Why do we capitalize borrowing costs?
In accounting, as per NAS 23 – Borrowing Costs, borrowing costs are capitalized when they are directly attributable to the acquisition, construction, or production of a qualifying asset. Qualifying assets are assets that necessarily take a substantial period of time to get ready for their intended use or sale.
When capitalizing borrowing costs, these costs are added to the cost of the qualifying asset rather than being recognized as an expense immediately. The capitalization of borrowing costs is in line with the accrual accounting principle, which aims to match costs with the revenue they generate. However, it’s important to note that not all borrowing costs are eligible for capitalization. They must meet specific criteria outlined in accounting standards. View my other post where we dissect the difference in the concept of “interest cost” in much more detail: ITA vs IFRS: Interest Costs on Debts
Differences between NFRS and ITA
Difference in capitalization/deduction
IAS 23 Borrowing Costs – allows the capitalization of borrowing costs (both general and specific) that are directly attributable to the acquisition, construction, production in a qualifying asset that takes a substantial period of time to get ready for the intended use. However, for the purpose of tax laws, as per Section 14(1) and Section 38(1)(Ka) of the Income Tax Act, 2058 – where the borrowing has been used to acquire an asset but the asset has not been put to use for the current year, the interest cost will constitute the outgoing cost of the particular asset. So this creates a difference between financial accounting and tax accounting when a particular asset is being developed throughout the year and gets put to use towards the end of the year. Under tax laws the entire interest cost attributable to the production of the asset will be allowed for deduction during the year as an interest deduction, but for the purpose of the financial accounting, the capitalization of the interest cost in the said asset would be ceased once the asset is ready for the indented use – irrespective of whether or not it gets put to the intended use or not. This is the major difference.
Difference in the meaning of “interest costs”
The distinction may arise from variances in the definitions of “borrowing costs” and the scope of items encompassed within the realm of borrowing costs as outlined by Accounting Standards and Income Tax Laws.
It is important to note that not all expenditures categorized as “borrowing costs” according to NFRS align with the corresponding classification under tax laws. This disparity predominantly stems from the specific regulations delineated in the Income Tax Act, 2058, along with its accompanying Rules and Directives, which provides specific guidelines pertaining to the definition of terms such as “interest,” “lease,” and other fees associated with borrowing costs. Consequently, this variance influences the quantification, timing, and recognition of interest costs, thereby differentiating the eligibility criteria for capitalization in both accounting and tax contexts. Further insights into these nuanced distinctions in the concept of “interest cost” can be explored in my other corresponding post: Link to the detailed analysis of interest cost on debts.
Laxmi Intercontinental v/s LTPO
While this case in specific doesn’t bring anything new to the table, it just restates what we talked about earlier, so here it is:
In the matter of Laxmi Intercontinental Pvt. Ltd. (Taxpayer) v/s the Large Taxpayers’ Office (Revenue Authority), Case Number: 074-RB-0286 / 2080.01.25, the issue of deduction of interest cost associated with a capital work in progress arose. Subsequent examination revealed that these assets were not utilized in the business activities of the taxpayer for that particular fiscal year.
The contention arose on whether the interest expenses incurred on the property in question should be capitalized in accordance with Nepal Accounting Standards (NAS), or claimed as deductions under Section 14 of the Income Tax Act, 2058. Section 14 of the Income Tax Act, 2058, stipulates that a taxpayer is entitled to deduct all interest expenses paid for loans related to business income. However, Section 14(1) of the Act imposes specific conditions for eligibility of deduction of interest costs, stating that the loan/borrowing in question must have been used in the same financial year or employed to acquire property used in that year for conducting business or earning income.
In light of these legal provisions, it was determined that the interest expenses paid for the bank loan, which was used for the property not engaged in income-earning activities or was a work-in-progress for the particular fiscal year are not deductible according to Section 14 of the Income Tax Act, 2058 but are subject to capitalization under Section 38(1)(Ka) by treating it as an outgoing (i.e. tax base of the asset) for that particular fiscal year.