Article

Auditing & Accounting

November 2023

Posers in Relation to S. 198 of the Companies Act, 2013

Background: S. 198 of the 2013 Act lays down the manner of computing the net profits of a company in any financial year. The net profits so computed is required for (i) determining the managerial remuneration under S. 197 of the 2013 Act; and (ii) computing the minimum amount to be spent by a company in pursuance of its Corporate Social Responsibility (“CSR”) under S. 135(5) of the 2013 Act.

Prior to the 2013 Act, S. 349 to 351 of the Companies Act, 1956 provided the manner of computing the net profits for statutory restriction over the amount of managerial remuneration that could be paid by companies. These restrictions were imposed so as to ensure that the companies do not artificially inflate their profits and that the remuneration is paid only out of the operating profits and exclude certain items of income and expense of exceptional or not so in the ordinary course of profit earning apparatus.

Further, under the erstwhile Schedule VI to the 1956 Act, the companies were also required to disclose the details of the manner of computing managerial remuneration which enabled the users to ascertain the items that were considered for computing the net profits in terms of the then S. 349 to 351 of the 1956 Act. However, though such disclosure requirement was done away when Schedule VI of the 1956 Act was revised, it is imperative that one would ought to know what items would be considered as per S. 198 of the 2013 Act while computing the net profits. Further, though through the Companies (Amendment) Act, 2017 (‘the 2017 amendment’) has specified that while calculating the net profit, credit shall not be given for “any amount representing unrealised gains, notional gains or revaluation of assets”, to address the treatment of items arising due to application of the Companies (Indian Accounting Standards) Rules, 2015 by companies (‘Ind AS companies’), it may yet pause a question - whether a particular item would or would not be covered while arriving at the net profits ?

Now, under the 2013 Act, the requirement to obtain approval from the Central Government beyond the limits prescribed had been done away with by way of the 2017 amendment. Presently, the only requirement is to obtain shareholders’ approval. Thus, after the 2017 amendment,even though the computation of net profits for the purpose of managerial remuneration may have lost its utility, yet the computation of net profits would matter and more particularly, for the purpose of computing the amount payable as CSR.

Certain issues while computing net profits under S. 198 of the 2013 Act

A tabular representation of the items which should or should not be considered for computing the net profits of a company in any financial year as per S. 198 of the 2013 Act is given in Annexure A. Even though the provisions of S. 198 of the 2013 Act have materially been prevalent since the 1956 Act, there are still some issues which may warrant attention. This article attempts to bring some pausers that may arise while computing net profit under S. 198 of the 2013 Act11 and some of those are : 

Starting Point

∞ For companies which follow Ind AS companies, whether the starting point to compute net profits would be before other comprehensive income (“OCI”) or after OCI?

∞ Whether prior period items (recognized in the Statement of Profit and Loss during the year or in the comparative period or opening reserves) should be considered while computing the net profits?

∞ For Ind AS companies, whether adjustments made in the opening reserves on change in accounting policies to be considered while computing the net profits?

No credit in relation to profits of a capital nature

∞ Whether profit arising on disposal of an investment property should be excluded from the computation of net profits, whether it is a real estate entity, investment entity or any other trading or manufacturing entity ?

∞ S. 198 only provides for exclusion of profits arising on ‘sale of undertakings’. In case where there is acquisition of business and a company recognizes gain on bargain purchases in OCI in accordance with Ind AS 103 on Business Combinations, whether the same would be considered while computing the net profits?

∞ Whether profit/loss recognized on distribution of non-cash assets to shareholders in terms of Appendix A of Ind AS 10 on “Events after the Reporting Period” would be considered as ‘adjustment arising on sale of an undertaking’ so as to be excluded from the computation of net profits?

∞ Whether profit recognised on extinguishment of financial liability in case of one-time settlement or debt restructuring be considered while computing the net profits?

∞ For Ind AS companies, in case of joint operations, the share of assets, liabilities, incomes and expenses of the joint operation are shown as the company’s own assets, liabilities, incomes and expenses. However, joint operations are separate and distinct legal entities. Whether the profits or losses of the joint operations can be considered while computing the net profits?

No credit/deduction in relation to any change in carrying amount of an asset or of a liability recognized in equity reserves including surplus in profit and loss account on measurement of the asset or liability at fair value  

∞ For Ind AS companies, whether the unwinding of interest in relation to assets or liabilities measured at amortized cost would be construed as ‘fair value’ so as to be excluded from the computation of net profits?

∞ Whether gain/loss recognized in relation to hedging contracts which are marked to market would be construed as ‘fair value’ so as to be excluded from the computation of net profits?

∞ Whether actuarial gain/loss can be considered as ‘fair value’ so as to be excluded from the computation of net profits?

∞ Whether gain/loss arising on translation of foreign currency transactions can be considered as ‘fair value’ so as to be excluded from the computation of net profits?

∞ Whether employee benefit expense recognised on account of measuring Employee Stock Options at fair value on the grant date would be considered as ‘fair value’ so as to be excluded from the computation of net profits? 

No credit in relation to any amount representing unrealised gains, notional gains or revaluation of assets 

∞ Clause (f) of sub-section (3) states that credit shall not be given for unrealised gains, notional gains or revaluation of assets; however, no such provision is given for unrealized losses or notional losses – Would this mean that these items should be deducted while computing the net profits?

∞ For Ind AS companies, whether adjustments arising on accounting for leases in accordance with Ind AS 116 would be considered as notional so as to be excluded from the computation of net profits?

Deduction in relation to usual working charges

∞ Sub-section (4) provides for deduction of usual working charges – Would this mean that exceptional losses cannot be deducted while computing the net profits? 

Deduction in relation to interest

∞ If interest on debentures or mortgages or unsecured loans capitalised to the cost of property, plant and equipment or intangible assets should be deducted while computing the net profits?

∞ For Ind AS companies, whether interest on preference shares issued (classified as financial liability) can be deducted while computing the net profits?

No deduction in relation to interest paid/ payable as per the provisions of the Income-tax Act, 1961

∞ Whether interest paid / payable as per the provisions of the Income-tax Act, 1961 would fall within the ambit of ‘income-tax payable’ and hence, should not be deducted while computing the net profits?

This is just a beginning and not the end, we will take you through the journey in near future.

Annexure A

S. 198(1)(a): Credit to be given in relation to items specified in S. 198(2)

- Bounties and subsidies received from any Government, or any public authority constituted or authorised in this behalf, by any Government, unless and except in so far as the Central Government otherwise directs

S. 198(1)(a): No credit to be given in relation to items specified in S. 198(3) 

- Profit, by way of premium on shares or debentures of the company, which are issued or sold by the company unless the company is an investment company as referred to in clause (a) if the Explanation to S. 186

- Profits on sales by the company of forfeited shares Profits of a capital nature including

- profits from the sale of the undertaking or any of the undertakings of the company or any part thereof

- Profits from the sale of any immovable property or fixed assets of a capital nature comprised in the undertakings of the company, unless the business of the company consists, whether wholly or partly, of buying and selling any such property or assets: Provided that where the amount for which any fixed asset is sold exceeds the written down value thereof, credit shall be given for so much of the excess as is not higher than the difference between the original cost of that fixed asset and its written-down value

- Any change in carrying amount of an asset or of a liability recognised in equity reserves including surplus in profit and loss account on measurement of the asset or liability at fair value

-Any amount representing unrealised gains, notional gains or revaluation of assets

-Any change in carrying amount of an asset or of a liability recognised in equity reserves including surplus in profit and loss account on measurement of the asset or liability at fair value

S. 198(1)(b): Deduct sums specified in S. 198(4) 

- All the usual working charges

- Director's remuneration

- Bonus or commission paid or payable to any member of the company's staff, or to any engineer, technician or person employed or engaged by the company, whether on a whole-time or on a part-time basis

- Any tax notified by the Central Government as being in the nature of a tax on excess or abnormal profits

- Any tax on business profits imposed for special reasons or in special circumstances and notified by the Central Government in this behalf

- Interest on debentures issued by the company

- Interest on mortgages executed by the company and on loans and advances secured by a charge on its fixed or floating assets

- Interest on unsecured loans and advances

- Expenses on repairs, whether to immovable or to movable property, provided the repairs are not of a capital nature

-  Ongoings inclusive of contributions made under S. 181

- Depreciation to the extent specified in S. 123 The excess of expenditure over income, which had arisen in computing the net profits in accordance with this section in any year, in so far as such excess has not been deducted in any subsequent year preceding the year in respect of which the net profits have to be ascertained

- Any compensation or damages to be paid in virtue of any legal liability including a liability arising from a breach of contract Any sum paid by way of insurance against the risk of meeting any liability such as is referred to in clause (m)

-  Debts considered bad and written off or adjusted during the year of account

S. 198(1)(b): Not to deduct sums specified in S. 198(5) 

- Income-tax and super-tax payable by the company under the Income-tax Act, 1961, or any other tax on the income of the company not falling under clauses (d) and (e) of sub-section (4)

-Any compensation, damages or payments made voluntarily, that is to say, otherwise than by virtue of a liability such as is referred to in clause (m) of sub-section (4)

- Loss of a capital nature including loss on sale of the undertaking or any of the undertakings of the company or any part thereof not including any excess of the written down value of any asset which is sold, discarded, demolished or destroyed over its sale proceeds or its scrap value

- Any change in carrying amount of an asset or of a liability recognised in equity reserves including surplus in profit and loss account on measurement of the asset or the liability at fair value