An overview of key accounting implications arising from recent amendments in the Income-tax Act

An overview of key accounting implications arising from recent amendments in the Income-tax Act

The recently enacted Finance Act (No. 2), 2024 (the Finance Act 2024) has made certain key amendments in the Income-tax Act, 1961, as applicable to companies. These amendments include (i) abolition of the concept of acquisition cost indexation of specified capital assets to compute long-term capital gain (LTCG) arising on transfer of the asset, and (ii) shifting the incidence of taxation on buyback of shares from the issuer company to the holder of shares. Among other implications, these amendments need to be carefully evaluated with regard to current and deferred tax accounting. In this article, we analyze key potential accounting implications of these two amendments.

Abolition of the concept of indexation of cost of acquisition of specified capital assets

Except for transition relief to specified non-corporate assessees for “grandfathered” immovable property acquired before 23 July 2024, the Finance Act 2024 has removed the concept of acquisition cost indexation whilst computing long-term capital gains arising on transfer of a long-term capital asset (i.e., capital asset transferred after meeting prescribed holding period criteria). With this change, the Finance Act 2024 has also made changes in the holding period for assets to be classified as long-term capital asset and also tax rate applicable on the long-term capital gains. Given below is the broad summary of key changes as applicable to companies.

Taxability of long-term capital gains in few categories of capital assets which are likely to impact a broad range of Indian companies:

These amendments are applicable to all transfer of capital assets taking place on or after 23 July 2024.

Under Indian Accounting Standard (Ind AS) 12 Income Taxes, the indexed cost of acquisition, if allowed under the applicable Income-tax Act, was considered as tax base of the asset to determine resultant deferred tax asset/ liability arising on the asset concerned. Obviously, the deferred tax asset, if any, arising on the asset is recognized only to the extent that it is probable that taxable profit will be available against which the deductible temporary differences can be utilized. The removal of indexation benefit along with other changes will impact the determination of tax base of the asset concerned and deferred tax asset/ liability to be recognized (assuming, probability criterion is met to recognize deferred tax asset, if any).

This can be explained with below example:

Besides mutual fund investments, such an impact can arise in many other cases as well. Consider that a company purchased a land several years ago. For financial reporting purposes, it is determined that the cost of the land at initial recognition is 50.00 crore and the same amount was its cost of acquisition for income tax purposes

Assuming that company has not intended to sale its land through slump sale route, prior to the amendment, under the Income-tax Act, assuming long-term capital gain arising from transfer of land will be determined basis its indexed cost of acquisition. For simplicity, it is assumed that the indexed cost of acquisition of the land as of 31 March 2024 was 85.00 crore and it is also assumed that the applicable long-term capital gains tax rate for the year ended 31 March 2024 was 20%. For financial reporting purposes, the Company was measuring land at cost using the cost model as prescribed under Ind AS 16, Property, Plant and Equipment. In accordance with Ind AS 12, there was a deductible temporary difference of 35.00 crore between the carrying amount (Original Cost) and its tax base (indexed cost) as of 31 March 2024. Assuming Ind AS 12 criterion for recognition of DTA was met, the Company had recognized deferred tax asset (DTA) of 7.00 crore [deductible temporary difference of 35.00 crore multiplied by applicable tax rate of 20%] as at 31 March 2024. Upon enactment of the Finance Act 2024 in August 2024, this deductible temporary difference ceases to exist since the indexed cost of acquisition is no longer allowed.

It is obvious that the above changes will require companies to revisit previously recognized deferred tax asset/ liabilities, if any. The application of this requirement results in certain key questions. The relevant questions and our perspective thereon are given below.

Whether changes in deferred tax asset/liability should be recognized in the financial statements for the year ended 31 March 2024 or financial results for the quarter ended 30 June 2024 issued after the enactment of the Finance Act, 2024 on 16 August 2024?

The following points may also be noted in this regard:

• In accordance with Ind AS 12, deferred tax is measured by reference to the tax rates and laws, as enacted or substantively enacted by the end of the reporting period. [Paragraph 47 of Ind AS 12].
• In accordance with Ind AS 10 Events after the Reporting Period, changes enacted after the end of the reporting period are ignored for measurement purposes and the effect is disclosed as a non-adjusting event [Paragraph 10.22 (h) of Ind AS 10].

In the instant case, the Union Budget 2024 was presented in the Lok Sabha in July 2024 and enacted on 16 August 2024. Hence, the Finance Act 2024 did not represent a tax law that was enacted or substantively enacted by the end of the reporting period, i.e., by 31 March 2024 or by 30 June 2024. Hence, the financial statements for the year ended 31 March 2024 or financial results for the quarter ended 30 June 2024 will not be adjusted to reflect the effect of the change brought out by the Finance Act, 2024. This would be the case even if the approval of these financial statements/ results took place after the enactment of Finance Act 2024. This is because Ind AS 12 requires the measurement of tax assets and tax liabilities (whether current or deferred) to be based on tax rates and tax laws that have been enacted or substantively enacted by the end of the reporting period. However, depending on materiality evaluation, companies will need to disclose the change and its impact as a non-adjusting event in the financial statements for the year ended 31 March 2024 and/ or financial results for the quarter ended 30 June 2024 issued after the enactment of the Finance Act, 2024.

In respect of financial statements/ results for period ending after the enactment of the Finance Act, the changes are actually enacted and will need to be applied.

Whether changes in deferred tax asset/ liability arising from the Finance Act 2024 will be recognized through the statement of profit and loss? Alternatively, can they be recognized through the Other Comprehensive Income (OCI) or directly in equity?

Paragraph 60 of Ind AS 12 provides as below:

“60. The carrying amount of deferred tax assets and liabilities may change even though there is no change in the amount of the related temporary differences. This can result, for example, from:

a) a change in tax rates or tax laws

b) a reassessment of the recoverability of deferred tax assets

c) a change in the expected manner of recovery of an asset

The resulting deferred tax is recognized in profit or loss, except to the extent that it relates to items previously recognized outside profit or loss.”

Hence, it is clear that changes in deferred tax asset/ liability will be recognized in the statement of profit and loss, unless the changes relate to items previously recognized in OCI or directly in equity. If this is the case, then only changes in deferred tax asset/ liability will be recognized in OCI or directly in equity.

Many companies impacted by the change may be required to or otherwise preparing and presenting financial information more frequently than on an annual basis. For example, listed companies report their financial results every quarter. For companies preparing and presenting interim financial report and having 31 March year-end, the Finance Act 2024 represents a tax law enacted/ substantively enacted during the second quarter of the current financial year. Are such companies required to adjust the impact of the change entirely in the quarter ended 30 September 2024 or they can spread the impact over the remaining quarters of the current financial year using the effective tax rate?

Paragraphs 29 and 30(c) of Ind AS 34, Interim Financial Reporting, provide as below:

“29. Requiring that an entity apply the same accounting policies in its interim financial statements as in its annual statements may seem to suggest that interim period measurements are made as if each interim period stands alone as an independent reporting period. However, by providing that the frequency of an entity’s reporting shall not affect the measurement of its annual results, paragraph 28 acknowledges that an interim period is a part of a larger financial year. Year-to-date measurements may involve changes in estimates of amounts reported in prior interim periods of the current financial year. But the principles for recognizing assets, liabilities, income, and expenses for interim periods are the same as in annual financial statements.

30. To illustrate:

(c) income tax expense is recognized in each interim period based on the best estimate of the weighted average annual income tax rate expected for the full financial year. Amounts accrued for income tax expense in one interim period may have to be adjusted in a subsequent interim period of that financial year if the estimate of the annual income tax rate changes.”

Taxation is one of the most difficult areas of interim financial reporting, primarily because Ind AS 34 does not clearly distinguish between current income tax and deferred tax, referring only to ‘income tax expense’. This causes tension between the approach for determining the expense and the asset or liability in the balance sheet. In addition, the standard’s provisions combine terminology, suggesting an integral approach to measurement with guidance requiring a year-to-date basis to be applied in respect to recognition. Overall, the integral method appears to be the basis used in determining the effective income tax rate for the whole year, but that rate is applied to year-to-date profit in the interim financial statements. In addition, under a year-to-date basis, the estimated rate is based on tax rates and laws that are enacted or substantively enacted by the end of the interim period. Changes in legislation expected to occur before the end of the current year are not recognized in preparing the interim financial report. The assets and liabilities in the balance sheet, at least for deferred taxes, are derived solely from a year-to-date approach. Hence, overall, it appears reasonable that at each quarter-end, the Company will calculate effective income tax rate for the whole-year using tax rates and tax laws that are substantively enacted by the period-end and apply such rates to the relevant year-to-date profit to determine income tax expense/ income for the period.

While Ind AS 34 does not provide further guidance on determination of weighted average annual income tax rate, we believe that the following guidance provided in illustrative examples of IAS 34, Interim Financial Reporting, is relevant under Ind AS 34 too:

“To the extent practicable, a separate estimated average annual effective income tax rate is determined for each taxing jurisdiction and applied individually to the interim period pre-tax income of each jurisdiction. Similarly, if different income tax rates apply to different categories of income (such as capital gains or income earned in particular industries), to the extent practicable, a separate rate is applied to each individual category of interim period pre-tax income. While that degree of precision is desirable, it may not be achievable in all cases, and a weighted average of rates across jurisdictions or across categories of income is used if it is a reasonable approximation of the effect of using more specific rates.”

IAS 34 also provides that for interim financial reporting, the tax effect of ‘one-off’ items are recognized in computing income tax expense in that interim period, in the same way that special tax rates applicable to particular categories of income are not blended into a single effective annual tax rate.

Since the change impacts only the amount taxable under the head capital gains, a company, while presenting financial results/ statements for the quarter ended 30 September 2024, will need to calculate separate effective income tax rate for the whole-year as applicable to the capital gains using tax rates and tax laws that are substantively enacted by the period-end, i.e., till 30 September 2024. It will then apply such a rate to the year-to-date profit taxable under the head capital gains to determine income tax expense/ income for the period. In our view, given the specific guidance, it is not acceptable to calculate overall effective tax rate for the Company and apply such rate to total income of the Company, including income taxable under the head “profits and gains from business or profession,’ unless the Company can clearly demonstrate that the results of both the approaches give similar results.

In certain situation, considering the irregular nature of income taxable under the head capital gains, it may not be practical for a company to estimate separate effective income tax rate for the whole-year as applicable to the capital gains. For example, this may be the case where a company has not generated income taxable under the head capital gain nor it is anticipating sale of capital asset in the near future, resulting in gains taxable under the head Capital Gains. In such cases, it may be appropriate to recognize the impact of the change entirely in the quarter ended 30 September 2024.

Taxation of buyback of shares under section 68 of the Companies Act 2013

The Finance Act 2024 has also made significant changes to taxation of buy back of shares made by a company under section 68 of the Companies Act 2013 (as amended) (hereinafter referred to as ‘buyback’ or ‘buyback of shares’). The amended taxation provisions apply to any buyback of shares that takes place on or after 1 October 2024.

Pre-amendment, in the case of a buyback, income tax was levied on the (domestic) company effecting the buyback (‘the issuer company’) under section 115QA of the Income-tax Act 1961. Income chargeable to tax for this purpose meant “the amount of distributed income by the company on buy-back of shares from a shareholder,” i.e., the consideration paid by the company on buy-back of shares as reduced by the amount, which was received by the company for issue of such shares. In the hands of a shareholder whose shares were bought back, any income arising to the shareholder on account of the buyback was exempt from tax under section 10(34A) of the Act.

The 2024 amendments shift the incidence of taxation on buyback of shares from the company, affecting the buyback to the shareholders. As per the amendments:

• The total amount received by a shareholder pursuant to such a buyback would be taxable as dividend income under section 2(22) of the Income-tax Act (as amended). It is important to note that the entire proceeds – not just the excess of proceeds over cost of acquisition of the relevant shares – will be taxed as dividend income.
• The cost of acquisition of the bought back shares would be regarded as a capital loss in the hands of the shareholder. Such capital loss would be allowed to be set off and/ or carried forward in accordance with the provisions of the Income-tax Act.
• Buyback of shares that takes place on or after 1 October 2024 will no longer be taxable in the hands of the Company affecting the buyback.
• Consequential amendments have also been made in section 194 of the Act to bring distribution on the buyback under the ambit of dividend for the purpose of deduction of tax at source by the issuer company.

From the shareholder perspective, the application of the above amendment implies that whilst they will need to pay tax on buyback amount as soon as buyback is affected. However, the realization of capital loss will be subject to availability of appropriate capital gains against which such loss can be offset. If a Company has no convincing evidence on availability of capital gain to offset losses, it may not be able to recognize deferred tax asset on the carry forward of capital losses. This raises an interesting question whether the Company should upfront be required to create deferred tax liability regarding tax payable on potential buyback of shares while ignoring recognition of deferred tax asset for carry forward of losses? Should such treatment be given for all investment holdings? In our view, the following key points need to be considered to arriving at an appropriate view:

a) The buyback of shares is generally uncertain, and shareholders may have no visibility whether the Issuer Company will go for buyback of shares in the foreseeable future till any firm announcement is made by the Issuer Company? Also, timing of buyback may be uncertain.

b) Buyback of shares under section 68 of the Companies Act 2013 (as amended) is generally optional for the shareholders. The Company affecting such buyback normally make an offer for buyback and it is up to the shareholders to decide whether they want to offer such shares under the buyback. Thus, buyback is at the option of the concerned shareholder.

c) The issue stated above related to mismatch, i.e., amount received being taxable as dividend income and cost of acquisition being treated as capital loss, arises only in case of buyback of shares. However, in case of sale of shares, the consideration received on sale net of the cost of acquisition is taxable under the head capital gains.

d) Ind AS 12.24 generally prohibits recognition of deferred tax asset or liability on differences arising from initial recognition of an asset or liability in a transaction which is not a business combination and at the time of the transaction, affects neither accounting profit nor taxable profit. However, such prohibition (commonly known as ‘initial recognition exception’) does not apply to the transaction, which give rise to equal taxable and deductible temporary differences. Albeit under different heads, consideration received is taxable and cost is allowed as deduction under the Income-tax Act. Hence, in our view, initial recognition exception will not apply in such cases and a Company cannot avoid deferred tax accounting basis this argument.

e) Considering alternates possible with regard to realization, attention is invited to below requirements of Ind AS 12:

“51. The measurement of deferred tax liabilities and deferred tax assets shall reflect the tax consequences that would follow from the manner in which the entity expects, at the end of the reporting period, to recover or settle the carrying amount of its assets and liabilities.

“51A. In some jurisdictions, the manner in which an entity recovers (settles) the carrying amount of an asset (liability) may affect either or both of:

a) the tax rate applicable when the entity recovers (settles) the carrying amount of the asset (liability), and

b) the tax base of the asset (liability).

In such cases, an entity measures deferred tax liabilities and deferred tax assets using the tax rate and the tax base that are consistent with the expected manner of recovery or settlement.”

Hence, we believe that to decide appropriate accounting, a Company will need to assess whether it expects to realize its investments or a portion thereof through buyback or sale. Considering uncertainties, companies holding shares in many cases may not be able to demonstrate realization through buyback till there is clear indication of buyback plan from the Issuer Company. If this is the case or the Company is not intending to offer the shares under buyback, then intended manner of realization is through sale. In such case, there is no need for recognizing separate deferred tax liability on consideration received/ receivable and deferred tax asset for capital loss. Rather, the Company will compare carrying amount of the investment with its tax base and decide recognition of deferred tax asset/ liability on differential amount as per the requirements of Ind AS 12.

However, in cases where the company holding shares has a clear indication of buyback plan from the issuer company and it intends to offer the shares under buyback, then intended manner of realization is through buyback. in such a case, deferred tax liability and asset recognition will be based on buyback being the intended manner of realization to the extent the company expects its investment to be realised through buyback route. particularly, this will require the company to recognize separate deferred tax liability on related carrying amount of the concerned investment, assuming it will be realized through buyback by the issuer company and the company will pay tax on dividend income. Separately, the holder company will have capital loss equal to cost of the investment and it will evaluate whether it can recognize deferred tax asset on the same as per the requirements of Ind AS 12. In most cases, both the impacts will be recognized in the statement of profit and loss as the impact is arising due to change in expected manner of realization.