ….”

Although it is for the purpose of defense funds the principle of exempt incomes is clearly borne out.

 5.0 Whether tax treatment in the hands of the payer is relevant?

The last question is whether the tax treatment of the amount paid as agricultural rent or exempt income in the hands of the payer will have any effect on the TDS applicability.

TDS provisions nowhere mention anything about the tax treatment for payments made in the hands of the payer.

As explained hereinabove TDS provisions are not applicable to agricultural land rent or exempt incomes. Hence, this will not have any adverse effect in the hands of the payer i.e. lessee/company, as far as the TDS provisions are concerned. The questions u/s.40(a)(ia) have already been resolved by various Court decisions as discussed in the foregoing paras.

Considering all the relevant facts and the law as discussed hereinabove, and relying and based on the same as mentioned above, it is obvious that, TDS provisions are not applicable to Rent for Agricultural land and TDS cannot be deducted there-from or from incomes which are expressly exempt.

The Great Financial Meltdown and the Accounting Profession 139

Article

The last thirteen months have been witness to the unfolding
of an unprecedented crisis in the international credit and equity markets
resulting in the ultimate demise of the large independent multinational
Investment Bank as a business. It all started with the onset of a correction in
the US real estate prices in mid 2007 leading to the sub-prime crisis which in
turn brought about the near seizure of the mortgage backed securities market
ending with the ‘guided’ absorption of Bear Sterns and Merrill Lynch, the
well-respected Wall Street Investment Banks, by two large commercial Banks — JP
Morgan and Bank of America, respectively. The US financial services business
model has truly been shaken at its roots with the bankruptcy of the iconic
Investment Bank, Lehman Brothers, the US Government bail-out of the mortgage
majors Fannie Mae and Freddie Mac, as also the largest insurance company,
American International Group and the conversion of the illustrious Investment
Banks Goldman Sachs and Morgan Stanley to commercial banks. To unfreeze the
international interbank money markets that had become virtually non-functional
on account of the fear of the imminent collapse of counterparty Banks, the US
Government has come up with the largest ever bail-out, the US $ 700 billion
Troubled Asset Relief Program (TARP) under which the troubled assets of the
banking system would be bought over by the US Treasury to enable banks to clean
up their books and hopefully resume business as usual. The size of the troubled
assets in the US banking system could be at least five times the planned bailout
and hence it is possible that more bail-outs and recapitalisations will become
necessary before the markets come back to normalcy. While the crisis has
substantially dented the fortunes of the US $ 14-trillion US economy, the
bail-out package and its possible successors may just about manage to pull
through the US economy from a further catastrophe. On the other side of the
Atlantic however, the size of the banking crisis is disproportionately large,
relative to the size of the host country economies. Consequently, the banks once
considered too big to fail have now become too big to save for individual
countries. Hence the process of European bank bail-outs would require more than
one country to chip in and a virtual Government takeover of the ownership of the
banking system is currently in progress.


It is worthwhile examining how the problem assumed such
gigantic proportions without some corrective action being initiated sufficiently
early in the cycle. Mortgages offered by banks and housing finance companies are
subject to the capital adequacy norms prescribed by regulators, which requires
them to back the risk in lending with certain minimum capital. The growth in the
mortgage business of a company is hence limited by the quantum of capital
available. Pursuing a more aggressive growth path would entail new capital to be
raised periodically, which limits the attractiveness of the company in the
equity market. To overcome this problem, companies started selling the loans
that they had originated through a process called ‘securitisation’. This
consists of carving out pools of housing loans with different risk and return
characteristics and selling the same through innovative structures to new
investors in the same way a bond is sold in the debt market. Certain new
attributes were added to the pool of housing loans to make the pool more
marketable by offering credit enhancement — by providing that say the first 5%
of default in the pool will be paid for by the seller — or by a third party
offering credit insurance. Such pools — known as collateralised debt obligations
(CDOs) — are rated by credit rating agencies based on the past repayment history
and the value of the underlying house properties that are mortgaged. The
mortgage companies by becoming originators of mortgage loans who sell the assets
at a profit to other investors — typically mutual funds, insurance companies,
hedge funds, etc. — enhance their return on equity without having the need to
constantly raise capital. The CDOs are generally sold at a yield less than the
contracted yield with the individual mortgagees, thus deriving a profit
approximately equal to the difference between the net present values of the cash
flows at the two yields. The system represents the best form of specialisation
with the mortgage companies concentrating on finding credible borrowers to
originate the loan and the ultimate buyers deploying their large resources in a
pool of assets with reasonable yields. Typically the CDOs are divided into
tranches ranging from investment grade — representing borrowers with a good
credit history and loans with high security coverage — to less than investment
grade, also called sub-prime CDOs and sold at varying yields to investors with
different risk appetite. The risk that a mortgage will not be serviced has
certainly not gone out of the system, but is shared between the originator and
the credit insurer to the extent they are liable and the ultimate holder of the
CDO for the balance amount.

The sub-prime woes in the US are a result of the excesses in the system caused by pushing the balance between risk and return beyond prudent levels. Aggressive US Banks were offering attractively priced mortgages to sub-prime borrowers in the hope that the boom in the real estate market will continue and the security cover will be more than adequate when repossession and sale becomes essential on loan default caused either by rising un-employment or firming interest rates. The prospect of being able to quickly sell these loans as COOs at a profit certainly prompted banks to lower lending standards. The continuing bullishness in the real estate market lulled credit enhancers and insurers to take on risks at a price that they would otherwise have not taken and the ultimate investors – frequently high-yield funds promoted by the very banks who originated the mortgages – to hold securitised assets at low yields emboldenedby credit insurance and softening interest rates. Once the real estate prices started correcting and interest rates firmed up, the holders had to mark-to-market the asset-backed securities incurring considerable losses and the credit enhancers/insurers who had taken leveraged bets while underwriting these risks had to suffer huge losses. Aggressive repossession of housing assets and subsequent sale in an already weak housing market caused a further slide in real estate prices, thus jeopardising the asset coverage of CDOs. This chain of events finally left the Wall Street bankers holding billions of dollars of COOs and other asset-based exotica that represent – variously sliced and diced – home loans made out to sub-prime borrowers. With the supply of these securities exceeding natural demand, when they found that there are no real buyers for these securities, they created buyers called structured investment vehicles (SIVs) who would borrow short-term money from the commercial paper market – based on good credit rating from friendly credit raters – and use the money to buy the long-term mortgage assets from these banks. The catch however is that for this game to continue, the commercial paper would need to be rolled over every few months. With the correction in real estate markets getting worse by the day, the sub-prime borrowers started defaulting in servicing their loan obligations and the value of the mortgaged homes could not cover the outstanding loans. With this, the asset-backed commercial paper market dried up, thus denying the SIVs their primary source of funding.

Under these circumstances, the’ SIV could either liquidate the mortgage securities on a forced sale basis or plead with the sponsoring bank to extend their credit lines. The problem with the first option is that the sale at distress prices will force banks to mark-to-market their holdings of similar illiquid securities worth several billion dollars causing huge losses to be booked. Banks therefore preferred the second option, so that they could continue to value their illiquid securities at ‘fantasy’ prices without providing for mark-to-market losses. In a well-functioning capital market, the SIVs would reflect the real-world prices of their underlying assets and on this basis there would be enough funding available from hard-nosed capitalists through the market mechanism. The mark-to-market valuation would necessarily reflect the distressed nature of these assets and the risk appetite of the capital providers. Some help was at hand from the US Financial Accounting Standards Board in this regard with the adoption of FASB 157 from mid-November 2007, which sought to standardise ‘fair value’ accounting. Under this dispensation, assets are classified into three levels, with the first level involving assets with prices quoted in active markets and the second level involving less-traded securities which are valued using the prices of similar assets. At the third level are securities like COOs that are not traded and are valued with the help of financial models based on a series of assumptions, known as the mark-to-model method. The accounting standards require institutions to classify securities such that the mark-to-model method is kept to the minimum and as far as possible, to value level-3 securities based on a gridded or extrapolated level-2 value. Appropriate disclosures of the methods used to estimate the fair value of assets is a requirement. Avoiding the use of market prices or proxies for market prices in preference to mark-to-model methods became increasingly difficult where the accountants sought to strictly implement the provisions of the accounting standard. If truth be told, the implementation of these standards was not uniformly strict.

One of the aspects of the problem that should concern the accounting profession is the fact that the large banks affected by the sub-prime mortgage meltdown had to take on obligations beyond what were considered contingent liabilities and factored into capital adequacy calculations. Bailing out bank-sponsored off-balance sheet vehicles such as conduits, structured investment vehicles and even money market funds beyond the formal legal ob-ligation of the sponsoring bank was at the root of the massive write-downs. This was indeed necessitated by the need to protect the hard-earned reputation of the sponsoring banks, much beyond the scope of enforceable contracts. This development has far-reaching implications for shareholders, the accounting profession, as also bank regu-lators. For shareholders, this was a risk that they never bargained for, but still had to pay for in terms of value erosion. The accounting profession would do well to revisit the level of disclosures and consider putting in place a reporting standard that requires disclosure on such qualitative and unquantifiable risks. Regulators would need to have a rethink on the adequacy of risk capital that may need to factor the financial consequences of banks opting to take on such unenforceable obligations. The dilution of the credit creation function of banks that would be the inevitable consequence of any deleveraging prescription would need to be balanced with the potential benefits of a healthier banking system.

Another lesson that is worth learning from the ongoing credit crisis and is again relevant to the accounting profession is the inappropriateness of leaning too heavily on complex risk and valuation models. The basis of the high credit rating of pools of sub-prime mortgage loans was the assumption that mortgage defaults were essentially independent of each other. This enabled credit raters to use risk models on the basis of the ‘Law of Large Numbers’ that allowed large portions of these pools to be rated AAA on the premise that the probability of a default of more than 20% of principal was very small. The reality however is that defaults in sub-prime mortgages are not independent events when confronted with a steep interest rate rise or a nationwide housing price collapse. Moreover, the dimension of market liquidity is not factored into financial models because there is no agreed method to value liquidity. Regulators need to be concerned that the soon-to-be-enforced Basel II prescriptions rely largely on the use of such discredited complex risk models. The risks to the financial system on the back of reduced capital adequacy norms based on third-party credit rating of risk assets merits a careful evaluation in the light of recent events.

The Vodafone Tax Dispute — A Landmark Judgment of the Bombay High Court

Article

The ongoing tax dispute between
the Indian Tax Authorities and Vodafone in connection with taxability of the $
11.2 billion Hutch-Vodafone deal is one of the biggest controversies in Indian
multijurisdictional M&A history. The quantum of tax demand by the Indian Revenue
Authorities in this particular case could be around Rs.12,000 crore plus
interest. Further, the outcome of this dispute could also have implications on
other similar cross-border deals being scrutinised by the Indian Tax Authorities
for possible loss of tax revenue. As a result, the developments of this case are
being closely followed by many multinationals, M&A consultants and even by the
International business and tax fraternity.

We have summarised below the key
aspects of the recent landmark judgment of the Bombay High Court on the Vodafone
tax dispute and have also given our personal comments on some of the questions
generally being raised by fellow professionals post this judgment.

Background of the case :

In December, 2006, Hutchison
Telecommunications International Ltd. (HTIL), a company incorporated in Cayman
Islands and having its principal executive office at Hong Kong, held 66.9848%
interest in an Indian company, Hutchison Essar Ltd. (HEL) through a maze of
subsidiaries in British Virgin Islands, Cayman Islands and Mauritius (around 15
offshore companies) and through complicated ‘option’ agreements with a number of
Indian companies. HEL along with its Indian subsidiaries held licences for
providing cellular services in 23 telecom circles in India. The balance 33.0152%
interest in HEL was held by the Essar Group of Companies.

Vodafone (through its
Netherlands entity) entered into a share purchase agreement with HTIL in
February 2007 to acquire the said 66.9848% interest in Hutchison Essar Ltd. and
it claims to have acquired the same through purchase of the solitary share of a
Cayman Island company of the Hutch Group [viz., CGP Investments



(Holdings) Ltd. (CGP)].

The Indian Revenue Authorities
alleged that Vodafone International Holdings B.V., Netherlands (Vodafone BV) had
failed to withhold income-tax on the payment of consideration made to HTIL and,
hence, sought to assess tax in its hands as a taxpayer in default and it issued
a notice to Vodafone.

Vodafone BV had challenged the
issue of this notice before the Bombay High Court and the case was decided
against it. Vodafone filed a petition before the Supreme Court (SC); however,
the same was dismissed by the SC and it directed the Revenue Authorities to
decide whether it had jurisdiction to tax the transaction and it also said that
if the issue was decided against Vodafone BV, Vodafone BV was entitled to
challenge it as a question of law before the High Court.

The Revenue Authorities by an
order in May 2010 held that it had jurisdiction to treat Vodafone BV as an
assessee in default u/s.201 of the Income-tax Act, 1961 for failure to deduct
tax at source.

This order was challenged by
Vodafone BV before the Bombay High Court, by a writ petition. The key issue
before the HC was whether the Indian Revenue Authorities have the jurisdiction
to proceed against Vodafone BV and tax the transaction.

Primary contention of Vodafone :

The basic contention of Vodafone
was that the transaction represents a transfer of a share (which is a capital
asset) of a Cayman Island company, i.e., CGP. CGP through its downstream
subsidiaries, directly or indirectly controlled equity interest in HEL. Any gain
arising to the transferor or to any other person out of this transfer of a share
of CGP is not taxable in India because the asset (i.e., share) is not situated
in India.

Primary contention of Revenue :

The contention of the Revenue is
that the share purchase agreement between HTIL and Vodafone and other
transaction documents establishes that the subject-matter of the transaction is
not merely the transfer of one share of CGP situated in Cayman Islands as
contended by Vodafone. The transaction constitutes a transfer of the composite
rights of HTIL in HEL as a result of the divestment of HTIL’s rights, which
paved the way for Vodafone to step into the shoes of HTIL. Such transaction has
a sufficient territorial nexus to India and is chargeable to tax under the
Income-tax Act, 1961.

Decision of Bombay High Court :

The High Court dismissed the
petition of Vodafone BV and has accepted the argument of the Income-tax
Authorities that the transaction in question had a significant nexus with India
and the proceedings initiated by it cannot be held to lack jurisdiction.


    (i) The key aspects observed by the High Court :

Before analysing the facts of the instant case, the High Court made observations on certain general principles, some of which are given below :

    – Tax planning is legitimate so long as the assessee does not resort to a colourable device or a sham transaction with a view to evade taxes;

    – A controlling interest which a shareholder acquires is an incident of the holding of shares and has no separate or identifiable existence distinct from the shareholding;

       – S. 195(1) of the Income-tax Act, 1961 provides for a tentative deduction of income-tax, subject to a regular assessment;

The Parliament, while imposing a liability to deduct tax has designedly imposed it on a person and has not restricted it to a resident and the Court will not imply a restriction not imposed by legislation.

        ii) Analysis of facts:
The High Court analysed the various agreements entered into by the parties (like share purchase agreement between HTIL and Vodafone BV, term sheet agreement between HTIL and Essar group for regulating the affairs of HEL which was later replaced by a similar term sheet agreement between Vodafone and Essar group, brand licence agreement granting a non-transferable royalty-free right to Vodafone BV to use IPRs for a certain period, agreement for assignment of loans to Vodafone BV, framework agreements for option rights, etc.) and the various disclosures made by the parties (like disclosures made by HTIL in its annual reports, disclosures made by Vodafone in its offer letter, disclosures made by Vodafone before the FIPB, etc.) for ascertaining the subject-matter of the transaction and the business understanding of the parties to the transaction.

        iii) Conclusions:

Based on the analysis of the above documents and disclosures, the High Court held that:

The transaction between HTIL and Vodafone BV was structured so as to achieve the object of discontinuing the operations of HTIL in relation to the Indian mobile telecommunication operations by transferring the rights and entitlements of HTIL to Vodafone BV. HEL was at all times intended to be the target company and a transfer of the controlling interest in HEL was the purpose which was achieved by the transaction. The due diligence report of Ernst & Young also emphasises this and it also suggests that the transfer of the solitary share of CGP, a Cayman Islands company was put into place at the behest of HTIL, subsequently as a mode of effectuating the goal.

The rights under the option agreements were created in consideration of HTIL financing such Indian companies for making their investments in HEL. The benefit of those option agreements with Indian companies had to be transferred to Vodafone BV as an integral part of the transfer of control over HEL.

The transfer of the CGP share was not adequate in itself to consummate the transaction. The transactional documents are not merely incidental or consequential to the transfer of the CGP share, but recognised independently the rights and entitlements of HTIL in the Indian business, which were being transferred to Vodafone BV. These rights and entitlements constitute in themselves capital assets.

For Income-tax Law what is relevant is the place from which or the source from which the profits or gains have generated or have accrued or arisen to the seller. If there was no divestment or relinquishment of HTIL’s interest in India, there was no occasion for the income to arise. The real taxable event is the divestment of HTIL’s interests which comprises in itself various facets or components which include a transfer of interests in different group entities.

Apportionment of the consideration lies within the jurisdiction of the Assessing Officer during the course of the assessment proceedings. Such an enquiry would lie outside the realm of the present proceedings.

The transaction between HTIL and Vodafone BV had a sufficient nexus with Indian fiscal jurisdiction. The essence of the transaction was a change in the controlling interest in HEL which constituted a source of income in India. Accordingly, Indian Tax Authorities have acted within their jurisdiction in initiating the proceedings against the Petitioner for not deducting tax at source. As regards the withholding obligation on a non-resident, the High Court held that once the nexus with Indian fiscal jurisdiction is shown to exist, the provisions of S. 195 would operate.

    Issues involved and our view :
1. Whether all offshore share transactions which indirectly involve transfer of underlying Indian assets are taxable in India?

Ever since the Indian Revenue Authorities initiated proceedings against Vodafone, we have been hearing this concern from everyone including many international tax experts that how can the Indian Revenue Authorities tax a transaction of sale of shares of a foreign company by one non-resident to another non-resident by taking an argument that pursuant to such sale of shares, underlying assets in India get transferred?

We believe that in the instant case, the Revenue is not seeking to tax the transaction in India on the ground that there is an indirect transfer of underlying assets situated in India on account of a transaction of transfer of shares of a foreign company. It seems that the Revenue’s contention is that on evaluation of the various transaction documents executed by HTIL and Vodafone, it can be established that the transaction itself is for transfer of composite rights including, in particular, rights under a joint venture agreement (which constitute a capital asset situated in India) and the transfer of share of an overseas company is only a mode for facilitating the transaction.

It has to be accepted that for evaluating the taxability of a transaction, one needs to first understand the true nature and character of a transaction.

The High Court before analysing the facts in the instant case, laid down the general principle that legal effect of a transaction cannot be ignored in search of ‘substance’ over ‘form’. However, the High Court has also rightly held that in assessing the true nature and character of a transaction, the label which parties may ascribe to the transaction is not determinative of its character. The nature of the transaction (i.e., ‘form’ of the transaction) has to be ascertained from the covenants of the contract and from the surrounding circumstances. The subject matter of the transaction must be viewed from a commercial and realistic perspective. The terms of the transaction are to be interpreted by applying rules of ordinary and natural construction.

After going through the facts available on record, including various public disclosures made by the Hutch and Vodafone Group and share purchase agreement and other transaction documents entered into between the parties, which have been very well analysed by the High Court in its judgment, there is no doubt in the mind of the High Court that the subject-matter of the transaction in the instant case, even in ‘form’, is not one share of the Cayman Islands Company, but it is a transfer of controlling interest (including various rights and entitlements) in HEL, India. As noted by the High Court, the acquisition of one share of the Cayman Islands company was only a mode chosen by the parties to facilitate the process.

The High Court thus rejected the submission of Vodafone that the transaction involves merely a sale of a share of a foreign company, which is a capital asset situated outside India and all that was transferred was that which was attached to and emanated from such solitary share. The High Court also noted that it was based on such false hypothesis that it was being urged by Vodafone that the rights and entitlements which flow out of the holding of a share cannot be dissected from the ownership of the share.

Thus, it is based on the detailed evaluation of the specific facts and documents of this transaction that the High Court finally concluded that the real taxable event is the divestment of HTIL’s interests in India and it accepted the argument of the Revenue that the transaction in question had a significant nexus with India and the proceedings initiated by it cannot be held to lack jurisdiction.


Hence, the High Court ruling does not at all hold that offshore share transactions which indirectly involve transfer of underlying Indian assets can be taxed in India.

2. Whether withholding is required on the entire consideration or there needs to be an apportionment?

The High Court has held that an enquiry on the aspect of apportionment of the total consideration would lie outside the purview of the proceedings before it and the aspect of apportionment lies within the jurisdiction of the Assessing Officer during the course of the assessment proceedings. Thus, it would be for the Assessing Officer to determine during the course of assessment proceedings whether there is any income out of the total consideration which cannot be said to have accrued or arisen in India or cannot be deemed to have accrued or arisen in India and hence cannot be taxed in India. The observations clearly relate to ‘assessment’ and not to deduction of tax.

It would also be relevant to note that the High Court while laying down the principles governing the interpretation of the provisions of S. 195 held that S. 195(1) provides for a tentative deduction of income-tax, subject to a regular assessment.

The High Court has only held that the composite payment by Vodafone had nexus with and included payment giving rise to income accruing or arising in India. Consequently, the High Court has decided the question before it, viz., whether the Indian Tax Authorities have the jurisdiction to take action against Vodafone for having made the payment without deducting tax as it was required to do u/s.195.

The High Court has not gone into, nor made any observations or given any decision about whether the whole or part of the payment would be liable to deduction of tax, the rate at which tax is to be deducted, etc. The High Court was not required to and has expressed absolutely no views on any of these matters which the Officer has to adjudicate.

3. Is there an inconsistency in the observation made by the High Court on the aspect of controlling interest not being a capital asset and its final conclusion?

The High Court before analysing the facts in the instant case, laid down the general principle that the controlling interest which a shareholder acquires is an incident of the holding of shares and has no separate or identifiable existence distinct from the shareholding. After a detailed evaluation of the specific facts and documents of this transaction, the High Court finally concluded that the essence of the transaction was a change in the controlling interest in HEL which constituted a source of income in India. With due respect to the High Court, is there an inconsistency in the observation made by the High Court and its final conclusion?
        
In our view, there is no inconsistency, as the entire order needs to be read harmoniously. The term ‘controlling interest’ in the general principle laid down by the High Court that ‘the controlling interest which a shareholder acquires is an incident of the holding of shares and has no separate or identifiable existence distinct from the shareholding’ seems to refer to controlling interest acquired as an incidence of acquisition of a particular number of shares. The High Court has not made any general observations about a case where the subject matter of the transfer is the ‘controlling interest’ and the requisite number of shares are transferred or delivered, directly or indirectly, for achieving the transfer of the ‘controlling interest’. In any case, the term ‘controlling interest’ used by the High Court in its final conclusion represents the entire business interest of HTIL in the Indian mobile telecommunication operations, i.e., HTIL’s interest in HEL, which includes (a) Equity interest of 42.34% held by HTIL through its subsidiaries (b) Equity interest of 9.58% held by HTIL through minority equity holdings of its subsidiaries in certain Indian companies which in turn held equity interest in HEL (c) Rights (and call and put options) representing HTIL’s economic interest in 15.03% equity of HEL (d) Assignment of loans (e) Other rights and entitlements.

Further to the above, it may also be worthwhile to evaluate if the above general principle will hold good in a situation where the transaction between the parties incidentally results in the acquisition of controlling interest in a subsidiary company (say, an Indian company) as a consequence of transferring shares of an overseas parent company. The same does not seem to have been evaluated by the High Court in the instant case, may be because such evaluation was not necessary here as the transaction was for transfer of entire business interest in HEL which included various rights and entitlements which anyway could not have been transferred in the manner in which they were transferred by the transfer of one share of CGP and the consideration was for the transfer of such entire business interest as a package.

4. Will the Vodafone case create a negative perception of India in the eyes of foreign investors?

As could be seen from the High Court order, the action of the Indian Tax Authorities in this particular case is based on a proper and detailed analysis of the facts and circumstances of this case and the relevant provisions under the domestic Income-tax law which are very widely worded. It is important to note that no tax treaty is applicable in this particular case and hence it is not a case that the Indian Government is not honouring its commitment to foreign investors by proposing to tax the impugned transaction in the case of Vodafone. Also, here it is not the claim of Vodafone that there is double taxation on the income from the transfer of controlling interest in HEL. Further, it has to be appreciated that tax cost is only one of the various costs of a business and business decisions are not taken entirely on the basis of tax cost.

The order of the High Court has not been stayed by the Supreme Court, on the contrary the Supreme Court directed the Income-tax Department to pass an order to quantify the tax liability. Thus, the action of the tax authorities in this particular case has not only been held as reasonable and not without substance, but also legal, and it will be taken in the right perspective by foreign investors and it should not have an adverse impact on M&A activity in India.

Auditing Beyond Compliance

Article

1. Background :


It is a matter of general perception that the role of the
auditor is only to do whatever in order to issue an opinion of ‘true and fair’
on the financial statements of the company under audit. Statutory audit cannot
therefore be perceived to do anything beyond audit of the relevant books of
account, obtaining explanations and representations from management and other
relevant stakeholders such as banks, suppliers and customers.

The role of the auditor together with the duties and
responsibilities are contained in several provisions of the Companies Act. The
said Act and the ICAI’s Code of Ethics are very specific in terms of the roles
and responsibilities of the auditor and the ‘bounds’ within which he should
operate. The Companies Act of 1956 and the Code of Ethics of the ICAI also deal
at length with the issues relating to ‘independence’ and under which, there can
be various penalties for non-compliance.

In addition, the general understanding of the role of audit
on the part of auditors is that it is a compliance function where the auditor is
appointed to audit the books of accounts for a very specific purpose and that is
to express an opinion of ‘true and fair’. More importantly, the perception is,
had it not been for the requirement under the Companies Act, it is possible that
the client would dispense with this service.

The aforesaid factors have, in one manner or the other, had
their impact on the auditor who believes that his role is that of a compliance
officer of the company that he audits.

Companies also share the general perception that audit is
primarily a ‘compliance’ function and therefore, the auditor should restrict his
role to that of a compliance officer. This thinking sometimes also arises on
account of the belief that auditors do not ‘add value’ beyond audit of the books
of accounts; companies perceive that audit as a function exists to meet
requirements prescribed under the Companies Act with regard to proper
maintenance of books of account.

A number of accounting firms also believe that audit is
purely a compliance function and have therefore set limitations on every aspect
of their work. As a result, clients perceive very little ‘value add’ in terms of
the services rendered and whatever doubts that existed in their minds about the
role of audit gets further confirmed. Companies also use this argument whilst
fixing or negotiating auditor’s fees, little realising the services the auditor
renders.

The purpose of the article is to highlight the fact that
‘looking beyond compliance’ is very much within the overall role of compliance,
except that we need to understand the fact that it is important to shed the
traditional thinking that the role of the auditor begins and ends with pointing
out errors in accounting, non-compliance with law and getting them rectified or
reported.

2. Widening the horizon : What does ‘Auditing Beyond Compliance’ mean !


The perception of audit as a compliance function has to start
with the auditors recognising the fact that they cannot be putting ‘fetters’ on
themselves by playing merely the role as ‘compliance officers’. The important
thing to understand at this stage is, what does ‘auditing beyond compliance’
actually mean. Most professionals imagine this entails adding value in terms of
identifying areas for cost reduction and control, process improvements through
the identification of processes that do not add value, etc. Auditing Beyond
Compliance need not always involve going beyond the normal call of duty as an
auditor as one can see in the following paragraphs :

A. Adopting a pro-active approach to audit :


Most auditors fail to recognise the importance and value in
adopting a pro-active approach to auditing. Transparency and proactivity can
build trust and the auditor must recognise that this policy works in almost all
cases. For example, many auditors involve their client personnel in important
decision making such as planning of the audit. Client staff is invited for
sessions where the audit approach is explained at a broad level; what are
auditor’s expectations from the client in terms of information, the timing of
information, etc., providing general guidance to client staff in the preparation
of certain audit schedules without getting into ‘conflict of interest’
situations, etc. are some of the simple ways of going beyond compliance. Client
staff becomes very comfortable dealing with auditors who work alongside them and
help them understand and address some of the complex requirements. Helping
client staff in various procedures involved in a simple stock-take can add
value. For example, auditors can provide critical inputs in helping client staff
keep the production area clean and demarcated to facilitate stock-count.
Similarly, many auditors transfer knowledge on important areas such as revenue
recognition to enable client staff to record revenue correctly. Cut-off
procedures invariably pose a challenge and the auditor can provide inputs to
client staff achieve effectiveness of cut-off procedures. The auditor can add
significant value in the process of assisting clients without compromising on
his independence as auditor.

B. Partnering clients :


In addition to assisting clients during course of audit, many
auditors partner clients in many other ways: For example, clients face
difficulties in understanding the implications of new accounting standards and
therefore, get delighted when auditors play a pro-active and partnering role.
Thus, when AS-30 was introduced, many clients were not conversant with the
complex requirements. Auditors provided the much-needed knowledge on how to
comply with the requirements relating to ‘hedge accounting’ including
documentation requirements. Clients were advised what needed to be done right
from the beginning, so that they understood the key aspect of ‘hedge
accounting’.

Many auditors recognise the importance of keeping clients informed on all major developments in terms of new laws and accounting requirements, etc. that impact companies in general and a client in particular. As a result of this communication, auditors develop a relationship that results in a ‘no surprises’ audit. This is because, most contentious issues are discussed and resolved prior to year end, particularly with the top management to ensure that nothing is taken to the audit report as a ‘matter of qualification’. All issues that have a reporting implication are discussed well in advance and remedial action taken to ensure closure of issues. It is possible that even after all this, the auditor may decide to go ahead with a qualification in his report. But, this will be seen as clearly the last alternative, as opposed to a feeling that ‘not all options were explored’.

In the past few years, many medium-sized companies have been entering into M & A transactions, collaboration agreements and royalty agreements, etc. These are out of the ordinary transactions and involve complex accounting and other issues where the auditor can play an important role. Many auditors provide clients that are in the process of entering into such transactions, ‘on line’ accounting and other advice, so that accounting implications that have a significant bearing on the transaction can be taken into account before finalising the transaction. Also, it would provide the client with comfort that these transactions will not be subject to accounting review at the year end, since they are already ‘agreed upon’ with the auditors.

Similarly, audit of transactions on a quarterly basis, asking for confirmation of balances during the year or a date close to year end date (without diluting the effectiveness of the audit procedure), etc. are some of the ways in which significant value can be added.

C. Adhering to client deadlines, targets, etc. :

Many auditors believe in the importance of adhering to client deadlines in terms of finalising the accounts. Invariably, board meetings for adoption of accounts are fixed well in advance and cannot be postponed except at great embarrassment and heartburning. In such cases, auditors discuss the entire schedule to finalisation well in advance with the client to ensure that a timeline is drawn up that is adhered to by both parties. In case the timeline is very aggressive, the matter is taken up with management immediately and conveyed. Even in such cases, clients are asked to draw up a schedule to demonstrate that the timelines are workable and realistic. Once agreed upon, there is no question  of ‘backing  out’  at the  last moment.

Fixed timeline audits invariably lead to many arguments and heartburning because the schedule is not adhered to and the ‘blame game’ starts with the auditor invariably being held responsible for the delay. Auditors therefore maintain a very pro-active and open communication with the client where, any potential problems are escalated and thrashed out in advance only, to avoid the blame game. Auditors foresee such issues well in advance and discuss the issue with the client in an open and free manner to save on the ‘last minute’ surprises.

D. Conflict    resolution:

Auditors who do not adopt the ‘Compliance Auditor’ mindset adopt a very positive attitude towards conflict resolution. By adopting an attitude where ‘solutions need to be found if they at all exist’ as opposed to ‘how can solutions be found in such cases’, auditors go beyond the compliance approach to partner clients on a very pro-active basis and in the process add significant value. The auditor perceives his role not merely as a ‘compliance officer’ whose job it is to find mistakes, errors, deviations from accounting practices and non-compliance with law, but looks at such issues with an open mind to ascertain whether solutions exist, before reporting them to the members.

Most auditors believe that finding solutions to problems is not their ‘business’, whereas clients feel delighted when auditors perceive their role as ‘solution finders’ and not merely, ‘fault finders’. As a result, clients see great value even in cases where the auditor is constrained to report such deviations, etc. in his audit report.    .

E.  Mentoring and knowledge sharing:

An auditor gathers Significant amount of business knowledge during the course of audit. In many cases, such knowledge does not get shared and is a waste. However, many auditors share the knowledge they have acquired during course of audit by way of communication to audit committees and boards. In addition to sharing knowledge gathered by him, management letters containing areas of cost reduction, better compliance, etc. are high-lighted and discussed with the client together with a clear plan of action to avoid recurrence. Clients also feel delighted with auditors who identify areas which help remedy faults from recurring. In the process, the auditor adds value that goes beyond the ‘compliance function’.

F. Conclusion:

Adopting the right attitude towards the audit function and working beyond self-imposed constraints are options that are clearly available to the auditor without compromising on any of his duties and responsibilities as the auditor. Auditors need to recognise that playing the role of the ‘compliance officer’ does not mean putting a fetter on one’s ability and attitude towards the role. In fact, the auditor invariable gets an opportunity to play a pro-active, positive role in terms of partnering the client. Assisting the client improve upon his stakes is the best way to transform. As a matter of fact, the only way to transform is to play an active role in helping and mentoring clients change for the better.

If audit is to be given the right place and value, auditors, companies and other institutions need to work towards getting audit its rightful place and that is, it is one of the most valuable and insightful functions that is awarded to an ‘outsider’, who is provided with an opportunity to look at various transactions entered into by the company in a systematic and insightful manner, evaluate at times business risks in addition to various aspects of internal control including assessing the ‘tone at the top’ that is set by the management in the course of business.

The profession of accountancy and audit is on the threshold of significant changes in the wake of the business failures that we are witnessing by the day across the world and if it has to serve its role effectively, it will need to get rid of the shackles it has put itself under and work towards expressing itself constructively, in a pro-active manner. An auditor should work as a partner to the business by communicating to the audit committee, the board and the management in a timely manner on all important issues of which he has gained knowledge during course of audit.

Lastly, the ICAI has embarked on a massive project aimed at making the entire accounting framework IFRS compliant, by 2011. Auditors have been provided with the most valuable opportunity to assist clients in this process in several ways without, at the same time, getting conflicted out. Auditors of companies have already started advising companies what the implications are and what the impact would be in the year of transition. Companies are therefore delighted that auditors have become very pro-active and this augurs well for the profession.
 
‘Auditing Beyond Compliance’ therefore is largely, a mindset issue and auditors really need to embrace change to become more relevant to their clients by adopting a more proactive, constructive and ‘partnering’ approach towards clients. The challenge before the auditor is to become the client’s trusted advisor and partner, without losing out on ‘independence’.

Fair Value Accounting

Article

Fair value accounting is a concept that has attracted
worldwide debate as to its appropriateness in financial statements. Terms such
as ‘mark to myth’ and one based on judgmental aspects which tend to demean the
very concept of prudence are slated as arguments for the same. It is also true
that most of the criticism comes from the ‘old guard’ who have always
believed that historical cost is one of the most verifiable concepts in
accounting. The fact is that the world has moved on and fair valuation is a
measure by itself. The accounting profession needs to wake up to this reality
and take necessary steps to make sure fair valuation (now a big element of the
‘true and fair’ opinion) is well understood. Our profession needs to be well
equipped to make sure we use it appropriately and not expose it to abuse the way
it is feared to be.


The issue is : what is Prudence. ‘Prudence is the
inclusion of a degree of caution in the exercise of the judgments needed in
making the estimates required under conditions of uncertainty, such that assets
or income are not overstated and liabilities or expenses are not understated.
However, it completely ignores assets or liabilities that expose an entity to
market-related risks. The issue is : Is that prudent ? Especially in today’s
times when in free markets, entities are exposed to market risk (intentional or
unintentional).


Fair value accounting envisages accounting for unrealised
gain to reflect a ‘true and fair’ view of the state of affairs.

Fair valuation has brought to the notice of an investor the
true profits in companies like Enron, WorldCom and Waste Management in
the past and a host of financial services companies in the current credit market
meltdown. This is mainly because over the years, the masters of business have
been under acute pressure to show results and the masters of finance have helped
them achieve it at any cost. This has led to the use of financial and other
instruments in our financial statements, making fair valuation a very important
aspect of today’s financial statements. Also, the use of derivative instruments
has been genuinely necessitated as we globalise businesses and as countries open
up to free trade.

Let’s now examine what are the flaws with fair value
accounting. The biggest issue to fair value is that of illiquidity and its
related concern that in both boom and bust time market values are not
real. Firstly, India does not have any traded benchmarks except government
securities, and secondly, over-the-counter products are very difficult to
measure. Accordingly, we prefer not to record any perceived market losses unless
we believe they are permanent. Gains are a complete no unless realised.
Unfortunately we judge losses with the same parameters as we assess gains, but
only record the former should the diminution be permanent. How fair is that from
a ‘true and fair’ perspective ?

The reality is that companies have certain investments of a
permanent nature (HTM held to maturity) and some of a trading nature (short-term
investments or positions taken which do not actually hedge any underlying
transaction). The former is normally treated as a long-term asset where
values would be realised over the period to maturity with any diminution being
recorded should there be a perceived risk. The trading assets and
derivates which do not necessarily hedge an underlying transaction are
effectively hexposures to market risk and hence, are not intended to be held to
maturity. Accordingly, these should be marked to market at any accounting period
to bring into the results and perceived gain or loss from the asset. The fact
that such gain is permanent or temporary is not of concern. The financial
statements should reflect the results of the market risk position taken by an
entity. Our legacy accounting principles completely ignore this concept, as
these did not exist in India until the recent past when our economy opened up as
part of our reforms.

Another example where we completely ignore fair valuation is
in while recording debt with equity conversion features. We seem to
completely ignore the optionality to convert in financial statements
today. And the only way to record these is through fair valuation. Take FCCBs
for instance. Our corporates have been recording the FCCB as if the conversion
is not an option but a definite event. In the present situation where stock
prices have fallen and conversions are unlikely to happen, companies are faced
with cash redemptions and huge back-ended interest costs. Fair value accounting
would have valued the options at fair value and treated the balance as a debt.
The option value would tend to become zero near redemption should conversion
price and market price of stock converge. This would ensure an equitable profit
or loss and the optionality clearly being recorded on the balance sheet. Our
traditional cost system records the consequence of conversion as an unlikely
contingent event which ends being ignored by investors and analysts alike.


A key understanding that most accountants, bankers and CFOs
alike tend to get confused with is the difference between hedging and hedge
accounting. This is where most transactions get confused as hedges and hence are
not fair valued. Hedging is a dynamic measure where a decision-maker consciously
performs a correlation exercise to identify how an underlying market risk can be
hedged. Hedge accounting is a measurable principle which provides
guidelines as to when a derivative instrument can be regarded as a hedge to an
underlying. For example, if someone sees a correlation between the price of
apples and the price of oil, he could effectively buy oil futures to hedge
against moving apple prices. That would make his P&L immune should his
hypothesis be correct. However, this would not qualify for hedge accounting as
it may not meet the criteria of commonality of risks. However, if the hypothesis
is true, then whether hedge accounting is followed or not, the impact on the
profit and loss account would be similar.


We also seem to have mixed issues of fair value accounting with capital adequacy norms (especially in the financial services sector). The issues revolve around certain companies not reflecting pension costs in line with AS-15 or transferring of securities initially purchased as trading to HTM. These are artificial coverages to maintain adequate capital. However, there should be a distinction made in special situations between regulatory and financial capital adequacy. We tend to break or amend the financial thermometer, but do not succeed in improving the health of the patient. Instead we make the doctor’s task more difficult as the problems do not go away through accounting solutions.

Having considered fair valuation as a bane in most situations, India is possibly one of the few countries which allow asset revaluations which completely goes against the historical cost concept or prudence and is a way to fair valuation of assets provided the increase is of a permanent nature (which only restates balance sheets at replacement costs, a completely unverifiable proposition). However, as this is an age-old practice we continue it.

While it is easy to point the faults inherent in fair value accounting, it is less easy to identify an alternative method which would better fulfil the features of relevance, reliability, comparability and understand ability . Reference to historical prices would provide less comparable and much less relevant information given that the company itself views the underlyings at fair value (e.g., options). Illiquid financial instruments are a challenge, but even there the idea of reducing the scope of fair value has not resulted in credible options. An al-ternative is to ‘mark to model’. Models have been widely used and may aid transparency if backed by detailed disclosures about underlying instruments and mark to model assumptions.

Another issue debated is the relevance of fair valuation in the present markets. Should assets be marked down to reflect losses as these are not the values at which companies may sell? My own argument is that if a company sold its assets at the balance-sheet date, fair value is what it would receive for the assets, regardless of whether such values are artificially low in current markets. Irrespective of the company’s intention to hold this until markets improve, the lack of liquidity in current markets can, and has, forced companies to sell assets at these ‘artificially’ low values. In the current market situation, any accounting which fails to highlight liquidity risk in the way that fair value accounting does, would fail to capture the risk appropriately. Fair value accounting reflects the reality that investors are faced with as far as trading assets are concerned.

In the final analyses, fair value accounting as prescribed internationally and in AS-30 can best be described in the same breath as Churchill’s portrayal of democracy, “It’s the worst system with the exception of all others”. Though there is a lot of judgment involved and there is enough potential to abuse it especially in an illiquid environment, there is a lack of any other credible alternative. Though there is a need to have a vigorous debate around fair value, the fact remains that as a profession we need to. clearly understand the concept and see how we could challenge the interpretations taken by our industry and banking colleagues.

Desirable?

Article

We are heading towards full convergence of the Indian GAAP
with the International Financial Reporting Standards (IFRSs) subject to certain
small exceptions. Otherwise also, the recently issued accounting standards are
based on either the corresponding IFRSs or the International Accounting
Standards (IASs). Thus, the process of convergence has already begun. The chief
reason given for such convergence is that in a globalised economy and with
investors in all countries looking for outbound investments, it is desirable
that corporations the world over follow the same set of principles in preparing
their accounts. Another area of concern is that the present accounts fail in
disclosing strength or weakness of a corporation, as the figures in financial
statements, in most cases, represent ‘cost,’ which has hardly any relevance in
times of changing values.


The conceptual difference between the accounts under IFRSs
and under the Indian GAAPs is that in many instances (except in the case of
inventory, where the age-old principle of ‘lower of cost or net realisable
value’ will continue to apply) the figures in accounts under the IFRSs will be
reported on the basis of ‘fair value’ of the items, whereas such items by
and large are reported at present at ‘cost’, unless the fair value happens to be
lower than the cost — for example — investments. The fair value concept demands
that if an item has appreciated in value over its cost, the appreciation will be
recognised and if it has declined in value, the decline will also be recognised.
Thus, basically, the fair value-based accounting amounts to abandoning the
concept of prudence — that is — unrealised gains are not to be accounted.

The question is : should India fully converge with IFRSs and
adopt fair value as the basis of accounting in place of ‘cost’ ? The answer
depends on the following discussion.

First, let us see reasons that are in favour of ‘cost’
forming the basis of accounting. ‘Cost’ of an item can be computed with
reasonable certainty. Cost of an item may comprise elements like cost of labour,
material, finance charges, etc. It is possible that different corporations may
define ‘cost’ differently for the purpose of accounting an item. However, once
‘cost’ is defined by a corporation for a particular purpose, it is uniformly
adopted for all purposes. All elements of cost would be such as have resulted in
an outgo of resources or in creation of an obligation if there is no immediate
outgo of resources. In short, cost of an item is by and large a figure arrived
at objectively. Such cost yields itself to verification and to its reliability.
Thus, the accounts presented under the cost-based accounting are
reliable.

Let us also see the reasons that represent weakness of the
cost basis of accounting. The most significant weakness of such accounting is
that it fails to reflect ‘changing values’ and fails to account for inflation
(or deflation) in the value of currency. Because of such weakness, it is argued,
accounts fail to reflect strength or weakness of a corporation and fail to yield
to comparison with the accounts of another corporation. This weakness is real.

Let us examine the technical soundness of the conceptual
aspect of the IFRSs. As seen above, the IFRSs are fair value-driven unlike our
present conservative approach to accounting displayed in the principle of ‘lower
of cost or net realisable value’. IFRSs require write-up of financial assets of
trading nature if their fair value exceeds the cost just the same way as they
require such assets to be scaled down if the fair value drops below the cost.
This is quite in contrast to the principle of ‘prudence’, which so far formed
the basis of accounting policies and standards.

Thus, fair value-based accounting does remove the above
weakness of cost-based accounting. Hence, accounts under the ‘fair value’ basis
will show the present value of a corporation representing the changing values of
assets, and may therefore, be more useful to users. It is argued that accounts
prepared on ‘fair value’ will be more realistic as they reflect the correct
value of a corporation.

However, the major weakness of the fair value-based
accounting is that such accounts will depend a lot on valuation of assets. Value
of an asset is determined by an open market if the asset is freely traded there,
or arrived at on the basis of such valuation models as accountants and valuers
use, or a combination of both. Fair value accounting implicitly assumes that
such value is the correct value of the asset. It is questionable whether this
implicit assumption is correct. Valuation of an asset involves a good amount of
individual skill, the making of a number of assumptions, forecasting future,
using several valuation models and accepting value arrived at under one method
or accepting an average of values arrived at under different models. Only the
naïve can be convinced that such valuation is objective as there will be a
good deal of subjectivity involved in the process of valuation.
Any valuation necessarily involves looking into the future, making assumptions,
and the terms ‘future’ and ‘uncertainty’ are synonymous. No two individuals,
astrologers included, foresee the future in the same manner. When we contemplate
the large numbers that the accounts of modern corporations contain, we can
understand the significance of a small error, intentional or otherwise,
committed in arriving at fair value of items and its impact on the truthfulness
of accounts.

If accounts adopt values discovered by an open market wherever that is possible, for the purpose of preparation of accounts, the scenario may look better than the one under which value is determined by one or more valuers. However, it is also a myth that the value discovered by the free market is always ‘true value’. In fact, the way the markets behave one may wonder whether there is at all any thing like ‘true value’, especially in the context of financial instruments whose accounting will be greatly impacted under the ‘fair value’ accounting. Stock exchanges are the epitome of free markets and continually strive to discover value of securities. But high degree of volatility in the market makes the whole exercise speculative. Falls in the share market witnessed recently the world over exploded into smithereens the myth of reliability of market valuation. If one studies the recent market trends world over, one might think that the present times are ripe to abandon ‘fair value’ accounting and revert to prudence and cost-based accounting. I repeat recent market volatility should serve to establish the weakness of the ‘fair value’ accounting.

I believe ‘fair value’ accounting makes accounting subjective and financial statements prepared on the basis of subjective criteria hardly inspire confidence. Such accounts offer a great scope for manipulation at times with mala fide intentions. The hope that auditors willdetect such manipulations willalso prove to be a myth, not because auditors do not do their job but because auditing has its own limitations which the society and the users must recognise. We must admit that with the introduction of accrual basis of accounting we had introduced some degree of subjectivity in accounting especially whilst making provisions. Still, by retaining ‘cost’ as the basis of accounting coupled with prudence we have succeeded in eliminating much of subjectivity in the accrual system of accounting. We have been able to produce by and large reliable accounts. Fair value-based accounts will raise doubt about the reliability. As fair value-based accounts are deemed to be more relevant than cost-based accounts, it appears reliability is taking a ‘back-seat’ to relevance. The issue is : should this happen, is it good for business?

Let us also see whether the fair value-based ac-counting completely serves the purpose which it avowedly professes to serve. It is said that such accounting will help determine the true value of a business, which, in accounts prepared under the cost-based accounting is not possible. However, this argument in favour misses one vital point : that the value of a business is not only a function of the value of its assets, but is also a function of intangible assets including human resources, which are mostly off-balance sheet items. Hence, these two vital elements, namely, intangible assets and human resources, which influence the value of a business, still remain outside the books of account. Let us not forget that value of business is a perception. It is at times the price paid to enter the market to eliminate competition or acquire market share.

Though the fair value-based accounting has its advantages, like any other method of accounting may have, it is a question whether the fair value should form the basis of accounting replacing the cost as a concept. Fair value-based accounting may satisfy one group of readers of accounts, but it may throw up several issues of far greater significance. For example, balance sheets and income statements prepared under the fair value-based accounting will still have to be certified as being true and fair. May be such accounts are relevant for a purpose, yet it will be difficult to say that they are reliable. We need to decide what we want: relevant accounts or reliable accounts; I am of the opinion that reliability should not be sacrificed. However, to make financial statements more relevant all that is necessary is to require managements to provide on the value of assets including intangibles. The managements should also be required to disclose all off-balance sheet liabilities. The analysts and the investors I am sure would know how to make use ‘of this information. I don’t think we should play with the reliability of financial statements. In any case, no big investments in corporations are made without undertaking what is known as ‘due diligence’ exercise. Therefore, at the time of such exercise, all required information can be elicited from the management.

To sum up, fair value-based financial statements being highly subjective, are a myth open to manipulation for ulterior purposes. The age-old concept of ‘true and fair’ is in jeopardy. I don’t think, business and the profession should take or accept the ‘risk’ – risk of manipulation. Let us stick to prudence and reliability.

Good Bye Prudence

Article

‘I think it is hard to argue with the conceptual merits of
fair value as the most relevant measurement attribute. Certainly, to those who
say that accounting should better reflect true economic substance, fair value,
rather than historical cost, would generally seem to be the better measure’.


[Robert Herz, Chairman of the Financial Accounting Standards
Board in CFO Magazine, February 2003, page 40, quoting from a speech at a
conference of Financial Executives International].


‘I know what an asset is. I can see one, I can touch one, or
I can see representations of one. I also know what liabilities are. On the other
hand, I believe that revenues, expenses, gains, and losses are accounting
concepts. I can’t say that I see a revenue going down the street. And so for me
to have an accounting model that captures economic reality, I think the starting
point has to be assets and liabilities’.

[Thomas Linsmeier, Member of the

Financial Accounting Standards Board,

in “Will Fair Value Fly?” on CFO.com,

September 20, 2006].

1.1 ‘Accounting concepts’ have evolved over time and
therefore ‘accounting’ is commonly referred to as being an ‘art’ rather than
‘pure science’. Hitherto, financial statements were commonly prepared in
accordance with an accounting model based on ‘historical cost’. However,
times have changed, and there has been a conscious move to the ‘fair value’
model, driven by expectation gaps that historical model caused.

1.2 It needs to be noted that even under existing standards,
some account balances are determined using ‘some sort of fair valuation’, for
example, provision for doubtful debts or diminution in the value of investments
and inventories. But going forward, in the changed scenario fair valuation
principles are expected to be applied more extensively in the preparation of
financial statements. India will be adopting International Financial Reporting
Standards in 2011 and the Institute has notified AS-30 and AS-31, which are
extensively fair value driven.

2.1 Among the questions being debated are : How fair is
fair value ? How does fair valuation measure up on the principles of
relevance and reliability ? How easy is it to audit fair value ? How will
fair value accounting work in practice and what are the implications for
performance measurement ? Furthermore, the profits arising from value changes
may not have been realised, and recognition of unrealised gains goes against
the traditional prudent approach to accounting. Worse, if the unrealised
gains get distributed as dividends, it may create major liquidity and
going-concern issues. This article is an attempt to provide a balanced
assessment of this controversial and multifaceted topic.

2.2 The IASBs Framework for the Preparation and
Presentation of Financial Statements adopted by the IASB in April 2001
stated that the objective of financial statements was to provide information
about the financial position, performance and changes in financial position of
an entity that is useful to a wide range of users in making economic decisions.
As per the Framework, the four principal qualitative characteristics ‘financial
statements’ should have are ‘understandability, relevance, reliability and
comparability’. Other qualitative characteristics are
materiality, faithful representation, substance over form, neutrality,
prudence and completeness. The Framework is now under revision. In the
Exposure Draft, relevance and faithful representation are identified as key
characteristics. The enhancing qualitative characteristics are comparability,
verifiability, timeliness and understandability. Interestingly, prudence and
reliability do not find any place in the proposed revised
Framework.

2.3 The International Accounting Standards Board (IASB) has
given significant importance to fair valuation in IFRS. IASB’s new and revised
standards are based, to a great extent, on an accounting model that focuses on
fair valuation for recognition, measurement and disclosure of assets and
liabilities and that income and expenses are determined by reference to
increases and decreases in assets and liabilities, rather than the reverse, as
in the case of the historical model. Besides financial instruments, other
standards that require use of fair valuation include business combination,
employee compensation, share-based payments, impairments, intangibles,
biological assets and investment properties.

2.4 However, at this point in time fair value is definitely
not well defined even in IFRS standards, and the determination of ‘fair
value’ can be highly subjective. Though many IFRS standards require fair
valuation, there is no single standard that prescribes how to determine ‘fair
value’. Some argue that in the preparation of financial statements, IASB has
placed too much emphasis on ‘relevant information’ and has given
inadequate consideration to reliability and understandability. The danger
to relevance, reliability and comparability of financial statements using
calculated, hypothetical, non-market-based fair values was well illustrated in
an exercise conducted by an accounting firm to determine ‘employee stock
option charge’. By making changes to the input variables, all within the
allowable parameters of IFRS, option expense as a percentage of reported income
could vary as much as 40% to 155%.

2.5 Worse still, current IFRS standards include a variable
blend of both historical cost and ‘fair value’ measurement, for example :

  •  assets held to maturity are accounted on the basis of amortised cost, if held to maturity intention is demonstrated.

  • changes in ‘fair value of ‘assets available for sale’ are recognised in equity, whereas in the case of trading assets, the ‘fair value’ changes are recognised in the income statement.

  • hedge accounting brings in the matching concept, so that fair valuation volatility is contained. Therefore in the case of hedging, fair value changes in a derivative are not immediately recognised in the profit and loss

  • account, but matched with future changes in the fair value of the hedged item.
  • both cost and fair valuation approach is permitted for investment properties. If the fair value model is applied, the changes in fair value are recognised in the income statement.

  • only the fair value approach is followed in )-the case of biological assets, with changes in fair value recognised in the income statement.

  • fixed assets are accounted either by applying the cost model or the fair valuation model. If fair value model is used, the changes in fair value are not recognised in the income statement, but are recognised in a reserve account.

  • intangible assets are predominantly accounted for using the cost approach with the fair value approach allowed only in the case of a few intangibles that have a ready market

2.6 With this hotchpotch, the understand ability prerequisite of financial statements prepared under IFRS has been compromised. Users are likely to be confused as financial statements have become an aggregation of apples and oranges.

3.1 We will now seek to understand the difference between ‘historical cost’ and ‘fair value’ accounting, how they measure up to the qualitative characteristics identified in the Framework and why prudence and reliability have lost their relevance in the changed scenario. Other alternative accounting models are: current cost, reproduction cost, replacement cost, net realisable value, value in use and deprival value. However, this article is restricted to a discussion between the historical cost and fair value approach.

3.2 Under historical cost, assets and liabilitiesare recorded at historical cost, followed by amortisation or depreciation. On the other hand in the ‘fair value’ model, assets and liabilities are recorded at the amount for which an asset or liability could be exchanged between knowledgeable and willing parties in an arm’s-length transaction. Historical cost gives no consideration to recoverability. It is only a measure of the amount expended. It has been observed that the value of an asset is represented by the future economic benefits expected to flow. The historical cost of an asset lacks this attribute, and therefore it must be supplemented by a measure of recoverable value to meet the ‘true and fair’ test. This aspect has been partly taken care of by requiring an impairment provision when recoverable amount falls below the historical carrying amount.

3.3 Some argue that a presumption of recoverability is implicit in the historical cost and amortisation, because it can be generally presumed that an entity will not pay more for an asset than it believes to be its value either in use or sale. However, the belief of asset cost recoverability may reflect entity-specific expectations that mayor may not be reasonable, and supported by observable evidence.

3.4 In contrast, ‘fair value’ stands on its own as the value could be exchanged between knowledge-able and willing parties dealing at arm’s length. Hence, the value of probable future economic benefit is reflected in the ‘fair value’. Further, ‘fair value’ of an asset needs no additional assessment of recoverable amount, because ‘fair value’ repre-sents the market’s measure of its recoverable value.

3.5 The historical cost-based accounting is premised on ‘cost-revenue matching’ objective. The ‘cost-revenue matching’ objective’ has its roots in the economic premise that costs are generally incurred to earn revenue. Business entities are set up with the objective of transforming various inputs of goods and services into outputs that can be sold for revenues that exceed the cost of inputs. The traditional accounting objective has been to recognise the cost of an asset as an expense when the revenues to which the asset is considered to contribute are recognised. Net income is then measured on the basis of matching costs with related revenues.

3.6 This traditional matching objective has undergone significant changes. It is now well accepted that an input must meet the definition of an asset to warrant capitalisation and that its cost should be carried forward only to the extent that it can be considered to be recoverable from future cash-generating activities or sale. Further, the market-place is the final arbiter in determining the recoverable value of an asset.

3.7 To carry forward an asset at historical cost that differs from its fair value results in wrong in-formation being given in later periods when the asset is ultimately realised (through sale or use) and would be violative of the basic accounting principle of cost matching revenue. It is reasoned that carrying an asset at ‘fair value’ is actually in line with the concept of ‘true and fair’.

3.8 Further, historical cost concept is not for-ward looking. In comparison, ‘fair value’ of an asset embodies market expectations and helps users to evaluate the risk and volatility dimension. In addition, financial disclosures that use ‘fair value’ provide investors with insight into prevailing market values, thereby enhancing the usefulness of finan-cial reports.

3.9 It is axiomatic that it is better to know what something is worth now than what it was worth at some time in the past. . . Historic cost data is never comparable on a firm-to-firm basis, because the costs were incurred on different dates by different firms or even within a single firm.

3.10 Today, investors are concerned with value, not costs. ‘Fair value’ accounting would in principle lead to better insight into the risk profile of the financial entities than is presently the case, more so in the light of the requirement to move many relevant off-balance sheet items onto the balance sheet. Financial stability could benefit if shareholders, uninsured depositors and other debt holders are in a position to readily identify a deterioration in the safety and soundness of an entity. In fact, their reactions either by directly interfering in managerial choices or by exiting from the investment could put pressure on the entity’s management to take early corrective action.

3.11 ‘Fair value’ accounting is timely because it brings economic reality into the balance sheet. With growing concern on ‘going concern’ of entities, a balance sheet prepared on ‘fair value’ basis will provide more relevant information as compared to a balance sheet prepared on outdated historical cost.

3.12 ‘Fair value’ balance sheet is a better representation of the net worth of an entity’s financial position than compared to a historical model. ‘Fair value’ measure of assets and liabilities is attractive because it meets many of the Framework’s qualitative characteristics of useful financial information. ‘Fair value’ can also be viewed as a better presentation of stewardship, as fair values are essential for determining performance ratios such as return on capital employed.

3.13 ‘Fair value’ of an asset or liability depends only on the characteristics of the asset or liability and not on the characteristics of the entity that holds the asset or liability or when it was acquired. ‘Fair value’ is a market-based measure that is not affected by factors specific to a particular entity; accordingly it represents an unbiased measurement that is consistent from period to period and across entities.

3.14 ‘Fair value’ is a solution to the accountant’s problem of income measurement: In accordance with the widely-accepted Hicksian definition of income is ‘a change in wealth – the change in fair value of net assets on the balance sheet yields income’. Hence, ‘fair value’ measure is to be preferred to the hundreds of rules underlying historical cost income. The issue is – how do we take control of the reported numbers out of the hands of corporate management? We do it by requiring that assets and liabilities be reported at ‘fair value’.

3.15 Whilst one could debate the use of fair valuation for non-financial asset and liabilities, there is little debate as regards valuation of financial assets and liabilities. The issue really is : how does one use historical cost to value stock options or derivatives ?

3.16 ‘Fair value’ seems to be the only basis for valuing financial assets and liabilities. FASB be-lieves:

  • ‘fair value’ for financial assets and financial liabilities provides more relevant and under-standable information than cost or cost-based measures.

  • ‘fair value’ to be more relevant to financial statements users for assessing the current financial position of an entity, because fair value reflects the current cash equivalent rather than the price of a past transaction.

  • with the  passage  of time,  historical  prices become irrelevant in assessing an entity’s current financial position.

3.17 In case there is a well-defined and liquid market, defining ‘fair value’ is not problematic. However, for illiquid assets or liabilities it may be necessary to use a model to derive ‘fair value’, such as one based on the present value of ‘future cash flows’. But model’s assumptions, such as the r relevant discount rate, may vary widely between in-stitutions and types of assets/liabilities and such variations raise questions about reliability. As a result, some opponents of ‘fair value’ suggest that:

  • ‘model’ can only sensibly be used in relation to items for which there exists an efficient market.

  • ‘model’ at times may fail the ‘consistency and comparability’ test.

  • value based on internal models will have implications for the auditors, as their verification is dependent upon accepting the logic underlying the model.

3.18  The counter argument is that even if there is a degree of potential unreliability as to the values, they are still useful to decision-making, because they represent economic reality as opposed to an accounting ‘fiction’ in the form of historical cost. A ‘fair value’ based balance sheet is a better representation of the net worth of an entity than one based on historical cost.

4.1 Having considered the superiority of fair valuation over the historical model, now let’s look at the pitfalls of fair value. Clearly ‘fair value’ is not a panacea for all ills. At this point in time ‘fair value’ methodology is definitely not well established in IFRS or US GAAP, and the determination of fair value can be highly subjective. In the absence of any specific guidance, ‘fair value’ raises a number of issues, such as:

  • What should be the level of unit at which fair value is determined ?
  • Whether market price will be adjusted be-cause of size?
  • Whether block discount or block premium are considered for determining fair value?

  • Whether fair value would be the entry price or exit price ?
  • Which market is the most advantageous or principal market considered for determining fair valuation?

  • How are transaction costs treated for deter-mining fair valuation?

  • Should fair value measurement assume the highest and best use of the asset by market participants even if the intended use of the asset by the reporting entity is different?

  • Where quoted market price is not available, which valuation technique is appropriate: should it be the market approach, cost approach or income approach?

  • Within the various valuation techniques, how are the various assumptions made, for ex-ample, if the income approach is used, how would the cash flows be discounted to present value and risk adjusted for uncertainty?

  • What is to be done where market inputs are not available, for example, the credit worthiness of a home loan portfolio.

4.2 The term ‘Fair value’ implies active and liquid markets with knowledgeable and willing buyers and sellers and observable arm’s-length transactions – not values calculated on the basis of hypothetical markets, with hypothetical buyers and sellers.

4.3 ‘Fair value’ also increases the risk of misunderstanding on the part of existing or potential investors. ‘Fair value’ might be the realisable market value, but it will not necessarily equate to the market value of the entity because of the existence of internally generated goodwill or other intangible assets. It cannot be denied that ‘Fair value’ brings balance sheet value closer to the market value. However, using fair values for decision-making remains relatively difficult, but probably less difficult when compared to the historical model.

4.4 In the absence of market value, a surrogate has to be used by regarding a mathematical calculation of a hypothetical market price as a fair value. This is illustrated in the following ‘fair value hierarchy’ that has been developed by the US FASB and embraced by the IASB. This indicates the process that should follow for determining ‘fair value’ :

4.5 The reality is that a Level 3 subjective assessment will be required to measure ‘fair value’ in many situations. This will apply to intangible assets acquired in a business combination, unquoted equity securities, equity securities quoted on illiquid markets, derivatives, pension costs, provisions for share-based payments, asset revaluations, impairments and biological assets during the growth phase.

4.6 The fundamental question is whether such hypothetical amounts are sufficiently understandable, reliable, relevant and comparable for financial reporting.

1.    Do the users understand how hypothetical and subjective ‘fair value’ can be?

2.    Can valuations that are not independently verifiable be considered reliable?

3.    Is information that is not reliable, relevant in the world of financial reporting?

4.7 ‘Fair value’ measurement models have been developed for some contractual assets and liabilities especially financial instruments. There seem to be fewer prospects for developing reliable fair value measurement models for non-contractual assets that are inputs to revenue-generating processes – assets that do not generate cash flows by themselves, but contribute along with other inputs to a cash-generating process – can present significant fair value measurement problems when there are no observable market prices for identicalor similar assets, for example, an equipment that is configured for a specialised use. It could be concluded that realisable value in the marketplace is nothing beyond its value as scrap, or the market value of unspecialised equipment less estimated costs to restore to its unspecialised condition. This view presumes that the market does not attribute any value to use. This would be an unreasonable presumption.

4.8 The reliability of fair value estimates is de-pendent not only on how well a model replicates accepted market pricing processes, but also on the reliability of data inputs and assumptions that marketplace understands – for example – data inputs required by ‘accepted stock option’ pricing model includes the current price of the underlying stock, the volatility of that price, the effects of vesting provisions, and the risk-free interest rate for the expected life of the option. The market prices of certain of these inputs can be readily observed, for example, the risk-free inter-est rate can be derived from the price of government bonds and the current price of the underlying stock can be observed if it is traded in a market. The market’s measure of some other inputs may not be so readily determinable, for example, the effects of vesting provisions and the appropriate measure of volatility. Further, the measure of volatility on pricing an option is commonly based on past volatility, which may not be fully indicative of future volatility. Consistency of such data with market expectations requires careful evaluation in the context of the particular circumstances and disclosure of the basis of such data, underlying assumptions and the extent of measurement uncertainty. It may not be out of place to quote Warren Buffet, who feels that ‘marking to market’ has changed to ‘marking to a model’ but is actually ‘marking to myth’.

4.9 As many assets and liabilities do not have an active market, the inputs and methods for estimating their fair value are subjective making ‘fair’ valuation less reliable. Federal Reserve research shows that ‘fair value’ estimates for bank loans can vary greatly depending on the valuation inputs and methodology used.

4.10    Banking  regulators    have observed  that  minor  changes in the  assumptions in a pricing model can have a substantial impact  and reliability can be a significant concern. However, FASB feels  that reliability can  be  significantly enhanced  if market inputs are used whilst valuing.

However, because management uses significant judgment in selecting market inputs when market prices are not available, reliability will continue to be an issue. Management’s use of judgment bias – whether intentional or unintentional in the valuation process, may result in inappropriate fair value also resulting in misstatement of earnings and capital. This is the case in the overvaluation of certain residual tranches in securitisations in recent years in the absence of active market. Significant write-downs of overstated asset valua-tions have resulted in the failure of a number of entities operating in the financial market.

4.11 It should be clear that the date and purpose of valuation is critical in establishing a ‘fair value’. A valuation determined at a particular point in time generally should not be relied upon for value on any other date. In the same vein, a valuation made for a particular purpose may not be appropriate for another purpose. Moreover, given the current state of the art, particularly with regard to credit risk models, reliability of financial statements could be negatively affected as fair values do not always convey precise information regarding an entity’s risk profile. Misjudgement can trigger overreaction, which can have a negative impact on the valuation of an entity.

4.12 We continue to read stories about earnings manipulation under the ‘historical cost’ model. The author believes that in the absence of reliable fair value estimates, the potential for misstatements in financial statements prepared using fair value measurements is greater. Moreover, valuations that are not based on observable market prices but on management judgments will be difficult to audit.

4.13 Volatility in earnings is another constant argument one hears against fair valuation.

1.    For assets and liabilities held to maturity, the volatility reflected in the financial statements is artificial and misleading as any deviations from cost will be gradually compensated during the life of the financial instrument, ‘pulling the value to par’ at maturity.

2.    An excessive reliance on fair values, including non-actively traded assets on illiquid secondary markets run the risk of embodying ‘artificial’ volatility, driven by: short-term fluctuations in financial market or caused by market imperfections or by inadequate de-velopment of valuation model.

4.14 The counter argument is that financial in-stitutions may have an incentive to take proactive measures in order to prevent this from occurring, by building additional reserves and thereby increas-ing their resilience in case certain binding finan-cial ratios are exceeded (e.g., capital requirements or ratios used in loan covenants that could trigger actions such as repayment).

4.15 Increased volatility is not necessarily a problem if investors correctly interpret the information disclosed. In particular, market analysts and institutional investors should try to extrapolate fair valuations from a variety of sources and mature financial markets would be in a position to appropriately interpret this increased volatility.

4.16 Implementation and maintenance of a fair value accounting system will cost time and resources. There may be other alternatives that may make more sense in a given situation. A case in point is one where biological assets are required to be fair valued by fAS 41. Other than questioning the need to fair value non-financial assets, the fact that biological assets are generally owned by small enterprises should not be ignored. These enterprises may find the whole process defeating, since fair value done at prohibitive cost may be completely useless for the purposes of decision making.

4.17 IAS 41 requires biological assets to be fair valued. IAS 41 met with severe criticism because many biological assets are simply not capable of reliable estimate of fair value. For example:

Take for instance, a colt which is kept as a potential breeding stock, grows into a fine stallion. The stallion starts winning race events and is also used in Bollywood films, as the stallion earns substantial amount for its owner from breeding and other services, the stallion gets older, his utility decreases. Eventually the stallion dies of old age and the carcass is used as pet food. At each stage in the life of the stallion, the ‘fair value’ would change significantly, but estimating the fair value would be extremely subjective and difficult. The issue is : if changes in fair value of fixed assets are not recognised in the income statement, then why should the treatment be different in the case of biological assets?

Vineyards and coffee and tea plantations have similar measurement issues. The relationship between the vines and coffee or tea plants and the land that they occupy is unique and integrated. The vine or plant itself has relatively little value. However, in conjunction with the land, they do have value. Determining the fair value for a vine-yard, coffee or tea plantation involves esti-mating production along with sales prices and costs for a number of years in the future, together with estimating a terminal value and the application of a discount rate to calcu-late the net present value – an enormously complex and subjective task. The value of the vines and plants would then have to be determined as a residual because it would be calculated by deducting the value of the un-improved land and the value of the infra-structure from the aggregate value. It is clear that the valuation in the above examples is based on subjective estimates and is open to substantial variability.

4.18 Pitfalls – of using ‘fair value’ for biological assets are:

  • these are subject to droughts, floods and diseases which events are difficult to mea-sure.

  • during the transformation process, it could be very difficult to determine ‘quality of the assets and their value’.

  • accounting for unrealised gains arising from changes in fair value can give a distorted picture of the financial results. It could be misunderstood and may lead to inappropriate decision-making, such as dividend declaration from unrealised profits.

4.19 Applying the ‘fair value’ option to the report-ing entity’s liabilities poses a particular problem, especially from a prudential point of view. As, under the fair value option, fair value measurement is not restricted to market developments (e.g., market interest rate fluctuations or changes in the exchange rate parities), but is all-encompassing, i.e., it also includes fluctuations caused by changes in the reporting entity’s credit rating – for example – a deterioration in the entity’s credit rating and the resultant devaluation of its own liabilities leads to an increase in its capital, for example, if an entity that has borrowed at 10%, credit worthiness goes down subsequently, and can now borrow only at 12%, it would record a fair value gain on the earlier loan reflecting the 2% gain on account of its own credit deterioration. From a prudential point of view, this is unacceptable.

4.20 In case of banks and financial institutions:

  • Upward revaluations of assets (when asset prices are increasing) would be reflected in bank profits and bank management could face pressure from shareholders to distribute dividends, including unrealised gains on assets.

  • Banks’ ability to smooth intertemporal shocks would therefore be adversely affected.

  • Historical cost, on the other hand, applies the principle of prudence which does not recognise unrealised gains.

  • Historical cost makes it possible to build up reserves during good times, which can then be depleted during bad times. Historical cost would translate into lower variability in banks’ income and would allow banks to insure themselves against unforeseen circumstances.

4.21 However, the flaw with the above argument is that:

  • prudence does not reveal the truth, hence is certainly not liked by investors, who want to know the truth.

  • prudence is an arbitrary concept and one sided, requiring unrealised losses to be recognised, but does not allow unrealised gains to be recognised.

  • prudence results in unrealistic accounting – take for instance, two investments of absolutely the same type, except that one distributes entire earnings by way of dividend whereas the other does not pay any dividends. If prudence were to be applied, then the two investments would be valued differently. Dividends would be recognised as income; however, in the case of the other investment, which is equally profitable, no income would be recognised. Such mis-match would not occur if both investments were recorded at ‘fair value.’

  • ‘Prudence’ also is seen by many as a means by which entities could inappropriately smoothen their profits through the creation of excessive provisions.

4.22 The inadequacy of historical cost, transac-tion-based approach for dealing, in particular, with derivatives (which have little or no initial cost but can expose companies to very substantial financial risk) and diminutions in the value – impairments of assets, have encouraged standard-setters to espouse an asset/liability approach to recognition of income and a ‘fair value’ basis of measurement of assets and liabilities.

4.23 Although the recognition of unrealised gains and losses on financial assets is achieving wider acceptance, the IASB has not yet put forward any convincing arguments in favour of a ‘fair value’ model for non-financial assets. IAS 41 does not require the existence of active market for using fair value in case of biological assets. This approach is inconsistent with other international standards, for example – for valuing intangibles under IAS 38, the existence of an active market is a perquisite for using fair value.

5.1 The arguments for and against fair value accounting raise fundamental questions about core accounting issues, such as how performance should be measured, and the relative merits of the qualities of relevance versus reliability. Fair value accounting is a paradigm shift – it moves away from ‘historic focus’ to a ‘current perspective’ on value. However, the standard-setters now face a significant dilemma :

how can they continue to pursue their mark-to-model approach to asset/liability measurement and, at the same time, promul-gate accounting standards that will lead to a style of financial reporting that enables investorsto evaluatemanagement performance and assess enterprise value to make sound
investment decisions ?

5.2 The issues are:

  • How can shortcomings of the ‘fair value’ model be addressed !
  • How to improve reliability of level-3 valuation!

5.3 The answer is :

  • IASB should develop a standard on fair valuation and address the basic interpretative issues that are currently prevalent (lASB is working on this project).

  • IASB should be clear as to whether it would want to draw a distinction between financial assets and liabilities and non-financial assets and liabilities, because non-financial assets and liabilities are held for long-term use in the business and ‘fair value’ cannot be reliably determined. Comparatively, financial assets and financial liabilities are more liquid and can be fair valued with greater reliability.

  • Develop an appropriate accounting model by drawing a distinction between financial items and non-financial items. The accounting model is then applied consistently, eliminating any disparities or inconsistencies that could confuse users.

  • Make valuation systems and processes more robust by having specificity and clarity on fair valuation techniques to ensure more reliable valuation numbers and eliminate chances of bad judgments.
  • Another alternative is limiting application of the fair value model to those assets and liabilities that have real and determinable market value, along with compulsory disclosure of ranges of possible fair values together with assumptions and sensitivity analyses. A point to’ be noted is that users need financial statements that have predictive value in terms of providing a sound basis for decision-making, which is a quite different matter from supplying users with financial statements that give the impression that they are themselves predictions. Unfortunately, IASB has so far chosen not to follow this path.

5.4 The most interesting question in everyone’s mind is how long it will take for the full range of non-financial assets, and particularly internally generated goodwill, to be measured using ‘fair valuation’. That would make future balance sheet, a valuer’s balance sheet rather than an accountant’s balance sheet.

5.5 Using fair values to measure assets and liabilities is attractive because it meets many of the Framework’s qualitative characteristics of useful financial statement information. These criteria are to be applied in the context of the primary objective of financial reporting, which is to aid investors and other users of financial statements in making economic decisions. The criteria include relevance, comparability, consistency, and timeliness. Fair values are relevant because they reflect present economic conditions, i.e., the conditions under which the users will make their decisions. Fair values are comparable because the fair value of any particular asset or liability depends only on the characteristics of the asset or liability, not the characteristics of the entity that holds the asset or liability or when it was acquired. Fair values enhance consistency because they reflect the same type of information in every period. Fair values are timely because they reflect changes in economic conditions when those conditions change. In addition, fair values can be viewed as fulfilling a stewardship role for financial reporting because the financial statements reflect the values of assets at the entity’s disposal. Such values are essential for determining performance ratios such as return on capital employed. The author would conclude by stating that despite its faults, ‘fair value’ is here for good and as the valuation models become more established in future accounting standards, many of the criticisms on fair valuation would disappear. If marking to market is a myth, then historical cost accounting is rather a mystery. A return to full historical model would be a retrograde step. Investors are definitely not seeking financial statements that have outdated information. Change to ‘fair value’ is a challenge to our profession and I am sure we will meet the challenge.

Innovation in Services

Article

‘Innovation’ is one of the most used buzzwords in
21st-Century management vocabularies. However, when most of us think of
‘Innovation’, what comes to our mind is sleek, user-friendly products such as
iPhone. People have a good idea of what technical innovation is, but innovation
in services, as in the case of professionals, is more hidden and unknown. Its
important to discuss what innovation means for a professional like Chartered
Accountant and how it helps him in serving his client better. Client-focussed
innovation will benefit both the client as well as the professional organisation.
Client will be benefited by more value-added services and the professional
organisation will effectively combat the increasing competition and help it in
client retention.


What do you mean by innovation in professional services ?

It is not a rocket science as people think it is. It is a
skill that can be learnt and taught. For me innovation is an original concept,
new or improved process or service. A new method or idea of doing things faster
and in a better manner, in other words, where there is a value addition.

Does a client need innovative solutions ?

A client is always in need for innovative, different ideas
which will make them distinctive in comparison to their competitors’. In today’s
world, where the client has a strong in-house team, they would be very well
equipped to handle day-to-day and routine matters. Further, the in-house team is
also capable of providing the routine, conventional and a standard solution
which a normal professional organisation would give. In such a case, the client
would start thinking : Why should we hire an external professional
organisation when it is going to provide us the same solutions at a higher cost ?
Clients need more than just standard solutions for which it is important for a
professional organisation to innovate on a continuous basis. If the professional
organisation does not realise this fact, it may lose out on such client. Here
comes the need for innovation in providing services.

How does a client and the professional

organisation benefit from innovation ?

Innovation could be radical in nature i.e., a
different solution/idea by means of which the client is benefited tremendously.
The client could benefit in terms of savings of tax or in terms of economics of
the project. For example, a professional organisation may provide an out-of-box
solution by which the client saves service tax and the entire
economics/commercial feasibility of the project may change in favour of the
client. Such kind of innovation gives a huge advantage to the client and his
competitors may be totally outplaced, if they do not take measures before their
market position is completely lost. By providing such solutions, the
professional organisation gets loyalty from its clients and it ensures that it
stays ahead of its competitors.

Innovation could be proactive in nature. Proactive innovation
means proactively searching for solutions to problems of the client. It starts
with asking the client right questions, defining a problem or opportunity which
the client is facing. The second step would be to gather or collate information
from various sources (including the client himself) to gain more knowledge of
the facts. This is the most important process of ‘creative’ thinking whereby new
ideas are generated by analysing the information. Thus, in this manner a new
solution is developed which will solve the problem on hand and adhere to client
needs. Thus, innovation in services cannot take place overnight. It is normally
a steady, hard-headed response to client needs and not the accidental insight or
idea. However, proactive thinking also means that identifying a problem which
the client is facing where the client is not aware of the potential problem and
the impact of such problem. In such a case, the professional organisation has to
proactively approach the client and has to warn him of the potential problem and
provide him an appropriate solution, without thinking whether the client pays
its fees for such advice or not. This pro-activeness would delight the client.

Sometimes it is possible that the problem which the client is
facing is being faced by all the companies which are in the client’s business.
In such a case, a combined solution can be sought by asking the client to join
hands with its competitors and make a joint representation to the government or
any other regulatory authority. This will ensure that the client is benefited,
as the representation will get more importance as it is made by all the players
in that particular industry and chances of it getting approved are enhanced.
Further, the client would suffer a lower cost as the cost is shared by all the
professional organisations and the client is also benefited as it comes into
limelight in front of all the industry players and would certainly generate
income from them in future.

Innovation could also be in the nature of incremental change.
Incremental change can be in the form of generating good, new ideas to support
existing services, service delivery or processes. In other words, a better way
or method of doing the same thing in a more efficient manner. Certainly, one
may think, how does incremental change benefit the client ? This type of
innovation certainly improves efficiency of the professional organisation and
ensures that the deliverables are faster. This gives the professional
organisation a competitive advantage and also leads to client satisfaction. Some
of the ways in which efficiency can be ensured is by providing short, clear and
practical advice. It should be remembered that client normally wants a quick
advice. Therefore, at times it is better to talk over the phone and discuss the
matter rather than sending out long emails which may take good amount of time.
The conclusion of such teleconference could always be circulated later.

Why should there be innovation ?

Professional organisations can no longer remain static or arrogant as in the past, because the clients have become more informed and more demanding in these times of information boom. They now question the opinions, the approach and the manner and get satisfied only with a thorough response. Gone are the days when professional organisations were rewarded for simply providing excellent services. Clients also want their consultants to help them network and improve their businesses. They want services to be efficient, cost-effective, and technologically advanced. The professional organisation cannot take the client for granted and has to realise that the client is always in need for new and distinctive ideas. The professional organisation has to ensure that the client is satisfied with its service. Hence, it has to be innovative at all times.

How can the professional organisation innovate in order to provide client satisfaction ?

A professional organisation can innovate in a number of ways. In my opinion, the following are some of the ways in which a professional organisation can innovate and ensure client satisfaction:

  • Ability to act as business advisors and not mere tax advisors or consultants. Professionals need to understand client’s business in detail and provide him a solution which meets his requirements, taking into consideration the practical difficulties which will be faced by the client in implementing the solution. The professional organisation should not only provide a technically correct answer, but also ensure that the same is implementable;

  • Providing complete range of services from start to end. A client prefers a professional organisation that holds his hands from starting of the project till the project is completed. If the professional organisation is not an expert in that field, it can recommend the best person who could render such services and probably network with the best person;

  • Examining existing problems of the client from a new perspectives and providing distinctive solutions;

  • Providing client service by way of interactive websites where clients could post the queries. The website would also host data which would be useful to the client in his day-to-day business;

  • Provide regular news updates on cases/ amendments, circulars, relevant to the client as well as a note on how such updates/amendments would impact the business of the client;

  • Ability to identify and articulate areas or opportunities for the client that if improved/ adopted could yield a source of advantage of any kind to the client. e.g., advising the client that would give him a business advantage (even though it is not your scope to advise him on such areas);

  • Ability to quickly respond to the client queries and understanding the fact that time lag on the part of professional organisation could have implications such as loss of business opportunity;

  • Ability to take risk and actually spending time and cost in the innovation process, even taking into account the fact the innovation process may fail.

Clearly, fabulously successful enterprises such as Gillette razors and Coca-Cola have been applying innovation at the point where it matters most – the client’s/customer’s changing needs. In other words, innovation has to be something which has the end-objective of keeping the client happy. Generating ideas and being innovative are important contributors to business success.

A classic example of innovation could be a trans-formation of an enterprise which is willing to innovate and chunk old traditional ideas e.g., ICICI Bank and HDFC Bank. The banking system in India as recently as in late 1990s was stuck in the rut of big and static PSU banks, the whole of the banking sector was ailing from syndrome of ‘Over-branched but underserviced’. In this scenario, these banks emerged and changed the entire landscape. Keeping the customer service as its prime focus, they embraced technology as its main aid and kept on innovating services to meet client satisfaction. The result is for everyone to marvel. This is a classic example of turnaround of the company by keeping the clients/customers happy.
 
To add value to our conventional practice of audit we can innovate, for example whilst reviewing:

  • internal control procedures, advise the client on risk mitigation;
  • financial cost, suggest alternative modes of financing to reduce costs;
  • power costs, even bring in a business advisory team to suggest means for reducing cost, in other words, conduct a ‘power’ audit;
  • consider compliance with environment laws as environment is becoming a major risk.

Another area is assisting and advising clients in the discharge of ‘social responsibility’. It is an area where we can innovate and be a catalyst. Let us accept that charity in today’s environment is big business. Let us assist business in carrying out philanthropic activities which are in the interest of business.

In my view, innovation is the need of the day and organisations including professional organisations should encourage innovations and have to ensure that their clients are continuously fed with more and more innovative solutions. IBM, for instance, has recently run a series of television commercials on innovation. The theme is the need to innovate because: “in today’s world your new idea on Monday is a commodity on Wednesday … “

I would conclude  by stating:

“Innovate to survive by anticipating need, nay, creating need for those whom we serve.”

Chartered Accountants don’t retire — they fade away

Article

Retirement — what is retirement ? Chartered accountants just
do not know the meaning of this term ‘retirement’. Hence the statement —
chartered accountants ‘never retire, but they just fade away’. The irony is that
even when they retire — either because of commitments or circumstances, they
still continue to be involved with ‘accountax’. They never truly retire.


Talking of retirement reminds me of this story of Henry Ford.
When asked a question : “When are you going to retire ?” His reply was “Only
after I cease being useful — which stage I will never attain.”

Chartered Accountants also seem to believe that they will
never cease to be useful.

Thinking about retiring takes me almost 40 years back in
time. I met a German equivalent of a CA who was well past 65 and yet quite
active. On being asked by me as to why he was not retiring, his reply was :

“Young man, in my country a CA can never afford to retire
on what he makes and so must it be in your country too.”


Passage of time, and years of experience have confirmed the
truth of these words. A CA cannot afford to retire on his earnings. Most of us
continue to work as we cannot afford to retire both economically and even
emotionally.

Once again my mind slips into the past and memories of my
articleship days come flooding, reminding of an instance when I was appearing
for my C.A. finals. My father came to drop me at the centre. He met a friend who
asked my father as to why he was at the centre. “I have come to drop my son” was
his reply. My father asked the same question to his friend as to why he was at
the centre, “My children have come to drop me for the Exam.” was his prompt
reply. He did ultimately clear the Exam. What perseverance ! What
determination !

How could this friend of my father ever think of retirement ?

So much efforts go into being a CA that one has to work for
many many years to recoup his investment in terms of time and money. Perhaps
that is why a CA cannot think of retirement.

Retirement is also not conceivable, because a chartered
accountant loves his profession and it is very difficult to get over ‘love’ — a
life-long relationship. CA’s relationship with the profession, especially that
of my generation, can be compared to an arranged marriage. In an arranged
marriage you fall in love after marriage and live in devotion till ‘death do –
us – part’. A relationship with a client might start on a professional basis,
but it matures into a personal bond and the CA is virtually treated as a member
of the family. Even in his senility and dreams he thinks of how best he can
serve his clients. Ask an accountant : when he will retire and I am sure the
reply will be : Retirement is fifteen years away and he will also raise the
question :

Please tell me to what should I retire to !

We as CAs are so committed to work that we forget our
families, our friends and everything and give first place in our life to our
work. I will illustrate with a story. I heard this one, decades ago at one of
our conferences : ‘There was a chartered accountant. He was totally committed to
his work. He would leave early morning and come back late at night. One day
someone told him that while he was sweating away at office, things were going on
behind his back in his home . . . . indicating that someone was visiting his
house and a clandestine affair was going on behind his back. He was enraged. He
decided to put an end to this matter. Next day after leaving home at 8 a.m.,
instead of going to the office he climbed a tree in front of his house with a
gun in his hands, waiting for ‘that’ person to come. 9 O’clock — no one, 10
O’clock — no one . . . Yet he waited patiently. However at 12 Noon, he suddenly
realised that he was not even married !’

Work is CA’s life, his reason for existence. This is
exemplified by a chartered accountant friend of mine. Apart from being a
successful practitioner, he is an eminent writer, a musician of repute and a
very knowledgeable person. In one of his articles he confessed that whenever he
saw a picture of a beautiful and gorgeous film star like Mallika Sherawat or
Katrina Kaif, his imagination ran riot and his first thought was of what could
be her Permanent Accountant Number ?

How can such a person ever think of retiring from the
profession? Without work he would be like fish out of water . . . He would start
gasping for breath.

There is a story of a senior citizen. He, a widower, would
visit his lady friend daily and spend his evenings with her. This went on for
years. A friend like me suggested that he should marry her. His response was,

“Well, I have considered this many a time. But if I marry
her how do I spend my evenings . . . . ?

The dilemma of a CA is similar : how does he spend his time
after retirement ?

I think that in the ultimate analysis, a CA goes on working
all his life, first to make both ends meet, then later perhaps for the ‘fame and
name’, and still later because it has become a habit which he cannot break and
also because he does not know what else to do.

Another friend of mine, a retired accountant, who recently
retired, was sarcastically questioned by a friend at an office gathering :

Q. How to you spend your time as you are no longer changing
‘figures’.



Ans. Hitting golf balls and cracking nuts.

However, he went on to add : “The benefits of retirement are
— I don’t have to comment on :

  • The implied and intended violations of law
  • Deviations from standards
  • Violations of ten commandments  of S. 227
  • Values being fair
  • On affairs being  ‘true  and  fair’
  • and above all on ‘frauds  committed by you.’
 
A thousand years ago Shankaracharya lamented in ‘Bhaja Govindam’ as under:
“The body has become worn out. The head has turned gray. The mouth has become toothless. The old man moves about leaning on his staff. Even then he leaves not the bundle of his desires.”

He laments that no one at any age has time for God. Let us listen to his advice and seek God before it is too late in our life.

We have one shining example  to follow. Shri N. V. Iyer, a person renowned in our profession, retired from the profession when he had reached great heights and he completely cut himself off from the profession from the day of the retirement itself to follow higher and nobler pursuits.

Let us then have courage to retire at a proper time and follow the higher path. Let us prove that CAs also can retire and need not just fade away in oblivion.

I would conclude :

Some of us fear that retirement may lead to senility. We forget that retirement is an opportunity to put life into our years – do what we missed – revive our hobbies and our relationships, discover old and make new friends. Life after retirement can be equally challenging. Retirement is also an opportunity to be creative, to do something we haven’t done during our working years. We can on retirement seek a blend of ‘client service’ and ‘service to profession’ or better still blend ‘service to profession’ and ‘service to society’. As Albert Einstein said :

‘The  highest  destiny  of individual is to serve’.

Let us learn to retire, contribute to society and seek our real growth rather than fade away.

Works Contracts

Article

1. Composite Contracts — Introduction :


A composite contract is one which has constituent elements
but the customer is interested in the final outcome of the contract. In such a
contract, the constituent elements are so integrally connected and
interdependent with each other that it is not feasible to look at the elements
in isolation. Such composite contracts may also include minor elements which are
incidental and ancillary to the main objective of the contract. Such elements of
a composite contract are to be treated as means of attaining the ultimate object
of the contract. For example, in a turnkey contract for design engineering,
procurement, construction, installation and commissioning of a power plant, the
individual element of engineering cannot be viewed in isolation of the
procurement, construction, installation and commissioning. In a lighter vein,
one can say that the icing on the cake cannot be viewed separately from the cake
itself !

1.1 Works Contracts — Species of Composite Contracts :


Composite contracts involving both the supply of materials
and rendering of services (in reasonably dominant proportions) are known as
works contracts. A turnkey contract of the nature referred to above is a good
example of a works contract. In a works contract, there is a transfer of
materials from the contractor to the employer/contractee, however, the said
transfer is not by means of sale.

In a works contract, the contractor agrees to perform some
work on the client’s property (may be moveable or immoveable). The performance
of work also involves the use of some materials of the contractor. As the
contractor uses these materials to perform the work, the materials get attached
to the property of the client in such a fashion that such contractor’s materials
can no longer be removed without substantial damage either to the contractor’s
materials or the contractee’s property. Since the property which is the subject
matter of the work belongs to the client, the ownership of the materials so
attached on the property passes on to the client albeit in an indirect fashion.

1.2 Accretion :


Consider the case of a building contractor who constructs a
building on the land of the client using his owned bricks, sand, cement, etc.
Till the stage he applies the cement on the land and lays a brick on it, the
cement and brick belongs to the contractor. But once the cement paste and the
brick are applied on the land, these ingredients fasten themselves to the land.
It is then not possible or viable to remove the cement or brick from the land
(without fundamental damage). Since the land belongs to the contractee, the
ownership in the cement and brick gets transferred to the contractee by
inference and not by way of sale. This process of the contractor’s materials
getting embedded in the client’s immoveable property is referred to as the
transfer of ownership in goods through the process of accretion.

1.3 Accession :


Consider another example of a garage undertaking to paint the
car of its client. Similar to the earlier example, till the stage the garage
applies the paint on the car, the paint belong to the garage. But once the paint
is applied on the car, the liquid paint gets attached on the metal of the car.
It is then not possible to remove the paint without fundamental damage. Since
the car belongs to the client, the ownership in the paint also gets transferred
to the client by inference. This process of the contractor’s materials getting
embedded in the client’s moveable property is referred to as the transfer of
ownership in goods through the process of accession.

1.4 Blending :


One more situation of works contract could be a case where
multiple moveable products owned by the contractor are ‘blended’ together to
create a new moveable product which is non-marketable in nature. Consider the
case of a printer who uses paper and ink to print cheque books for its client
bank.

In this case, the transaction cannot constitute a sale
because cheque books are not marketable and there-fore are not goods. However,
the properties in the paper and the ink have passed on to the bank the moment
the printer blended these two moveable products. Thus, there is a transfer of
the ownership in goods through the process of blending.

2. Nature of Indirect Taxes and applicability to Composite Contracts :


At this juncture, it may be relevant to broadly classify the
indirect taxes based on the nature of the taxes. At one end of the spectrum are
duties on goods like customs duties and excise duties which are levied on
specified activities i.e., the activity of import/export of goods or the
manufacture of goods. Since the levy of duty is on an activity and not on a
transaction, it is apparent that the duty is attracted irrespective of whether
the product constitutes an end in itself or a means to an end.

At the other end of the spectrum are taxes like sales tax
(VAT) and service tax which are levied on specified transactions i.e.,
the transaction of sale of goods or the provision of services. Since the levy of
the tax is on a transaction, one has to look at a transaction. A transaction is
the cake itself (i.e., the end) and not the icing on the cake (i.e.,
the means to an end). This therefore suggests that for taxing the transaction,
one looks at the tax implications on the cake and not on the icing !

3. Composite Contracts — Judicial Thinking :


Before proceeding any further, it may be relevant to look at
the judicial thought process on this aspect.


In a landmark case1
pertaining to sales tax, the Supreme Court held that a building contract is one
entire and indivisible contract; there is no sale of goods as a separate
contract. A series of judgments of the High Courts and the Supreme Court
followed this case taking the same view.

In another situation, the contract provided for progressive release of payments dependent on the stage of execution of a particular component. The Supreme Courf observed that in an indivisible, composite contract, it is not possible to vivisect the same. The Court accepted the commercial practice in spreading the contractual payments over the entire period of the execution of the contract and held that progressive release of payments would not have any bearing on the nature of the contract.

In a case pertaining to income tax, an Indian company entered into separate contracts with the foreign company for purchase of equipment and for supervision of erection, start-up, putting into commission, etc. of the equipment. The A.P. High Court held that the terms of the separate agreements clearly showed that it was one and the same transaction. One could not be read in isolation of the other. The considerations for services in connection with the supervision of erection, start-up, putting into commission, etc. were part of the payment of the sale price of the equipment. Thus, in spite of two separate contracts, the High Court considered these as part of single sale transaction.

In a landmark judgment? pertaining to service tax, the Department tried to levy service tax on the drawing, designing and commissioning activities, for which separate amounts were indicated in the price break-up in the turnkey contract. Negating such attempt, the Tribunal held that the contract between Daelim and IOCL was a works contract on turnkey basis. It cannot be vivisected for subjecting a part of the contract price to service tax.

From each of the above decisions, it is amply clear that the judiciary has consistently looked at composite contracts as a whole and has not permitted a vivisection of such composite contracts.

4.    Constitutional Amendment & Implications under VAT:

On the basis of recommendation of the Law Commission, the Parliament passed 46th Constitutional Amendment, introducing a legal fiction by defining ‘tax on the sale or purchase of goods’ in Article 366(29A) to include certain types of deemed sales. Thus, the following non-sale transactions were brought within the service tax net:

(a)    Non-voluntary transfer of goods for consideration
(b)    Transfer of property in goods involved in the execution of works contract
(c)    Delivery of goods on hire-purchase or instalment payments
(d)    Transfer  of right to use goods
(e)    Supply of goods by unincorporated association or body to members for consideration
(f)    Supply of food or beverage by way of or as part of service.

With respect to works contracts, one of the deemed sales, in view of the above amendment, sales tax/VAT could be levied on the value of the supply portion of the contract. Thus, there is a sale of the goods supplied in the execution of works contract for the limited purpose of sales tax/VAT. In this sense, through legal fiction, an indivisible composite contract becomes divisible. However, the Supreme Court” has held that the 46th Constitutional amendment is valid only for those entries in the three lists in the Seventh Schedule where the expression ‘tax on the sale or purchase of goods’ appears. Effectively, the amendment is applicable only with respect to sales tax/VAT law and not for any other law. This amendment has not brought any change in the normal legal meaning of ‘sale’. Therefore, for purposes outside sale tax/VAT, the concept of indivisible composite contract continues to be valid. Further, the Supreme Court”, held that even after the 46th Constitutional amendment it is not permissible to split composite transactions except in the case of works contracts and supply of food and beverages as part of the service in restaurants and hotels for sales tax/VAT. In other words, the principles enunciated in Gannon Dunkerley & Co. case, survives for purposes other than tax on these two deemed sales introduced by the Constitutional amendment.

5. Implications under Service Tax -before 1-6-2007:
The above discussion brings to light a question regarding the applicability of service tax provisions to composite contracts. Over a period of time, there has been a gradual expansion in the scope of taxable services. Some relevant service categories are listed in the table below :

Right from the time the category for taxing consulting engineering services was brought into the Statute, there were constant attempts to levy service tax on the ‘consulting’ element of the composite contracts. While the 46th Constitutional Amendment permits the States to levy tax on transfer of goods involved in the execution of a works contract, no specific authorisation is available to the Centre for artificially vivisecting such contracts for the purpose of levy of service tax and hence the Courts have consistently held that composite contracts cannot be made liable for service tax? under the category of consulting engineering services.

Since 2003, the Legislature has gradually expanded the scope of taxable services to cover various activities involving performance of work. From an industry perspective, such performance of work could be either on a stand-alone basis or as an element of a composite contract. While there were no doubts on the coverage of activity done on a stand-alone basis (‘labour job’), there was uncertainty on the coverage of the activity done as a component of a composite ‘works contract’.

The Department interpretation at that stage was to argue on the principle of aspect theory and suggest that the levy of service tax was, in principle, in order. To address the issue of valuation and cascading impact of taxes, the Department provided the following alternatives:

1. Discharge of service tax on the full value of the contract with corresponding credit of duties/taxes paid on inputs and input services

2.    Discharge of service tax on the value of the service component (by identification and reduction of the value of the goods sold) with corresponding credit of taxes paid on input services

3.    Discharge of service tax on a presumptive value of the service component (i.e., 33% of the gross value of the contract) with no credit of taxes paid on inputs/input services.

Notwithstanding the above mentioned options, can it be argued that there really is no authority to levy a service tax at all in the absence of a specific constitutional amendment? After all, even for levy of sales tax, a Constitutional amendment was required and it has already been held that the Constitutional amendment has only restricted applicability vis-a-vis  sales tax laws.

The answers to the above questions could be debatable and would depend on whether one treats a works contract as a whole as constituting an activity and therefore a service (View 1) or one looks at works contract as independent of both goods and services (View 2).

In case View 1 is adopted, the levy of service tax can be said to be effective from the date the respective category for execution was introduced, say construction service. All the three alternate options for discharging the tax liability would ensure that there is no cascading effect. In case View 2 is adopted, the levy of service tax would actually require a Constitutional amendment.

Before the dust could settle down on the said controversy, the judiciary was flooded with a plethora of cases wherein the Department’s attempt to tax the services embedded in a composite contract was challenged. In fact, the Bangalore Tribunal went ahead and held that a composite contract cannot be vivisected to levy a tax on the erection, commissioning and installation component of the said composite contract”.

6.    Implications under Service Tax – from 1-6-2007:

In order to overcome the above controversy and specifically provide for a mechanism to tax the service component of a works contract, a new category of service was introduced with effect from 1-6-2007 to tax specified  works contracts.

However, as highlighted earlier, in case a view is taken that the service component is embedded within a composite contract, the composite contract cannot be vivisected merely by insertion of a taxable category of service. Hence the levy of service tax under the category of ‘Works Contracts Services’ can be constitutionally challenged.

If one holds the conservative view that the entire composite contract is a service, there was really no need for the introduction of the category of ‘Works Contracts Services’, since the basic categories were wide enough to cover the impugned transactions. In either of the situations, the introduction of the category of ‘Works Contracts Services’ becomes redundant. The law cannot be interpreted to bring about redundancy in any of the provisions.

Therefore it can be strongly argued that the levy of service tax is not constitutionally valid even after the introduction of works contract services as a category, since the Legislature does not have the authority to vivisect a composite contract.

7.    Non-Vivisection –  Practical Ramifications:

While there is a strong legal justification to challenge the applicability of service tax on works contracts, a business needs to evaluate the position taken from a practical perspective. Being an indirect tax, any aggressive position taken can result in an opportunity cost (since the tax would have been recovered from the client in the case of a conservative position). Further, the availability of CENVAT Credit to both the service provider and service recipient (in many cases), effectively results in no additional cost on account of adoption of a conservative position. Thus, one may reconcile the position to accept the levy of service tax under the category of ‘Works Contract Services’ with effect from 1-6-2007.

With the introduction of a new category to tax only speCified works contracts, it can be argued that the Legislature accepts the principle that the works contracts could not be taxed under the basic category itself and therefore the new category was created. Therefore, no service tax was payable in the past periods in cases where works contract tax was payable. This view has already found favour with the judiciary 10. Thus, one can safeguard the liability for the past periods.

8. Conclusion:

The article tries to explain in a nutshell the theory of non-vivisection of composite contracts and its ramifications vis-a-vis levy of service tax on works contracts. It does not deal with the issues concerned with valuation and claim of credit, since they are secondary to the basic issue of levy of service tax itself.

The article also does not deal with the tax implications of other types of composite contracts wherein, say, multiple services are bundled. Over a period of time, the law will evolve. It appears that a long-term solution could be to have an integrated Goods and Service Tax with a comprehensive coverage of all supplies of goods and services. Till the time such a GST regime is evolved, these issues will continue to present uncertainty for the industry.

It is a challenge to both the profession and the business to confront and comply with uncertainty.



Convergence and Conflicts of Accounting and Taxation

Article

1. Commercial Accounting Principles — basis of taxable profits :


Income-tax is a branch of law and its practice falls within
the domain of lawyers. We Chartered Accountants have, however, entered and have
successfully carried on practice in this field for the reason that income-tax is
tax on income, profits and gains, and determination thereof needs expertise in
accounting principles. The Apex Court has held time and again that in working
out profits, the principles that have to be applied are those which are a part
of commercial practice or which an ordinary man of business will resort to when
making computation for his business purposes1. More recently, the Supreme Court
has held in CIT v. U.P. State Industrial Development Corporation, (1997)
225 ITR 703 (SC) that it is well-accepted proposition that “for the purposes of
ascertaining profits and gains the ordinary principles of commercial accounting
should be applied, so long as they do not conflict with any express provision of
the relevant statute”. The Apex Court quoted with approval the principle laid
down by the English Courts2 and also reiterated the principle laid down earlier
by the Supreme Court in P.M. Mohammed Meerakhan v. CIT, (1969) 73 ITR 735
(SC) that it was the duty of the Income-tax Officer to find out what profit the
business has made according to the true accountancy practice.

2. Modification/Deviations from accounting principles :


While the commercial accounting principles do form the basis
of computing profits for tax purposes, the law-makers have a variety of agenda
to be achieved through the Income-tax Act for which purpose, the commercial
accounting principles are either given a complete go-bye or are somewhat
modified or deviated from. Objectives of such deviations could be either
simplification of the tax law or provision of incentives for economic
development or just as a measure of ensuring effective revenue collection or
check evasion. The objective of simplification is achieved by — for example —
enacting provisions for presumptive taxation. This involves computing taxable
income as a percentage of, say, gross revenues or some other quantitative
measure like tonnage capacity in case of ships or number of trucks in case of
small transport operators, etc. The objectives of incentives for economic
development may involve creation of special-purpose statutory reserves (like SEZ
Reserve or erstwhile Investment Allowance Reserve) that are otherwise not
required under commercial accounting principles. Similarly, the objective of
ensuring effective revenue collections is achieved by, say, allowing deduction
for statutory liabilities only on actual payments, irrespective of whether the
taxpayer follows mercantile or cash method of accounting. The exercise in
computation of taxable income, thus, essentially involves sound knowledge of :


à
Commercial accounting principles that form the basis for computation of
profits; and


à
The provisions of the law that require deviation from such commercial
accounting principles or may just provide for artificial formulae in computing
taxable profits.



3. Statutory recognition of commercial accounting
principles & practices :



S. 145 of the Act provides that income chargeable under the
head ‘Profits and gains of business or profession’ or ‘Income from other
sources’ be computed in accordance with either cash or mercantile system of
accounting regularly employed by the taxpayer. It empowers the Central
Government to notify accounting standards to be followed for computing such
profits. Pursuant to the said powers, the Central Government has notified two
accounting standards (AS), one of which needs to be mentioned here. The notified
AS defines ‘Accounting Policies’ to mean the specific accounting principles and
the methods of applying those principles adopted by the assessee in the
preparation and presentation of financial statements. It further provides that
the Accounting Policies adopted by an assessee should be such so as to represent
a true and fair view of the state of affairs of the business, profession or
vocation in the financial statements prepared and presented on the basis of such
accounting policies. For this purpose, the major considerations governing the
selection and application of accounting policies are the following, namely :

(i) Prudence : Provisions should be made for all
known liabilities and losses, even though the amount cannot be determined with
certainty and represents only a best estimate in the light of available
information;

(ii) Substance over form : The accounting treatment
and presentation in financial statements of transactions and events should be
governed by their substance and not merely by the legal form;

(iii) Materiality : Financial statements should
disclose all material items, the knowledge of which might influence the
decisions of the user of the financial statements.


The notified AS provides that ‘Accrual’, ‘Going Concern’ and
‘Consistency’ are the fundamental accounting assumptions in preparation and
presentation of accounts. If these are not followed, a specific note is
required. These terms are defined as follows :

‘Accrual’ refers to the assumption that revenues and costs
are accrued, that is, recognised as they are earned or incurred (and not as
money is received or paid) and recorded in the financial statements of the
periods to which they relate;

‘Consistency’ refers to the assumption that accounting
policies are consistent from one period to another;

‘Going concern’ refers to the assumption that the assessee
has neither the intention nor the necessity of liquidation or of curtailing
materially the scale of the business, profession or vocation and intends to
continue his business, profession or vocation for the foreseeable future.

There seems to be a significant convergence between the major considerations and fundamental assumptions as laid down in the CBDT-notified AS and the.AS issued by the Institute of Chartered Accountants of India (ICAI),the apex accounting body in the country. Some differences, however, that are significant are discussed subsequently at appropriate places.

4. Prudence:
The accounting consideration of Prudence is adopted and recognised in several tax cases. A prominent illustration is where Courts have held that the closing stock ought to be valued at cost or market price whichever is lower. Courts have also held in favour of providing for actuarially valued liabilities, though the amount cannot be determined with certainty and represents a best estimate in the light of available information. There are, however, conflicts on the aspect of point of accrual to which we shall refer a little later.

5. Substance over form:
The consideration of Substance over form has been a major area of tax disputes for ages and the Courts have generally leaned in favour of substance rather than forms, though earlier there have been some exceptions, In fact, the Courts have held that the accounting entries, though are indicative of the nature of the transaction, they are not decisive of the true legal character thereof 7. This is a classic tax law principle that demonstrates convergence within divergence.

6. Accrual:
The accounting assumption of Accrual essentially means that if accounts are not prepared on Accrual basis, appropriate disclosures should be made. The Companies Act was amended in 1988 so as to make Accrual as the method of accounting compulsory for all Companies. S. 145 of the IT Act permits cash and mercantile methods of accounting. There is an age-old fight between the accounting concept of accrual and the tax concept of accrual. While the accounting concept refers to matching of costs and revenues, the tax law concept refers to ‘vesting of right to receive’s so far as income accrual is concerned and it refers to incurring or crystallising of the liability? so far as the expense accrual is concerned. One of the recent exceptions is the decision of the Supreme Court in Madras Industrial Investment Corpora-tion v. CIT, (1997) 225 ITR 802 (SC) wherein the Apex Court held that “ordinarily revenue expenditure which is incurred wholly and exclusively for the purposes of business must be allowed in its entirety in the year in which it is incurred. It cannot be spread over a number of years even if the assessee has written it off in his books over a period of years. However, the facts may justify an assessee who has incurred expenditure in a particular year to spread and claim it over a period of ensuing years. In fact, allowing the entire ex-penditure in one year might give a very distorted picture of the profits of a particular year”. Saying so, the Supreme Court held that discount on issue of debentures is an instance where although the assessee has incurred the liability to pay the discount in the year of issue of debentures, the payment is to secure a benefit over a number of years and the liability should, therefore, be spread over the period of debentures. This is a classic case of convergence of accounting accrual with the tax accrual. Yet another illustration is the decision of the Supreme Court in the case of Bharat Earth Movers v. CIT, (2000) 245 ITR 428 (SC) wherein the Apex Court held that even if the liability to pay leave encashment to employees is not due but it has definitely accrued (which is asserted by actu-arial evaluation of the liability), it should be held as allowable for tax purposes.

Although such instances seem to suggest the same direction of accounting and tax accrual, still lot of ground needs to be covered for achieving convergence. For instance, when a bank does not recognise revenues in respect of interest on sticky advances, the Tax Department still contends that income has accrued, though not recognised in the books. The Supreme Court held, in the case of State Bank of Tranvancore v. CIT, (1990) 186 ITR 187 (SC) that where interest on doubtful advances though not credited to the profit and loss account but credited to interest suspense account should be regarded as accrued and taxed accordingly. This view was once again reiterated in Kerala Financial, Corporation v. CIT, (1994) 210 ITR 129 (SC). There is thus a marked conflict between the accounting theory for revenue recognition and the tax law theory. This seems evident from an apparent difference between the understanding of the accounting consideration of Prudence under the ICAI Standard and the CBDT Standard. While the former specifically includes “In view of the uncertainty attached to future events, profits are not anticipated but recognised only when realised though not necessarily in cash”, the latter is conspicuously silent on this aspect of Prudence. In the context of NBFCs, the Tribunal held, in some cases!”, that provisions made as per prudential norms ought to be allowed for tax purposes independent of the provisions of S. 36, while it held in some other cases!’ that such provisions can be allowed only if they fall within the specific provisions of the IT Act and not otherwise. The Kolkata High Court has recently upheld the former view in the case of CIT v. Brabourne Investment Ltd., (ITANo. 333 of 2007). One doesn’t know the fate of this conflict if and when it reaches the Apex Court. But the point to be noted is that in the areas of revenue recognition and provisioning, the accounting and tax law concepts of Accrual have a long way to travel before a complete convergence is experienced.

7. Consistency:

Consistency principle finds a very satisfactory convergence in accounting and taxation. Courts have always held that the method of accounting regularly followed by the assessee and accepted in the past ought to be generally accepted 12. However, in CIT v. British Paints India Ltd., (1991) 188 ITR 44 (SC) the Apex Court held that even though the Tax Department has accepted for past several years the assessee’s method of valuing closing stock of finished goods only at the cost of raw material and totally excluding overheads, the Tax Department was entitled to reject such method and require the valuation on the basis of raw material cost plus overheads. In this case the Court deviated from the principle of consistency, only because the method consistency followed was a wrong method of valuation not recognised even under the accounting theory. Barring such cases, the Courts have always held that though the concept of res judicata does not apply to tax cases, the rule of consistency does apply and hence if the facts and the law remain the same, the Tax Department should not take different views on the same subject matter in different years”. Courts have also held that when a change in method of accounting (e.g., stock valuation) is bona fide (i.e., more appropriate or required due to change in law) such change should be permitted for tax purposes, but the taxpayer should thereafter consistently follow the changed method”.

8. Going concern:
Going Concern assumption follows one set of rules for accounting and if the enterprise is under liquidation, the accounting rules change. This is recognised even for tax law purposes when the Supreme Court held, in the case of A.L.A. Firm v. CIT, (1991) 189 ITR 285 (SC) that “the principle of valuing closing stock of business at cost or market value whichever is lower is a principle that would hold good only so long as there is a continuing business and that where the business is discontinued, whether on account of dissolution or closure or otherwise by the assessee, then the profits cannot be ascertained except by taking the closing stock at market value. The assets have to be valued on the basis of the market value on the date of dissolution”. There is thus a significant convergence as regards this concept from accounting and taxation perspectives.

9. A glimpse of some areas of conflict:

While the above provides a bird’s-eye view of the fundamental or directional issues, the nitty-gritties and nuts and bolts issues are far too many and a lot needs to be done for resolving them if the desire is to achieve substantial convergence between accounting and taxation and thereby minimise tax litigation at least on this aspect. For achieving convergence between the Accounting Standards issued by the ICAI and the Accounting Standards required to be followed under the Companies Act, initially S. 211(3C) was enacted in the Companies Act in 1999 and today we have Companies (Accounting Standard) Rules, 2006. However, convergence for tax purposes has a long way to go. This article is not aimed at discussing right v. wrong, but the purpose is to have a glimpse of some of the major areas of conflicts and open up a discussion as regards the way forward to achieve convergence. Readers may take note of these and many other areas of conflict between accounting principles and taxation.

  • Income earned during the period of construction of a project by an entrepreneur goes to reduce the cost of the project as per well-established accounting principles. However, the Apex Court held in the case of Tuticorin Alkali Chemicals & Fertilizers Ltd. v. CIT, (1997) 227 ITR 172 (SC) that certain income ought to be taxed as income from other sources. Though in certain subsequent decisions 15, this decision has been explained and distinguished and the effect thereof is to a great extent diluted in respect of income that can be regarded as inextricably linked to the setting up of the project, the basic rationale – that commercially speaking, investment of temporary surplus funds go to reduce the cost of the project – which forms the basis of the accounting treatment remains disapproved and hence unrecognised for taxation purposes.

  • AS-2 of ICAI requires valuation of costs of purchases at a price including duties and taxes ‘other than those subsequently recoverable by the enterprise from the taxing authorities’. As against this, S. 145A of the Income-tax Act requires valuation of purchases, sales and inventories inclusive of duties and taxes paid ‘notwithstanding any right arising as a conse-quence to such payment’. Thus, the ICAI Standard recommends exclusive method, while the tax law requires inclusive method. A pre-dominant legal view'” is that both the methods result in the same profits. However, the issue has been a subject matter of immense tax litigation.

  • AS-11 requires recognition of exchange differences in variety of situations. Year-end recognition of such exchange differences debited or credited to the profit and loss account have been a subject matter of litigation. Questions have arisen whether such debits are allowable for tax purposes or not. Fundamental principles were laid down by the Supreme Court in Sutlej Cotton Mills v. CIT, (1978) 116 ITR 1 (SC) to decide when the exchange loss can be treated as capital and when revenue. However, the controversy takes new dimensions with every different case. The Delhi High Court in a recent decision in CIT v. Woodward Governor India P Ltd., (2007) 162 Taxman 60 (Del) held that “judicially accepted position appears to be that in determining whether there has in fact been accrual of liability or income, the accountancy standards prescribed by the ICAI would have to be followed and applied”. In so deciding, the Delhi High Court took into consideration the various important aspects of AS-11. On the other hand, the Uttarakhand High Court, in CIT v. ONGC, (2008) 301 ITR 415 (Utt) has held that the foreign exchange loss claimed by the assessee on revenue account on, accrual basis on account of foreign exchange fluctuation on the last day of the accounting year was only a contingent and notional liability, and did not crystallise or accrue in the year under consideration and hence was held as not allowable. On a plain reading of the judgment, one finds that there is no discussion at all on AS-11 and its requirements. Poor taxpayer is at a complete loss as to what the correct position in law is on the subject.

  • AS-28 provides for impairment of assets and requires recognition for such impairment in certain circumstances. Indeed, the question whether such impairment is allowable for tax purposes or not is something that one may have to reckon with as and when the issue arises.

The list can go on. This is just a food for thought in the Diamond Jubilee issue. We may have an occasion to discuss this article further, may be in some RRC of the SCAS, which we all seldom miss!

Can Tax Laws ever be simplified ?

Article

Cost of Complexity :


1.1 The often quoted statement is : ‘Equity and taxes are
strangers’; one could add that ‘tax laws and simplicity are also strangers’.
In the Wealth of Nations, Adam Smith famously noted that complexity makes taxes
“more burdensome to the people than they are beneficial to the sovereign”.
The cost of taxes is not just the taxes we pay, but also the cost of complexity,
popularly now termed as ‘compliance cost’. There seems to be universal agreement
that the present tax code is way too complex and needs to be completely
overhauled.

1.2 Tax laws world over are complex, but the Indian
Income-tax Act has the unique distinction of being amended every year, often
retroactively and at times the law is amended even before it has become
applicable. This has resulted in an already complex law being made almost
incomprehensible.

1.3 Our tax laws live up to Senator Spark M. Matsunaga’s
statement :

‘They say there are only two certainties in life, taxes and
death. The only difference is, death doesn’t get worse every time Congress
meets.’


Why Tax laws are complex ?

2.1 Equity and certainty are two basic canons of taxation
that constitute the foundation of all discussion on the principles of taxation.
The canon of equity demands that tax paid should be commensurate to the
respective abilities of the tax-payers. That the rich should contribute to the
public expense not just in proportion to their revenue, but more than that. The
canon of certainty, as Adam Smith put it so succinctly entails that “the tax
which each individual is bound to pay ought to be certain, and not arbitrary.
The time of payment, the manner of payment, the quantity to be paid, ought all
to be clear and plain to the contributor, and to every other person, so that the
taxpayer is not put in the power of the tax gatherer“.

2.2 The economic reality is that no other branch of law
touches human activity at so many points and therefore tax laws will necessarily
be complex. The unfortunate truth is that it is difficult to design a tax code
that is simple and yet provides both equity and certainty.

2.3 The Government in the past has appointed several
committees to rationalise and simplify tax laws. Each report is a complete
report, but the irony is that the authorities have been selective in accepting
recommendations. This selective approach of the authorities has further
complicated the law. The need of the changing environment, if India is to emerge
as an economic superpower, is to bring about clarity in tax laws, where ‘tax
liability’ can be determined with certainty.

What is complexity ?

3.1 Taxation concepts by themselves are complex and are
troublesome enough, but when expressed in complex language, the confusion is
worse confounded. Hence, the case for simplicity is usually considered as
self-evident and is advocated as the panacea for all tax woes. However, there is
hardly any agreement as to what simplicity entails. For some, it means encoding
the tax law in a simple and easy to understand language. To others
simplification means a statute that contains a minimal number of distinctions
and exceptions, so that all arrangements or transactions with similar economic
effects receive the same tax treatment. In other words, deletion of exemptions
and deductions for different economic interest groups, resulting in a small and
simple Income-tax Act with fewer sections.



Can simplicity be achieved ?


4.1 Simplicity can be achieved by adopting any one of the
following broad parameters :


à
A “butcher’s knife” approach. This could be outrageously discriminatory and
grossly inequitable and unfair to a lot of people. For example, a fixed tax of
Rs.10,000 for every individual (irrespective of his income) would be very
simple, but would be totally unacceptable and unjust.


à
A flat rate of tax — that is — doing away with the slab system. This is
prevalent in some countries like Czech Republic, Mauritius, Russia, etc.
However, this system by itself can achieve only limited simplification unless
it is accompanied with removal of exemptions and deductions.


à
Make tax laws (like accounting standards) principle-based and not rule-based.
In other words don’t try to solve every conceivable problem or plug every
possible loophole, but instead enact a generalised statute that lays down
principles and clearly indicates their purpose. Surely, in today’s complex
business environment, this is a pipe dream. Even assuming such an approach
were attempted it would necessarily have to rely predominantly on voluntary
compliance. Advocates of this approach canvass that simplicity would promote
voluntary compliance and thereby boost revenue collections.


à
Social and political objectives for development of areas or special interest
groups should be through direct subsidies and not through tax laws. Subsidies
however have proved to be very costly and ineffective and experience now
suggests that these should be introduced only under very special
circumstances.



The reasons for complexity :

5.1 It is also undisputed that world over taxpayers are resorting to ever more complex tax structures to reduce their tax liability. Indeed, taxpayers (with the help of consultants) are blurring the line between tax evasion, tax avoidance and tax planning. Complex business structures, use of tax-friendly jurisdictions (tax havens), off balance-sheet transactions, interdealings with related enterprises, etc. are as much an integral part of the modern business as they are tools to minimise tax liability.

5.2 Indian laws are not any more complicated than in the US and many other European countries.
 
Tax laws world over are complex and will unfortunately remain so, as they have to deal with businesses that are complex and intricate.

5.3 Besides, modern tax laws are not just about revenue collection. They are also fiscal tools to achieve social, economic and political objectives. Despite the rhetoric from businesses and Government that they prefer a free market economy as a vehicle for the desired distribution of economic resources, in practice there is little faith shown in unassisted market to deliver optimal economic and employment growth. Special interest groups as well as political groups regularly lobby, often successfully and often justifiably, in carving out exceptions to the tax laws and thereby adding to complexity. It is routinely touted that exemptions and deductions should be reduced. However, the reality is that many groups will have special problems and their appeal for special treatment willsound perfectly fair and justified.

5.4 The bottom line is that as long as we continue to use tax codes to achieve economic, social and political objectives beyond raising revenue for necessary government programmes, it is impossible to achieve true tax Simplification.

5.5 To summarise, the primary reasons for tax laws being complex world over are:

  • Complex nature of transactions and business structures.

  • Multiple character of transactions.

  • Diverse nature of business, local, national and transnational.

  • Use of tax law as tools to achieve social, economic and political objectives, for example, education cess of 3%.

  • Exemptions granted to special interest groups or areas for encouraging economic development, for example, tax benefits granted to north-eastern States ‘and developers of residential real estate.

  • Desire of every taxpayer to arrange his affairs in a manner that minimises his tax liability.

  • Desire of every government to tax a part of profit arising out of a transnational transaction.

5.6 In India, the confusion is worst confounded on account of additional problems, which are purely administrative in nature :

  • Use of different languages in similar provisions, for example, some Sections in chapter VI-A use the term ‘attributable to’ as opposed to ‘derived from’ used in other Sections resulting in endless litigation.

  • Desire to deny deduction to which the assessee is entitled, leading to prolonged litigation, for example, S. 80HHC.

  • Bad drafting of laws. This is despite the fact that all members of the CBDT are from the field and are conversant with the problems faced both by the tax gatherer and the tax-payer.

  • Desire of tax gatherer to collect the most rather than the correct share of tax.

Complexity must be reduced if it cannot be eliminated:

6.1 This does not mean that no attempt should be made to rein in complexity. Complexity in itself creates opportunities for tax avoidance and also causes difficulties for honest taxpayers. It leads to confusion and mistakes that are often hard to distinguish from dishonesty. Consequently, penalties become a less appealing approach to enforcement, while simultaneously, detection becomes costlier. In other words, complexity not only increases the cost of compliance for the taxpayer, but it also increases the cost of enforcement for the Government. Therefore, before giving in to demands of special interest groups, one must think hard about whether the alleged equity or advantage resulting from each new exception (exemption, “deduction, etc.) is really worth the added complexity and confusion.

6.2 Lessons can also be learnt from international best practices. For example, OECD and the United Nations have been incessantly working for reducing complexities in international taxation by drafting model treaties for avoiding double taxation.

Simplification of Tax Administration:

7.1 Given the limited possibility of reducing complexity, the focus must necessarily shift from simplification of tax laws to simplification in tax administration. Greater attention should be’ paid to improving compliance through equity, improvement in taxpayer services, transparency and accountability. The last disclosure scheme was questioned and criticised on the ground that it rewarded the dishonest taxpayer. But its success also demonstrated quite effectively that simplicity coupled with a responsive administration works.

7.2 US President Lyndon Johnson said, “I do not suppose we will ever get to the point where people are pleased to pay taxes, but we owe it to them to see that the collection is done as efficiently as possible, as courteously as possible and always honestly.”

7.3 The concept of good governance and fair treatment of stakeholder is not just applicable to the corporate world, but is with much greater force applicable to the Government, which has the primary duty to treat taxpayer with fairness and dignity.

7.4 The Citizens’ charter published by the tax authorities proclaims its commitment to excellence in providing service to the taxpayers. It is about time that the Tax Department is held accountable on this promise. Tax practitioners should also work in tandem in promoting voluntary tax compliance. The unfortunate experience of the taxpayer and the tax practitioner is that the general approach is to treat the taxpayer as a tax evader and tax practitioner as evader’s abettor.

7.5 Simplification of tax administration can be achieved through systemic changes, effective use of technology and by introducing transparency and accountability. If information is available electronically and the interface between taxpayer and Tax Department is minimised to only where absolutely essential, then it will not only reduce the scope for malpractice, but would also improve tax administration. Higher transparency will automatically also result in higher accountability. In the age of ‘Right to Information’ this is the need of the hour.

7.6 Innovative steps in this direction could be:

  • Statistics of additions made at assessment level as compared to additions finally sustained, total successful appeals out of total appeals filed by each section of the Department, and so on can be made public through Department’s website.

  • Broad and well thought out parameters and not just revenue collection, should be used as criteria to judge the performance of the tax officers. This would go a long way in improving tax administration and bring about a change in ‘rnindset’.

  • The bureaucrat, it is said is as good as his last mistake. This mindset results in paralysis of action, as mistakes are not forgiven, but non-performance is ignored and often (ironically) encouraged. Tax officers need to be rewarded for prompt decision and action and held accountable for inaction and delay.

  • Focussed training along with systemic changes by introducing transparency and accountability can certainly trigger the process of change.

  • The Department should discourage filing of frivolous appeals. Statistics establish that majority of the appeals are filed by the Department. The Courts should award ‘cost’ -nay – heavy costs to the assessee, in case it is of the opinion that the Department’s appeal is frivolous.

  • Where an issue is pending before the Supreme Court, the lower appellate authority should pass an order to the effect that the matter will be dealt with according to the decision of the Supreme Court. This will obviate the filing of an appeal by the assessee.

7.7 Given that the tax laws will necessarily remain complex, controversies should be addressed as soon as they arise in order to remove uncertainty. The Tax Department should communicate its stand on complex laws through Circulars that are unambiguous. Unfortunately, the present trend is to issue Circulars that are more complex than the original law they seek to clarify. Above all, the Department should follow a consistent approach across all jurisdictions.

7.8 It is well known that changes introduced in the name of simplicity cause the greatest confusion. Complexity in administration can also be reduced by avoiding frequent changes in laws and rules, as they only lead to fresh ground of litigations and confusion. Since amendments are often with retroactive effect, the complexity and uncertainty embedded in the laws are further compounded and sensible planning becomes impossible.

In Conclusion:
8.1 The biggest problem today is not that the law is complex, but that it is administered in a complex and unfriendly manner. Focus must therefore change from simplification of tax laws to improving tax administration.

8.2 It is the duty of the Government to create an environment where tax compliance is encouraged and every taxpayer is not considered guilty until proven innocent. As William Gladstone said, “it is the duty of the Government to make it difficult for the people to do wrong and easy to do right”.

8.3 Though tax laws will never achieve the simplicity we desire, the challenge is to have a responsive and efficient administration which can to a large measure prove John Have’s statement wrong. I quote:
‘Income Tax is capital punishment’.

Banks and Internal Audit

Article

Corporate governance, as we all know, has been under a strong
and critical public spotlight in recent years, in the wake of a succession of
blows to market confidence and integrity, particularly in the United States, but
echoed in India and other countries as well. The community’s expectations of
Boards and senior management, and of those charged with providing an independent
review of a company’s operations and financial accounts, have been raised. To
meet those expectations, governments and regulatory authorities around the globe
have mounted a concerted campaign to improve standards of corporate behavior and
transparency through international harmonisation of accounting standards,
strengthening the principles of corporate governance, lifting the bar on the
‘fitness and propriety’ of directors and managers and introducing improved
market disclosure standards.


In this demanding environment, the Boards and senior
management need quality advice from sources that can be trusted and that can
offer an objective viewpoint. Much of the focus of Sarbanes-Oxley in the United
States and Clause 49 in India has been on the external audit function. Equally,
however, there is a need to ensure that internal audit is organised, resourced
and empowered, so that it can provide competent, impartial and fearless advice.

This article offers a perspective on the role of internal
audit. It then sets out the expectations of internal audit held by regulators at
the national level and how internal audit needs to gear up to meet these
expectations.

My comments are offered in a constructive spirit to encourage
debate within the internal audit profession.

The role of internal audit :

What better starting point for my comments than the
definition of internal audit approved by the Board of Directors of the Institute
of Internal Auditors :

“Internal auditing is an independent, objective assurance
and consulting activity designed to add value and improve an organisation’s
operations. It helps an organisation accomplish its objectives by bringing a
systematic, disciplined approach to evaluate and improve the effectiveness of
risk management, control, and governance processes.”


I remind you of this definition because I want to draw a
distinction between internal audit and risk management. As we see it, the basic
function of internal audit is independent appraisal of an institution’s internal
controls, including controls over financial reporting. Of course, a by-product
of internal audit will be recommendations on internal control and process
improvements that could be made, an important role for internal audit in large
and complex institutions in particular.

Risk management, on the other hand, is about identifying and
assessing inherent risks in the products and activities of an institution, and
ensuring that appropriate risk management limits, control mechanisms and
mitigation strategies are in place to contain risk within the institution’s risk
appetite and capital support. The distinction is that risk management has the
important and continuous responsibility of understanding how actual risk facing
the institution is changing (day by day or month by month) and assessing if the
risk limits, controls or mitigations need updating.

Of course, the institutions need to ensure cooperation
between internal audit and risk management and a clarification of roles, so that
unintended gaps do not emerge.

The expectations of Regulators :

The pivotal role of internal audit in the corporate
governance of institutions is enshrined in international standards for
regulators, though they are high-level in nature.

In banking as a case in example, the Core Principles for
Effective Banking Supervision, developed under the auspices of the Basel
Committee on Banking Supervision, specifies the principle that banks should have
in place internal controls that are adequate for the nature and scale of the
business. These should include, inter alia, appropriate independent
internal or external audit and compliance functions to test adherence to these
controls as well as applicable laws and regulations.

In assessing adherence to this principle, the Basel
Committee’s ‘essential criteria’ for the internal audit function are that it :



  • has unfettered access to all the bank’s business lines and support
    departments;



  • has appropriate independence, including reporting lines to the Board of
    Directors and status within the bank to ensure that senior management reacts
    to and acts upon its recommendations;



  • has sufficient resources and staff that are suitably trained and have relevant
    experience, to understand and evaluate the business it is auditing; and



  • employ a methodology that identifies the key risks run by the bank and
    allocates its resources accordingly.



The Basel Committee also issued a paper, Internal audit in banks and the supervisor’s relationship with auditors, in August 2001 to provide more detailed guidance to bank supervisors. The paper has wider applicability and I recommend it to those who are not familiar with it. It sets out 20 separate principles for the internal audit function, dealing with such issues as continuity, professional competence, the audit charter and relationships with the external auditor.

My Assessment on Independence  of the Internal Audit Function:

Our starting ‘point is determining whether the internal audit function is in-house or outsourced, and whether this arrangement is appropriate. The following crucial benchmarks need to be in place for internal audit teams.

(i)    Independence:

The Board of the institution should ensure that the independence of the internal audit function is maintained. This independence may be compromised if the function is directly involved in risk management or operational processes. The internal audit function may provide valuable input to those responsible for risk management, but should not itself have direct risk management responsibilities. In practice, some institutions (particularly small ones) may give internal audit initial responsibility for developing a risk management programme. Where this is the case, institutions should see that responsibility for day-to-day risk management is transferred elsewhere in a timely manner. Where the internal audit function is outsourced there should not be any conflicts of interest – for example, internal audit should not be a source of referral business for the institution.

Some  food for thought!

I would like to offer you my thoughts on some key issues:

(i)    Establishing  the authority  of internal  audit:

It must be recognised as a core part of governance and not as some form of necessary burden or add-on. Asserting the importance of authority is one thing, earning that authority is another. In the end, it is the professionalism and quality of internal audit work that will show Boards, senior management and regulators that the function does add value. Clearly, the message that internal audit wants to send will not carry weight if it cannot demonstrate that the message is founded on both technical and commercial competence – a balancing of technique and ‘real world’ skills and experience.

(ii)    Transparency  and  independence:

The provision of independence assurance to the audit committee (or Board) is the central tenet of internal audit. The internal audit function should report directly to the audit committee of the Board, and not to management with operational responsibilities. A direct reporting line to the Board has now become international best practice.

In my view, having internal audit answer to management creates real concerns about the independence of the review function. Internal audit must be able to directly inform the audit committee (or the Board) about the adequacy or otherwise of internal controls, including those involving high-level management. Internal audit must know that the board is its master.

(iii)Audit Committees:
The effectiveness of internal audit comes down, ultimately, to the use that the audit committee and Board decide to make of it. These days, diligent and probing Board directors want a strong and active internal audit function to assist them. They rely on internal audit’s knowledge of the risks facing the institution and the control weaknesses, and its recommendations for improvement, to help them discharge their responsibilities.

(iv) Conflict situation:
Regulators can cite too many examples where weak corporate governance has undermined the financial soundness of an institution, whether through unfocussed global expansion, pursuit of growth for growth’s sake, a dominant chief executive officer or a ‘good news’ syndrome. Internal audit should be alert to such signs of weakness and raise them with the audit committee (or Board) as governance, controls or review concerns.

Concluding remarks:
The ever-increasing pressure on institutions to manage their affairs and risks prudently poses considerable challenges for corporate governance structures and for internal audit, a key line of defence in these structures. Every challenge, however, is an opportunity. For internal auditors as a profession, the current environment is an opportunity to cement your presence in corporate India where India is Rising and Shining.

The challenges and opportunities for internal audit in this risk-focussed environment can perhaps be simply summarised as ‘looking at the right things, not just doing things right’.

World Financial crisis : Major reasons and way forward

Article

1. Introduction :


1.1 The entire world, particularly the developed countries,
are submerged into unprecedented financial crisis caused by the subprime
mortgage lending in the US. It is the worst turmoil after the great depression
of 1930s. Because of this crisis, a number of financial institutions in the
world are in deep trouble. Within a short span of a few days, large investment
banks and other financial institutions (e.g., Lehman Brothers, Washington
Mutual) have gone bankrupt or got acquired (e.g., Merrill Lynch, Wachovia
Bank). It is an irony of fate that investment banks were created out of the
great depression of 1930s and now the major investment banks (e.g.,
Morgan Stanley and Goldman Sachs) in the US are reconverted into normal banks
because of the present financial turmoil.

1.2 This article briefly analyses, in simple language, the
main causes of this crisis, its possible impact on India and the way forward.

1.3 The major causes of the financial turmoil can be
attributed to the following factors :

(a) Faulty Business Model : Subprime Lending,

(b) Financial Derivative Instruments, such as
Mortgage-backed Securities (MBS), Collateralised Debt Obligations (CDO) and
Credit Default Swaps (CDS),

(c) Credit Rating System and Agencies,

(d) Fault of Borrowers,

(e) Oversupply of Housing Inventory Fuelled by Speculation,

(f) Poor Corporate Governance : Lack of Promoters,

(g) Inadequate Risk Management Systems,

(h) Inadequate Regulatory Oversight,

(i) Accounting Standards,

(j) Automation of Credit Approval Process, and

(k) Cascading Effect


Let us briefly discuss each of these factors.

2. Faulty Business Model : Subprime Lending :


The primary cause of the present financial crisis is the
Faulty Business Model of the US lenders in the housing and other markets. To
grow their business, many lenders started lending to subprime borrowers,
i.e., borrowers who were not credit- worthy or were less creditworthy. In
2007, the size of the subprime mortgages was approximately US $ 1.3 trillion.
Such a large-scale subprime lending was possible because of easy availability of
money at an affordable rate which led to excessive leveraging (i.e.,
borrowings) by the mortgage lenders. Even though the borrowers did not have
adequate income or adequate borrowing capacity, money was lent to them for
purchase of homes in the hope that they will be able to meet their financial
commitments out of the appreciation in the real estate prices. The expectation
was that in future the real estate prices would increase significantly, and then
the borrower would be able to refinance his loan at a lesser interest rate. As
long as the real estate prices were rising, this model worked. In 9 years up to
2006, the real estate prices increased by 124%. This model started showing its
weaknesses as the housing prices started declining. From the last quarter of
2006 onwards, a large number of subprime mortgage lenders in the US started
failing.

The ironic situation is that to overcome the recession of
1990s in the US, ample liquidity at a lower rate was injected in the system.
This made subprime lending business very attractive. This led to the housing
boom and eventual housing price bubble. Now, the subprime failure has caused
unprecedented financial tsunami including big liquidity crisis. To solve this
problem, most of the Central Banks are injecting large amount of liquidity in
the system. If the bail-out packages are not carefully administered, it may lead
to further problems.

The fundamental problem is the price bubble in the real
estate market and the valuation bubble in the mortgage financing market. Once
the price bubble burst, the valuation bubble also burst.

3. Financial Derivative Instruments :


Once the original subprime mortgage lenders ran out of funds
for lending (even after excessive leveraging), the investment bankers and others
started creating financial derivative instruments, such as Mortgage-Backed
Securities (MBS) and Collateralised Debt Obligations (CDO). Further, these
instruments were made attractive by providing insurance through Credit Default
Swaps (CDS) instrument. These instruments were sold to various investors. Thus,
the original lenders got a seemingly unending supply of money for the purpose of
subprime lending. Through the creation of financial instruments in the home
mortgage market, the participants in the US home mortgage market were not only
home mortgage lenders but also investors who invested in the financial
instruments based on the underlying home mortgages. These investors are spread
all over the world and consist of banks, financial institutions, mutual funds,
corporates and HNIs. The private wealth management advisors and mortgage brokers
recommended this new asset class for investment purposes. This had a duel
effect : on the one hand, it supplied unusually large amount of money for
subprime lending and on the other hand, the risks associated with it were widely
distributed across the globe. Therefore, the adverse impact also is felt
instantly across the globe. If these financial derivative instruments were not
created, the amount of subprime lending and the consequential losses would have
been substantially lower.

4. Credit Rating System & Agencies :


The financial derivative instruments gained popularity,
because various credit rating agencies assigned investment-grade ratings to
these financial derivative instruments, on the ground that they are backed by
the underlying housing mortgages. They did not consider the housing price bubble
which was being built over a period of about nine years.

5. Fault of Borrowers :


Even though the subprimc borrowers had no known resources for paying the interest and repaying the housing loans, they borrowed recklessly, partly to capture the boom in the real estate market. Secondly, since they were high-risk borrowers, the interest rate for them was higher. To make it affordable, most of them opted for Adjustable-Rate Mortgages (or ARMs) with an initial lower rate of interest which was adjusted every two years. The borrowers borrowed money on ARMs in the hope that they would be able to refinance the loans at a lower rate of interest in future with the increase in the property prices. Since this did not happen, they were stuck with high interest-bearing loans. As the borrowers started defaulting on repayment of the subprime mortgages, foreclo-sures started. As the subprime lenders were not able to recover their money, a large number of subprime mortgage lenders went bankrupt.

6.    Oversupply of Housing Inventory Fuelled by Speculation:

Because of the nine-year long boom in the real estate market in the US, the builders started building real estate in the expectation that the boom would continue. To a great extent, the demand was pushed by investors and speculators who invested in the real estate in the hope that they will be able to make money by reselling them. The over supply reduced the home prices which further aggravated the problem.

7.    Poor Corporate Governance: Lack of Promoters & Conflict of Interest:

In the US, most of the financial institutions have no promoters. The salaries and bonuses of the senior management executives depend upon the performance of their companies. To get higher compensation from their companies, they need to show better current performance, without regard to the impact in the future. Thus, there is a conflict of interest situation in these institutions. How else can one explain that the CEO of now bank-rupt Lehman Brothers got bonus of US $ 22 million in March 2008 based on the performance of 2007 and after just a few months Lehman went bankrupt? Further, to acquire more funds for lending, the mortgage lenders required higher ratings for their financial derivative instruments. Rating agencies obliged because they would earn more fees. Relying upon the ratings given by the rating agencies, investors invested huge amount of money in the financial derivative instruments. Thus, one can say that there was a well-orchestred conspiracy for each party’s personal gain. This clearly shows that there was a poor corporate governance in these financial institutions.

In India, most of the companies have promoters with significant stake and therefore, they would not allow this type of conflict of interest situation to arise.

8.    Inadequate Risk Management Systems:

Several knowledgeable persons have asked: “How did such a financial tsunami arise despite the existence of the so-called sophisticated risk management systems in the US 7”. Firstly, the risk management systems are built around the business model. If the business model is faulty, no risk management system would help. Secondly, the risk management systems concentrated more on processes than on the business risks. Otherwise, the business risks would have been highlighted. Thirdly, conflict of interest also contributed to the inadequacy of the risk management systems.

9.    Inadequate Regulatory  Oversight:

Several mind-boggling questions arise in respect of the failure on the part of various regulatory agencies in the US in preventing or manaqinq the crisis. Various regulatory agencies, such as the Federal Reserve Bank, the Securities & Exchange Commission, Federal Deposit Insurance Corporation, etc., could not identify the crisis even after several bank-ruptcies took place among the housing mortgage lenders. Though the housing meltdown started from the last quarter of 2006, and a number of home mortgage lenders started facing crisis, the response of the government and the regulatory agencies was not only reactive but also delayed.

10.    Accounting Standards:

The accounting standards, particularly the mark-to-market requirement initially accounted for ‘unrealised profits’ resulting in rosy picture being presented of the financial health of the subprime lenders. Subsequently, as the borrowers started defaulting, the mark-to-market requirement had double adverse impact, because the provisioning or write-offs required increased significantly. Only a few months prior to the failure of several large finance companies in the US, their accounts were certified, both by their management and auditors, to represent a true and fair view of the state of their financial health! Does this situation not raise an eyebrow?

11.    Automation of Credit Approval Process:

The entire credit approval process for lending to the subprime borrowers was made objective and therefore, it was automated. For example, a few BPO companies located in India were authorised to approve subprime mortgage loans to US borrowers. It is obvious that subjective judgment was almost absent. Similarly, approval for the financial derivative instruments was also automated to a great extent, resulting in sky-rocketing of subprime lending.

12.    Macro Balance  Sheet:

To gain better understanding of the overall scenario of the financial crisis, let us assume that following is the consolidated balance sheet of all the players in the home mortgage financing market:

Let us say that the value of the mortgage houses has dropped by US $ 2 trillion. The houses have not disappeared; just their values have dropped. This loss is divided over the three categories of the providers of finance. The major loss will be borne by the holders of the financial instruments because its size is large. Since those investors are very large in number and spread across the globe, the financial turmoil in the US market has an adverse impact across the globe and is spread very widely among thousands of investors. The problem is compounded, because many investors in the financial derivative instruments have leveraged their investments. Further, even investors who have not leveraged are affected because of the substantial value erosion. Moreover, shareholders of finance companies and of companies holding the financial instruments have suffered because of the steep fall in the values of shares of those companies (e.g., the market caps of Freddie Mac, Fannie Mae, AIG, and Wachovia have fallen by more than 90%).

13.    Cascading  effect:

The liquidity crisis in the financial market has affected even companies which had no direct or indirect role in the mortgage financing market, because they are not able to easily get finance required for their businesses. In turn, their employees, suppliers and shareholders are affected. This reduces the purchasing power of the people all around because they are affected directly or indirectly. This, in turn, has an adverse impact on businesses because sales decline.

Even prime borrowers  may become subprime borrrowers or may default on their loan obligations if they lose their jobs or wealth because of the adverse economic scenario. It has also engulfed good mortgage-backed securities and therefore, the entire mortgage-backed securitised market has collapsed.

Thus, there is a multiplier negative cascading effect on the economy.

14.    Impact on Indian Economy:

Because of several unknown factors and unpredictable events which may happen abroad, it is very difficult to predict accurately what would happen in India. But the most-likely scenario is that in the short run, the Indian economy will be impacted to some extent, because of the withdrawal of investments by FIIs in the stock market, liquidity crunch, demand recession abroad, fear psychosis, etc. Some of the major adverse impacts would be difficulty”in raising funds through IPOs, FDls and borrowings; value erosion; slackness in the real estate market; fall in real estate prices; slowdown in industrial production, etc. The Indian financial systems are sound, the fundamentals of the Indian economy are strong and India has a large domestic market, and therefore, in the mid term and long term, India should not be materially affected by this turmoil. In fact, it can benefit from it, because after things settled down, more inflow of foreign funds will come to India as there are better opportunities for investments in India. However, the pre-requisite for this is that the RBI, SEBI, the Finance Ministry and the Government in general, should take appropriate measures to ensure adequate liquidity at an affordable rate and to sustain confidence among businesses and investors. Impact on the individual companies would depend upon the sector in which they are and their strategies. In the short run, cash-flow management and assets protection are more important than profitability and growth.

15.    Way forward : Expected major changes:

As a result of the financial crisis and the subsequent steps taken to tackle the same, the following major changes are likely to take place in the world:

  • The Emerging-7 Economies are likely to replace Highly Developed Economies (the Existing G-7) sooner than the year 2050, as was expected earlier. It was expected that by 2020, India will be the 4th largest economy in the world and by 2050 it would be the 2nd largest economic superpower in the world. Now, it seems that this will happen much sooner.

  • The financing business models, the structured financial products, the risk management systems and the regulatory mechanism in the financial market world over will undergo significant changes.

  • The accounting standards will also need to be revised significantly so as not to contribute to such crisis and be able to detect the same earlier.

  • Chartered accountants both as CFOs and as auditors will have to sharpen their skills to be able to detect signals of trouble earlier.

Corporate Governance — What is wrong with it

Article

Change, business leaders are fond of exhorting their
employees, is a constant. Within business organisations, owners and CEO’s are
fond of continuously changing the structure of the organisation, its reporting
responsibilities, its compensation practices and its business strategy. However,
when it comes to their own existence, all three participants in the world of
corporate governance (shareholders, directors and senior management) have
withstood any change. They ensure that the relationships between each of them
and the basic structure of those relationships have remained unchanged since the
first corporation came into existence. During this period of fossilisation, they
have been ably supported by business academicians in remaining in that state.


The first modern corporation established 500 years ago was
the East India Company. No Companies Act existed in those days and any corporate
entity could come into existence only by obtaining a Charter from the King.
Charles II issued a Charter imbuing life into the East India Company. This
company became the first juridicial person, ever. The Charter contained those
provisions that today one finds in a memorandum and articles of association and
in the Companies Act. It required that the shareholders of the company annually
hold a general meeting. The general meeting would elect the Board of Governors
(Directors) and also the head of that Board (Chairman and CEO). The Governor and
the Board of Governors were responsible for overseeing the management of the
company’s business. Each shareholder had a voting right proportionate to his
share-holding. Detailed bylaws would be prepared and those would have to be
approved in a general meeting. In the century that followed the setting up of
the East Indian Company similar Charters were proclaimed for companies that
traded with Russia, the Levant and Canada (Hudson Bay Co.). The last named still
exists and is the oldest extant corporation in the world. The Dutch also set up
corporations. As the readers will observe, the fundamental principles of
Corporate Governance laid down 500 years ago remain unchanged today. These are
that shareholders ‘own’ a company, managements manage the business on their
behalf and directors provide management oversight as agents of the
share-holders.

The basis for this form of democracy in corporations goes
back to far earlier times. After all, democracy is a word associated more with
the governance of nations than with the governance of companies. The oldest
known form of democracy was the Greek city states. However, that form of
democracy died with the decline of those city states and for over a thousand
years after that the world had no form of democracy. Democracy returned (to
Britain) in the 11th century A.D. The Anglo-Saxons and the Normans had grand
councils that advised the ruler. However, this was not of lasting nature and it
was only after the signing of the Magna Carta by King John that kings in the
U.K. were deprived of divine and absolute rights over their subjects. The Magna
Carta resulted in the establishment of the first Parliament in 1265. In the next
500 years this evolved but in essence Parliament represented the landed class.
While there were seats reserved for the clergy, essentially, the members of
Parliament were those who gave taxes and soldiers to the King. These happened to
be landlords because in those years land revenue was the only source of taxation
and land owners had powers over their serfs; they used these powers to send
serfs to the king’s army when he had to fight his wars.

The grant of the right to participate in democracy depended
upon whether an individual contributed to the State. Those who made no
contribution had no say in Parliament. Vast sections of the population were
deprived, whereas the landed classes became very powerful. The 18th century saw
a change in this thinking. French thinkers such as Voltaire influenced the
public thinking that eventually led to a revolution and the end of monarchy in
France. However, the Parliament that was established after the French Revolution
still did not provide for universal adult franchise. The true founders of a
democracy based on adult franchise were the founding fathers of the United
States of America. They propounded, for the first time, the concept that every
human being who is affected by the behaviour of a State should have a say in the
election of its Parliament. There was considerable debate upon how it would be
possible to provide for voting by millions of Americans spread right across the
country, many of whom had no concept of democratic participation. However, the
founding fathers persevered. Eventually, this belief spread across the world and
all countries today equate democracy with universal adult franchise. It would be
preposterous to even suggest that a person’s right to vote should depend upon
whether he paid taxes to the State or contributed to it in some other fashion.
Every person who is affected by the conduct of the Government is considered to
have the right to vote in the elections for its Legislature.

When the scheme of corporate governance for the East India
Company was conceived of, public thinking was limited by the democratic model
then prevailing in the British Parliament. Only three participants were
identified — management, directors and shareholders. In those times, there was
no scarcity of land or of labour; of the three economic factors, only capital
was in short supply. Consequently, the providers of capital, the shareholders,
were granted the right to elect the Board of Directors and approve their
corporation’s regulations. The contributions made by other factors of production
were wholly ignored. At that time, wealth was tangible. It consisted of
classical assets such as land, precious stones and metals. All tangible assets
were tradable for money and their ownership could change hands freely.
Consequently, he who had money would acquire wealth. Without money, the
acquisition of wealth was not possible. Indeed, capital was the only factor of
production that had mobility. Today, wealth lies not in tangible assets but in
intangibles such as ideas, technology, new ways of doing business, intellectual
property and other such intangibles. These are created not through vast outlays
of money, but through having outstanding individuals in an enabling environment.
In many companies now, tangible assets are amongst the smallest items in their
value.

Since the setting  up of the  East India Company through the Industrial Revolution and until the mid-20th century, business was mainly concerned with the rudimentary conversion of natural resources to meet basic human needs. Today, business comprises of the sophisticated networking of large numbers of stakeholders.

However, the world of governance is yet to comprehend these changes. The guru of American-style governance, Milton Friedman, has pro-pounded the capitalist view that management and directors should never be motivated by any consideration other than profit maximisation. Relationships with vendors, customers and employee are only transactional, governed by contracts. Those with the government and the public are legal, governed by the laws. Friedman believed that conscience should not motivate companies – only maximising shareholder value within the confines of laws should.

It is such thinking that has resulted in the nasty outcomes less than ten years ago in major U.S. companies (the Enron years) followed shortly after by the collapse of Wall Street. These events have shaken confidence in a model driven by Friedmanian greed. Worse, global companies have changed public behaviour – greed has engendered hedonism. And hedonism (combined with unchecked population growth in India) is the cause of climate change.

Not only has the old form of governance resulted in losses of trillions of dollars, it has created a threat to the very existence of the natural world. It is time this changed.

If the concept underlying democracy in a public sphere can also be applied to corporate democracy, it will require that anybody who is affected by the conduct of a corporation should have a say in electing its governors. In other words, all stakeholders in business should influence its governance, not only its shareholders and management. This would require a fundamental shift in thinking. The nature of reporting by directors and management (stewards), the holding of meetings, the provisions of memoranda and articles of association, the nature of resolutions requiring stakeholder approval and many other governance issues would need to be changed. So too, would be the change in the nature of the audit of stewardship reporting. Indeed, finance would be only one of the disciplines required of auditors. The first rudiments of such change are already visible in the Global Reporting Initiative. GRI reports bring out information classified by different stakeholders, but they are still attuned towards segmenting the information stakeholder-wise for use by shareholders. If stakeholders are to have a say in governance, such reporting would not be different.

It is unlikely that such a tectonic change will occur in the near future. It needs to overcome powerful vested interests including the entire world of the capital markets. But, until that happens, many of the major aberrations of corporate behaviour are unlikely to be controlled.

The way ahead for corporate governance in India

Article

Corporate governance includes providing assurance to
stakeholders within and outside the organisation that their interests are
protected by management on a sustainable basis. This noble objective makes the
Boards of listed companies responsible to absorb more mature governance
practices. Therefore, the market value of a corporate entity is a collective
perception of the stakeholders about its governance practices.


At present it appears that each day headlines announce
another bank failure in the United States arising from the sub-prime/cash crunch
fallout. It is inevitable that organisations across the world will be
significantly impacted by the resulting financial slowdown. Based on the media
reports, banks globally have taken sub-prime/cash crunch-related write-downs to
date totalling $ 500 billion including $ 250 billion from investments made in
Collateralised Debt Obligations (CDOs) in respect of Residential Mortgage-Based
Securities (RMBS) which have since ‘gone bad’. When these initial shocks subside
and legal actions are taken against the parties involved in the CDOs to recover
losses, no doubt questions will be raised about the code of corporate governance
in these organisations (arranging banks, portfolio managers, issuers,
professional advisers and rating agencies) — whether senior managements were
greedy and whether independent directors and advisers had abetted this greed. It
is unclear at this time to what extent our Indian banks will be shielded from or
exposed to the events unfolding in the United States, Europe and elsewhere.

Governance in family-owned companies :

Numerous listed companies in India continue to be family
owned or controlled. Most need better governance structures to thrive in an era
of globalisation. A key objective of successful corporate governance in these
organisations is to protect the interests of minority stakeholders, since
decisions are generally in the interests of preserving and growing family wealth
without necessarily benefiting minority stakeholders. In several mature
economies, stock markets are sceptical about family-owned businesses. When
family members are not bickering, it is thought they are looking after their own
interests rather than those of the business.

With deregulation in India and the increased number of
multinational corporations lining up to enter our country, many family-owned
businesses find that they are unable to match the multinationals in size,
strategy, leading-edge management techniques and spending power. Large
family-owned businesses in India should shift to strategies that will enable
them to compete more successfully and prosper in a changing environment. To
pursue any meaningful strategy, they need stronger governance models to prevent
the family bickering from damaging the business, help them attract and retain
professional management talent, and provide for a smooth succession plan to the
next generation.

Indian laws and regulations are complex, subjective and
confusing. They provide opportunities for family-owned businesses to feather
their nests. The ownership structures and shareholding patterns are left for the
families to decide, and minority shareholders do not have enough say in those
matters.

An advantage of family-owned businesses is their quick
decision-making capability, since most decisions are driven by the family’s
vision. However, it can be a disadvantage when adapting to the changing business
environment, since the majority of family-owned businesses have rigid and
inflexible goals. Another feature is that the performance of a family-owned
business generally reflects the consistency of the family’s thought process
where any conflicts could have a direct impact on its functioning.

Succession planning is poorly done in many Indian
family-owned organisations, since this may have extreme consequences like
fracturing the group into smaller pieces, changes in strategies or vision, and
consequent changes in policies which may adversely affect other stakeholders.
Family-owned businesses tend to have informal governance structures aimed
primarily at complying with laws and to make it possible for the business to
deal with the family’s concerns. As a result, many such businesses cling to the
family’s traditions, especially those that carry on its name and secure its
position in the community.

Most Indian family-owned businesses have long-term strategies
and are diversified in various industries, a throwback to the licensing days of
the ‘raj’. This approach usually means better sustenance and continuing benefits
for the minority stakeholders. The risk of losing family wealth also prevents
these companies from taking excessive risk and decisions are taken after lengthy
deliberations, albeit within the family’s key decision-makers.

The way ahead :

The Asian financial crisis in the late 1990s compelled many
countries, including India, to improve corporate governance. India now requires
listed companies to have independent directors and audit committees. Securities
laws and listing requirements of stock exchanges have been toughened, regulatory
authorities have more powers, and the media are more probing. Yet progress with
corporate governance is patchy. There are still a large number of listed
companies that appear to be unconvinced of the value of good governance. Laws
and regulations are not enforced rigorously and trained accountants and
management professionals are in short supply. Boardroom practices will not
change overnight, so regulators need to be patient.

Corporate governance laws and regulations are important because they set the platform for change. However, given the vast differences in ownership structures, business practices and enforcement capabilities, merely copying corporate governance codes from the U.S. or Western Europe Is a mistake. Nevertheless, the temptation to do so, prompted by foreign institutional investors, private equity firms and foreign-aid donors, is high. For example, the requirement under clause 49 to have the majority of directors as truly independent is unrealistic given the acute shortage of independent directors in India. In addition, non-compete and confidentiality clauses in contracts are difficult to implement, so companies are hesitant to give independent directors too much insight into their performance and strategy for fear that this information may be used against them. It is therefore better to enforce basic governance rules vigorously in India than to promote requirements that breed a ‘check-the-box’ attitude or go unheeded.

Government regulations, clause 49 and alignment of the legal framework in India with global regulations provide a greater degree of control over the governing boards of family-owned companies, making them more accountable and attentive to market demands. Disclosure requirements and auditing practices are also improving, as India moves closer to harmonising its accounting standards with IFRS. Quarterly reporting is now mandatory for listed companies, although it is dubious whether this truly improves corporate governance if the underlying numbers are unreliable.

Although India has strengthened her accounting standards and adopted minimum corporate governance rules via clause 49, she lags behind in enforcement. This is because business and politics are generally still intermingled, and the mechanisms for conflict of interest resolution are underdeveloped. Further, the government’s need to promote short term economic growth makes them reluctant to pester large businesses to protect minority shareholders.

One would expect investors and creditors to pressure Indian companies to comply in letter and in spirit with clause 49 rules. In practice, however, most of India’s domestic and foreign investors are reluctant to challenge management and would rather sell their shareholdings without making a fuss. It would be good for investors to be more vocal in support of corporate governance reform and more willing to question management. Many independent directors too are naive about their fiduciary duties and view their directorships as offices without real responsibility. They therefore need to be educated. Bodies like KPMG’s Audit Committee Institute are dedicated to providing independent directors with a forum to exchange information and knowledge with other independent directors, and support to enhance audit committee practices and processes.

To be fair, there are some Indian listed companies that have embraced corporate governance reforms. Infosys Technologies Limited, for example, discloses the extent of compliance with multiple corporate governance codes, reconciles its financial statements with various accounting standards (including U.S. GAAP), and its board has a majority of independent directors as well as independent audit, nominations and remuneration committees.

More common however are Indian companies with basic governance structures, such as boards with a few truly independent directors, but fall behind in actual board governance. Many boards follow the letter rather than the spirit of clause 49. To move to the next level, they should behave differently by asking management challenging questions, setting corporate strategy, monitoring risk management, contributing to CEO succession plans, and seeing that management meets their performance goals. Many Indian corporate titans publicly speak of the benefits of better corporate governance. But they also know that in the short term many practical barriers and hindrances block necessary changes. New forms of boardroom behaviour will take more time to become entrenched.

Sustainability  :

Progressive organisations need to demonstrate that they are aware and concerned about their socio-economic responsibilities in addition to their profit orientation. Organisations also need to contribute to improve the environment. The emergence of this thinking stems from sustainability being a global concern and organisations that contribute to sustainability of environmental and human resources are seen as responsible corporate citizens. So sustainability is an important element of corporate governance for any listed entity’s growth.

Factors contributing to the emergence of sustainability as an important corporate governance element:

  • The focus on the environment is due to increasing global concern on carbon emissions, resource diminution, global warming and other environmental threats. Society believes that corporate entities should take responsibility for conserving the environment and its resources by maintaining a healthy balance between increasing profits and saving our planet.
  • ‘Value’ today is perceived more in terms of the intangible assets of an organisation. An organisation aiming at continuous growth needs to build intangible assets like reputation, goodwill, a corporate image that depicts socio-environmental awareness, brand value and human capital. Thus market value is a function of an organisation’s ability to sustain its intangible assets in complex and competitive market conditions. Boards should monitor the sustainability of intangible assets in addition to other governance aspects.

  • Stakeholders now determine market sensitivity by assessing those who continuously supervise the entity’s corporate culture. The definition of ‘stakeholders’ broadly includes consumers, suppliers, government agencies, compliance boards and investors, who collectively and continuously assess an organisation’s ability to deliver value to its stakeholders. Thus sustainability is a strategic issue that requires the board’s attention.
  • Governing bodies and regulators have begun to monitor organisations’ contributions to society and the environment in addition to their economic contributions. Businesses planning to tap the global capital markets need to adopt global governance practices which marry an entity’s contribution to sustainability of our planet and people with its ability to generate profits in the long run.

Emergence of  the ‘triple bottomline’:

The ‘triple bottomline’ concept was introduced by Shell. The term describes the three essentials to assess an entity’s performance in the 21st century – People, Planet and Profits. An organisation’s contribution to society with regard to these three essentials is a gauge of its sustainability in the long term. A balanced contribution among these three aspects is seen as an indicator of a responsible organisation, with developed corporate governance practices and a positive corporate image among its stakeholders.

‘People’ refers to the society in which the entity functions ..The organisation’s practices should promote harmony and well-being of the social elements. This includes humanitarian labour policies, timely payment of wages, improved working conditions, and contribution to social initiatives like education and healthcare. Organisations have also started contributing to primary producers and other non-profit initiatives.

‘Planet’ refers to sustainability of natural resources like air, water, forests and minerals. Conservation of energy, reduction in generation of hazardous wastes, use of bio-degradable components and reduction of carbon emissions are initiatives taken by entities to pursue environmental sustainability. The less harm caused to the environment, the higher is the positive impact on the triple bottomline.

‘Profit’ not only refers to internal profits of the organisation in the accounting sense, it includes economic benefits enjoyed by society at large due to the organisation’s activities.

Markets perceive sustainable organisations as those who ensure that the negative effects of their operations are balanced by the positive effects of their social and environmental contributions.

Conclusion:

My personal views on the way ahead  are to :

  • Develop a code of governance specifically for family-controlled companies that are not as stringent as clause 49.
  • SEBI and stock exchanges to be more responsive to changes in the environment to ensure timely disclosure.
  • Indian organisations to develop an image that positions them as well-governed enterprises that protect the minority stakeholders’ interests on an ongoing basis.
  • Sustainability should become a key focus of corporate governance, with the corporate governance report including how entities have responded to their social, economic and environmental responsibilities.

Importance of Audit of Financial Intermediaries

Article

There cannot be any other appropriate time to write this
article, when the US financial crisis has engulfed the financial sectors across
the globe. This financial storm is no doubt worse than the Great Depression of
1930, and many more aftershocks are yet to be witnessed. The strongest and the
most respected institutions have either been declared defaulters or are in
near-default situations. Financial health of many companies reported to be very
strong in one quarter is suddenly showing a gloomy picture in the subsequent
quarter and declaring insolvency in the quarter next. The role of an auditor has
come under the scanner.


All these simply reflect that unexpected changes
in the economy have come faster than its capacity to meet the ‘challenges of
change’. Due to this paradigm shift in financial sectors the traditional
approach to auditing has lost its shine. At the same time, Auditor’s Report will
now be the sovereign document providing the testimony to the health of the
company as auditors whilst reporting consider the concept of ‘going concern’.
This Article aims to provide some newer approach for audits of financial
intermediaries.

Financial Intermediaries :

Financial intermediaries are broadly classified into two
types :

(1) Advisory or fee-based financial intermediary,

(2) Asset-based financial intermediary.


Whereas the advisory/fee-based financial intermediaries
charge fees for services rendered, the asset-based financial intermediaries earn
their income from interest spread or say from difference in currencies. Many
financial intermediaries also have their proprietary business models in addition
to providing services to their clients. Some of the financial intermediaries
are :

à
Stockbrokers.


à
Portfolio Managers


à
Mutual Funds


à
Financial Institutions


à
Merchant Bankers


à
Depository Participants


à
Venture Capital Companies


à
Non-banking Financial Companies . . . . etc.



ICAI in its various pronouncements on ‘Accounting’ and
‘Auditing and Assurance’ Standards has dealt in details about the way auditing
needs to be done. In spite of that, everyday we hear about how companies have
played fast and loose with accounting norms. Therefore, an auditor needs to
equip himself with modern techniques of auditing. The following are some of the
important aspects of auditing of financial intermediaries.

Regulatory Compliances :

During the last few years, there have been substantial
regulatory and operational changes for financial intermediaries. Regulators such
as SEBI, RBI have travelled a long way in mandating the code of conduct, and
do’s and don’ts for the intermediaries. These are brought in with the objective
of improving market efficiency, transparency and preventing unfair trade
practices, and thereby raising the standards of operations.

Is business taking priority over compliances ? or it’s
otherwise, is a key indicator for hidden intentions. Irregular business
practices, weak controls and process gaps are some of the areas an auditor needs
to study. The auditor also needs to study compliance norms applicable to these
organisations, degree of adherence and probe into reasons for non-compliances.
At times, periodic compliance reports are submitted to the regulators, copy of
which needs to be obtained. Internal reports of compliance officer, and
correspondence with the regulators also need to be studied to gauge the risk of
non-compliance.

Risk Management :

As robust, flawless and seamless manufacturing activities are
paramount to survival of any manufacturing organisations, so is ‘Risk
Management’ for Financial Intermediaries. There can be various types of
risks such as credit risk, IT risk, process risk, regulator’s risk, market risk,
operational risks, etc. The nature and degree of risk depends on the business
model of the financial intermediaries. Models such as retail, agency,
proprietary, distribution, advisory will have different risks associated to its
business.

For measuring the risk, the auditor needs to employ his
analytical skills in addition to his mathematical skills. He should be in a
position to travel beyond the financial numbers and assess ‘vulnerability’.
He should be more alert in volatile market conditions as regards valuations,
open exposures, accruals or deferment of gain and liquidity positions. He needs
to see whether the risk management policies stand the test of time and there are
no human tampering or human intervention of sacrosanct risk parameters set in
the system. Exception reports, process of decision-making and documentations
also need to be studied. At times, the revenues or exposures are concentrated to
certain set of customers, branches, products or regions posing a greater threat
of defaults. The auditor needs to verify whether risk is well spread or
concentrated, and whether or not the system is capable of throwing early alerts.

Auditing under IT Environment :

Technology is a key enabler for accounting, operations and internal controls. In today’s times, companies operate in a highly complex IT structure and environment. From computerised accounting the companies have moved far away to computerised processes, operations, documentation, controls, etc. They also operate in highly fragmented environment using different softwares for different activities. Though controls have been shifted to computers, occurrences of frauds are still continuing, only the way the fraud is happening is changing.

The objective and the scope of audit does not change in an IT environment. However, the use of computer changes the processing, storage, retrieval and communication of financial information and may affect accounting and internal controls. With e-commerce, the auditor needs to develop e-audit capabilities. He needs to gather sufficient understanding of computerised environment, the source data, the data which is getting processed, the parameters and constraints used in processing the data and lastly the reliability of the output. Some of the other important audit checks are:

  • Degree of security levels and policy of escalations.
  • Interaction with process heads to understand and to obtain requisite reports from them.
  • Reconciliations of MI5 reports with financial data.
  • Testing the effectiveness of controls by performing ‘walk throughs’.
  • Verify the audit trail for critical transactions and test the result outside the system.
  • To study IT policy, IT business reports, compliance status, report of external expert, etc.
  • If needed, have a meeting with back office/accounting software vendors.
  • To verify whether end-to-end integration, process of validations, maker-checkers are in place or not.
  • Review physical securities, access logs, network accounts, remote access, no. of servers, connectivity, etc.

Creative Accounting:
Creative accounting refers to accounting practices that may “follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules.” They are characterised by excessive complication and use of novel ways of determining income, assets or liabilities. Such innovative and aggressive ideas are also found in accounting of financial intermediaries. These ideas/practices are used for variety of reasons which include favourable effect on share prices, improved credit rating, incentive compensation plans, promises given to private equity investors, etc. Even smaller companies sometimes resort to such practices for tax planning.

The book on ‘The Financial Numbers Game’ by Charles W. Mulford and Eugene M. Chomiskey has described in details how to detect such practices. The duty of the auditor in such circumstances is very delicate. He should be in a position to distinguish fraud from error by identifying the presence of intention. Recurrence of non-recurring items, inappropriate accruals, exotic products and innovative valuations are some of the forms of creative accounting. It is said that the great tragedies of history have occurred when both parties were right. Therefore, if some accounting treatments are ‘not wrong’, the auditor should clearly spell out that “they are not right”.

Accounting for Financial Instruments:

Accounting Standards, AS-30, 31 and 32 have been recently notified by ICAI, detailing recognition, measurement, presentation and disclosures of financial instruments, including. derivatives contracts. These standards are set to form new rules of accounting for financial products. Fair value accounting and hedge accounting are two major departures from the principles of convertism and prudence. Though the recent U.S. economic crisis has given rise to some doubts on ‘fair value accounting’, as of now it remains on the books.

The auditor needs to obtain thorough understanding of these standards, especially for derivatives contracts. Off-balance sheet exposures, marked to market valuations, fair value identification, hedge relationships are a few of the tricky situations where the auditor needs to exercise judgment. At times, in volatile market, post-balance sheet events are very critical for framing an audit opinion. The more complex is a contract, the simpler and clearer should be its accounting entries, is a fundamental rule. Even in case of sub-prime crisis, nobody knew where the ultimate loss rests – in other words – who is bearing the loss. The auditor should understand and pierce the web of complex contracts created with the help of multi-layered corporations.

It is, I repeat, necessary to apply the standards of ‘fair valuation’.

Other Common Approaches:

Apart from emphasis on above specific approaches, the auditor has to give due importance to the following procedures :

  • Review internal audit reports, their scope, coverage and observations.
  • Review of critical operations outsourced to external agencies.
  • Review of audit committee’s observations.
  • Adherence to the requirements of clause 49 for corporate governance.
  • Decision-making processes, whether system-based or person-based.
  • Continuous review of latest Circulars, Notifications applicable to the auditee.
  • Mapping of all the procedures in a sequential flow, so as to establish reliability on final output.
  • Whether there is bifurcation of own funds and securities from client fund and securities at all levels.
  • Rotation of audit staff and giving them adequate training and authority to conduct audit.
  • Interaction with departmental heads and review of business reports.
  • Do comparative analysis with other entities in the same industry.
  • Verify the transactions with related parties/ group concerns.

Conclusion :

The accounting system is currently under stress. On the one hand, creative solutions and interpretations on complex issues are put forward in the name of innovations to suit intentions and achieve objectives and on the other hand the value system is diluting.

Though the old principle of auditing, ‘Independence, Integrity, Objectivity’ coupled with competence still holds good, one needs to re-invent the audit approach. Auditor’s ‘Independence of fact’ blended with ‘Independence of appearance’ is of utmost importance to maintain public confidence and to enhance the value of audit function.

These are challenges of change. Though the challenges are tough, I have no doubt that the profession will change faster than the change and grow stronger than the challenges.

Arthashastra : The guide for managerial effectiveness

Article

In the present era of globalised business environment,
corporate history has shown that it has become more difficult for successful
organisations to remain successful. The corporate world is full of examples of
companies such as Nissan Automobiles of Japan and I.B.M. of U.S.A. taking a
knock. A study of such companies has identified managerial effectiveness as the
essential element for any organisation to remain successful in the present
dynamic and continuously evolving business environment. It is interesting to
note that Arthashastra, a treatise on Economic Administration, written by
Kautilya in the 4th century before Christ, identifies managerial effectiveness
as the key element for continuous prosperity and growth of any kingdom.


Kautilya has identified eight elements for managerial
effectiveness as under :



  1. Leadership
  2. Strategy
  3. Structure
  4. Execution
  5. Culture
  6. Talent, Temperament & Technique
  7. Innovation
  8. Strategic Alliance



Interestingly, these eight elements have also been identified
by a study made by the MIT Sloan School of Management, of successful
corporations in the decade of 1991-2000.

Kautilya wrote Arthashastra as a guide for ‘those who govern’
after studying ancient literature such as Atharvaveda, Brahaspati Sutra and
Mahabharata. Kautilya identified these eight elements as essential in the
practice of governance for growth and prosperity.

Kautilya explains each of these eight elements as under:

Leadership :

Leadership in society rested with Swami, the king, and
leadership essentials, such as duties, responsibilities and strategies are :



  • A king who observes his duty of protecting his people justly, according to
    law, goes to heaven, unlike the one who does not protect his people or
    inflicts unjust punishment.



  • A king, who flouts the teachings of Dharmashastra (values) and Arthashastra,
    (material well-being) ruins the kingdom by his own injustice.



  • A king has responsibility for promoting economic well-being by preserving law
    and order through developing extensive administrative machinery.



  • Duties of a king in internal administration are three :




  1. Raksha : Protection of the state from external aggression
  2. Paalana : Maintenance of law and order within the state
  3.  Yogakshema : Safeguarding the welfare of the people




  • A king has to understand that prosperity of the state and its inhabitants
    cannot be maintained continuously, unless new territory is acquired by
    settlement of virgin lands through conquest or alliance.



  • Self control, as a discipline, is essential for a king. Self control can be
    acquired by controlling six emotional devils, such as :




  1. Krodha : Anger
  2. Kaama : Lust
  3. Lobha : Greed
  4. Mana : Vanity
  5. Mada : Haughtiness
  6. Harsha : Overjoy




These leadership essentials are relevant to our corporate
world. They highlight the responsibilities and duties of any CEO, both in
internal administration as well as in developing strategies for expanding the
operations of a corporation.

Kautilya defines a wise king as Rajarishri and highlights the qualities which are necessary for a wise corporate leader of the 21st century. These qualities are:

  • Cultivation of intellect through association with elders (experts)

  • Striving for improvement of own discipline by continuous learning in all relevant branches of knowledge

  • Keeping vigilance on challenges and threats to security and welfare of the state through developing process of accurate information gathering

  • Developing capabilities through specific efforts to enrich people and doing good to them

  • Ensuring observance of Dharma through practice and setting one’s own example through-out the kingdom

  • Power of reasoning, based on strong and clear intelligence, can prevail over external circumstances and shape events. Victory is assured when one sees things as they are and shuns illusions

  • Developing self control through controlling emotional devils

  • The king should be ever vigilant and protect himself against machinations of his own min-isters

  • Educating the successor through providing education to the Prince in Dharmashashtra, (ethics), Arthashastra, (economic administration) and Dandaneetee (protection).

The above explanation about leadership in Arthashastra is universal and is relevant even after 2000 years.

Strategy :

Kautilya defines objectives of an organisation as :

  • Acquire power
  • Consolidate  what  has been  acquired
  • Expand  what  has been  acquired
  • Enjoy what  has been  acquired

 
This set of objectives exactly meets the concept of economic performance developed by management scholar Peter Drucker in 1951 in his article on ‘Concept of a Corporation’. Drucker’s concept of economic performance is based on the following strategies :

  • Make present business  effective
  • Identify potential  and  realise it
  • Make it a different business for different future

To meet the objectives of a kingdom, Kautilya identifies two sets of strategies, internal and external. Internal strategies focus on making the state i.e., kingdom, effective and efficient. External strategies focus on the challenges to the kingdom, in terms of opportunities and threats from external environment. Kautilya’ s inputs in strategy evolution are as under:

 Internal  strategies  :

“A king can rule only with the help of others. One wheel does not move a chariot. Therefore, a king should appoint advisors, councilors & ministers and listen to their advice.”

A king should govern by the Rule of Law, Dharma and Nyaya which alone can guar-antee security of life and welfare of his people.

A king should develop self discipline and encourage others to develop self discipline. Self discipline can be developed through mental faculties, such as

  • Obedience to a teacher
  • Desire and  ability to learn
  • Understanding what  is learnt
  • Capacity  to retain  what  is learnt
  • Ability to make inferences through deliberation on what is learnt

Social order should be maintained through

  • Legal framework designed specifically to enact laws and control unsocial behaviour and to dispense justice
  • It is also necessary to take initiative to enact or promote new laws as per the need of the situation
  • Clear  regulations regarding penalties with regard to fire, hygiene, sanitation, privacy as well as consumer protection are essential for any kingdom.

  • The route to wealth is economic activity and lack of it will lead to material distress. Hence productive forests, mines, cultivable lands, water reservoirs, production and storage units have to be established to nurture and promote trade and commerce.

  • Creation of a network of secret agents, gudha purush, is essential for security of the kingdom as well as for expansion by conquest.

External strategies:

  • External strategies of a king should be based on power equation between two kingdoms.

  • Power is not a factor which is constant over time. Power can be influenced by intangible and unpredictable factors. Hence strategies to change power equation should be based on identifying such factors.

  • A king should always keep long-term advantage in mind and should be willing to sacrifice short-term advantage for a distinctive long-term gain.

  • When faced with a strong king, a comparatively weak king should always remember that in the strength of a strong king lies his weakness.

  • It is always advisable to have allies, Mitra, for strategic alliance which would be necessary to ward off the designs of a strong king.

  • Acquisition of another kingdom, Sangha, is more desirable in the long term than an alliance.

  • Every external strategy should be based on Mantra, the sum total of good counsel, analysis and judgment.

  • Sangha, that is kingdom, can be raised to a condition of greatness and power by taking advantage of a stroke of fortune or by treachery. One needs to study from history how successful kings have analysed the environment and developed strategies to win.


Structure:
Kautilya is aware that to execute any strategy, there has to be a structure with the king, Swami, at the head of the structure. However, he also shows his awareness of the fact that tall or hierarchical structure can be an impediment in successful execution of strategy. He advocates a ‘flat’ structure.

Kautilya, therefore, specifies that a king should have only four reporters. They are:

  • Amatya : Prime Minister
  • Purohit : Chief Justice
  •  Senapati : Chief of Armed Forces
  • Yuvaraj : Prince/Successor to the king

He also proposes a routine for the king to meet his subjects to get a chance to verify information supplied to him by his reporters as well as to get a first-hand information about the success or failure of the strategies developed for the benefit of the kingdom.

Kautilya is keen to ensure that the king always gets correct information and which is cross-checked. Hence in his design of the management information system, he proposes the use of ‘Gudha Purush’ – the spy mechanism.

Kautilya’s stand on shorter span of control, such as ‘four reportees’ is accepted by major management theorists who emphasise on flat structure and sharp information gathering system for strategic decision making.

Execution:
Kautilya emphasises that successful execution of strategies is very important to meet the fundamental aims of any kingdom. He highlights that the important element in execution is power, ‘Dandaneetee’. He highlights four aspects of execution that are based on power. These are :

  • Acquisition of what has not been acquired.
  • Preservation of what has been acquired
  • Augmentation of what has been preserved
  • Distribution among those who deserve what has been augmented

These aspects can be seen from the point of view of the execution of strategies in the corporate world, especially in the present era of globalised world. He points out again and again that concentration of the king should be on exploitation of natural resources and development of national income.

Power that is needed for execution of strategy, ac-cording to him comes from seven elements of the kingdom. These elements are:

  • Swamy    : King
  • Amatya  : Prime  Minister
  • Janapada: People
  • Durga  : Fort
  • Kosha  : Treasury
  • Bala  : Defence  Forces
  • Mitra  : Allies

These elements can be seen in the corporate world as under :

  • Swamy : Owners or Board  of Directors
  • Amatya : Chief Executive Officer/Managing Director
  • Janapada    : Employees    of the  organisation
  • Durga  : Defensive  Strategies
  • Kosha  : Cash  Flow/Financial  Position
  • Bala : Specific skills such as Marketing, Operations, Finance, H.R.
  • Mitra  : Strategic  alliances

Culture:

Kautilya promotes the idea of a culture based on Dharma and Nyaya (values and fairness) to ensure concern for fairness and civic responsibility through-out the kingdom. At the time Arthashastra was written, the constitution of a society was based on Varna, the caste system – different stakeholders. Kautilya highlights the roles of each stakeholder in the society and the king co-ordinates the role of each stakeholder for effective and efficient running of the kingdom. He, therefore, emphasises the importance of roles played by the lower castes and gives them the status of Aryas to connote the theme of equality in society.

His advice for developing a healthy culture within the society is based on teaching of Vedas. He emphasises the supremacy of Vedas by stating “The kingdom, when maintained in accordance with Vedas, will prosper for ever and not perish.” The concept of culture emphasised in Arthashastra is perfectly applicable to the corporate culture. The corporate culture will be fair and responsible only when everyone working realises the roles played by different functional areas such as marketing, finance, operations, systems and human relations and their importance for effective and efficient operations. Similarly, the culture within the orga-nisation will be strong and healthy when it is based on values and fairness as it would help create the corporate brand, which is essential for attraction and retention of talent.

Talent, temperament  and technique:

Kautilya is very specific in terms of the officials to be appointed by the king for the administration of the kingdom. He specifies officials in three categories : Statesmen, Warriors & Artisans and specifies their duties. Statesmen have the duty of making laws and govern the state in accordance with the laws. The duty of the warriors is to protect people from both internal and external danger and the duty of artisans is to undertake economic activities to satisfy the needs of society.

Kautilya highlights talent and temperament as the qualifications of officials to be appointed by the king. He advises the king to make a thorough check on the prospective candidates. He sets out a procedure to select suitable candidates as under:

  • Family background, nationality and amenability to discipline of the candidate should be verified from reliable people.

  • Knowledge  of functional areas should be verified by experts from different functional areas.

  • Intelligence, perseverance and dexterity of the candidate should be evaluated from the past performance.

  • Eloquence, boldness and presence of mind should be ascertained through a personal interview.

  • Closely observing how the candidate deals with others will show his energy, endurance, integrity, friendliness, loyalty and ability to suffer adversities.

  • Health, character, strength, amiability and love of mankind of the candidate should be found out from his close friends as well as personal observations.

Kautilya is very specific in suggesting that even after appointment, the king should test integrity through a variety of secret tests. The tests should highlight the qualities such as Dharma, the values, Artha, the financial judgment and Nyaya, the sense of fairness.

Kautilya highlights the importance of effective thinking for success. He emphasises study of history as it reveals the essential features of the historical processes and provides an insight into cause and effect relationship, which in those times was attributed to chance or providence. Kautilya states that chance or providence is not to be considered as given. Chance and providence can be brought under human control through systematic thinking.

The technique to merge talent and temperament is necessary for success. According to Kautilya, this lies clearly in the hands of the king, who should develop the art of getting the best out of his people by regular assessment, rewards and promotions for effective and efficient officials.

Kautilya’s thinking on talent, temperament and technique provides an ideal platform for designing corporate H.R. policies. His ideas highlight the need for identifying training areas required for continuous growth and for controlling attrition, which is a major concern of H.R. specialists in the corporate sector.

Innovation :

Kautilya in Arthashastra identifies innovation as a key element in war and covert operation strategies. He has been blamed by the western historians for proposing gudha purusha system, that is spy mechanism. However, considering the challenges to a king in those times, this was a unique innovation for safety of the state.

Kautilya provides a variety of options for selecting secret agents. These were mundajatila, the shaven headed ascetics, a sadhvi, the nun, a rich widow, orphans, dumb persons, astrologers, readers of omens, barbers, caterers, among others. The selection is based on the fact that these persons have social acceptability and are invited by villagers to come to their houses and also stay there, if the need arises. Hence, they have easy access to information. These agents were to be trained in sign language, palmistry, magic and illusions. He also points out that transmission of information gathered is important and this needs innovative ways. He identifies ways such as songs, story telling, signals and signs and hidden messages in the musical instruments.

In terms of war strategies, Kautilya emphasises the importance of innovative moves for victory. He identifies incidents such as a weak king facing a strong king in the battle ground and states, “In the strengths of the strong king, lies his weaknesses.” He illustrates by providing an example, such as when faced with an elephant brigade, the weak king needs two crocodiles. He highlights that the elephants are mightily frightened of crocodiles and when confronted by them, they will try to turn around and run, and hence crocodiles will foil the attempt of the strong king to trample over the army of the weak king.

Kautilya also points out that power, time and place are interdependent and any event is a total product of these three forces acting and reacting upon one another. Hence he claims that success does not belong to divinity, that is, Daivam, which is considered beyond man’s control, but belongs to Manushyam, that is thoroughly seen by man and brought under control. Manushyam is based on effective and timely thinking ability of a person.

Another innovative idea Kautilya provides is benchmarking. He advises the king to identify cultivation and trading practices as well as war strat-egies of the neighbouring kingdoms, which could be deployed for better output and trading gains and security throughout the kingdom.

In the corporate world of the 21st century, innovation has been accepted as the key element of success in the globalised environment and some of the examples from Arthashastra are good pointers for devising strategies to win in the market place.

Strategic  alliance:

In the globalised corporate world, to enter into new markets and to develop competitive advantage, strategic alliance has been identified as an important strategic move. Strategic alliance, in principle, is a tie-up between companies which bring their specific core competencies together for specific products or markets, while keeping their individual identities. It is not a merger, but an alliance for growth, a basically win-win situation for both parties. In the recent past, Indian companies have started forming such strategic alliances to enable them enter foreign markets as well as to compete effectively in the home markets. To cite an example, Bajaj Electricals have made a strategic alliance with a Chinese company for making electrical components in China, which are sold by Bajaj Electricals in India as well as in other countries. Similarly, General Motors of USA have forged a strategic alliance with Sundaram Fastners for de-veloping and producing auto components for Indian as well as South-East Asian markets.

Kautilya has visualised the scope of strategic alliances for security and prosperity of a kingdom in the 4th century prior to Christian era. He identifies kings with whom a king can forge a strategic alliance as Mitra and classifies them it) three categories, such as dangerous allies, worthy allies and best allies.

Dangerous ally is one

  • whose past shows that he has attacked an ally by joining forces with others or under the influence of others
  • who has sold himself for a price to the enemy and withdrawn himself at crucial times
  • who would change affinity due to weakness or greed.

Worthy ally is one

  • who exerts  himself on behalf  of the  alliance
  • who is worthy  of respect

Best ally is one who  shows  six qualities

  • Ally of the family for a long time
  • Amenable  to control
  • Powerful  in his support
  • Shares  common  interests
  • Ability to mobilise troops and resources quickly
  • Has never betrayed a friend.

 

Kautilya points out that in choosing allies, one has to make choices, as there could be different options. He identifies such options by giving examples as under:

  • If the choice is to be made between two allies, one who is constant, but not amenable to control and the other who is temporary but controllable. Many scholars felt that a constant ally, though not amenable, is to be preferred. But Kautilya disagrees. His choice is the temporary ally who is controllable, because he remains an ally so long as he needs help. The real characteristic of an ally, according to Kautilya, is giving help.

  • If a choice is to be made between two allies, both are amenable to control, but one can give substantial but temporary help, while the other can give little but constant help. Many scholars would prefer an ally who gives substantial help. Kautilya, however, preferred constant ally even if he gives little help. He argues that the con-stant ally provides help continuously over a long period of time and therefore, contributes more to the alliance.

  • If the choice is between a mighty ally who mobilises slowly and a less mighty ally who mobilises quickly, Kautilya prefers the one who mobilises quickly, as he states success depends on interaction between power, time and place.

If these choices can be seen from the position of options a company has in the present environment for strategic alliance, it shows an in-depth understanding of the issues which need to be tackled from the point of view of managerial effectiveness.

Arthashastra was written by Kautilya as a guide for those who govern. Throughout the treatise, he implies that good governance is based on managerial effectiveness and highlights areas a king should concentrate on for managerial effectiveness. His insight into issues involved in managing a kingdom effectively, makes his treatise an excellent guide for managerial effectiveness, which has relevance to the corporate world of the 21st century.

Kautilya challenges us to use these concepts.

Service of order — Original receipt of service not produced — Statement of proprietor of courier service agency cannot be accepted.

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Service of order — Original receipt of service not produced —
Statement of proprietor of courier service agency cannot be accepted.



[Carter Hydraulic Power P. Ltd v. UOI, 2010 (256)
ELT 394 Cal.]

The appeal filed before the Commissioner of Central Excise
(Appeal II) was barred by limitation, therefore, the appeal was dismissed. The
said order was upheld by the Tribunal. On further appeal before the High Court
the appellant submitted that the copy of order of adjudication from the
Department was not at all delivered, therefore the appeal was not barred by
limitation.

The advocate for the Department filed a photocopy of the
receipt allegedly obtained by the courier service agency at the time of
alleged delivery of the order to an employee of the appellant. It was
submitted that the original was not available. A copy of the statement by the
proprietor of the courier service agency was produced, which stated that he
personally delivered the envelope to one Mr. Das, who was an employee of the
appellant company. The appellant submitted that the copy of order was never
delivered. It was submitted that there was no such employee as ‘Sri Das’ in
the organisation of the appellant.

The Court held that it was not clear whether the
adjudication order was ever delivered to the appellant company. Unfortunately,
the original receipt was not available, therefore it would be too risky to
accept the contention of a proprietor of a private courier service in order to
frustrate a statutory right of a citizen. To avoid all future controversies in
the matter, the order of the Tribunal was set aside and held that the appeal
was presented in time. The Commissioner of Central Excise (Appeal II) to
consider the appeal on merits.

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Dishonour of cheque — When cheque is issued by partnership firm from its bank account, the cheque is said to be issued by all partners — Partnership Act, 1932 S. 18.

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Dishonour of cheque — When cheque is issued by partnership
firm from its bank account, the cheque is said to be issued by all partners —
Partnership Act, 1932 S. 18.



[Mukesh Raoji Navadhare v. Ajit Bhaskar Kasbekar & Anr.,
AIR 2010 (NOC) 817 (Bom.); 2010 (3) AIR Bom. R 195]

The petitioner and the complainant were carrying on
business in partnership in the name and style of M/s. Shantakrupa Corporation.
The firm issued a cheque to the complaintant. The cheque was signed on behalf
of the firm by the petitioner as its partner. The cheque was dishonoured.
Pursuant thereto a complaint u/s.138 of the Negotiable Instrument Act was
filed but the firm was not joined as a party. The issue arose whether such a
complaint was maintainable.

The Court held that a partnership firm is not a body
corporate. S. 4 of the Partnership Act defines ‘partnership’ as relation
between the persons who have agreed to share profit of a business carried on
by all or any of them acting for all. The persons who have entered into a
partnership with one another are called individually as partners and
collectively ‘a firm’. The name under which the business is carried on is the
firm name. The firm name is merely a compendious name given to group of
persons who have agreed to carry on business in partnership.

In this case, the cheque was drawn from an account in a
bank maintained in the name of the firm. It bears the rubber stamp of the firm
and the petitioner had signed it as a partner of the firm. In law, when a
cheque is issued by the firm and from an account maintained by the firm, the
cheque is issued by all the partners and one of the partners merely signs it
as an agent of the firm i.e., agent of all partners. The complainant
who is a partner of the firm would, therefore, be regarded as one of the
drawers being a part of the firm. Thus, the complainant is co-drawer as well
as payee of the cheque. He, therefore, cannot prosecute himself or other
partner u/s.138 of the Act. The position may be different when a firm issues a
cheque not to its own partner but to a third person. There, the firm would be
liable as also the partners subject, of course, to the provisions of S. 141 of
the Act and in particular Expl. (b) thereto.

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Passports Act — Refusal to issue fresh passport on ground that divorce deed was not registered or authenticated by Court — Improper — Passport Act, 1967 S. 5.

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Passports Act — Refusal to issue fresh passport on ground
that divorce deed was not registered or authenticated by Court — Improper —
Passport Act, 1967 S. 5.



[Sonalben Keyurbhai Patel v. Superintendent, Regional
Passport Office & Anr., AIR 2010 Gujarat 136]

The petitioner belongs to a village Valasan, District Anand.
The petitioner got married with one N. M. Patel according to Hindu rites and
customs at her village. The petitioner stayed with her husband at Nairobi. Due
to matrimonial dispute, the petitioner and her husband separated and divorce
deed was executed on 28-2-2001 in presence of relatives and witnesses.
Thereafter the petitioner married one K. B. Patel according to Hindu rites and
customs. This marriage was registered with the Registrar of Marriage at Anand.
The petitioner had two children and their birth was also registered. The
petitioner had applied for passport as her earlier passport had expired. The
petitioner had approached the Passport Office and had explained that in Patel
community of Anand District, customary divorce was permissible and therefore
not registered. The petitioner had also explained to the Passport Office that
u/s.29(2) of the Hindu Marriage Act, no divorce deed is required if customary
divorce was permissible. However the Passport Officer refused to issue
passport to the petitioner.

On a writ petition filed by the petitioner against the
Passport Authority, the Court held that the petitioner separated from her
first husband way back on 20-2-2001 and the deed of divorce was executed on
that day in presence of two witnesses. The facts regarding the divorce and
second marriage are not in dispute and more than nine years have passed. For
the purpose of issuance of fresh passport with change in the husband name, the
petitioner has already furnished the divorce deed and also an affidavit is
filed to that effect. It was true that the divorce deed was neither notarized
nor registered nor the petitioner has obtained decree of divorce from the
competent Court. However, divorce by custom was permissible. It was held in
the case of Twinkle Rameshkumar Dhameliya v. Superintendent, (AIR 2005
Guj. 267) that the stand taken by the Passport Authority insisting for divorce
deed duly registered before Sub-Registrar or authenticated by the Court cannot
be sustained since customary divorce can be said to be permissible, unless it
is objected to by either party to the divorce deed or any person who is
directly affected by the divorce deed. In the present case, in view of the
fact that more than nine years have passed since second marriage and the
petitioner has two issues from the second marriage, the affidavit of the
petitioner has already been filed and divorce deed has not been disputed by
anyone till date. The petitioner also belongs to Patidar community and
customary divorce is permissible in that community.

The Court directed that the Passport Authority should act
on the basis of the divorce deed and the petitioner can get it certified by
the Public Notary on the basis of original divorce deed and such certified
copy can be placed before the Passport Authority.

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Stamp Act — Document insufficiently stamped liable to be impounded — Stamp Act 1899 S. 33, S. 35, S. 38 and S. 40.

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Stamp Act — Document insufficiently stamped liable to be
impounded — Stamp Act 1899 S. 33, S. 35, S. 38 and S. 40.



[Umesh Kumar Prakashchandra Sharma v. Rajaram Ramchandra
Jat and Anr., AIR 2010 Madhya Pradesh 158]

The petitioner Umesh Kumar had filed a civil suit for
specific performance of the contract and possession of the property. The
petitioner had produced a document dated 2-6-2001, which was admitted. The
document contained recital that the possession was delivered, therefore the
document was required to be executed on appropriate stamp paper and as it was
not on appropriate stamp paper it was liable to be impounded and to pay stamp
duty, penalty, etc. The Trial Court impounded the document in question and
directed the petitioner to pay duty and penalty.

The petitioner challenged the aforesaid order in writ
before the High Court. The High Court held that on perusal of S. 33 of the
Act, it was clear that when a person authorised under law or by consent of the
parties has powers to receive evidence, then such person would be obliged to
impound the document when any document which is insufficiently stamped is
produced before him. The word ‘impound’ does not mean that the Court which is
in possession of the document has immediately to recover duty and penalty. The
word ‘impound’ would only mean to authorise the Court to keep the document in
the custody, because the Court is of the opinion that the document is either
suspected or is insufficiently stamped.

Once a Court comes to the conclusion that the document is
insufficiently stamped, then it has to keep the document in its custody and
then proceed in accordance with law.

Article 5 of the Indian Stamp Act, deals with an agreement
or memorandum of an agreement. If the agreement is in relation to the property
or sale of the same, then ordinarily the stamp duty payable would be Rs.50,
but in case the document contains a recital that the possession of the
property has already been transferred or handed over to the proposed
purchaser, without executing a conveyance or it shall be handed over to the
purchaser without execution of the conveyance in future, then the document
shall come out of the definition of an ‘agreement’, but would become a
‘conveyance’, as provided under Article 23 of Schedule I-A. In the present
matter, the Court below was absolutely justified in holding that because of
the recital in the document, the agreement stood converted into a conveyance
and was chargeable with the duty of 7½% on the market value of the property.
The Court below was also justified in requiring the plaintiff to pay 7½% duty
on the face value of the document and pay ten times penalty in accordance with
S. 33, S. 35 and S. 38 of the Indian Stamp Act. The order passed by the Court
below is not bad.

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