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FAQs on profit computation under section 198 of the Companies Act, 2013
Should you expect adjustment in profits for “Expected Credit Loss”?
– Customised profits for CSR and managerial remuneration under Section 198 of the CA, 2013
– Pammy Jaiswal and Sourish Kundu | corplaw@vinodkothari.com
Background
The presentation of the profit and loss account has been outlined under the Schedule III of the Companies Act, 2013 (‘Act’) and the profit computation method has been provided for under the applicable accounting standards [See IND AS 1]. The basic principle is to showcase a true and fair view of the financial position of a company. Having said that, it is also significant to mention that the Act provides for an alternative method for computing net profits, the basic intent of which is to arrive at an adjusted net profit which does not have elements of unrealised gains or losses, capital gains or losses and in fact any item which is extraordinary in its very nature. The same is contained under the provisions of section 198 of the Act. This section, unlike the general computation method, has a limited objective i.e., calculation of net profits for managerial remuneration as well as corporate social responsibility.
There are four operating sub-sections under section 198 which provides for the adjustment items:
- Allowing the credit of certain items – usual income in the form of govt subsidies
- Disallowing the credit given to certain items – unrealised gains, capital profits, etc.
- Allowing the debit of certain items – usual working charges, interests, depreciation, etc
- Disallowing the debit of certain items – capital losses, unrealised losses, usual income tax, etc
It is important to note that items other than those mentioned above need not be specifically adjusted unless their nature calls for adjustment under the said section. Now if we discuss specifically for items in the nature of Expected Credit Loss (‘ECL’) for companies following IND AS, it is important to understand the nature of ECL in the context of making adjustments under section 198 of the Act. See our write on Expected Credit Losses on Loans: Guide for NBFCs.
Understanding ECL and Its Accounting Treatment
Reference shall be drawn from Ind AS 109 which defines ‘credit loss’ as ‘the difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive (i.e. cash shortfalls), including cash flows from the sale of collateral held.’ ECL is essentially a way of estimating future credit losses, even on loans that appear to be fully performing at the time of such analysis (Stage 1 assets). It is based on expected delays or defaults, and the estimated loss is recorded as a charge to the profit and loss account, based on a 12-month probability of default.
As per Ind AS 109, ECL is used for the recognition and measurement of impairment on financial assets both at the time of origination as well as at the end of every reporting period. ECL is a forward-looking approach that requires entities to recognize credit losses based on the probability of future defaults/ delays.
However, this does not result in a reduction in the carrying value of the asset (unless the asset is already credit-impaired, i.e., Stage 3). In that sense, while ECL reflects asset impairment, it does not operate like a direct write-down. And unlike conventional provisioning, ECL is not a “provision” under traditional accounting – it is a loss allowance rooted in forward-looking estimations. Further, it is also important to understand that the booking of ECL does not mean that there has been a credit loss in the actual sense, the same is a methodical manner of estimating the probable default risk association with the asset value.
Treatment of ECL under Section 198
Section 198 requires excluding unrealised or notional adjustments, such as fair value changes or revaluation impacts in terms of Section 198(3) of theAct.
The section also refers specifically to actual bad debts, under Section 198(4)(o). This raises the natural interpretational question: should model-driven, probability-weighted ECL charges – which do not reflect realised losses – really be allowed to remain deducted while computing such customised profits? Well, the answer lies in the requirement and nature of such an item being required to be deducted from the profit and loss account under IND AS 109.
Alternative approaches -Treatment of ECL
The question around the treatment of ECL can be viewed from two perspectives. The first being the nature of ECL and the second on the routine treatment and calculation of ECL. If we look at the nature, it is clear that while it is imperative for companies to compute ECL at the time of origination as well as at the end of every reporting period, it is important to note that there is no loss or default in the actual sense. This means that the amount computed as ECL has not been an actual default.
On the other hand, if we look at the need for such computation and the methodical approach to arrive at the value of ECL, the same is likely to be considered as a usual working charge which is charged to the profit and loss account. Accordingly, we have come across two possible and permissible approaches to the treatment of ECL while computing the profits under section 198. The same has been discussed below with the help of illustrations.
Approach 1: Disallowing ECL in the year of its booking and subsequent adjustment of bad debt
| Year 1 | Year 2 |
| PBT – 1000 Depreciation – 20 ECL – 40 Loss on sale of fixed asset – 15 | PBT – 1200 Depreciation – 20 ECL – 35 Actual Bad Debt – 15 Profit on sale of equity shares – 25 |
| Year 1 | Amount | Year 2 | Amount |
| PBT | 1000 | PBT | 1200 |
| Depreciation | – | Depreciation | – |
| Add: ECL | 40 | Add: ECL | 35 |
| Add: Loss on sale of fixed asset | 15 | Less: Profit on sale of equity shares | (25) |
| PBT u/s 198 | 1055 | PBT u/s 198 | 1210 |
Notes:
- ECL has been ignored in profit computation u/s 198 considering the same is an unrealised loss and therefore reversed.
- Depreciation and actual bad debt has not been adjusted again as it has already been deducted under normal profit computation.
- Capital gains and losses have been adjusted/ reversed under the computation.
Approach 2: Allowing ECL in profit computation and netting off actual bad debt from the same in subsequent period
| Year 1 | Year 2 |
| PBT – 1000 Depreciation – 20 ECL – 40 Loss on sale of fixed asset – 15 | PBT – 1200 Depreciation – 20 ECL recovered – 35 Actual Bad Debt – 15 Profit on sale of equity shares – 25 |
| Year 1 | Amount | Year 2 | Amount |
| PBT | 1000 | PBT | 1200 |
| Depreciation | – | Depreciation | – |
| ECL | – | ECL | – |
| Add: Loss on sale of fixed asset | 15 | Actual bad debt | – |
| ECL recovered | – | ||
| Less: Profit on sale of equity shares | (25) | ||
| PBT u/s 198 | 1015 | PBT u/s 198 | 1185 |
Notes:
- ECL has been considered in profit computation u/s 198 and therefore, not adjusted to reverse the impact
- Similarly, ECL recovered has been considered part of normal or routine adjustment and hence, not reversed.
- Actual bad debt is not to be considered at the time of profit computation under the regular computation since it can be adjusted from the ECL already booked.
- Capital gains and losses have been adjusted/ reversed under the computation.
Concluding remarks
All listed companies are required to comply with Ind AS and given that an instance of a company having nil receivables is a rare occurrence, the discussion on how ECL is to be treated while computing net profit in terms of Section 198 becomes more than just an academic debate.
As long as the impact of any P&L item being extra ordinary in nature is taken off from the profits computed u/s 198, the same serves the purpose and intent of section 198 of the Act. ECL, while valid for accounting, is fundamentally an estimated, non-actual loss. It exists because accounting standards demand alignment of income with credit risk and not because a real outflow has occurred. However, it cannot be said that ECL already deducted while calculating profit before tax as per applicable accounting standards will be reversed while calculating profits in terms of Section 198.
Further, given that ECL is based on expectation calculated using due accounting principles, the actual bed debt, if within the ECL limit, does not impact the P&L. On the contrary, in case of the actual bad debt being in excess, the P&L warrants a subsequent debit of the net amount. For example, under approach 2 if the actual bad debt would have been 50, i.e. in excess of the ECL booked in the previous period by 10, the normal profit computation would have allowed a debit of 10.
In fact, both the approaches lead to the fulfilment of the intent of section 198 and hence, it is not necessary to consider any one approach as correct. Having said that, it is imperative to follow uniform practice in this regard in the absence of which the profits u/s 198 may be impacted.
Therefore, where the statutory and accounting frameworks intersect – but are not necessarily aligned – companies must adopt a carefully considered, principle-based approach as even a single line item like ECL can materially influence the base for managerial remuneration and CSR spending unlike other estimate based items such as revenue deferrals viz. sales returns or warranties, which are made as a matter of accounting prudence, but does not represent outflows for statutory computation purposes. Accordingly, there is no reason for deviating from the Indian GAAP principles for the purpose of customised calculation of net profits for specific purposes.
Read more:
Cash in Hand, But Still a Loss?
Ongoing Projects, Unspent Funds, and the April 30 Countdown
– Sourish Kundu, Executive | corplaw@vinodkothari.com
Every year, as companies close their books on 31st March, a silent timer begins ticking — one that could turn a minor delay into a major compliance miss. 30th April isn’t just another date on the calendar; it’s a hard stop for companies to take action regarding their unspent CSR (Corporate Social Responsibility) obligations.
Why 30th April? What must you do? What if you don’t? Let’s walk through it — step by step.
Why 30th April?
In terms of Section 135(6) of the Companies Act, 2013:
“Any amount remaining unspent under sub-section (5), pursuant to any ongoing project, fulfilling such conditions as may be prescribed, undertaken by a company in pursuance of its Corporate Social Responsibility Policy, shall be transferred by the company within a period of thirty days from the end of the financial year to a special account in any scheduled bank called the ‘Unspent Corporate Social Responsibility Account.'”
Thus, by 30th April, companies must transfer unspent CSR amounts related to ongoing projects into a special CSR account.
What Must Be Done by 30th April?
- Open a dedicated bank account titled “Unspent Corporate Social Responsibility Account FY [Year].”
- Transfer the unspent CSR amount related to ongoing projects into this account.
- Update the Board Report appropriately (explained below).
What If You Don’t Do It?
If the company:
- Fails to transfer the amount by 30th April — it’s a default under Section 135(6).
- Fails to spend the amount altogether — Section 135(5) steps in:
“If the company fails to spend such amount, the Board shall, in its report made under clause (o) of sub-section (3) of section 134, specify the reasons for not spending the amount and, unless the unspent amount relates to any ongoing project referred to in sub-section (6), transfer such unspent amount to a Fund specified in Schedule VII, within six months of the expiry of the financial year.”
In short:
1. Unspent on non-ongoing projects? → Transfer to a Schedule VII Fund within 6 months of FY end (i.e., by 30th September).
2. Unspent on ongoing projects? → Transfer to Unspent CSR Account by 30th April, then spend it within 3 years, failing which again transfer to a Fund.
What is an Ongoing Project?
Rule 2(1)(i) of Amendment Rules defines the term ‘ongoing project’ as:
- a multi-year project, stretching over more than one financial year;
- having timeline not exceeding three years excluding the year of commencement
- includes such project that was initially not approved as a multi-year project but whose duration has been extended beyond one year by the Board based on reasonable justification.
The same should have commenced within the financial year to call it ‘ongoing’. This includes a project that was initially not approved as a multi-year project. The intent is to include a project which has an identifiable commencement and completion. The expenses which are recurring in nature should not be included in the ongoing project.
For example, if a company contributes to the annual running expense of a cancer hospital, the spending for the next year cannot be regarded as an “ongoing project”. However, if installation of a new facility at the same hospital is already undertaken during the year, such expense should be regarded as an “ongoing project”.
Board’s and Auditor’s Responsibility
- Board’s Responsibility: In the Board’s Report (Section 134(3)(o)), specify reasons for any unspent CSR amount.
- Auditor’s Responsibility under Rule 3 of CARO, 2020:
The auditor must specifically report:
- (xx)(a) whether, in respect of other than ongoing projects, the company has transferred unspent amount to a Fund specified in Schedule VII within 6 months of expiry of the financial year, in compliance with the second proviso to Section 135(5);
- (xx)(b) whether any amount remaining unspent pursuant to any ongoing project has been transferred to the Unspent CSR Account within 30 days from the end of the financial year, as required under Section 135(6).
Thus, both the Board and Auditor are responsible for ensuring, documenting, and reporting CSR compliance – and failure can attract regulatory scrutiny and penal consequences.
Read more:
Knowledge Centre for Corporate Social Responsibility (CSR)
Need for strategic vision in CSR spending by companies
Corporate law changes: small steps towards procedural simplification
Scaling up skilling by using CSR funds: Any takers?
Employment & Skilling has been identified as one of the top priorities for Vikshit Bharat in the Union Budget, 2024. To this end, the Govt has proposed a scheme that looks novel and innovative, and would supposedly encourage top 500 companies to use their CSR funds for providing internships to eligible youth. However, even if a large company takes 100 interns, it will use only Rs 6 lakh [100 X Rs 5000 X 12 – 90% govt. share] out of its CSR budget, which is trivial for a company of that size.
More details will possibly be rolled out over time, from whatever is available, it seems there is quite a lot of procedure for companies, who may opt for this scheme only at their discretion.
Read more →CSR spending in the Indian sports sector
-Shreya Salampuria | corplaw@vinodkothari.com
Background
Corporate social responsibility (CSR) spending in India, as is well known, is focused on certain statutorily recognised social activities, of which sports is one. Schedule VII, clause (vii) deals with activities related to “training to promote rural sports, nationally recognised sports, paralympic sports and olympic sports”.
Most of the attention under the schedule is taken away by contribution on activities connected with healthcare followed by education.
Khelo India, Kheloge toh Khiloge, an attempt to improve the performance of our vast country in sports, however, can we tap csr funds for the same?
When it comes to choosing or prioritizing the sports related activities, the outlook of the Indian companies cannot be said to be very impressive, however, there has been an increment on the CSR spending under the sports sector.
Read more →Responsibility by rod: MCA adjudication orders deal punches of penalty for CSR breaches
– Vinod Kothari | corplaw@vinodkothari.com
If the intent of CSR provisions coded in the law was to promote socially responsible conduct on the part of companies, that lesson of responsibility is being taught the very hard, indiscriminately harsh way – by imposing penalties of 2X of the amount involved in CSR breaches, even if the breach was a pure timing mismatch. By now, there are several such adjudication orders – purely as an example, is where the order clearly notes that there has been no failure on the part of the company to spend the failed amount of Rs 14.50 lacs. The amount was indeed spent, as intended for “ongoing projects”, but there mere segregation of this money into a separate bank account, required to be done within 30 days, was missing. Applying the provisions of sec. 135 (7) which provides for a “penalty of twice the amount” which failed the segregation requirement, though it did not fail the spending requirement.
There are several points that arise here: segregation of the amounts meant to be spent for ongoing projects is merely a ring-fencing requirement, such that companies are aware of the purpose for parking the money, and such money is indeed not commingled with the company’s own funds. If the funds are indeed spent for the purpose for which they are to be segregated, the failure to segregate is, at the most, the failure of the method and not the ultimate result. The failure was transient, and only a timing issue, and not a substantive failure. Therefore, even if punishable, the punishment could not have been the maximum amount provided by the law.
Read more →Understanding CSR for NGO
– Pammy Jaiswal, Partner | corplaw@vinodkothari.com
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Open in new tab Corporate succession events: Treatment of unspent or overspent CSR obligations
CS Aisha Begum Ansari, Manager & Payal Agarwal, Deputy Manager | corplaw@vinodkothari.com
Background
The identity of a corporate entity may undergo various restructurings, either in the form of merger, demerger, sale of one or more divisions or undertakings. conversion of a company into LLP etc. Let us, for the sake of convenience, call them a “corporate succession” event, implying a situation where a corporate entity is succeeded by another entity, or its business, operations or undertaking shifts to another entity. In some cases, say, amalgamation, the erstwhile corporate entity gets dissolved. In case of a demerger, the transferor entity continues. In case of conversion into LLP or vice versa, a company gets transformed into an LLP or other way round.
Usually, in corporate succession events, the assets and liabilities forming part of an undertaking are shifted to another undertaking, say, the successor entity. The assets and liabilities that are comprised in an undertaking are mostly defined to include all liabilities existing on pertaining to a certain date, let us call it “appointed date”.
One of the perplexing aspects of this process of transfer of assets and liabilities may be the treatment of the unspent CSR obligations, or excess spending, by the corporate entity which is undergoing a change in its identity. The question becomes increasingly significant in the present day regulatory environment due to the shift in CSR from COPEX (Comply or Explain) to COPP (Comply or Pay Penalty).
In the present write-up, we discuss the treatment of CSR obligations as a result of the following actions resulting into a change in the identity of a corporate –
- Merger
- Demerger
- Sale of a division/ undertaking (“Slump sale”)
- Conversion of a company into LLP
Can companies avail GST benefits on CSR spending?
– By Harsh Juneja | Executive (corplaw@vinodkothari.com)
(Updated as on February 03, 2023 by Lovish Jain | Executive)
Background
Section 135(5) of the Companies Act, 2013 (‘the Act’) requires every eligible company [as per section 135(1)] to spend at least 2% of the average of net profits of immediately preceding 3 financial years towards Corporate Social Responsibilities(‘CSR’) activities. The CSR spending may sometimes include contributions made to NGOs or other beneficiaries, or money paid to implementing agencies. However, quite often, the expense may relate to procurement of goods or services which are applied to one or more CSR activities. This procurement of goods or services comes with the tax cost, viz., GST. So the question is, does this GST paid, while acquiring goods or services, give rise to an input tax credit, such that the same may be claimed as a set off? A related, and more important question is, whether CSR expense for the purpose of sec. 135 (5) be the amount net of the ITC, if the ITC is claimable, or the gross amount paid?
Input Tax Credit
Eligibility
Section 16(1) of the Central Goods and Service Tax (‘CGST Act, 2017’) prescribes the eligibility criteria for taking Input Tax Credit. It states that “Every registered person shall, subject to such conditions and restrictions as may be prescribed and in the manner specified in section 49, be entitled to take credit of input tax charged on any supply of goods or services or both to him which are used or intended to be used in the course or furtherance of his business and the said amount shall be credited to the electronic credit ledger of such person.”
Until the Budget 2023 announcement, there was no explicit provision clarifying the position whether input tax credit would be available for acquiring goods or services for carrying out CSR activities. In the Finance Bill, 2023, a proposal has been made for amendment in section 17 of the CGST Act, 2017 to disallow the availability of input tax credit for expenditure made towards CSR activities. Please refer to our article on the same
There have been rulings by Appellate Tribunal and Advance Rulings under GST w.r.t. the same.
Hon’ble CESTAT Mumbai, in the case of M/s Essel Propack Ltd. vs Commissioner of CGST, Bhiwandi, gave a view that the CSR gives a company an economically, socially and environment sustainability in the society in the long run, as a company can not operate without providing benefits to its stakeholders. Therefore, it held that if companies are unable to claim input services in respect of activities relating to business, production and sustainability of the companies themselves would be at stake.
Hon’ble High Court of Karnataka, in its judgement, in the case of M/s Commissioner of Central Excise, Bangalore vs. Millipore India (P) Ltd., also was of view that CSR Expenses are mandatorily incurred by employers towards benefit of the society and “to maintain their factory premises in an eco-friendly manner”. Therefore, the tax paid on such services shall form part of the costs of the final products and thus, the company can claim these taxes paid as input services.
Uttar Pradesh Authority for Advance Ruling (‘AAR’) in the matter of M/s Dwarikesh Sugar Industries Ltd held that a company is mandatorily required to undertake CSR activities and thus, forms a core part of its business process. Hence, the CSR activities are to be treated as incurred in “the course of business”.
Telangana State AAR in the matter of M/s. Bambino Pasta Food Industries Private Limited has clearly held that expenditure made towards CSR, is an expenditure made in the furtherance of the business. Hence the tax paid on purchases made to meet the obligations under CSR will be eligible for ITC.
Section 135(7) is a penal provision under the Act which deals with penalty on non-compliance of section 135(5) and (6). It was observed by the AAR that a Company fulfilling eligibility criteria under section 135(1) of the Act is required to mandatorily spend towards CSR and thus, must comply with these provisions to ensure smooth run of business.
Thus, Uttar Pradesh AAR held that the expenses incurred by the Company in order to comply with requirements of CSR under the Act qualify as being incurred in the course of business and are eligible for ITC in terms of the Section 16 of the CGST Act, 2017.
Contrary ruling: Free Supply of Goods
Section 17(5)(h) of the CGST Act excludes “goods lost, stolen, destroyed, written off or disposed of by way of gift or free samples” for the purpose of availing ITC on payment of GST. The term ‘gift’ is not defined anywhere in the CGST Act. However, in layman’s language, gift means a thing given willingly to someone without payment.
In the matter of M/s. Polycab Wires Private Limited, Kerala AAR held that distribution of necessaries to calamity affected people under CSR expenses shall be treated as is if they are given on free basis and without collecting any money. Hence, for these transactions, it was held that ITC shall not be available as per section 17(5)(h).
However, a contrast has been drawn in the Uttar Pradesh AAR Ruling towards goods given as ‘gift’ and given as a part of CSR activities. Gifts are voluntary and occasional in nature whereas CSR expenses are obligatory and regular in nature. AAR held that since CSR expenses are not incurred voluntarily and have to be incurred regularly, they are not to be treated as ‘gift’ and thus, should not be restricted under section 17(5)(h) for claiming ITC.
One may also refer to explanation 2 to Section 37(1) of Income Tax Act, 1961, as also cited by Hon’ble High Court of Delhi in the matter of Pr. Commissioner of Income Tax vs. M/s Steel Authority of India Ltd which provides that, any expenditure incurred by an assessee on the activities relating to CSR referred to in section 135 of the Companies Act, 2013 shall not be deemed to be an expenditure incurred for the purposes of the business or profession.
Availing Benefit through Beneficiary
A company contributes a sum towards a beneficial organisation such as NGOs, Charitable Trusts and Section 8 Companies (‘implementing agencies’) towards fulfillment of CSR activities. However, these implementing agencies also need to hire services of vendors to complete these activities. These vendors charge GST on the services rendered by them. Since these implementing agencies often do not generate any output, the question raises can these organizations also claim ITC on the services rendered by them?
There is a concept of ‘pure agent’ in GST. Explanation to Rule 33 of CGST Rules, 2017 prescribes that a pure agent means a person who –
The implementing agencies fulfill this eligibility criteria of being a ‘pure agent’. Rule 33 also contains some conditions on the fulfilment of which, expenses incurred by the supplier as a pure agent of the recipient of the supplier of goods or services, are excluded from the value of supply-
In our case, if an implementing agency avails any goods or services from a vendor to fulfil the CSR activities for a company, then the payment of any such amount to the vendor shall be treated as a supply made as a pure agent by the implementing agency on behalf of recipient of supply, i.e., the company. Thus, these expenses incurred by the implementing agencies shall be excluded from the value of supply and therefore, are not liable for payment of GST.
CSR Contribution: Pre-GST or Post-GST?
The Act does not clarify that the amount to be contributed towards CSR activities should be inclusive or exclusive of taxes. However, it seems that since GST is charged on supply of goods and services, irrespective of the intention of social benefit, the amount contributed towards CSR can be both inclusive and exclusive of GST. Having said that, the question still pertains on the inclusivity of the amount of GST paid towards the amount of CSR expenditure for the purpose of section 135(5) of the Companies Act, 2013.
Conclusion
While the rational view would be, expenses incurred on GST for fulfilment of CSR activities should be eligible for claiming input tax credit, however, the Finance Bill, 2023 proposes otherwise. The effective date of the amendment will be 1st April 2023. Hence, once the Budget proposals are passed, any acquisition of goods or services for CSR purposes will be denied the benefit of GST set off. So the next question is whether the CSR expenditure would be inclusive of GST. We deal with the same citing illustrations in our article.