'The Interconnect': MAT levy under IND AS regime – An unintended blow to strategic debt restructuring?
Ketan Dalal (Managing Partner, Katalyst Advisors LLP)
Currently, macro global factors apart, back at home, India Inc is reeling under the pressure of mounting debt, stressed assets and NPAs. With big corporate houses finding it difficult to manage their debt and the numbers sometimes running into thousands of crores, the Indian Government, RBI and the consortium of banks and creditors are now in overdrive, and seeking to address the situation.
One step in that direction has been the June 2015 Strategic Debt Restructuring Scheme (SDR) of RBI which aimed at reviving the stressed assets and NPAs of the banks. Under SDR, banks who have given loans to a corporate borrower get the right to convert the full or part of their loans into equity shares in the borrower company. Another measure is the enactment of a new Insolvency and Bankruptcy Code 2016 which not only replaced all existing Indian laws on insolvency but also ushered in a stringent regime of “creditor in control”. Whatever be the trigger, it seems that corporate debt restructuring (CDR)/ SDR is going to be the flavour of the year if one has to protect the interest of stakeholders against India Inc’s mounting debt pile.
While a CDR/ SDR exercise may be a good reason to cheer for the stakeholders as well as the borrower company, walking down that path could possibly be like trying to get to the other end of a maze filled with surprises at each turn! One such unexpected surprise is the possible MAT liability (or related litigation) in the hands of the borrower company which could be triggered due to the SDR/ CDR exercise, especially in light of the treatment accorded to financial liabilities under the newly applicable IND AS regime.
Introduction to recent amendments to Sec 115JBB of the Income-tax Act, 1961 (ITA)
Given that a large number of companies are either moving to (or will migrate to) IND AS, the Finance Act, 2017 amended s.115JB of the ITA Act, 1961, with effect from AY 2017-18 to incorporate the steps to be followed by IND AS compliant companies while calculating their “book profits” for MAT purposes. This amendment broadly segregates the computation of book profits of IND AS companies into two baskets which are (i) computation of book profits on transition from Indian Generally Accepted Accounting Principles (IGAAP) into IND AS [Sec 115JB (2C)] and, (ii) computation of book profits on an ongoing basis, subsequent to the transition [Sec 115JB (2A)].
In relation to (ii) above, s.115JB(2A) of the ITA, based on a clarification issued by the CBDT on 25th July, 2017, the starting point for computation of book profit shall be the Profit / Loss before the OCI items (ie Other Comprehensive Income statement) as prescribed under the IND AS regime. Further, Sec. 115JB(2A) of the ITA provides this book profit shall be increased / decreased by the items credited / debited to the OCI, only under the head “Items that will not be re-classified to the profit or loss”.
In this two-part article, we have captured the possible accounting treatment for a CDR/ SDR exercise in the borrower’s books under the IND AS regime and the corresponding possible MAT impact (on first time adoption (FTA) as well as ongoing transaction) thereon.
Accounting for Financial Liabilities under IND AS 109 and possible MAT impact
I.“Financial liability” and meaning thereof under IND AS 109
Since IND AS prescribes a paradigm shift in the way liabilities are recognised and accounted for, it is imperative to understand what constitutes a \"financial liability\" before analysing the impact thereof. Hence, to start with, let’s take a look at the meaning of financial liability under the IND AS 109.
A financial liability is defined as a contractual obligation on the issuer to either deliver cash or other financial assets or exchange financial assets with another entity under conditions that are potentially unfavourable to the issuer. It also includes contracts that will or may be settled in the issuer’s own equity instruments. Simply put, it is a contractual obligation to deliver cash, financial asset or own equity and therefore covers bank loans, trade payables, finance lease payables, financial guarantees, redeemable preference shares, etc (but not tax liability, convertible preference shares, etc). As one would observe, under the Indian GAAP regime, preference shares were treated as equity, irrespective of whether they were convertible or redeemable, which is not the case under IND AS. Similarly, corporate guarantees given were only disclosed but not recorded as financial liability under the erstwhile accounting regime.As such, the IND AS recognises substance over
As such, the IND AS recognises substance over form of the financial instrument, whereas IGAAP respected the legal form thereof. What is also introduced under IND AS 109 is the concept of a hybrid or compound instrument. Under this, a single legal instrument maybe split and recorded part as liability and remaining as equity, depending on what are the terms of the issue of the instrument. For example, preference shares issued with a fixed coupon rate but convertible at the option of the issuer has the characteristics of a debt component (i.e. fixed interest) and an equity component (convertible at option of the issuer). Hence, such an instrument is accounted for as a liability to the extent of the debt component and for the residual part as equity – accounted for under “Other Equity” in the Balance Sheet of the company.
Since, by definition, equity represents a residual interest in the assets of the issuer, it would be relevant to see through the terms of the issue and determine whether the same needs to be classified as equity, liability or a hybrid in the hands of the borrower. The benchmark of existence or otherwise of a contractual obligation, the principle of substance over form and the stated definitions in the IND AS, need to be applied to achieve this objective. This, in turn, will dictate balance treatment for accounting as well as tax purposes.
Under IND AS, a contract is also recognised as liability in the books of the issuer if a financial instrument may require delivery of cash depending on occurrence or non-occurrence of uncertain future events and if such events are beyond the control of issuer whereby the issuer cannot unconditionally avoid delivering cash or another financial asset. Simply put, if the issuer can, by virtue of an uncertain future event within its control, unconditionally avoid delivering cash or another financial asset, then such an instrument is not liability.
II. MAT Impact of Other Equity under s. 115JB of the ITA, 1961
As mentioned above, a hybrid or compound instrument is recorded as part financial liability, and balance “Other Equity”. The MAT impact of the financial liability component is dealt with in the later part of this article.
In case of the equity component classified as Other Equity, the MAT treatment can be divided into two baskets: (i) Treatment in the year of adoption, and (ii) Treatment on an ongoing basis. In case of the former, as per Sec. 115JB(2C) of the ITA, the amount of Other Equity in the year of convergence shall be considered as “transition amount” and hence, be liable to MAT in 5 equal instalments for 5 consecutive financial years.
In case of (ii) mentioned above, currently there is no provision for considering Other Equity towards computation of book profit under Sec. 115JB. However, the Committee, on 17th June, 2017, has recommended that the ITA be amended to ensure coverage of such Other Equity transactions under the purview of MAT to bring parity on first time adoption and ongoing transactions. If such an amendment is accepted, there is a possibility that the capital component of a financial liability is made subject to MAT.
Further, having looked at what constitutes a financial liability, let’s take a look at its prescribed classification and recognition in the books of accounts and the possible ensuing MAT impact.
III. Classification and measurement of “Financial liability”:
(a) Accounting under IND AS 109
IND AS provides the following two optional categories under which financial liabilities can be classified.
- Fair Value through Profit and Loss Account (FVTPL):
- Amortised Cost Method (ACM):
While classification is really at the option of the issuer (alongwith the Auditor’s confirmation), from a tax perspective, it is important to understand the basis of recognition / measurement driven by such classification. While initial measurement / recognition for both is at fair value (where the transaction value does not represent the fair value), liabilities classifies as FVTPL are to be recorded at fair value at every subsequent balance sheet date i.e. subsequent measurement. Any difference arising on such fair valuation of FVTPL liabilities (on initial measurement or subsequent measurement) is recognised only in the Profit and Loss Account. One exception to this rule is that at the time of subsequent measurement of a financial liability, if the change in fair value is partly / wholly attributable to “changes in the credit risk of the liability”, the impact will be recognised via the Other Comprehensive Income [‘OCI’] statement and not the Profit and Loss Account. In brief, this change in credit risk relates to the creditworthiness of the issuer; for example, if an entity issues a collateralised liability and a non-collateralised liability that are otherwise identical, the credit risk of those two liabilities will be different, even though they are issued by the same entity. The credit risk on the collateralised liability will be less than the credit risk of the non-collateralised liability. The credit risk for a collateralised liability may be close to zero.
As far as ACM liabilities are concerned, initial recognition is at fair value (difference qua transaction cost recorded in Profit and Loss Account). At every subsequent measurement (as defined above) in the balance sheet is at amortised cost i.e. initial measurement value minus the present value of the principal payments, plus or minus the cumulative amortization using the effective interest method (EIR) of any difference between that initial amount and the maturity amount. (The Effective interest rate is the rate that exactly discounts the estimated future cash payments through the expected life of the financial instrument to the amortised cost of a financial liability).
(b) MAT Impact under s. 115JB of the ITA, 1961
As discussed, measurement of financial liability is either at FVTPL or at ACM. In case of initial measurement at FVTPL or at ACM, the difference between the actual transaction value and the fair value of financial liability is recognised in the Profit and Loss Account. This is therefore, MAT exposed. Given that this could lead to additional MAT outgo in year 1 on initial recognition of ACM liabilities, the MAT impact is offset by additional interest deduction using EIR method over the life of the ACM liability.
In case of subsequent measurement of a FVTPL financial liability, the difference between the carrying amount in the books of account and the fair value on the balance sheet date is adjusted to the Profit and Loss account, and is therefore MAT exposed. Further, the amount attributable to the OCI (on account of credit risk variations) is also MAT exposed pursuant under Sec. 115JB(2A) of the ITA.
Further, the transaction costs, if any, incurred in relation to a FVTPL financial liability are charged to the Profit and Loss Account and are therefore also MAT deductible. Whereas, in case of transaction costs incurred in relation to an ACM liability, these are added to the financial liability; therefore, it is MAT deductible but over the life of the ACM liability.
Although, IND AS 109 does not distinguish between a financial liability for revenue or capital purposes, under the ITA, based on past precedents, can it be said that only revenue items are MAT leviable and capital items are not to be considered for computation of book profits? This issue still remains litigious and has been specifically dealt with in the second part of this article.
* This article has been co-authored by Megha Dhanuka, with inputs received from Rituraj Jaipuriar
 Clarifications issued for “computation of book profits under s. 115JB by IND AS companies”, by way of Circular number 24/2017 issued by the Central Board of Direct Taxes (CBDT) dated 25th July, 2017