The Hindu : Banking on tax credit: Bonanza for banks?

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Monday, Jun 30, 2003

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Banking on tax credit: Bonanza for banks?

The effect of unreal profits arising out of deferred tax asset ought to be neutralised. Otherwise, one will see some troubled banks in India, like their counterparts in Japan.

BANKS IN India have been declaring substantial profits in the last two years and most observers have attributed this to the higher income from trading in government securities and not from the core banking business of lending. Another unusual item of income — one may call it an accounting jugglery — has also contributed to the bank profits during the last two years. This has been enabled by the deferred taxation concept by which a portion of the income tax actually paid has been taken as income. This practice, if continued without any change, can lead to bizarre consequences such as a bank declaring dividends out of the tax actually paid, as explained later.

The concept of deferred tax has been in existence in the U.S. and the U.K. for many years and was introduced in India in 2001, by the Accounting Standard 22 (AS 22). At that time, almost all the old companies had to dip deeply into past profits to make extra provisions. It was then felt that AS 22 would mainly go to depress profits. None was bold to predict that it could also result in boosting profits, on an ongoing basis. Such a beneficial impact is now seen in many banks that have recently published their annual accounts. It is for serious consideration whether the provisions of AS 22 should be revised in respect of deferred tax assets.

The basic premise of AS 22 is sound: revenues and expenses of an accounting period should match each other, and the disparity in income tax between "taxable'' income and "book'' income should be properly resolved.

The differences between the two sets of computation of income can be classified into two categories: permanent and timing differences. Permanent differences arise in respect of expenses that are legitimately incurred by a company, but are wholly or partially disallowed by the income tax authorities under Section 40A of the Income-tax Act. These and other similar expenses do not give rise to deferred tax provisions.

Temporary differences are those allowed by the tax authorities but the timing varies between tax and book computation. A typical example is the provision for depreciation: both for book purposes and for taxation, companies can and do provide for the full (or nearly full, that is, 95 per cent) value of the asset (building and machinery) over the useful life of the asset. However, the rates prescribed in Income-tax Act vary from those provided in the Companies Act. Further, there is a difference in the method of computation.

The net effect of the above is that the depreciation provision is lower as per books than for tax purposes in the initial years of the asset; this trend should get reversed in the later years. Resultantly, profit would be more as per books in the initial years than "tax'' profits. Prior to 2001, Indian companies were providing for income tax on the basis of what they paid during a year and not what would have been payable as per book profits. This created an anomaly as it resulted in cash basis accounting (not accrual basis) for tax and further, the matching principle was not adhered to. Therefore, the Institute of Chartered Accountants adumbrated AS 22 to make provision for deferred taxation.

Under AS 22, companies are required to make provision for income tax on the basis of what is payable as per book profits (other than permanent differences that result in permanent disallowance by tax authorities) and not what is paid actually in a year. Generally, for all companies, this would mean that the tax provision is more than what is paid, in the initial years of an asset, the excess being set off in later years. The excess charge is debited to the profit and loss account and since it is payable in future years, the amount is indicated in the balance sheet as a deferred tax liability (DTL).

Banks as a class would generate temporary differences of another kind. They are required to provide a stated percentage of "impaired'' loans (doubtful debts) under the income recognition norms stipulated by RBI; such norms are followed by almost all countries.

Much before a loan is considered irrecoverable, banks start providing for loan losses if the borrower delays payment of interest or repayment of principal; beginning with 10 per cent, the provision is gradually stepped up to the full extent of the loan over the years. In many cases, the tax authorities do not allow such provisions in the initial years unless the loan is actually written off. Thus, the book profits of banks tend to be lower in the initial years than the tax profits, to be reversed in later years; this creates a deferred tax asset (DTA).

By following AS 22, banks are required to provide for lesser tax than what they actually pay in an accounting period. In other words, a portion of the tax paid is written back and is accounted for later when the tax authorities allow the loan loss. An example will illustrate:

If the bank had provided for the tax actually paid, it would have no net profit (that is, profit after provision less tax paid 45-45) to declare. But, by adopting AS 22, it can declare a profit of Rs.31.5 crores and, even pay dividend out of that profit. Put it bluntly, a bank can pay a dividend out of the tax already paid, by not accounting for the full amount of tax paid, in its books.

The bonanza of DTA is evident from the financial statements published by many banks in India. A sample of two banks will illustrate. Oriental Bank of Commerce: "The creation of deferred tax assets during the year (02-03) has resulted in increases in the general reserve by Rs.140 crores and net profit by Rs. 61 crores.'' South Indian Bank: "Net deferred tax asset of Rs. 25.01 crores relating to the current year on account of provision for loan NPAs (doubtful debts) has been recognised in the accounts.'' In other words, net profit had increased by that amount. However, two other banks — United Commercial Bank and United Bank of India — have not taken DTA as profit, because of the "uncertainty of adequate future profits.''

DTA seems to have a huge beneficial impact on Japanese banks also. The Economist in its May 21 issue reported that in many big Japanese banks, the component of DTA in their Tier I capital (that is, share capital and accumulated reserves or profits) is large. It was over 80 per cent for Mitsui Trust, 60 per cent for Resona Bank (a troubled bank) and over 40 per cent for Mizuho.

While the basis of deferred tax concept is not questionable — a combination of matching and accrual principles — the treatment accorded to DTA needs to be reviewed. The author would argue that the amount of DTA should not be taken straight to profits but kept as a separate reserve (tax recoverable account). But then the DTL should be reduced from profits. A parallel could be drawn here to the revaluation of assets. If the asset value is increased by revaluation, the difference is taken to revaluation reserve, without affecting profits, but if the value is decreased, it is written off as a loss. The author would argue for a similar treatment in respect of deferred tax provisions.

To conclude, the effect of unreal profits arising out of deferred tax asset ought to be neutralised.

Otherwise, one will see some troubled banks in India, like their counterparts in Japan, revealing a good financial position solely by adopting the new concept of deferred taxation.

R. Viswanathan

(Retd. Deputy Managing Director, State Bank of India)

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