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AS-22 and book profit
December, 06th 2007

The apex courts observations strengthen the view that deferred tax liability is a provision for an ascertained liability; hence the same cannot be added back in the computation of book profit.

Over the years, Minimum Alternative Tax (MAT) has been contributing substantially to the corporate tax kitty. One of the primary reasons for this is the gradual extension of MAT to companies that have been enjoying tax holidays in some form or the other, and accordingly, do not pay any tax under the normal provisions of the Income-Tax Act, 1961. The latest to join the bandwagon are software companies operating as software technology park (STP) units or export-oriented units (EOUs).

Conceptually, where the tax payable by a company under the normal provisions is less than 10 per cent of its book profits, the tax payable is deemed to be 10 per cent of such book profits as MAT. Book profit has to be computed as per the formula prescribed under Section 115JB of the I-T Act.

The formula provides for certain adjustments by way of additions and deletions to the net profit of the company as computed under the Companies Act. The computation of book profits under Section 115JB has been a subject matter of litigation between taxpayers and the tax department. Of late, one of the issues coming up frequently before the appellate authorities is the treatment of deferred tax liability (DTL) debited to the profit and loss (P&L) account in accordance with Accounting Standard (AS) 22.

The recent Supreme Court decision in the case of J. K. Industries and a batch of other appeals, dealing with the validity of the AS-22 in the light of the provisions of the Companies Act and the I-T Act, could have an impact on the issue.

Technically, the question of addition of DTL to be made to the net profit to arrive at the book profit could arise under the following clauses of Section 115JB:

the amount of income-tax paid or payable, and the provision thereof;

the amount carried to any reserves, by whatever name called; and

the amount set aside to provisions made for meeting liabilities, other than ascertained liabilities.

Tribunal decisions

In terms of the judicial precedents directly on the issue, there are a couple of reported Tribunal decisions.

The first is the decision of the Kolkata Tribunal in the Balarampur Chini Mills case, where it has held that the DTL cannot be added to the net profit under any of the above clauses of Section 115JB. The broad reasons given by the Tribunal are:

DTL is a provision for tax effect of the difference between accounting and taxable income, and not a provision for income-tax paid or payable;

DTL is not a reserve, as it cannot be utilised for issuing bonus shares or declaration of dividend and it cannot be unilaterally transferred back to the P&L account;

DTL is not a provision for an unascertained liability, as it is calculated scientifically as per the requirements of AS-22.

The second decision is that of the Jodhpur Tribunal in the Maharaja Shree Umaid Mills Ltd case, wherein a similar conclusion was drawn. However, as mentioned before, the validity of AS-22 recently came up for consideration of the Supreme Court in the J. K. Industries case under the Companies Act and under the I-T Act. The constitutional validity of AS-22 was also questioned before the Supreme Court. The basic contention of the petitioners was that DTL was a future and a notional liability and, accordingly, not required to be charged to the P&L account of the current year. Since the liability did not exist on the balance-sheet date, AS-22, requiring the recording of such an item, is against the accrual concept of accounting under the Companies Act and the I-T Act.

Interesting observations

The Supreme Court left the question of constitutional validity open. However, while upholding the validity of AS-22 in other respects, the court made some interesting observations with respect to the nature of the DTL. The court has, inter alia, held that:

DTL is a known liability, though payable in future period(s);

Tax effect of timing differences is a real liability for which provision is required in the P&L account;

Deferred tax is nothing but accrual of tax due to divergence between accounting profit and tax profit.

These observations of the Supreme Court strengthen the view that DTL is a provision for an ascertained liability; hence the same could not be added back in the computation of book profit.

However, with respect to the Supreme Courts observation that DTL is a known liability which is payable in the future period(s), it becomes important to analyse as to whether DTL can be said to be a provision income-tax payable (albeit in the future period) under Section 115JB, and accordingly, can be added back in the computation of book profit.

For this, the normal meaning and the judicial exposition of the word payable under the Act becomes very significant.

The dictionary meaning of the word payable seems to suggest something for which an obligation to pay currently exists and which can be legally enforceable. As per the interpretation received in the judicial precedents in the context of other provisions of the Act, the word payable seems to suggest something which is due.

In view of this, it is still possible to argue that the words provision for income-tax payable appearing under Section 115JB should be interpreted to mean the provision towards tax liability which has actually become due, that is, provision for current tax, and not something which could arise in the future period, that is, provision for deferred tax. However, one needs to wait and watch as to how the tax authorities interpret the meaning of DTL in the light of the Supreme Courts above observations.

K. R. Girish
Himanshu Patel

(The authors are Bangalore-based chartered accountants.)

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