Corporate liabilities: `Taxing' issues

Suresh Krishnamurthy

TAXATION has always represented an area of immense possibilities for most Indian companies.

Over the years, considerable time and effort have been gone to understand the taxman's jargon to reduce the incidence of tax. The challenge for many companies was to boost profits reported to shareholders, and at the same time, offer lower profits for tax. Many companies have succeeded in doing it. The tax laws too, by bestowing incentives in the form of accelerated depreciation, allowed the companies much leeway.

The outcome is that the effective tax incidence for companies varies widely. Companies such as ACC and BSES paid less than 10 per cent of their profits as corporate tax in the year ended March 2001. This suggests that the profits offered for tax were much lower than that reported in the annual accounts. In contrast, companies such as Britannia Industries and Nestle paid around 40 per cent of their profits as taxes during the same period.

In the latters' case, profits offered for taxes are likely to have been higher than reported in the annual accounts. It is in such a situation that the Institute of Chartered Accountants of India has introduced the accounting standard on deferred taxation.

What is deferred tax?

Accounting Standard 22 (AS 22) intends to make a significant change in the way corporate taxes are accounted. AS-22 wants companies such as ACC and BSES to ascertain if the lower tax incidence is because the tax has been deferred to future years, to any permanent tax benefits or other factors. If it has been deferred, companies will have to account for the taxes immediately. Similarly, if taxes deferred earlier materialise in the tax year, that will not be charged against profits of that year.

For instance, in the case of ACC, the tax incidence rose 24 per cent in the quarter ended September 2001. In Nestle's case, it decreased to 29 per cent. The changes in the tax incidence for these two companies are mainly due to the impact of the new accounting standard.

Overall, such an accounting system intends to match taxes to the year in which the income arose. Irrespective of the profits offered for tax, a provision has to be made based on accounting profits. If the tax payable is lower than the provision, then a deferred tax liability will be created. If the tax payable is higher, then deferred tax asset will be created.

Under AS-22, companies are also to quantify the deferred tax amounts for past years, till March 2001. A few companies have disclosed the deferred tax liabilities. The amounts are significant, and in some cases, represent up to 24 per cent of the company's reserves. It is also interesting to note that HDFC Bank has a deferred tax asset - an indication of the aggressive provisioning norms followed by the company.

Essentially, AS-22 will bring into view an item outside the balance-sheet, about which companies made no disclosures. This may not lead to disclosure of material information in all cases. However, in a few cases, the information disclosed will be significant.

For instance, take ITC Bhadrachalam. The company had accumulated losses of more than Rs 400 crore calculated in accordance with I-T rules. To a potential acquirer, this represented an asset the value of which was Rs 125 crore. Till now, this asset was recorded in the books of accounts. However, from this year, this asset will find a place in the balance-sheet.

However, accounting according to AS-22 may not materially alter the balance-sheet in all cases. Thus, the analysis of the deferred tax of companies assume significance.

Analytical issues

In the case of deferred tax liability, the important analytic issue pertains to whether the liability is likely to fructify at all in future years. It is also important to understand that the computed deferred tax amounts do not represent assets or liabilities - what is relevant is the present value of the amounts. However, Indian accounting practices do not allow for present value accounting.

Importantly, studies in the US suggest that a significant portion of the deferred tax liability does not reverse. In other words, a significant portion of the liability does not represent liability at all. Consider the deferred tax liabilities of Grasim, Larsen and Toubro, Tata Steel, Reliance, and Tata Engineering. Their deferred tax liabilities are more than 20 times the tax paid for this financial year.

For these companies, the deferred tax liability may keep growing every year if the rate of growth of profit is high. This is because these companies cannot grow their profits without fresh investments. Fresh investments then would become the source of deferred tax liabilities. In this backdrop, it is clear that even if the companies do not make fresh investments in future years, a substantial portion of the liabilities is unlikely to materialise.

On the other hand, take the case of Hindustan Lever, Digital Globalsoft, ICICI, or Infosys. In their case, it is unlikely that large fixed asset investments will be made in future years. In this backdrop, the deferred tax liabilities may materialise in the next few years.

While analysing a company's performance, the pre-tax profits and the cash flow from operations are better parameters. This is because the provision for tax from now would be affected by issues not connected to the operations of the period under review. Importantly, the provision will also be influenced by management choices.

While valuing the stocks, it is important to ascertain at what level the deferred tax liabilities will stabilise. If there is a possibility of their stabilising at current levels, then the entire amount needs to be added to the company's profits and reserves for calculating ratios such as EPS and Book Value. If it were likely to stabilise at a lower level, then the lower amount will have to be added to the profits and reserves.

Overall, it may be better to add even up to 90 per cent of the deferred tax liabilities to reserves. That too seems to be the verdict of the stock market. The disclosure of large tax liabilities by companies such as Reliance, Larsen & Toubro, Tata Engineering and Tata Steel have not affected their share prices; therefore, it can be concluded that the stock market does not expect the liabilities to materialise in the near future.

In the case of computing ratios, such as debt-equity ratio, too, it may be better to add a significant portion of the liability to equity. In the least, they should not be added to debt of the company. That may serve to project quite a conservative picture.