Global standards for I-T norm

DIRECT TAX

Keeping pace with international practices, AS-22 was introduced by the Indian Institute of Chartered Accountants (ICAI) and deferred tax accounting was made mandatory for all Indian listed companies.

As per AS-22, a company is liable to provide for deferred tax liability on the first day it accounts for such income. The basic premise being that revenues and expenses of an accounting period should meet matching principle and disparity in computing income for tax and book purposes should be appropriately resolved.

Differences between the two sets of computation of income can be classified into two categories; permanent and timing differences. Permanent differences arise with respect to expenditure legitimately incurred but are wholly or partially disallowed for tax purposes.

Such expenses do not give rise to deferred tax provision. Temporary differences are those that arise due to timing reasons. A typical example is provision for depreciation with varying rates for book purposes and tax purposes. Rates prescribed for company law are minimum rates, taking into consideration useful life of the asset.

Further, the company gives an option to compute depreciation on straight-line basis or written down value basis. However, rates vary for tax amortisation purposes and have to be necessarily computed on written down value basis.

Historically, significant variations prevailed between the rates of amortisation and depreciation for book and tax purposes. However, successive Finance Acts in the past few years have bridged the gap, aligning with recommendations of Kelkar task force.

The net effect of varying rates of depreciation provision resulted in greater level of book profits in the initial years. Prior to 2001, Indian companies were providing for Income tax on the basis of what they paid and not what would have been payable as per book profits. This resulted in an anomaly and non- adherence to revenue-expenditure matching principle. Hence, the Institute of Chartered Accountants adumbrated AS 22 to make provision for deferred taxation.

Aligning to global best practices
Simply stated, under AS 22, companies are required to make provision for Income tax on the basis of book profits (other than permanent differences that result in disallowance of expenditure by tax authorities) and not income under the Income tax provision.

This would generally mean that the tax provision is more than what is paid, in the initial years of acquisition of an asset, the excess being set off in later years. The excess charge is debited to the profit and loss account and since it is payable in future years, the amount is indicated in the balance sheet as deferred tax liability (DTL).

Internationally, various methods are prevalent for accounting deferred tax. In the UK, under FRS 19 'Deferred Tax' recommends full provision method, where a provision is made for deferred tax assets and liabilities arising due to timing differences between recognition of gains and losses for financial statements and their recognition in a tax computation purposes.

The standard suggest that deferred tax should be recognised as a liability or asset if the transactions or events that give the entity an obligation to pay more tax in future or a right to pay less tax in future have occurred by the balance sheet date. Change in the provision adjusts the tax charge in the profit and loss account. In short, deferred tax irons out timing differences.

In the US, Statement of Financial Accounting Standards (SFAS) 109 was introduced by Financial Accounting Standards Board (FASB) to clarify accounting rules covering deferred tax assets. Under SFAS 109, a current or deferred tax liability or asset is recognised for the current or deferred tax consequences of all events that have been recognised in the financial statements or tax returns, measured on the basis of enacted tax law.

Further, under International Accounting Standard (IAS) 12, companies are expected to recognise deferred tax liability in their balance sheet.

Expectations from AS 22
The statement specifies the procedure to be followed to determine an enterprise's deferred tax expense liability and asset. The change in the deferred tax assets and liabilities is the deferred tax expense or benefit of a period.

The financial statement preparer is required to identify type and amount of temporary differences and the nature and amount of each type of operating loss and the remaining length of carry forward period.

Further, the total deferred tax liability for temporary differences using the enacted tax rate expected to apply in years the temporary differences will reverse.

Does AS 22 Conflict with Company law?
When the notification making AS-22 mandatory was published by the ICAI, it was challenged in the Courts. It was contended that the standard was ultra vires as it created a deferred tax liability which is notional liability charged to the profit and loss account (PLA). It was also contended that deferred tax liability due to timing differences can arise only in future years in respect of transactions which had taken place in the earlier period.

Defending AS22, the Supreme Court rendered a detailed decision last month observing that in an era of globalization where mergers & acquisitions play an important role, the buyer wants to know the real income and liabilities of a company.

Due to difference in the rates of depreciation statutorily prescribed under the Income Tax and Companies law, the concept of deferred taxation has been introduced to obliterate the difference between accounting depreciation and tax depreciation.

Observing that the objective behind the accounting standard was to evolve methods for more transparency and leave less room for subjective selection of methods, the court felt that the standard aimed at providing attention to quality of estimates used in arriving accounting income and that it is neither ultra vires nor inconsistent with the provisions of the Companies Act including Schedule VI.

In summary, deferred tax liability, is not a notional tax liability but a real liability since it would result in future cash outflow in the form of tax payments to the Revenue authorities.

Impact on Indian Corporates
The Court has made a wider observation ruling that Indian Accounting Standards (IAS) has to harmonise and integrate with the International Accounting Standards, which means harmonization of accounting policies, practices and principles.

AS 22 lays down the manner in which computation of tax liability has to be made in the balance sheet, therefore, in pith and substance AS 22, prescribes additional mode in which tax liability is required to be calculated.

Hence, accounting standards framed by ICAI establish rules relating to recognition, measurement and disclosures thereby ensuring that all enterprises would mandatorily follow them and their financial statements are not just true, fair transparent but comparable with International standards.

In a way, the SC's views resonate the decision taken by ICAI to integrate Indian Accounting Standards with those prescribed by International Financial reporting Standards by April 2011.

This would also eliminate an age-old practice followed by Indian companies to draw two sets of financial statements; one to comply with Indian Corporate law requirements and the other to deal with international investor community. The former one being aligned to Indian standards and the latter meeting with stringent reporting requirements as per international GAAP.

The author is a Partner with BMR & Associates and views are personal