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As per section 36(1)(viii) of Income Tax Act 1961 in respect of any special reserve created and maintained by a specified entity, an amount not exceeding twenty per cent of the profits derived from eligible business computed under the head "Profits and gains of business or profession" (before making any deduction under this clause) carried to such reserve account:

Provided that where the aggregate of the amounts carried to such reserve account from time to time exceeds twice the amount of the paid up share capital and of the general reserves of the specified entity, no allowance under this clause shall be made in respect of such excess.

Explanation.—In this clause,—

(a)  "specified entity" means,—

(i)  a financial corporation specified in section 4A of the Companies Act, 1956 (1 of 1956)17;

(ii)  a financial corporation which is a public sector company;

(iii)  a banking company;

(iv)  a co-operative bank other than a primary agricultural credit society or a primary co-operative agricultural and rural development bank;

(v)  a housing finance company; and

(vi)  any other financial corporation including a public company;

(b)  "eligible business" means,—

18[(i) in respect of the specified entity referred to in sub-clause (i) or sub-clause (ii) or sub-clause (iii) or sub-clause (iv) of clause (a), the business of providing long-term finance for—

(A) industrial or agricultural development;

(B) development of infrastructure facility in India; or

(C) development of housing in India;]

(ii)  in respect of the specified entity referred to in sub-clause (v) of clause (a), the business of providing long-term finance for the construction or purchase of houses in India for residential purposes; and

(iii) in respect of the specified entity referred to in sub-clause (vi) of clause (a), the business of providing long-term finance for development of infrastructure facility in India;

(c) "banking company" means a company to which the Banking Regulation Act, 1949 (10 of 1949) applies and includes any bank or banking institution referred to in section 51 of that Act;

(d) "co-operative bank", "primary agricultural credit society" and "primary co-operative agricultural and rural development bank" shall have the meanings respectively assigned to them in the Explanation to sub-section (4) of section 80P;

(e) "housing finance company" means a public company formed or registered in India with the main object of carrying on the business of providing long-term finance for construction or purchase of houses in India for residential purposes;

(f)  19"public company" shall have the meaning assigned to it in section 3 of the Companies Act, 1956 (1 of 1956);

(g)  "infrastructure facility" means—

(i)  an infrastructure facility as defined in the Explanation to clause (i) of sub-section (4) of section 80-IA, or any other public facility of a similar nature as may be notified20 by the Board in this behalf in the Official Gazette and which fulfils the conditions as may be prescribed 21;

(ii)  an undertaking referred to in clause (ii) or clause (iii) or clause (iv) or clause (vi) of sub-section (4) of section 80-IA; and

(iii)  an undertaking referred to in sub-section (10) of section 80-IB;

(h)  "long-term finance" means any loan or advance where the terms under which moneys are loaned or advanced provide for repayment along with interest thereof during a period of not less than five years;]

The eligible entities are getting deduction on Special Reserve created under this section by resulting into reduction of tax liability.

As we know that authorities like RBI & NHB  have asked to create Deferred Tax Liability of Special Reserve Created u/s 36(1)(viii) of Income Tax Act,1961.

In this connection I would like to invite some logical representations on some queries related it.

As per AS 22,

Deferred Tax is the tax effect of timing differences.

Timing differences are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods.

Taxable income (tax loss) is the amount of the income (loss) for a period, determined in accordance with the tax laws, based upon which Income tax payable (recoverable) is determined.

Accounting income (loss) is the net profit or loss for a period, as reported in the statement of profit and loss, before deducting income tax expense or adding income tax saving.

It is clearly written that accounting income / loss is the net profit / loss before tax effect. There is no differentiation of above line or below line entries. Profit before tax is to be considered as accounting income. And one more important view should be taken into account that Deferred Tax is to be calculated on the items which are the main cause for difference between accounting and taxable income. If a particular item reflects the same numerical value in both workings then that item cannot be treated as item creating difference between both income. We have to consider two main parts of Timing difference. First is that there should be difference between both calculation and that difference can be reversal in future at any point of time. If there is no difference between both calculation why should we create deferred tax on such item ?

Now take an example for this.

Profit & Loss Account:

Profit before tax and provisions- 10 lacs

Less provisions:

Depreciation on fixed assets-  2 lacs

Special reserve u/s 36(1)(viii)- 2 lacs

Leave encashment provision- 2 lacs

Profit before tax- 4 lacs                   

Computation of Income:

Profit before tax-  4 lacs

Add:

Depreciation as per books-  2 lacs

Special Reserve as per books- 2 lacs

Leave encashment provision-  2 lacs          

                                            -------              6 lacs

                                                                  --------

Total:                                                          10 lacs

Less:

Allowable deductions:

Depreciation as per I.tax Act-  3 lac

Special Reserve allowable- 2 lac

Leave encashment paid amount- 0.5 lac

                                               ------            5.5 lacs

                                                                 --------                                                                 

Taxable Income:                                         4.5 lacs

In this case, deferred tax liability on depreciation and deferred tax asset on leave encashment is to be created and because of no differentiation between special reserve booked and special reserve allowable, there will not be any deferred tax. The detailed calculation look like this :  

Assuming tax rate of 30%                                                               Rs in lacs

Details

Profit and Loss Account

Computation of Taxable Income

difference

DTL (+)
DTA (-)
@ 30%

Opening balance of
DTL(+) / DTA (-)

0.00

depreciation as per books and tax audit

2.00

3.00

1.00

0.31

special reserve u/s 36(1)(viii)

2.00

2.00

0.00

0.00

staff leave encashment provision / payment

2.00

0.50

-1.50

-0.46

Closing balance of
DTL(+) / DTA (-)

-0.15

Tax on book profit will be 4 lacs * 30% = 1.20 lacs which will be divided into two parts: 

Current tax on taxable income will be 4.50 lacs * 30% = 1.35 lacs

Deferred tax Assets as per above                               - 0.15 lacs  

So, net tax effect will be 1.35-0.15=1.20 lacs.

In other words Deferred tax is the bridge between tax on book profit and current tax on taxable income. In the above example taxable income is more than book profit by 0.50 lacs on which we have paid more tax say 0.50 * 30%= 0.15 lacs which will be reversed in future. But if any item shows same value both in books and in taxable income, there should not be any deferred tax. Whether it is reversible or not is the second question, first question is that is there any difference creating item between both income.

Special reserve created under s/c 36(1)(viii) of Income Tax Act,1961  becomes taxable in the year of reversal (withdrawn). In the year of withdrawal  it will be reflected both in books as well as in taxable income and will be taxed in that year.

Now, considering the guidelines issued by authorities if we create deferred tax liability on the advantage taken as deduction this year, what will be the actual position . The result is itself unremarkable !

The deferred tax liability on Special Reserve in the above example will be 2 lac * 30% = 0.60 lac. Which will increase tax liability this year. On the other hand the current tax liability was also decreased by 0.60 lac only on account of creation of special Reserve. So, if we create deferred tax liability on special reserve, the actual benefit of reduced current tax  creating this reserve , will be washed out by increase of deferred tax liability by the same amount.

Now, if we assume that deferred tax liability on special reserve is created the tax effect will be,

Tax on book profit will be 4 lacs * 30% = 1.20 lacs :

Current tax on taxable income will be 4.50 lacs * 30% = 1.35 lacs

Deferred tax liability as per above                                    +0.45 lacs  

( 0.31 on dep.+ 0.60 on spl.res. – 0.46 lv.enc )

So, net tax effect will be 1.35+0.45=1.75 lacs. Which is more by 0.60 lacs in comparison of tax of 1.20 lacs on book profit.

This if against the main objective of creating deferred tax to bridge the book profit and taxable income.

So, if provision created u/s 36(1)(viii) is the same as being deducted in taxable income there is no need to create deferred tax on it.

If provision created u/s 36(1)(viii) is the more than being deducted in taxable income there is no need to create deferred tax on it. As additional created special reserve will be added to taxable income and will be taxed in current year which is permanent difference.

if provision created u/s 36(1)(viii) is lower than allowable deduction in taxable income there is no need to create deferred tax on it as actually allowed deduction will be lower amount and surplus allowable will be ignored.

This are personal views and readers are requested to consult their consultants. The remarkable comments from consultants will be highly appreciated.

DIPESH SHAH

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