Lock, Stock, and Barrel for an Accountant
Equity, Debts and Derivatives are the set of Lock, Stock and Barrel for every accountant. Every accounting concept in the financial instruments accounting standards and tax laws applicable for financial assets and liabilities can be discussed between these three instruments completely.
Equity, debt, and derivatives each have distinct accounting and tax implications. It is crucial for accountants to understand the nuances of each instrument to accurately reflect their financial impact on a company’s financial statements and tax obligations. These three financial instruments are the building blocks of modern financial markets. As an accountant, understanding the accounting concepts and tax laws applicable to these instruments is crucial.
Quick Definitions:
- Equity: Equity represents ownership in a company and is typically in the form of common or preferred shares. Equity holders are entitled to a share of the company’s profits, and they may also have voting rights in important company decisions.
- Debt: Debt represents borrowed funds that need to be repaid with interest over time. The borrower agrees to make regular payments to the lender until the debt is repaid in full, usually with interest. Debt can take many forms, including loans, bonds, and other debt securities.
- Derivatives: Derivatives are financial instruments that derive their value from underlying assets, such as stocks, bonds, commodities, or currencies. They are contracts between two parties, with the value of the derivative depending on the price of the underlying asset. Examples of derivatives include options, futures, and swaps. Derivatives can be used for a variety of purposes, such as hedging against price fluctuations or speculating on future price movements.
Classification under IFRS
IFRS 09 on Financial Instruments Introduction specifies how an entity should classify and measure financial assets, financial liabilities, and some contracts to buy or sell non-financial items. IFRS 9 requires an entity to recognise a financial asset or a financial liability in its statement of financial position when it becomes party to the contractual provisions of the instrument.
Financial Assets
Financial assets are assets that represent a claim to receive cash, another financial asset, or a non-financial asset. They are classified under IFRS 9 into three categories:
- Financial assets at amortized cost: These are financial assets that are held to collect contractual cash flows and meet the criteria for amortized cost measurement. They are measured at amortized cost, which reflects the effective interest rate and includes any impairment losses.
- Financial assets at fair value through other comprehensive income (FVOCI): These are financial assets that are held to collect contractual cash flows and meet the criteria for FVOCI measurement. They are measured at fair value, with changes in fair value recognized in other comprehensive income, except for interest, impairment losses, and foreign exchange gains and losses, which are recognized in profit or loss.
- Financial assets at fair value through profit or loss (FVPL): These are financial assets that are held for trading or that are designated at fair value through profit or loss. They are measured at fair value, with changes in fair value recognized in profit or loss.
The below diagram helps us understand the basis for the classification of a financial asset:
The first line of test represents the Business Model Test
The Business Model Test evaluates the business model in which the asset is managed or how it is used to generate cash flows. There are two aspects to this test:
- Holding the asset to collect contractual cash flows (i.e. held to maturity)
- Holding the asset for collect contractual cash flows and sell (i.e. available for sale)
- Others (i.e. trading purposes)
The second line of test represents the Principal and Interest Payment Test
The Principal and Interest Payment Test evaluates the contractual cash flows of a financial asset. There are two aspects to this test:
- Contractual cash flows of the financial asset solely represents the payment of the principal and interest
- Other kinds of contractual cash flows
Financial Liabilities
Financial liabilities are generally held at amortized cost.
There are few exceptions to this which has been provided in para 4.2.1 of IFRS 09 on Financial Instruments Introduction, in which case the financial liability will be classified as FVPL. A financial liability is classified as a financial liability at fair value through profit or loss (FVPL) if it meets one of the following conditions:
- It is held for trading, or
- It is designated by the entity as being at FVTPL (note that such a designation is only permitted if specified conditions are met).
A financial liability is held for trading if it meets one of the following conditions:
- It is incurred principally for the purpose of repurchasing it in the near term
- On initial recognition it is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking, or
- It is a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument).
Examples of financial instruments that fall under this category include interest rate swaps, commodity swaps and foreign currency forwards and options.
Any further discussion on IFRS 9 will mean wandering away from the topic at hand. So with the basic understanding that financial liabilities are generally held at amortized cost, we will discuss the application of tax provisions in the financial instruments.
The “Howevers”
However, in this post we will discuss the accounting and tax treatment for debt instruments only. Equity and Derivatives for some other time in the future. But how can we make this “however” paragraph snarky in gun language since I have already compared Equity, Debt and Derivatives with Lock, Stock and Barrel in the beginning of this article?
Okay here is my best try – Well well well, it seems like we’re holstering our pistols and focusing solely on the debt provisions for now. But let’s not get trigger-happy and forget that equity and derivatives can pack a punch too. We’ll start off by loading up on all things debt, taking aim at accounting and tax treatment, and then we can holster those other firearms for a different range day. After all, in the world of finance, it’s always better to have a loaded arsenal than to shoot from the hip.
Provisions under Income Tax Act and Rules
Definition of Debt
दफा २(ट): “ऋण दायित्व” भन्नाले ऋण दाबी सरहको दायित्व सम्झनु पर्छ ।
Section 2(Ta): “Debt liability” means the liability equivalent to the debt claim.
दफा २(ठ): “ऋण दाबी” भन्नाले कुनै एक व्यक्तिले अर्को व्यक्तिबाट भुक्तानी प्राप्त गर्ने अधिकार सम्झनु पर्छ र सो शब्दले कुनै एक व्यक्तिले अर्को व्यक्तिलाई दिएको रकम फिर्ता लिने अधिकार, बैङ्क तथा वित्तीय संस्थाहरूमा जम्मा भएको निक्षेप लिनु पर्ने रकम, ऋणपत्र, विनिमयपत्र, बण्ड, वार्षिक वृत्ति अन्तर्गतको अधिकार, वित्तीय पट्टा र किस्ताबन्दी बिक्रीबाट रकम प्राप्त गर्ने अधिकार समेतलाई जनाउँछ।
Section 2(Tha): “Debt claim” means the right of any person to receive payment from another person, and the term also includes the right of any person to have repaid a loan lent by such person to another person, the right to receive deposits made in a bank and financial institution, to receive sums to which such person is entitled and to receive moneys from the sale of debentures, bills of exchange, bonds, rights under annuities, financial lease and installments.
Debt Claim for the purpose of Tax Laws is primarily the right of one person to receive a payment or repayment from another person. The list provided in the definition under Section 2(Tha) goes on to include forms of debt – it definitely is not an exhaustive list. It among others includes deposit with a financial institution, account receivable, note, bill of exchange, bond, rights under annuity, finance lease, installment sale and also the entitlement to receive money from the investment made in debenture and bonds. The definition has listed these few non exhaustive debt instruments because there are specific provisions governing few of these instruments provided in the tax laws. On the other hand, the term “debt liability” has been defined as a mirror opposite amount equivalent to the debt claim.
Definition of Interest
दफा २(कझ): “ब्याज” भन्नाले देहायका भुक्तानी वा लाभ सम्झनु पर्छः
(१) साँवा बाहेक ऋण दायित्व अन्तर्गतको भुक्तानी,
(२) छुट, ऋण दायित्व अन्तर्गतको छुट, प्रिमियम, अदलबदल भुक्तानी वा त्यस्तै भुक्तानीको माध्यमबाट प्राप्त गरिएको लाभ, र
(३) वार्षिक वृत्ति वा किस्ताबन्दी बिक्री अन्तर्गत सम्पत्ति प्राप्त गर्ने व्यक्तिबाट वा वित्तीय पट्टा अन्तर्गत कुनै सम्पत्तिको प्रयोग बापत कुनै व्यक्तिलाई गरिने भुक्तानीमध्ये ब्याजको रूपमा लिइने दफा ३२ बमोजिमका रकमहरू।
Section 2(KaJha): “Interest” means the following payment or profit:
(1) Payment under debt liability except the principal,
(2) Profit made from concession, concession under credit liability, premium, alteration payment or from similar payment, and
(3) The amounts referred to in Section 32 receivable as an interest out of the payment to be made by a person who acquires any property under annuities or installment sale or of the payment made to any person for the use of any property under a financial lease.
The definition of Interest has to be understood in threefold:
Firstly, Interest is a payment accrued under a debt obligation that is not a repayment of capital
As per the definition provided under The Commonwealth of Symmetrica Income Tax Act “repayment of capital” with respect to a debt claim or debt obligation means the payment or repayment of an amount derived by the holder of the obligation under the obligation that represents incomings for the obligation;
💡What does “incomings” in respect of liability mean?
Under Section 39 of the Income Tax Act, 2052, incomings in respect of a liability are the amounts derived by the person in respect of incurring the liability. For example – If a borrower borrows a loan of Rs 100,000 from a bank, it means that the borrower has received Rs 100,000 in exchange for the liability to pay the bank Rs 100,000 at some point in the future along with interest costs as agreed. In this case the “incomings” in respect to the liability is Rs 100,000.
Let’s take an another example – If a borrower borrows a loan of Rs 100,000 from a bank but receives Rs 95,000 after bank charges and processing fees of Rs 5,000 – it still would mean that the borrower has received Rs 100,000 in exchange of liability to pay the bank Rs 100,000 at some point in the future along with the interest cost as agreed. The difference of Rs 5,000 that the borrower received is intrinsically another transaction between the borrower and the bank to compensate the bank for its expenses. Whether or not, this Rs 5,000 paid for the bank charges and processing fees is treated as an interest cost – does not have any bearing on what constitutes the incoming in respect of the liability acquired in this example.
💡So what is interest cost and what is not for the purpose of tax laws?
Here is what paragraph 18.6.2 of the Income Tax Directive 2066 (Fourth Amendment 2078) provides in relation to the definition of Interest Cost: दफा २(कझ) को परिभाषा अनुसार व्याज खर्चमा निम्न खर्च पर्दछन्ः
|
ऋण दायित्व |
ब्याज |
|
कर्जा, ऋण, निक्षेप |
साँवा बाहेकका सवै भुक्तानी: सेवा शुल्क, नवीकरण शुल्क, व्याज, डकुमेन्टेशन शुल्क, अदलबदल शुल्क |
|
वार्षिक वृत्ति |
व्याज, प्रिमियम, बोनस |
|
वित्तीय पट्टा |
व्याज, प्रिमियम |
|
विनिमयपत्र, ट्रेजरी बील, डिप बण्ड, बण्ड, वचतपत्र |
व्याज, छुट, प्रिमियम |
|
नासो |
व्याज, वृद्धि |
Translated into English:
|
Debt Liability |
Interest |
|
Loan, Debt, Deposit |
All payments excepting for the repayment of principal: Service Fee, Renewal Fees, Interest, Documentation Fees, Swap Fees |
|
Annuity |
Interest, Premium, Bonus |
|
Finance Lease |
Interest, Premium |
|
Bills of Exchange, Treasury Bill, Deep Bond, Bond, Saving Bonds |
Interest, Discount, Premium |
|
Bail, Pledge |
Interest, Increments |
💡Is the definition of the interest under tax law similar to the principle used in calculating effective interest rate under the IFRS 9 for amortized cost method?
Yes more or less, the principle is similar – although the timing for the deduction of the interest cost is different under tax laws and under the effective interest rate method. Now, the table just above from the Income Tax Directive is only a clarification provided by the Directive and not supposed to be an exhaustive list. So we will have to resort to the explanation provided under the method of computing the “effective interest rate” provided in IFRS 09 on Financial Instruments Introduction. This will help us understand why costs like service fee, renewal fees, documentation fees, swap fees in relation to the debt claim are treated as interest cost under the tax law and what kind of costs may still be debatable to be treated as interest cost and similar gray areas.
💡What costs are treated intrinsically as interest cost for the purpose of calculation of “effective interest rate” under IFRS 9?
IFRS 9 defines “effective interest rate” at the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortized cost of a financial liability. When calculating the effective interest rate, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider the expected credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts. So when the definition of the “effective interest rate” is read with the clarification under paragraphs B5.4.1–B5.4.3 of IFRS 9 – we can say that the following costs are treated intrinsically as interest cost for amortized cost method:
1. Fees that are are an integral part of the effective interest rate
(a) Origination Fees received by the entity relating to the creation or acquisition of a financial asset. Such fees may include compensation for activities such as evaluating the borrower’s financial condition, evaluating and recording guarantees, collateral and other security arrangements, negotiating the terms of the instrument, preparing and processing documents and closing the transaction. These fees are an integral part of generating an involvement with the resulting financial instrument.
(b) Commitment Fees (aka Solicitation Charges) received by the entity to originate a loan when the loan commitment is not in the nature of derivative financial liability carried at FVPL and it is probable that the entity will enter into a specific lending arrangement. These fees are regarded as compensation for an ongoing involvement with the acquisition of a financial instrument. If the commitment expires without the entity making the loan, the fee is recognized as revenue on expiry.
(c) Origination Fees paid on issuing financial liabilities measured at amortized cost that creates an integral part of generating an involvement with a financial liability. An entity distinguishes fees and costs that are an integral part of the effective interest rate for the financial liability from origination fees and transaction costs relating to the right to provide services, such as investment management services.
2. Transaction costs
Transaction costs include fees and commission paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and security exchanges, and transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs.
3. Other premiums or discounts
Premiums or discounts in relation to a loan obtained from a bank refer to the difference between the initial amount borrowed and the amount that the borrower is obligated to repay over the term of the loan. Premiums may be charged in situations where the interest rate on the loan is lower than the prevailing market rate or where the borrower represents a higher level of risk to the lender. Discounts may be offered in situations where the interest rate on the loan is higher than the prevailing market rate or as an incentive for the borrower to enter into the loan agreement.
💡The conflict of “Loan Service Fees” between IFRS and Income Tax Law
Paragraph B5.4.3 of IFRS 9 clarifies that “fees charged for servicing a loan” is not an integral part of the effective interest rate and are accounted for in accordance with IFRS 15 (lenders account for fees as per IFRS 15 while borrowers account for this as an expense). However, although Income Tax Act and Rules are not very specific on the treatment of “fees charged for servicing a loan” – as observed in the table above – Income Tax Directive has clarified in the definition of interest that “service fee” is an Interest Cost.
💡But does the treatment of “Loan Syndication Fees” entail any conflict between IFRS and Income Tax Law?
Loan syndication fees refer to the fees paid to a group of financial institutions, typically led by an investment bank, to arrange and underwrite a loan for a borrower. In other words, loan syndication is the process of involving multiple banks or financial institutions to provide a loan to a borrower in order to spread the risk of the loan among the lenders. The fees paid to these financial institutions for their involvement in the syndication process are known as loan syndication fees. Loan syndication fees are typically negotiated between the borrower and the lead arranger(s) of the syndicate, and can be significant depending on the size and complexity of the loan.
Paragraph B5.4.3 of IFRS 9 clarifies that “Loan Syndication Fee” is generally an integral part of the effective interest rate and is considered for the purpose of amortized cost like transaction / origination costs except when the loan syndication fees is received by an entity that arranges a loan and retains no part of the loan package for itself (or retains a part at the same effective interest rate for comparable risk as other participants). The table above from the Income Tax Directive provides that “the cost of issuing debentures, bonds or saving bonds is not interest but an outgoings of the liability” but whether or not this “cost of issuing” as provided in the Income Tax Directive does or does not include the syndication fees is not clear. In the author’s opinion “loan syndication fee” is not intended to be covered in the “cost of issuing…”.
💡Does tax law treat “issue discount” as interest expense like IFRS does?
There is no doubt under the financial reporting standard as to whether or not the issue discount is an interest cost or not – it most certainly is. But is it viewed in similar fashion for tax laws as well? Well it should be but there is one caveat. As discussed earlier, in reference to the table above from Income Tax Directive – the term “cost of issuing …” has been particularly excluded from the definition of interest expense. This term “cost of issuing …” should definitely not include issue discounts but this lack of clarity could spell some practical confusions. However, we have one example in Income Tax Directive that treats the issue and settlement difference of a government bond issued with deep discount as “interest cost” (as it should have, of course) – which arguably assures us that yes “issue discount” will be treated as “interest expense” for tax purposes as well. How will the timing and portion of the settlement of the debt impact the tax deductibility of this “issue discount” – we will discuss in Section 48 of ITA – below.
Here is the example from the directive:
उदाहरण २.२.२: मानौं, एउटा बैइले नेपाल राष्ट्र बैडले जारी गरेको रु.१ करोडको ९० दिनमा | भुक्तानी प्राप्त हुने ट्रेजरी बील, रु.९८ लाख ५० हजारमा खरिद गरेको रहेछ । लगानी गर्दा रु९८ लाख ५० हजार लगानी गरेको भए तापनि भुक्तानीको समयमा सो बैङ्गलाई रु.१ करोड प्राप्त हुने हुँदा यसरी बढी प्राप्त भएको रकम रु.१,५०,०००/- लाई ब्याज मानिन्छ ।
उदाहरण २.२३: मानौं, एउटा वित्तीय संस्थाले वार्षिक रु.११,४८,०३७७- Fixed Installment मा तिर्ने गरी रु.५० लाखको कर्जा एकजना ग्राहकलाई प्रदान गरेको रहेछ । उक्त कर्जामा ब्याज दर १० प्रतिशत रहेछ भने सो प्राप्त गरिने किस्तालाई निम्नानुसार पूंजी फिर्ता तथा व्याज आम्दानी गणना गर्नुपर्दछ:
|
साँवा बाँकी रु. |
किस्ता रकम रु. |
साँवा फिर्ता रु. |
ब्याज रकम रु. |
|
५०,००,०००/- |
११,४८,०३७/- |
६,४८,०३७/- |
५,००,०००/- |
|
४३,५१,९६३/- |
११,४८,०३७/- |
७,१२,८४१/- |
४,३५,१९६/- |
|
३६,३९,१२२/- |
११,४८,०३७/- |
७,८४,१२५/- |
३,६३,९१२/- |
|
२८,५४,९९७/- |
११,४८,०३७/- |
८,६२,५३७/- |
२,८५,५००/- |
|
१९,९२,४६०/- |
११,४८,०३७/- |
९,४८,७९१/- |
१,९९,२४६/- |
|
१०,४३,६६९/- |
११,४८,०३७/- |
१०,४३,६७०/- |
१,०४,३६७/- |
|
६८,८८,२२२/- |
५०,००,०००/- |
१८,८८,२२२/- |
💡So what about these additional costs that are involved in debt issuance process? Are these the part of “intrinsic interest cost in effective interest rate” method under IFRS or are these treated as “interest expense” under Income Tax Laws?
In author’s opinion:
|
Nature of Expense |
Is it an intrinsic interest cost in an effective interest rate method under IFRS? |
Is it treated as interest expense under the Income Tax Law? |
|
Securities Registration Fee (0.2% of the Issued Capital to SEBON) |
No |
No |
|
Printing, Publication, Marketing and Software Charges, Rating Fee, Professional Fees (Auditors, Lawyer, Projection Certifiers, Valuators) |
No |
No |
|
Issue Management Fee |
Loan syndication fee could qualify (see above) |
Loan syndication fee could qualify (see above) |
|
Underwriting Fee |
No |
No |
|
Issue Discount |
Yes |
Discussed above |
💡Why does underwriting fee generally fall into the gray area of origination fees?
Underwriting fees is a kind of commission. The underwriter helps the issuer to determine the optimal price, timing, and amount of the securities to be issued, and then purchases them from the issuer at a discount. The underwriter then sells the securities to investors, often at a higher price, and keeps the difference as their fee. Although underwriters may provide origination services that create the financial instrument to the issuer/investor and oftentimes they do – but the practice of charging flat commissions puts this fee in the gray area. Moreover an issuer typically goes to the underwriter when the financial conditions, financial evaluation, collateral arrangement and preliminary study of the investment market has already been completed – so it it believed that the underwriters do not have much origination function to fulfill thereafter – so it lies in the gray area and thus underwriter’s fee will be viewed similar to any other independent professional fees that do not generally qualify to be treated as intrinsic interest expense for the purpose of effective interest method under financial reporting standards.
Second, gain realized by way of a discount, premium, swap payment, or similar payment
This heading basically doesn’t contain any new concepts – much of it was discussed in the first heading. Premiums or discounts in relation to a loan obtained from a bank refer to the difference between the initial amount borrowed and the amount that the borrower is obligated to repay over the term of the loan. Premiums may be charged in situations where the interest rate on the loan is lower than the prevailing market rate or where the borrower represents a higher level of risk to the lender. Discounts may be offered in situations where the interest rate on the loan is higher than the prevailing market rate or as an incentive for the borrower to enter into the loan agreement. These effectively are an adjustment to the interest cost and therefore by definition are interest expense.
In a similar fashion, swap payments under a loan are treated as interest cost because they too represent the cost of borrowing money. In a swap agreement, two parties agree to exchange one set of cash flows for another. In the case of a loan, the borrower may enter into a swap agreement with a counterparty to exchange their interest rate payments or altogether exchange the credits. This allows the borrowers / lenders to mitigate interest rate risk and stabilize their cash flows. The costs or gains from such swap transactions / adjustment are effectively made to manage the interest rate risks and are therefore intrinsically an interest cost.
Thirdly, amount treated as interest under Section 32
Section 32 is a specific provision that applies to annuities, installment sale and finance lease. Payments made to a person under an annuity or by a person acquiring an asset under an installment sale or finance lease are treated as interest and a repayment of capital under a debt claim in accordance with Section 32. Section 32 requires the parties to the arrangement of the annuity, installment sale and finance lease to prepare an amortization schedule and account for the interest and principal components based on the intrinsic rate of return calculated based on the repayment schedule.
💡Some helpful definitions from The Commonwealth of Symmetrica Income Tax Act
“Annuity” means the “annuity” means a periodic payment other than the one made from retirement fund, investment insurance or under an installment sale.
“Installment Sale” means a realization of an asset by way of sale under which any payment to be made to the seller in respect of the realization is to be made more than one year after the realization.
“Finance Lease” with respect to leasing an asset means a lease where any of the following condition is satisfied:
1. Arrangement is made in the lease agreement provides for transfer of ownership following the end of the lease term where, the lessee has an option to purchase the asset after expiry of the lease term for a fixed or presupposed price;
2. The lease term exceeds 75% of the useful life of the asset;
3. The estimated market value of the asset after expiry of the lease term is less than 20% of its market value at the commencement of the lease;
4. In the case of a lease that commences before the last 25% of the useful life of the asset, the present value of the minimum lease payments equals or exceeds 90% of the market value of the asset at the commencement of the lease term; or
5. The asset is custom-made for the lessee and after expiry of the lease term the asset will not be of practical use to anyone other than the lessee.
“Present value of lease payments” is calculated using a discount rate equal to the normal interest rate. Under Section 2(KaBa) means the rate of interest of fifteen percent per annum.
💡Difference between Hire Purchase Arrangement and Installment Sales Arrangement
Hire purchase arrangement is a form of finance lease arrangement. Installment sales arrangement is a form of credit sales arrangement. Hire purchase is an agreement to hire and later to buy. Installment is an agreement to buy. In hire purchase, the ownership transfers from the seller to the buyer on the payment of the last installment. In Installment sale, the ownership transfers outright on the date of entering into installment sales arrangement. In hire purchase, when there is a default in payment, the financier will take back the goods from the buyer. In installment sales, if there is a default of payment, the seller cannot take back the goods, but can only sue the buyer for recovery. Buyer cannot sell the goods to any third party until he pays the last installment to the financier in hire purchase. In case of installment sale, the buyer can sell to any third party as he is the owner of the goods.
💡Why is there a need for the re-characterization of some financing arrangements under Section 32?
Section 32 actually re-characterizes the payments under annuities, installment sales and finance lease to ensure the similar treatment between these substitutable forms of financing. Without this re-characterisation rule, payments under annuities may be considered to have purely an income character, i.e. involve no repayment of capital. By contrast, payments under installment sales may be viewed as having purely a capital character. Payments under finance leases would be treated as the payment of rent or royalties with no part being treated as a capital payment despite substantial equivalence between a finance lease and an installment sale.
Accounting and Tax Impact of Characterization under Section 32
Operating Lease
|
Point of Transaction |
Lessor |
Lessee |
||
|
Accounting |
Taxation |
Accounting |
Taxation |
|
|
Entering Lease with Liability of Decommissioning Cost (DC) |
– |
– |
Dr. RoUA [PV(LP,DC)+DP] |
– |
|
Down Payment (DP) |
– |
– |
– |
– |
|
Lease Payment (LP) Accrued |
Dr. Lessee |
Dr. Lessee |
– |
Dr. Lease Expense |
|
Depreciation Cost |
– |
– |
Dr. Depreciation |
– |
|
Unwinding Cost |
– |
– |
Dr. Interest Expense |
– |
|
Lease Payment (LP) Made |
Dr. Bank |
Dr. Bank |
Dr. Lessor |
Dr. Lessor |
|
Exiting Lease with Incurring of DC |
– |
– |
Dr. Lessor |
Dr. DC |
Note: RoUA means Right of Use Asset
Finance Lease
|
Point of Transaction |
Lessor |
Lessee |
||
|
Accounting |
Taxation |
Accounting |
Taxation |
|
|
Entering Lease with Liability of Decommissioning Cost (DC) |
Dr. Lessee [PV(LP,GRV)+DP] |
Dr. Lessee [MV of Asset] |
Dr. RoUA [PV(LP,DC)+DP] |
Dr. Asset [MV of Asset] |
|
Down Payment (DP) |
Dr. Bank |
Dr. Bank |
Dr. Lessor |
Dr. Lessor |
|
Lease Payment (LP) Accrued |
– |
– |
– |
– |
|
Depreciation Cost |
– |
– |
Dr. Depreciation |
Dr. Depreciation |
|
Unwinding Cost |
Dr. Lessee |
Dr. Lessee |
Dr. Interest Expense |
Dr. Interest Expense |
|
Lease Payment (LP) Made |
Dr. Bank |
Dr. Bank |
Dr. Lessor |
Dr. Lessor |
|
Exiting Lease with Incurring of DC |
– |
– |
Dr. Lessor |
Dr. DC |
Note: Also applicable for Hire Purchase Arrangement as hire purchase is also effectively a form of Finance Lease.
GRV means Guaranteed Residual Value of Lease
Normal Sales
|
Point of Transaction |
Seller |
Buyer |
||
|
Accounting |
Taxation |
Accounting |
Taxation |
|
|
At the point of Sales |
Dr. Receivable |
Dr. Receivable |
Dr. Asset |
Dr. Asset |
Sales with Deferred Terms of Payment
|
Point of Transaction |
Seller |
Buyer |
||
|
Accounting |
Taxation |
Accounting |
Taxation |
|
|
At point of Sales |
Dr. Ac Receivable [PV(IP)+DP] |
Dr. Ac Receivable |
Dr. Asset |
Dr. Asset |
|
Down Payment (DP) |
Dr. Bank |
Dr. Bank |
Dr. Payable |
Dr. Payable |
|
Instalment Payment (IP) Accrued |
– |
– |
– |
– |
|
Depreciation Cost |
– |
– |
Dr. Depreciation |
Dr. Depreciation |
|
Unwinding Cost |
Dr. Receivable |
Dr. Receivable |
Dr. Interest Expense |
Dr. Interest Expense |
|
Instalment Payment (IP) Made |
Dr. Bank |
Dr. Bank |
Dr. Payable |
Dr. Payable |
Note: Also applicable for Instalment Sales Arrangement as instalment sales is also effectively a form of sales with deferred terms of payment.
Illustrations from Income Tax Directive 2066 (Fourth Amendment 2077)
उदाहरण ७.७.१: मानौं, XYZ Co. ले YZ Co. बाट वार्षिक रु. १० लाख भाडा तिर्ने गरी Excavator पाँच वर्षको लागि भाडामा लिएको रहेछ र भाडा अवधि समाप्त भएपछि निज XYZ Co. ले रु. २० लाखमा खरिद गर्न सक्ने विकल्प रहेको कुरा सम्झौतामा स्पष्ट रूपमा | उल्लेख गरेको रहेछ भने यस प्रावधानमा लिजमा लिएको सम्पत्ति लिज समयको समाप्तिपछि निश्चित मूल्य रु.२० लाखमा खरिद गर्न सक्ने विकल्प रहेको हुँदा XYZ Co. र YZ Co. बीच भाडामा मेसिन लिने प्रबन्ध (Arrangement) वित्तीय पट्टा हो ।
उदाहरण ७.७.२: मानौं, YB & Co. ले BY Co. सँग कुनै एक मेसिन रु.१,००,०००/- वार्षिक किस्ता बुझाउने गरी ५ वर्षको लागि पट्टामा लिएको रहेछ । पट्टा लिँदाका अवस्थामा उक्त मेसिनको बजार मूल्य रु.२० लाख थियो । उक्त मेसिन ५ वर्षको समाप्तिपछि बिक्री गर्ने हो भने अनुमानित बजार मूल्य रु.२ लाख पर्दछ भने यस अवस्थामा मेसिनको अनुमानित बजार मूल्य १० प्रतिशत भएको हुँदा (२ लाख / २० लाख x १००) तोकिएको २४ प्रतिशतभन्दा कम भएको कारण यसलाई पनि वित्तिय पट्टा मानिन्छ ।
उदाहरण ७.७.३: मानौं, कुनै एक सम्पत्तिको उपयोगी आयु २० वर्ष रहेछ । उपर्युक्त सम्पत्ति १५ वर्षको अवधिभित्र नैमिति २०६६।१०।१ मा पट्टामा उपलब्ध गराएको तथा सो समयमा यसको बजार मूल्य रु.१०,०००/- रहेछ । प्रचलित व्याज दर १० प्रतिशत रहेछ, पट्टा अवधि ५ वर्ष तथा वर्ष समाप्त भएपछि तिरिने किस्ता रु.२,५००/- रहेछ भने निम्नानुसार ५ वर्षको Discounted Value रु.९,४७७ – (रु. १०,०००/- को ९० प्रतिशतभन्दा बढी) भएको हुँदा सो Transactionलाई वित्तीय पट्टा मानिन्छ ।
|
वर्ष |
किस्ता रकम |
Discount factor |
डिस्काउण्टेड मूल्य |
|
१ |
२,५००/- |
०.९०९१ |
२,२७३/- |
|
२ |
२,५००/- |
०.८२६४ |
२,०६६/- |
|
३ |
२,५००/- |
०.७५१३ |
१,८७८/- |
|
४ |
२,५००/- |
०.६८३० |
१,७०८/- |
|
५ |
२,५००/- |
०.६२०९ |
१,५५२/- |
|
१२,५००/- |
९,४७७/- |
उदाहरण ७.७.४: मानौं, Aban Construction Company Pvt. Ltd. एउटा निर्माण कम्पनी रहेछ। उक्त प्रा.लि.ले पहिलो वर्ष Heavy Duty अर्थमुविङ मेसिन वार्षिक रु.५ लाख भाडा तिर्ने गरी Zircon Exim Pvt. Ltd. बाट ५ वर्षको लागि भाडामा लिएका रहेछन् । ५ औं वर्षको अन्त्यमा Aban Construction Company Pvt. Ltd. ले उक्त मेसिन रु.३०,००,०००/- मा खरिद गर्न सक्ने व्यवस्था रहेछ । उल्लिखित व्यवस्थाका आधारमा Aban Construction Company Pvt. Ltd. लाई लिज समयको अन्त्यमा वा समाप्त भएपछि निश्चित रकम रु. ३० लाखमा खरिद गर्ने विकल्पको व्यवस्था भएको हुँदा यस्तो सम्झौता वा करारलाई ऐनको दफा ३२ को उपदफा (५) को खण्ड (क) बमोजिम वित्तीय पट्टा (Finance Lease) भनेर भनिन्छ । तसर्थ यस्तो पट्टालाई बिक्री मानिने हुँदा Aban Construction Company Pvt. Ltd. उक्त भाडामा लिएको मेसिनको मालिक (Owner) र भाडामा दिने Zircon Exim Pvt. Ltd. (Lessor) ऋण दावी गर्ने व्यक्ति मानिन्छ । तसर्थ यस्तो अवस्थामा ऐनको दफा ३२ लागू हुने अवस्था भएको हुँदा पट्टा अन्तर्गत तिरिने भाडा भुक्तानी रकमलाई ऋण दायित्व अन्तर्गत पुँजीको फिर्ता र ब्याज भुक्तानी गरी भाडा रकमलाई पुनः चारित्रीकरण गर्नु पर्दछ ।
भाडा रकमलाई पुनः चारित्रीकरण गर्ने क्रममा पट्टा अन्तर्गत गरिने सम्पूर्ण भुक्तानी र पट्टाको समाप्तिसँगै मेसिनको लागि तिरिने निश्चित मूल्यलाई एकमुष्ठ भुक्तानी मानी ऐनको दफा ३२ को उपदफा (२) अनुसार पुँजीको र ब्याजको भाग गरी छुट्टयाउनु पर्दछ । यसरी एकमुष्ठ रकम रु.५५ लाख (रु.३० लाख + रु.२५ लाख) मा पुँजीको भाग भनेको मेसिनको बजार मूल्य र बाँकी भाग व्याज हो । मानौं, मेसिनको बजार मूल्य रु ३५ लाख छ भने रु २० लाख व्याजको भाग हुन आउँछ । यसरी ऐनको दफा ३२ को उपदफा (३) अनुसार हरेक पट्टा भुक्तानीलाई पुँजीगत भाग र व्याज भाग निम्नानुसार छुट्याउनु पर्दछ ।
|
वर्ष |
सुरु साँवा रु. |
जम्मा भुक्तानी रु. |
ब्याजको अंश रु. |
साँवाको अंश रु. |
साँवा बाँकि रु. |
|
१ |
३५,००,००० |
५,००,००० |
४,२१,३५६ |
७८,६४४ |
३४,२१,३५६ |
|
२ |
३४,२१,३५६ |
५,००,००० |
४,११,८८८ |
८८,११२ |
३३,३३,२४४ |
|
३ |
३३,३३,२४४ |
५,००,००० |
४,०१,२८० |
९८,७२० |
३२,३४,५२४ |
|
४ |
३२,३४,५२४ |
५,००,००० |
३,८९,३९६ |
१,१०,६०४ |
३१,२३,९२० |
|
५ |
३१,२३,९२० |
३५,००,००० |
३,७६,०८० |
३१,२३,९२० |
– |
|
२०,००,००० |
३५,००,००० |
उदाहरण ७.७.५ः मानौं, Aban Construction Company Pvt. Ltd एउटा निर्माण कम्पनी रहेछ । उक्त प्रा.लि.ले Heavy Duty अर्थमुविङ मेसिन वर्षको सुरुमा तिरिने वार्षिक रु.१० लाख किस्ता ५ वर्षसम्म तिर्ने गरी Zircon Exim Pvt. Ltd बाट २०६६।१०।१ मा खरिद गरेको रहेछ । यस्तो किसिमको किस्ताबन्दी बिक्रीमा ऐनको दफा ३२ आकर्षण हुन्छ । यस अवस्थामा ऐनको दफा ३२ को उपदफा (८) बमोजिम सामान्य ब्याज दर प्रयोग गरी कुल मूल्यलाई Discounting गरी पट्टाको भुक्तानीको वर्तमान मूल्य अर्थात साँवा निम्नानुसार गणना गर्नु पर्दछ ।
|
वर्ष |
किस्ता रु. |
Discount Factor |
Discounted Value रु. |
|
१ |
१,०००,००० |
१.००००० |
१०,००,००० |
|
२ |
१,०००,००० |
०.९०९०९ |
९,०९,०९०.९१ |
|
३ |
१,०००,००० |
०.८२६४५ |
८,२६,४४६.२८ |
|
४ |
१,०००,००० |
०.७५१३१ |
७,५१,३१४.८० |
|
५ |
१,०००,००० |
०.६८३०१ |
६,८३,०१३.४६ |
|
जम्मा |
५,०००,००० |
४१,६९,८६५.४५ |
|
|
कुल भुक्तानी रु. |
५०,००,००० |
||
|
साँवा (पट्टाको भुक्तानीको वर्तमान मूल्य) रु |
४१,६९,८६५.४५ |
||
|
ब्याजको अंश रु. |
८,३०,१३४.५५ |
||
उपर्युक्त कारोबारको साँवा फिर्ता र ब्याजको अंश निम्नानुसार हुन्छः
|
वर्षको सुरु |
सुरु साँवा रु. |
जम्मा भुक्तानी रु. |
ब्याजको अंश रु. |
साँवाको अंश रु. |
साँवा बाँकी रु. |
|
१ |
४१,६९,८५६.४५ |
१०,००,००० |
– |
१०,००,००० |
३१,६९,८६५.४५ |
|
२ |
३१,६९,८६५.४५ |
१०,००,००० |
३,१६,९८६.५४ |
६,८३,०१३.४६ |
२४,८६,५८१.९९ |
|
३ |
२४,८६,८५१.९९ |
१०,००,००० |
२,४८,६८५.२० |
७,५१,३१४.८०१ |
१७,३५,५३७.१९ |
|
४ |
१७,३५,५३७.१९ |
१०,००,००० |
१,७३,५५३.७२ |
८,२६,४४६.२८ |
९,०९,०९०.९१ |
|
५ |
९,०९,०९०.९१ |
१०,००,००० |
९०,९०९.०९ |
९,०९,०९०.९१ |
० |
|
५०,००,००० |
८,३०,१३४.५५ |
४१,६९,८६५.४५ |
उपर्युक्त गणना बमोजिम Aban Construction Company Pvt. Ltd। ले भुक्तान गर्ने पाँच वर्षको कुल किस्ता रु.५० लाख मध्ये रु. ८,३०,१३४.५५ लाई ब्याज भुक्तानी मानिने तथा रु. ४१,६९,८६५.४५ लाई ऋण दाबी फिर्ता मानिन्छ । उक्त कम्पनीले पट्टा सम्झौताका आधारमा प्रथम वर्ष रु.द्धज्ञ,टढ,डटछ।द्धछलाई सम्पत्ति खरिदलेखाङ्कन (Debit: Fixed Asset)गरी सो बराबरको रकम ऋण दायित्व (Credit: Accounts Payable – Zircon Exim Pvt. Ltd. towards financial lease obligation) अन्तर्गत लेखाङ्कन गर्नु पर्दछ । सो कम्पनीले ब्याज अंश कुल रु. ८,३०,१३४.५५ लाई ऐनको दफा १४ अन्तर्गत रही खर्च कट्टी दाबी गर्न सक्दछ । त्यसैगरी Zircon Exim Pvt. Ltd। ले उक्त सम्पत्तिका पट्टाको भुक्तानीको वर्तमान मूल्य (साँवा) लाई प्रथम वर्षमा बिक्रीमा लेखाङ्कन गरी आयमा समावेशगर्नु पर्दछ र सो बराबरको रकम ऋण दाबी (Debit: Accounts Receivable – Aban Construction Company Pvt. Ltd.) अन्तर्गत लेखाङ्कन गर्नु पर्दछ । त्यसपछिका वर्षहरूमा माथिको तालिकामा उल्लेख गरे अनुरूप कुल रु. ४१,६९,८६५.४५ लाई पुँजी फिर्ता (Return of Capital) तथा कुलरु. 8,30,134.55 ब्याज आम्दानी मानी आयमा समावेश गर्नु पर्दछ ।
Deductibility of the Interest Cost under Tax Law
Section 14(1) of the Income Tax Act, 2058 provides the eligibility for the deduction of interest expense. If any of the following conditions is satisfied, all interest incurred by the person during any income year under a debt obligation of the person in the production of income from a business or investment is deductible:
1. Where the borrowing has been used during that year, or
2. Where the borrowing was used to acquire an asset that was used during that year,
The deductibility of the interest expense depends on the actual use of the borrowed funds and not the purpose for which the funds were borrowed. This means that where the use of the funds changes so does the deductibility of interest expense incurred.
💡How does Income Tax Law differ from IAS 23 Borrowing Cost in terms of recognition of interest expense?
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) 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.
💡Illustrations provided in Income Tax Directive 2066 (Fourth Amendment 2078)
१८.७.२ ब्याज कट्टी
ऐनको दफा १४ को उपदफा (१) अनुसार कुनै व्यक्तिले कुनै आय वर्षमा व्यवसायबाट भएको आयको गणना गर्ने प्रयोजनको लागि सो व्यक्तिले सो वर्षमा प्रयोग गरेको कुनै सम्पत्ति खरिद गर्न प्रयोग गरिएका ऋण दायित्व वा व्यवसायबाट आय आर्जन हुने कार्यका लागि सिर्जना भएको ऋण दायित्व अन्तर्गत सो वर्षमा लागेका सबै व्याज कट्टी गर्न पाउनेछ । तर त्यस्तो ऋण व्यवसायको काममा प्रयोग नगरिएको हदसम्मको व्याज भने खर्च कट्टी पाउँदैन ।
कुनै सम्पत्ति खरिद गर्न ऋण दावी सिर्जना भएकोमा सो खरिद गरिएको सम्पत्ति व्यवसायमा प्रयोग गर्न सुरु भएको वर्षदेखिको सो ऋणमा लागेको ब्याज खर्च कट्टी पाउँदछ । यस्तो सम्पत्तिको व्यवसायमा प्रयोग वर्षको बीचमा सुरु सो पूरै वर्षको ब्याज खर्च कट्टी पाउँदछ ।
उदाहरण १८.६.२: मानौं, कुनै व्यक्तिले चालु आय वर्षमा प्रयोग भइरहेको मेशिन खरिद गर्नको लागि २ वर्ष अघि ऋण लिएको रहेछ भने सो ऋण दायित्वमा चालु आय वर्षमा लागेका ब्याज कट्टी गर्न पाउनेछ । तर सो मेशिन प्रयोगमा आइनसकेको भए त्यस्तो व्याज भने पुँजीकरण गरी सम्पत्तिको मूल्यमा समावेश गर्नुपर्छ, खर्च कट्टी गर्न पाइदैन । यसको अलावा चालु पुँजीको (जस्तैः कर्मचारीलाई तलब दिन, उत्पादनमा प्रयोग भएको कच्चा (पदार्थ खरिद गर्न आदि) को निमित्त लिएको ऋणको व्याज पनि कट्टी गर्न पाउनेछ ।
उदाहरण १८.६३: मानौ, कनै व्यक्तिले यो वर्ष मेशिन खरिद गर्नको लागि १२ प्रतिशत प्रतिवर्षका दरले व्याज तिर्ने गरी श्रावण १ गते रु. २ करोड ऋण लिएको रहेछ । सो मेशिन | वैशाख १ गतेदेखि प्रयोगमा आएको रहेछ । ऋणका शर्त पूरा गर्न यो वर्ष निम्नानुसार खर्च व्यहोरिएको रहेछ
(क) सेवा शुल्क १ प्रतिशत वार्षिक नवीकरण शुल्क ०.५ प्रतिशत हरेक वर्षको श्रावण १ गते भुक्तानी हुने ।
(ख) कर्जा रजिष्ट्रेशन शुल्क रु.२०,०००/-
(ग) धितो मूल्यांकन रु. २०,०००/-, मालपोत रु.२,०००/-, बीमा रु.३०,०००/-
(घ) हरेक ३ महिनामा बैंक र बीमा कम्पनीले धितो स्वतन्त्र रूपमा निरीक्षण गराउँदो रहेछ र मूल्यांकनकर्ताले प्रति भ्रमण रु. २०००/- लिंदो रहेछ । यस्तो अवस्थामा निम्नानुसार खर्च कट्टी गर्न पाउनेछ:
● व्याज रकम रु.२६ लाख (व्याज रु.२४ लाख र सेवा शुल्क रु. २ लाख) हुनेछ र ऋण व्यक्तिगत प्रयोग भएको छैन ।
● ऋण र खरिद गरिएको सम्पत्तिको प्रत्यक्ष सम्बन्ध भएकाले भारित दर गणना गर्नुपर्दैन । खरिद गरिएको सम्पत्ति वैशाख १ मा व्यवसायमा प्रयोग गरिएकाले सो आय वर्षमा सो ऋणमा तिरिएको वा तिर्नपर्ने सबै व्याज दफा १४(१) बमोजिम कट्टी हुन्छ । तसर्थ पुँजीकरण हुने व्याज शून्य हुन्छ ।
● ऋण दावी भएको निकाय कर छुट हुने निकायद्वारा नियन्त्रित निकाय होइन । त्यसैले यो वर्षको ब्याज रु. २६ लाखमध्ये पुँजीकरण हुने रु० घटाई बाँकी रहेको रु.२६ लाख व्याज खर्च कट्टी हुन्छ । कर्जा रजिष्ट्रेशन शुल्क रु.२०,०००/- र धितो मूल्यांकन रु.२०,०००/- दायित्व बापतका आउटगोइंग हुन भने मालपोत रु.२,०००/-, बीमा रु.३०,०००/- र आवधिक निरीक्षण शुल्क ६,०००/- सम्पत्तिको सुरक्षासँग सम्बन्धित सामान्य खर्च हुन् ।
२१.६.२ ब्याज कट्टी
कुनै व्यक्तिको कुनै आय वर्षमा कुनै लगानीको आय निर्धारण गर्दा सामान्यतयाः कारोबारसँग सम्बन्धित व्याज सम्पूर्ण खर्च कट्टी दाबी गर्न पाउनेछ । ऐनको दफा १४ को उपदफा (१) अनुसार कुनै व्यक्तिले कुनै आय वर्षमा लगानीबाट भएको आयको गणना गर्ने प्रयोजनको लागि सो व्यक्तिले सो वर्षमा प्रयोग गरिएका कुनै सम्पत्ति खरिद गर्न प्रयोग गरिएका ऋण दायित्व वा लगानीबाट आय आर्जन हुने कार्यका लागि सिर्जना भएको ऋण दायित्व अन्तर्गत सो वर्षमा लागेका सबै व्याज कट्टी गर्न पाउँनेछ ।
उदाहरण २१.६.२. मानौं, गोविन्द नेपालले कुनै निकायमा रु१० लाख कर्जा लगानी गरेका रहेछन् । उक्त कर्जा लगानी गर्न निजले कुनै बैंकबाट रु.५ लाख कर्जा लिएका रहेछन् । आ.व. २०६४।६५ मा निजले सो लगानी वापत रु.१ लाख २० हजार व्याज आम्दानी गरेका रहेछन् र कर्जा बापत रु.५० हजार व्याज भुक्तान गरेका रहेछन् । यस्तो व्याज भुक्तानी लगानीको आय आर्जन गर्न निजले सो वर्ष खर्च गरेको हुंदा निजले सो व्याज भुक्तानी लगानीको आय आर्जन गर्ने कार्यसंग सम्बन्धित समेत भएकोले आ.व. २०६४/६५ मा व्याज खर्च दावी गर्न सक्दछ ।
Section 48 of ITA: Disposal by Separation
Section 48 of Income Tax Act, 2058 – not a tax provision that frequently requires visiting. But it has an important significance in the context of the treatment and deductibility of the interest expenses. We have now learnt that the effective interest rate based amortization method is followed only in specific re-characterization situations envisaged under Section 32 of the Income Tax Act, 2058 for annuities, installment sale and finance lease.
Debt instruments other than these three instruments will have to follow the definition and deductibility of the interest expenses as provided in the Act based on the loan repayment schedule.
In the headings above, we discussed what “interest expense” is for the purpose of income tax and financial accounting proposes. Some subtle and some not so subtle differences were noted. We also observed that some expenses still are in gray areas. But for a moment let’s assume that there are no gray areas and discuss how the absence of recharacterization of “effective interest rate method” for amortization classification is alternatively dealt with in the Income Tax Act under Section 48.
Section 48: Disposal of Assets and Liabilities by Splitting
Section 48: In the case where rights or obligations with respect to an asset owned or liability owed by one person are transferred another person, including by way of lease of an asset or part thereof, the following provisions shall be applied:
a. Where the rights or obligations are permanent, the one person is treated as disposing of part of the asset or liability but is not treated as acquiring any new asset or liability; and
b. Where the rights or obligations are temporary or contingent, the one person is not treated as disposing of part of the asset or liability but as acquiring a new asset or incurring a new liability, as the case requires.
Section 48 applies when assets or liabilities are disposed of in trances. When a debt instrument is settled by the way of repayment of principal in several trances, the issuer of the debt is not treated as acquiring new liability at every settlement, but is treated as part settlement of the same old instrument. So what implication does this have in relation to the “interest expense” recognition?
💡Let’s take an example to discuss further:
A company raised a 5 year debt with a face value of Rs 500,000. The company was able to collect Rs 440,000 after providing Rs 50,000 issue discount and Rs 10,000 professional fees in relation to raising the debt. The annual equal repayment will be Rs 150,000.
Step 1: Preparation of Repayment Schedule: Based on the above loan agreement, a repayment schedule per below will be agreed upon by the lenders and the borrowers:
|
Opening |
Interest |
Repayment |
Closing |
|
500,000 |
76,191 |
150,000 |
426,191 |
|
426,191 |
64,944 |
150,000 |
341,135 |
|
341,135 |
51,983 |
150,000 |
243,118 |
|
243,118 |
37,047 |
150,000 |
130,165 |
|
130,165 |
19,835 |
150,000 |
– |
|
Total |
250,000 |
750,000 |
EIR:15.24% |
Step 2: For accounting purposes both the lender and the borrower will follow the effective interest rate based amortization method treating the issue discount of Rs 50,000 as imputed interest cost. However, professional fee of Rs 10,000 is not an imputed interest cost and is treated separately as general expense by the borrower.
|
Opening |
Interest |
Repayment |
Closing |
|
450,000 |
89,360 |
150,000 |
389,360 |
|
389,360 |
77,318 |
150,000 |
316,678 |
|
316,678 |
62,885 |
150,000 |
229,563 |
|
229,563 |
45,586 |
150,000 |
125,148 |
|
125,148 |
24,852 |
150,000 |
– |
|
Total |
300,000 |
750,000 |
EIR=19.86% |
Step 3: The amortization schedule agreed under the loan deed will be considered for the purpose of income tax purposes and the amortization schedule prepared under Step 2 will be considered for financial reporting purposes.
Step 4: Reconciliation of expenses between financial reporting and tax purposes
|
Year |
Financial Reporting |
Tax Reporting |
||||
|
Interest |
Issue Discount |
Prof. Fees |
Interest |
Issue Discount |
Prof. Fees |
|
|
1 |
89,360 |
– |
10,000 |
76,191 |
10,000 |
10,000 |
|
2 |
77,318 |
– |
– |
64,944 |
10,000 |
– |
|
3 |
62,885 |
– |
– |
51,983 |
10,000 |
– |
|
4 |
45,586 |
– |
– |
37,047 |
10,000 |
– |
|
5 |
24,852 |
– |
– |
19,835 |
10,000 |
– |
|
|
300,000 |
– |
10,000 |
250,000 |
50,000 |
10,000 |
As per the above reconciliation the total expenses charged for the purpose of financial accounting (300,000 + 0 + 10,000) and tax accounting (250,000 + 50,000 + 10,000) both equals to Rs 310,000.
💡So how does the Section 48 come into play?
The treatment of the fees of Rs 10,000 is straightforward. It is not a fee related to the origination of the loan and thus the borrower treats this expense as a general expense i.e. it follows the same accounting treatment both for financial and tax purposes. The other expense of Rs 50,000 for issue discount is also treated as an interest cost for the purpose of income tax (refer to discussions above). Issue discount is also an imputed interest cost for the purpose of amortization method under financial reporting standards. But the issue discount despite being an interest cost doesn’t not constitute “payment” for the purpose of income tax unless the debt obligation settles – at the initial stage it will be treated as an outgoing related to the liability. The debt obligation in the example above settles in trances and as per Section 48 and Section 37 of the Act – when the person is treated as disposing the asset by splitting – which allows for the part of outgoing costs related to the liability to be expensed off at the point of part disposal of the liability. So this allows for the issue discount to be disposed off in proportion of the repayment of the principal amount of the debt obligation.
💡Would the treatment be different if the expense of Rs 50,000 in example above was a origination fees (e.g. loan processing fee)?
If the expense of Rs 50,000 in the example was a loan processing fee – similar to “issue discount” this would also qualify as imputed interest cost for both financial and tax purposes. The major difference would be that loan processing fee is the fee paid to the lender by the borrower and would thus qualify as “payment” for the purpose of income taxes. The entire amount would be eligible for deduction subject to the provision under Section 14(1) for deductibility of the interest expenses, assuming that the borrowing is a general borrowing. Had the loan been obtained specifically for the purpose of financing an asset and the asset was put to use during the income year, the entire amount of Rs 50,000 would be eligible for deduction in the year, elsewise if the asset is in continued development or not put to use yet, the imputed interest cost (i.e. loan processing fee) would be capitalized as an outgoing cost of the asset and depreciated later when the asset is put to use.
Some Relevant Decisions from Courts
Revenue Tribunal
Pashupati Iron Steels Pvt Ltd v/s Large Taxpayer’s Office
In the case of Pashupati Iron Steels it was observed that the loan taken by the petitioner was given to various other commercial taxpayers, namely Pashupati Ribbed Bar and Pashupati Wire Product, sister concerns of the petitioner. Although the entities are within the same group, they are considered independent for tax purposes and are inherently separate businesses. So the deduction of the interest amount for the loan taken from the bank by Pashupati Iron Steels was denied.
Lord Buddha Education Academy Limited v/s Large Taxpayer’s Office
Regarding disallowance of interest expenses, the applicant carried out the construction of a building with a bank loan in a land that was in ownership of another party. The academy also failed to comply with the provision under Section 8(3) of the Value Added Tax Act, 2052; Rule 6(b) of the Value Added Tax Regulations, 2053. Further the applicant was not able to provide any evidence of the contract with the landowner or the reasonability of the interest expenses during the hearing so the interest expense was denied deductibility.
Jayee Construction Pvt Ltd vs IRO
Applying a loan taken for one job to another job or relending the funds to another business is not only against the banking related laws, but it is also against the prudential norm of the banking system. In order to verify legitimate income or legitimate expenses, the legitimacy of the source and the legitimacy of resource utilization must also be verified. Taking a loan from the bank and paying interest on the same cannot be a complete basis for deduction of expenses. For that, it should be seen that the loan taken has been used in the related business and the return has been received.
NDEP Development Bank vs LTPO
Siddhartha Bank Limited v LTPO
According to Section 27(1)(d) of the Income Tax Act, 2058, if the interest paid by a person for a loan is less than the interest rate payable according to the prevailing interest rate, the favorable difference to the employee should be included in the employee’s employment income and tax deducted accordingly. Since the tax was not calculated, it seems that the initial decision of the revenue office is in agreement with the provision of the law.
Trishakti Investment Pvt Ltd vs TSO Battisputali
When an entity borrows funds from a financial institution under normal conditions, the entity will pay the interest on such borrowings. When such funds are transferred to the directors and shareholders of the company it is only reasonable that the company obtains an average interest rate from such advances made to the directors. Unless it can be confirmed by evidence that the amount provided to its directors is for the payment of the entity, interest must be charged albeit notionally and included in the income of the entity.
Supreme Court
LTPO vs Arihanta Multi Fibers Limited
It is reasonable that the taxpayer who has taken the loan sells goods on credit or loan to any other person or firm. However, when the entity borrows loans from the financial institution to support the insufficient cash and working capital requirements but advances these funds to other persons for different reasons – it can be argued that the funds so borrowed have not been used for the intended business purposes.
Highland Distillery vs Inland Revenue Department
This is a case of recognition of variable consideration for tax purposes and has been discussed in detail in my other post: Taxation on Variable Considerations
LTPO vs Prime International Pvt Ltd
According to Section 27(1)(d) of the Income Tax Act, 2058, if the interest paid by a person for a loan is less than the interest rate payable according to the prevailing interest rate, the favorable difference to the employee should be included in the employee’s employment income and tax deducted accordingly. Since the tax was not calculated, it seems that the initial decision of the revenue office is in agreement with the provision of the law.
Everest Bank Limited v/s Inland Revenue Department
This is a decision on the case of hybrid instruments containing both debt and equity elements and has been discussed in detail in my other post: How to combust a Financial Instrument and Residue its Equity Element?
Tax Office Dharan vs Ganesh Ferrosing Industries Pvt. Ltd.
Interest Expense incurred on Loan obtained pledging the bonds of third party unrelated to the company (Tax Office, Dharan Vs. Ganesh Ferrosing Industries Pvt Ltd. Part 10-Industry, Commerce & Tax; Precedent Collection, 2066- Pg.21). It was held that the loan utilized for the purpose of business can be claimed for deduction irrespective of the way how the loan has been obtained.
IRO Biratnagar vs. Nepal Trade & Service Link
(Supreme Court Decision date-2069 Ashoj 2) IRO disallowed interest expenses in Trust Receipt Loan citing the reason that the loan is utilized even when the company has excess cash to avoid taxes. IRO disallowed the interest expenses citing the reason that advances are made to irrelevant persons, so interest expense to the extent that loan utilized for such irrelevant advances is not allowed for tax purpose – Supreme Court upheld the decision.