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Edited Image courtesy: incometaxindia.gov.in
 
Both the corporate lobbyists and reformists across the world are always willing to lock horns over the depreciation of assets under the income tax law. 
This is because depreciation has gradually emerged as multi-facet window for tax incentives, overshadowing its primary function as a method for phased deduction of the cost of assets from annual pre-tax income over a period. The stakes are thus high both for the companies and the income tax department (ITD) in any country.  
This aspect came to the fore in 2014 that witnessed intense debate in the United States over the bonus depreciation. It allows businesses to make 50 deduction of investment on purchase of specified assets in the first year of purchase from their pre-tax income. This provision was revived in 2008 for limited period to reverse economic downturn.
Certain entities fiercely opposed its extension and others pitched not only for its retrospective extension but also for regularisation as a permanent feature of the Internal Revenue Code (IRC) of 1986.  
The Christmas-eve saw President Obama extending the bonus depreciation by one year, which resembles a compromise of sorts between two conflicting opinions. He did this by signing the Tax Increase Prevention Act 2014 on 19th December. 
Bonus depreciation is an attractive sop for companies if one goes by a case study done by Genpact, a global leader in Business Process and Technology Management.
The Study, aimed at hawking Genpact's tax planning skills, says: “The American Recovery and Reinvestment Act of 2009 instituted by the U.S. government included bonus depreciation for certain years. A major diversified manufacturing company expected a benefit of some $100MM for bonus year 2008 under the new law; however, it had no method of calculating the bonus in order to claim it. Genpact’s solution bridged the knowledge gaps to determine the actual value of this client’s depreciated assets, producing a P&L impact of $1.3MM and a tax shield benefit of $27MM within six months.”
The provision for Bonus depreciation is in addition to accelerated depreciation and certain other capital recovery allowances permitted under IRC 1986.
All variants of additional depreciation on tangible assets and amortization on intangible assets over and above the normal allowances for economic depreciation adversely impact tax collections. In other words, they increase the tax expenditure or revenue forgone by the Government. 
As put by Washington-based the Centre on Budget and Policy Priorities in a report titled ‘Ineffective Bonus Depreciation Tax Break Should Remain Expired’ released during November 2014, “Making bonus depreciation permanent is very expensive. Extending it permanently and expanding it, as the House has twice voted this year to do, would cost $276 billion over the coming decade (2015-2024), according to the Joint Committee on Taxation (JCT).”
It says: “accelerated depreciation is one of the largest corporate tax expenditures. The ability to write off investments faster than they depreciate is a valuable deduction for companies — and costly to the Treasury. Bonus depreciation is effectively accelerated depreciation on steroids, allowing companies to take half of the multi-year deductions immediately.”
The issue of accelerated depreciation has also been in the focus in Japan, Italy, China, Australia and elsewhere. 
A case in point is the Organisation Economic Co-operation and Development’s (OECD’s) base erosion and profit shifting (BEPS) project. The issue of utilization of legitimate depreciation incentive was raised by the Confederation of Swedish Enterprise, for instance, in its comments on the OECD Discussion Draft titled ‘BEPS Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances’ in April 2014
The Confederation stated: “Businesses should be allowed to respond to legislative tax initiatives such as accelerated depreciation or patent box regimes without being accused of aggressive tax planning.”
It is thus the variety and extent of use or abuse of special depreciation as an incentive or as tax avoidance tool that has emerged as a major area of tax reforms.
As noted by US Joint Committee on Taxation in its report on ‘Estimates of Federal Tax Expenditures for Fiscal Years 2014-2018’ submitted in August 2014, “One of the most difficult issues in defining tax expenditures for business income relates to the tax treatment of capital costs. Under present law, capital costs may be recovered under a variety of alternative methods, depending upon the nature of the costs and the status of the taxpayer.”
Unlike the US and other developed countries, India is burdened with depreciation conundrum. The depreciation scene is complicated not only by multitude of special capital allowances but also by multiple laws and administrative fiats. 
The need for clearing the depreciation mess has been pertinently articulated by Comptroller and Auditor General of India (CAG) in a report presented to Parliament on 19th December 2014. By coincidence, this is the date on which President Obama approved extension of the validity of bonus depreciation by one year.
In a report captioned ‘Performance Audit on Allowance of Depreciation and Amortisation’, CAG recommended the Finance Ministry should consider aligning depreciation rates under the Income Tax Act (ITA) with the rates of depreciation allowed under the Companies Act. 
CAG found that depreciation as per the ITA was higher in 6267 cases and was lower in 5926 cases by a difference aggregating to Rs 57665.41crore (about Rs 5766 billion) and Rs 11754.80 crore (about Rs 1175 billion) respectively.   
The depreciation allowed was at par in 10,441 cases in both as per the Companies Act and ITA. 
Experience shows that companies often opt for higher rates allowed under either of the two laws to reduce their taxable income. Such flexibility in accounting depreciation also makes financial comparison difficult among companies operating in a sector.
The flexibility can be judged by looking at the disclosure made by Nagarjuna Fertilizers and Chemicals Limited (NFCL) in its annual report for 2013-14.
The report says depreciation on fixed assets is provided on straight-line method at the rates and in the manner prescribed in Schedule XIV of the Companies Act, 1956 or at higher rates as stated below:
Citing many cases of wrong approval of depreciation, the resulting tax loss and conflicting court verdicts on certain depreciation provisions, CAG says the complexity should be reduced by harmonizing the depreciation rates under the two laws. 
It adds: “if any incentive is intended by way of depreciation, it may be expressly given by way of incentive instead of depreciation. ITD may carry out a cost-benefit analysis on the issue to ascertain the effectiveness of this incentive mechanism and decide on harmonizing the depreciation rates with those under the Companies Act.” 
Referring to Finance Ministry’s reluctance to harmonize rates, CAG report articulates: “More the alignment of depreciation is made, the less will be the chances of errors in calculation of depreciation.”
A limitation of CAG report is that it has not factored in the third set of statutory depreciation rates that electricity utilities have to follow under the tariff orders issued by Central Electricity Regulatory Commission (CERC).  It specifies lower or moderate depreciation rates to keep power generation, transmission and distribution tariff under check. 
There are thus three categories of depreciation rates – one under the Companies Act, another under ITA and third under CERC regulations framed the Electricity Act, 2003. One can reasonably assume that there are a few more rates followed in the computation of administered prices of other products in India. 
CAG is not the first to pitch for convergence of depreciation rates under ITA and the Companies Act. 
Way back in May 2001, the Advisory Group on Tax Policy and Tax Administration (AGTPTA) for the Tenth Five-Year Plan analysed the problem of excessive depreciation, zero-tax companies and imposition of minimum alternate tax (MAT).
AGTPTA observed: “Corporate tax legislation all over the world, no matter how streamlined at the outset, becomes subject to a ‘creeping incrementalism’ with respect to special concessions and provisions over time, typically through excessive depreciation allowances. This is because the corporate sector constitutes a focused interest group with financial backing. A group of so-called "zero tax companies" emerges.”
It contended that the major rationale for MAT was the erosion of the tax base is the provision relating to accelerated rate of depreciation for general category of machineries on their written down value.
It stated: “Excessive depreciation allowance also results in overcapitalisation. It encourages mergers and amalgamations often not justified on economic grounds. To the extent depreciation allowance provides tax shield, it distorts private investment behaviour. The distortion is further exacerbated if the allowance is generous. Allowing depreciation on replacement cost is tantamount to adjusting for inflation in the cost of the assets. Since none of the other heads of income and expenditure is adjusted for inflation, it is biased against investment in sectors where the amount of fixed assets is relatively low (e.g. the services sector).” 
In 2002, the Finance Ministry’s Task Force on Direct Taxes recommended revision of rates under ITA to reduce their divergence with the ones specified under the Companies Act. This proposal was, however, opposed by the industry.
It makes a lot of sense for the governments across the globe to eliminate or reduce to the bare minimum the use of additional depreciation as a tax incentive. This should be backed by matching reduction in income tax rates keeping the inflation in view.
This approach would certainly curb tax avoidance and evasion by companies. It is also the way to reducing litigation over interpretation and availing of different variants of additional depreciation allowance. 
Published by taxindiainternational.com on 6th January 2015
 
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