Deferred Tax asset on Depreciation Loss: a Moot
Creation of deferred tax asset in pursuance of accounting standard-22 requires existence of an intriguing situation called ‘Virtual Certainty’ for future taxable profits. ‘Virtual Certainty’ as opposed to ‘reasonable certainty’ (which is required for business losses) means very strong material evidence on hand which supports realistic improvement in business perhaps in a short term. Therefore this is not a simple exercise where one can just prepare a set of financial projections for the next few years and convince the regulator for allowing the DTA (Deferred Tax Asset).
The above frame is in theory. For a debate the respective core paragraph followed by explanation from AS-22 is being produced below,
“17. Where an enterprise has unabsorbed depreciation or carry forward of losses under tax laws, deferred tax assets should be recognised only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such deferred tax assets can be realised.
18. The existence of unabsorbed depreciation or carry forward of losses under tax laws is strong evidence that future taxable income may not be available. Therefore, when an enterprise has a history of recent losses, the enterprise recognises deferred tax assets only to the extent that it has timing differences the reversal of which will result in sufficient income or there is other convincing evidence that sufficient taxable income will be available against which such deferred tax assets can be realised. In such circumstances, the nature of the evidence supporting its recognition is disclosed.”
In practical world there is a popular perception (may not be correct) as a result of the above paragraph that if a company has accumulated losses in the Balance sheet, there is no virtual certainty and hence DTA should not be created. The first sentence in Para 18 that literally imposes the indicator is a real disaster. The flip side of this ruling is that even a newly set up company which has initial operating losses is obliviously not allowed to create DTA for unabsorbed depreciation, thanks to the requirement of Virtual certainty. But there are arguments to favour the creation of DTA in respect of unabsorbed depreciation loss,
· The Para 18 above says that DTA can be created to the extent there will be a reversal of timing differences that will result in sufficient taxable income. Consider a simple hypothetical case where the total depreciation is Rs.120/- for the asset. The depreciation permissible as per IT act is Rs.100/- and as per Companies act is Rs.20/- in year 1 and in year 2 it is Rs.20/- and Rs.100/- respectively. Assume the substantially enacted tax rate to be 30%. The deferred tax liability in year 1 is Rs. 24/- (i.e. 80*30%) (It is deferred tax liability because tax law gives more deduction in advance). Here it is virtually certain that the reversal of the difference on depreciation will happen in the immediate next year. So why not create DTA at least for this Rs.24/-? It is very sure that this reversal is going to create taxable income to this extent. If this be the case there is no need to create DTL as well, since as a right the entity can net off the DTL with the DTA.
· No creation of deferred tax asset in respect of depreciation loss considering current trading conditions only means that the very fundamental assumption of a ‘going concern’ in preparation of financial statements is being challenged on the Balance sheet date. It cannot mean we need to carry the assets at their liquidated value! This is what Para 19 says under the caption ‘Reassessment of unrecognized deferred tax assets’
“At each balance sheet date, an enterprise re-assesses unrecognized deferred tax assets. The enterprise recognizes previously unrecognized deferred tax assets to the extent that it has become reasonably certain or virtually certain, as the case may be (see paragraphs 15 to 18), that sufficient future taxable income will be available against which such deferred tax assets can be realized. For example, an improvement in trading conditions may make it reasonably certain that the enterprise will be able to generate sufficient taxable income in the future”
It may be noted that as per IT act the unabsorbed depreciation is eligible for an infinite years carry forward. Also as per Sec.72A the unabsorbed depreciation will be eligible for carry forward in the hands of the amalgamated company subject to fulfillment of certain conditions. The same applies for a demerger or reorganization. Unabsorbed depreciation can be thought to have a perennial run more likely than not.
· Let us add one more studious argument here. Why does the standard require creation of a deferred tax liability for the timing difference on account of depreciation? Isn’t it because there should be a taxable income in future when the IT depreciation drops down vis-à-vis the one admissible under Companies act? This being the rationale the same should hold well in creation of deferred tax asset for timing difference in depreciation.
The impact of illogical creation of DTL or not creating DTA is far reaching. One can imagine the net worth being eroded substantially and the worst thing is the banker demanding a promoter margin unnecessarily while approaching for funds.
Discussions apart, it is heartening to learn that IAS-12 differs and varies quite leniently from AS-22. This is what it says, “These deferred tax assets can be recognized if it is probable that the asset will be realized”. Thus what is required is a probability (More likely than not) for future taxable income which does not sound as stringent as jargons like virtual certainty. This condition applies across the board to all DTA. Hope the Indian ‘IAS-12’ will do way with all these confusions.