[The following post is contributed by Vinod Kothari of Vinod Kothari & Co. The author may be contacted at email@example.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% 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.
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
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.
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