Tuesday, January 19, 2016

Whether CSR Expenditure is Appropriation of Profits?

[The following post is contributed by Vinod Kothari of Vinod Kothari & Co. The author may be contacted at vinod@vinodkothari.com]

A circular of the Ministry of Corporate Affairs (MCA), with a set of FAQs along with response dated 12 January 2016 through general circular no. 01/2016 has clarified that the expenditure on corporate social responsibility (CSR) is not deductible as a business expenditure for tax purposes. The MCA circular has also clarified that the expenditure is based on the profits before tax (PBT) of the entity.

There is a question as to whether the CSR spending is an appropriation of profits, or a charge against profits? If it is an appropriation of profits, the spending is not debited as an expense to the profit and loss account; it will be treated a distribution of profits or application thereof, and accordingly, will not be recognised for the purpose of reporting of earnings of the entity, including earnings per share (EPS). On the contrary, if it is an expense, it is a charge to the profit and loss account. While the computation may be based on PBT, it will yet be an expense item, and the actual PBT will be determined after debiting the CSR spending.

This post examines the question. There are arguments on both sides of the motion. We discuss those.

Arguments for treating CSR spending as an appropriation:

The idea of CSR is that companies apply their profits not merely for shareholder wealth maximisation, but also for social good. Hence, while 98% of the profits of the company are distributable to shareholders, a small amount, 2%[1] of the profits, is applied for specified social causes. Thereby, the society becomes a stakeholder in the company.

“Expenditure” is what is laid out or incurred for business purposes, in ordinary course of business. CSR spending is certainly not incurred for business purposes. On the contrary, there is a clear contradiction between CSR spending and a business expense, since MCA’s circular provides that CSR spending cannot include an activity in the ordinary course of business[2].

Para 70 (a) of the Framework for Preparation and Presentation of Financial Statements defines “expense” as follows:

Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.


Para 78 further states:

The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity. Expenses that arise in the course of the  ordinary activities of the entity include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment.

The stress in para 78 seems to be on ordinary course of activities of the entity. In that sense, CSR is something which is completely outside the scope of ordinary activities.

Arguments for treating CSR as a charge against profits:

Properly speaking, CSR is a part of the business model of the entity. There seems to be a global convergence on business sustainability principles currently, that not only does a business have to run for profits, a business has to care for the society, community, environment, and so on, to make the business sustainable. The view towards sustainability is nothing but an approach that balances short term and long term objectives of a business. Thus, if a business spends on social good while running its business, it is not an act of philanthropy or distribution of the results of its enterprise – it is an effort towards ensuring those results are sustainable in nature.

CSR spending is based on profits, but it is not an appropriation of profits. The linkage with profit is merely the desired level of spending. In any case, CSR spending is based on average profits of 3 preceding years and is not even linked with the profits of the current year. Even if it was connected with the profits for the year, that by itself does not mean that the expenditure ceases to be an expense. For instance, managerial remuneration is based on profit – however, it is admittedly a charge against profits and not an appropriation.

ICAI issued a Guidance Note on Accounting for Expenditure on Corporate Social Responsibility Activities -

16. Presentation and Disclosure in Financial Statements

XX
From the perspective of better financial reporting and still be in line with the requirements of Schedule III in this regard, it is recommended that all expenditure on CSR activities, that qualify to be recognised as expense in accordance with paragraphs 10-14 above should be recognised as a separate line item as ‘CSR expenditure’ in the statement of profit and loss. Further, the relevant note should disclose the break-up of various heads of expenses included in the line item ‘CSR expenditure’

Importantly, the purpose of computation of earnings per share (EPS) is for equity participants to compute the earnings available to them, so that they may appraise the true value of the equity. If CSR is a spending made before the profits are available to the equity participants, certainly, the shareholders’ entitlement is to profits after CSR spending.

The issue of deductibility for tax purposes:

The Income tax Act was amended by Finance Act 2015 to provide specifically that CSR spending will not be claimed as an expense for the purpose of sec. 37 (1) of the Income-tax Act. However, the non-deductibility of an expense cannot become the basis to argue that the item is not an expense at all. Fiscal considerations are completely different. For example, there are several items of expenditure that either may be allowed subject to restrictions (sec. 36) or several items that may not be allowed (sec 40A, 43B), etc. However, each of these are items of expenditure.

Conclusion:

The definition of “expense” in Para 70 (a) of the Framework is to state that expenses include all those decreases in economic benefits that are done other than distributions to “equity participants”. There is no basis to regard the society as an “equity participant”. Hence, properly speaking, CSR spending should be treated as an expense rather than an appropriation of profits. The ICAI’s view on the matter, therefore, seems to be a correct view. Also, generally speaking, the guidance notes of ICAI have a strong recommendatory value and they are to be followed unless there is a strong reason to deviate therefrom.

- Vinod Kothari




[1] The percentage is actually based on average profits for 3 preceding years.
[2]  Which activity would not qualify as CSR - Activities undertaken by the Company in pursuance of its normal course of business.

4 comments:

vswami said...

OFFHAND
The 'expert' suggestion in the referred ICAI's official Guidance Note to disclose CSR as a 'separate line item' is not quite clearly understood. Anyway, that cannot, as independently viewed, be the guiding fact / support for deciding upon whether it is an 'expenditure' or ‘appropriation of profits’. Going by one's limited accounting knowledge, thus far only one 'imaginary'- not , in any sense, real - line is known to exist. Further, if not mistaken (open to correction), for tax purposes, to be precise sec 115 J has made inroads into that imaginary line, wholly to serve the purpose of the Revenue.
Under the scheme of things in the income-tax law, for deductibility, there is no such distinction known to have been made as between ‘ordinary’ and ‘extra-ordinary’ course /purpose of ‘business’. The VIRES of the amended sec 37 (1) is, to say the least , not free from doubt/debate , but may possibly be questioned.
The other point of doubt instantly arising in one’s mind is this: Whether CSR outgo is not open to be claimed as a ‘loss incidental to business’ – that is, as a thing that , per case law, comes upon him AB -EXTRA within the wider scope of section 29.
In view of the foregoing , the most disturbing angle requiring to be eminently explored by law pundits appears to be , - whether the tax deductibility of CSR outgo is going to prove itself one more added avenue for a war of wits and legal tangle.
Anyone seeing no substance or merit on the foregoing line of reasoning is at liberty to simply ignore.

AV said...

1 CSR accounting is in its nascent stage in India and some thoughts (projecting a mixture of accounting treatment) are given below. It is difficult to make a categorical statement if (i) CSR is a charge or appropriation or (ii) not a CSR at all. Happy reading!

2 Following expenditure out of the ambit of “CSR expenditure”
(a) Activities carried out as a pre-condition for setting up a business, or
(b) Activities carried out as part of a contractual obligation undertaken by the company, or
(c) Activities carried out in accordance with or in order to comply with any other law,
(d) Activities that benefit only the employees and their families shall not be considered CSR expenditure, unless the benefit is also available to the general public –see also 5 below.

3 For enabling ‘assets’ that are under-construction as on a reporting ate, entities must disclose it by way of footnote in the statement of Profit & Loss (P & L) together with other CSR expenditure as expressed under Item 5 (k) of the General Instructions for Preparation of Statement of Profit and Loss, Schedule iii.
As a result of CSR expenditure, if it meets the definition of an asset plus (i) control of the asset lies with the entity and (ii) future economic benefits are expected to flow, such a CSR expenditure should be capitalised in the books, but with a prefix CSR asset.
Once cost of the asset is included for CSR spend, then the book depreciation on such asset will not be included for CSR spend even if the asset is capitalized in the books of accounts and depreciation charged thereon.
4 CSR as revenue expenditure: On the other side, where an expenditure does not give rise to an ‘asset’ as explained above, the same may be treated as expenditure of revenue nature and continues to be charged to P & L accounts as part of its normal business activity.
However, it is important for the companies (covered under s. 135) at the first place to recognize whether the amounts incurred are part of its normal business activity or not.
Thus, CSR expenditure, incurred as part of the normal business activity (e.g. a FMCG company distributes its ready-to-eat products free of cost to people affected by flood), the same shall continue to be charged to the statement of profit and loss. On the contrary, if the CSR expenditure is not incurred as part of normal business activity (e.g. an IT company distributes ready-to-eat products free of cost to people affected by flood), the same shall be presented as an appropriation of profit.
5 Example of expenditure on training: incurred on existing employees will not qualify as CSR expenditure. However, if an entity incurs expenditure on skill development for apprentice trainees, cost of such training shall be eligible to be considered as CSR expenditure. This is irrespective of the fact that such training may increase the employability of the apprentices and that the entity may actually hire the apprentices as full-time employees at the end of their apprenticeship.
It would be a good idea to ascertain international accounting practices followed by matured economies on CSR spends where this (CSR type) requirement has been there for a while.

vswami said...

Apropos of posted previous comment : Reproduced below, is the useful input furnished,on request, by a learned colleague:
How to account for CSR expenditure
1 . CSR accounting is in its nascent stage in India and some thoughts (projecting a mixture of accounting treatment) are given below. It is difficult to make a categorical statement if (i) CSR is a charge or appropriation or (ii) not a CSR at all. Happy reading!
2. Following expenditure out of the ambit of “CSR expenditure”
(a) Activities carried out as a pre-condition for setting up a business, or
(b) Activities carried out as part of a contractual obligation undertaken by the company, or
(c) Activities carried out in accordance with or in order to comply with any other law,
(d) Activities that benefit only the employees and their families shall not be considered CSR expenditure, unless the benefit is also available to the general public –see also 5 below.

3 . For enabling ‘assets’ that are under-construction as on a reporting ate, entities must disclose it by way of footnote in the statement of Profit & Loss (P & L) together with other CSR expenditure as expressed under Item 5 (k) of the General Instructions for Preparation of Statement of Profit and Loss, Schedule iii.
As a result of CSR expenditure, if it meets the definition of an asset plus (i) control of the asset lies with the entity and (ii) future economic benefits are expected to flow, such a CSR expenditure should be capitalised in the books, but with a prefix CSR asset.
Once cost of the asset is included for CSR spend, then the book depreciation on such asset will not be included for CSR spend even if the asset is capitalized in the books of accounts and depreciation charged thereon.
4 . CSR as revenue expenditure: On the other side, where an expenditure does not give rise to an ‘asset’ as explained above, the same may be treated as expenditure of revenue nature and continues to be charged to P & L accounts as part of its normal business activity.
However, it is important for the companies (covered under s. 135) at the first place to recognize whether the amounts incurred are part of its normal business activity or not.
Thus, CSR expenditure, incurred as part of the normal business activity (e.g. a FMCG company distributes its ready-to-eat products free of cost to people affected by flood), the same shall continue to be charged to the statement of profit and loss. On the contrary, if the CSR expenditure is not incurred as part of normal business activity (e.g. an IT company distributes ready-to-eat products free of cost to people affected by flood), the same shall be presented as an appropriation of profit.
5. Example of expenditure on training: incurred on existing employees will not qualify as CSR expenditure. However, if an entity incurs expenditure on skill development for apprentice trainees, cost of such training shall be eligible to be considered as CSR expenditure. This is irrespective of the fact that such training may increase the employability of the apprentices and that the entity may actually hire the apprentices as full-time employees at the end of their apprenticeship.
FOOT NOTE: It would be a good idea to ascertain international accounting practices followed by matured economies on CSR spends where this (CSR type) requirement has been there for a while.
These should provide some guidance for a further study of related points.

vswami said...

ASIDE

Sec 37 (as now stands after repeated amendments) makes for a funny reading:
“37. (1) Any expenditure (not being.... expenditure of the nature described in sections 30 to 36 and not being....) laid out or expended wholly and exclusively for the purposes of.. shall be allowed......
Explanation 1.]—For the removal of doubts, it is hereby declared that any expenditure incurred.... SHALL NOT BE DEEMED TO HAVE BEEN INCURRED.... and no deduction or allowance shall be made in respect of such expenditure.
Explanation 2.—For the removal of doubts, it is hereby declared that... any expenditure incurred by an assessee on the activities relating to corporate social responsibility referred to in section 135 of the Companies Act, 2013 (18 of 2013) SHALL NOT BE DEEMED TO BE AN EXPENDITURE INCURRED ......
(2) [* * *]
(2B) Notwithstanding anything contained in sub-section (1), no allowance shall be made in respect of .....
(3) [* * *]”
To be noted:
The language (wording) used for denying allowance of expenditure, of varying types, including that as per the Explanation 2 of relevance herein, are not uniform, but are mutually at variance; rather makes for a clumsy reading.
Further, there is a patent flaw in the expression, - “shall not be deemed to ...”, used in two of the Explanations (as highlighted above); in that, the main provision (i.e. sub-section (1)) provides for allowance of any “expenditure incurred “, in the sense of it being factually incurred , -not deeming it to be so. The subtle point will be better appreciated if the Explanation (s) is read after substituting, rightly so, in place of the words “not be deemed to”, the words “be deemed not to”.