Dovetailing Financial Reporting and TP in backdrop of COVID-19

 

Given the arduous times arising as a result of the global pandemic, i.e. COVID-19, the Institute of Chartered Accountants of India (ICAI) has published an accounting and auditing advisory- “Impact of Coronavirus on Financial Reporting and the Auditors Consideration” (ICAI advisory) which highlights certain crucial aspects requiring particular attention in respect of financial reporting (FR).

In Part I of this article series, we discussed about the impact of COVID-19 on Financial Statements (FS) and its consequential TP implications, based on the guidelines provided in the ICAI advisory in relation to Revenue, Inventory and Modification/ Termination of Contracts and Going Concern assessment. In this

Part-II of the Article, we have endeavored to discuss the TP inferences in relation to Financial Instruments, Property Plant and Equipment, Interim Financial Reporting and certain other aspects along with overall conclusion.

1.    Financial Instruments:

 

►     As per ICAI advisory:

 

As per Indian Accounting Standard (IND AS) 109, financial instruments, inter-alia, loans, trade receivables, other receivables and financial guarantees are subject to impairment loss recognition and measurement, based on Expected Credit Loss (ECL) approach.

►     Inferences from TP perspective and suggested course of action (SCA):

 

Applying this principle from TP angle, in case of trade/ other receivables outstanding from the AEs, the credit risk arising pursuant to inter-company transactions, as stated in the risk analysis section, is generally reported as being mitigated since the transaction undertaken is between Group entities. However, in view of economic stagnation caused due to COVID-19, the credit risk could need to be reassessed for any potential defaults.

Further, financial guarantees provided by/ to AEs must be continually assessed, in light of COVID-19 situation, to determine whether a future outflow has become probable and make adequate provision where required. Moreover, it would also be important to ensure that the AE providing Guarantee is remunerated at an arm’s length, otherwise, the outflow from a probably non-arm’s length Guarantee transaction could be considered to be recoverable from the Indian entity by the tax authorities of the overseas AE.

Additionally, in order to overcome liquidity challenges, the AEs may consider providing moratorium on loans, reduction in interest rates or deferment of interest payment. The Multinational Enterprise (MNEs) should analyse such aspects from a TP perspective and undertake suitable disclosures by way of suitable notes in the FS.

2.    Property Plant and Equipment (PPE):

 

►     As per ICAI advisory:

 

Due to the pandemic, PPE can remain under-utilised or not utilised for a period of time, whereas, the AS requires charging of depreciation even if the PPE remains idle. Further, COVID-19 may have affected the expected useful life and residual value of PPE. The management may review the residual value and the useful life of an asset due to COVID-19 and, if expectations differ from previous estimates, it is appropriate to account for the changes as an accounting estimate as per Ind AS 8 and AS 5.

 

►     Inferences from TP perspective and SCA:

 

While this may be subject to practical applicability, however, due to COVID-19, reduction in estimated useful life and residual value of an asset, as compared to that prescribed under the Companies Act, 2013, may increase the depreciation amount debited to P&L account by the entity vis-à-vis the comparable companies and also the original estimate. This could also increase the operating costs of the tax payer. It may be advisable for the AE and the Indian entity, especially, a captive service provider to evaluate the treatment of such incremental costs and mark-up to be charged, if any. Where, the Indian entity is required to bear such cost, either since it is a risk bearing entity or if it is agreed with the AE after due deliberations, the Indian entity may consider undertaking appropriate depreciation adjustment, assuming that the comparables have not faced a similar situation.

 

 

3.    Interim Financial Reporting:

 

►     As per ICAI advisory:

 

Additional disclosure should be given in the interim FS to reflect the financial impact of the COVID-19 and the measures taken to contain it. Where significant, the disclosures required by paragraph 15B in Ind AS 34 should be included. Further, the preparers may consider making suitable disclosures in the Management Discussion and Analysis (MDA) section of the Annual Report (AR) about the effect of COVID-19 on the overall risks to the businesses in which the entity is engaged. Separately, the auditor may include an Emphasis of Matter paragraph in the auditor’s report to highlight such disclosures to users of the FS

►     Inferences from TP perspective and SCA:

 

In this regard, MNEs could provide disclosure of COVID-19 impact on overall Industry in the MDA section along with reference to reports of International agencies like International Monetary Fund (IMF), World Bank, Credit rating agencies etc. This could potentially support during TP audits that would be initiated by IRA in future.

Further, disclosure of re-assessed business risks in AR will help in re-visiting the risk analysis in TP study report. Similar disclosure in FS of potential comparable companies will possibly help in analysing functional comparability and impact of COVID-19 on the potential comparable companies vis-à-vis the tested party. This could potentially support in undertaking economic adjustments.

4.    Other relevant aspects and drawing inferences from the ICAI advisory:

 

►     Limitation on interest deduction:

 

Section 94B of the Income Tax Act (‘the Act’) limits interest expenditure deduction (exceeding INR 1 crore), in respect of any debt issued by an AE, to the extent of 30% of EBITDA of the borrower or interest payable, whichever is less.

In the current situation, where the EBITDA of the entity has declined significantly, the interest deduction would be limited to 30% only and the balance amount would need to be carried forward to the next Assessment Year. Indian subsidiaries could need to raise loans from AEs or from third party banks basis the Guarantees from AEs, for taking care of working capital/ long term needs. However, due to Section 94B, large portion of such interest could get disallowed.

Further, as per Ind AS 23 and AS 16 (Borrowing Costs) where development of asset is suspended, capitalisation of interest is suspended. Consequently, there could be scenarios wherein this interest would be debited to P&L Account which would become deductible from Income-tax perspective. However, in case this amount of interest is in respect of debt issued by AE, it would fall under the ambit of Section 94B and further exhaust the prescribed threshold limit of 30%. We need to wait and watch if the Government could allow deduction of more than 30% for COVID-19 impacted years similar to what was announced in USA

►     Exceptional Items:

 

Expenses which have been incurred due to COVID-19 to keep things running or additional expenses incurred, and which may be non-recurring in nature could be disclosed as exceptional items. Example: Loss incurred due to fall in oil & gas prices, asset mobilization costs, etc. While the ICAI advisory has not specifically dealt with exceptional expenses including unabsorbed cost and fixed costs not leading to ‘operating costs’, the MNEs must analyse these from a TP perspective and ensure that these are dealt with appropriately during TP compliance stage. A detailed analysis should be put in place by MNEs to determine and disclose these costs which could support in justifying before IRA in future, especially where such disclosure is forming a part of audited FS.

Concluding thoughts:

 

It is a well-known fact that the FR and TP aspects are interlinked. The IRA do scrutinize the disclosures in the audited FS of the tax payer as well as comparables while conducting the TP Audits.                                        Dovetailing the disclosures in the FS with TP aspects and rather ensuring an appropriate disclosure of the contemporaneous TP related decisions in the COVID-19 impacted period in the FS will help the users of the FS and the IRA to get an appropriate perspective of the impacts, decisions and the rationale behind the same. In a nutshell, accounting, assurance and TP professionals should work closely to analyse and incorporate the impact of COVID-19 in the FS as suggested in the ICAI Advisory. Further, information provided in ARs/ media reports for specific sectors should be assessed in detail and should be included while preparing TP documentation for COVID-19 impacted years.

 

Additionally, as mentioned in Part I of our article, MNEs could potentially think of controversy management option like Advance Pricing Agreement to achieve certainty on the TP outcome of its international transactions for COVID-19 impacted years.