‘Ind AS Transition Facilitation Group’ (ITFG) of Ind AS Implementation Committee has been constituted for providing clarifications on timely basis on various issues related to the applicability and /or implementation of Ind AS under the Companies (Indian Accounting Standards) Rules, 2015, raised by preparers, users and other stakeholders. Ind AS Transition Facilitation Group (ITFG) considered some issues received from members and decided to issue following clarifications1 on January 16, 2018:
Issue 1: Can Dividend Distribution Tax (DDT) paid on distribution of dividend to preference shareholders (that are classified as liability as per Ind AS 32, Financial Instruments: Presentation), be capitalised as borrowing costs with the qualifying asset in accordance with the principles of Ind AS 23, Borrowing Costs?
Response: Paragraphs 5 and 6 of Ind AS 23, Borrowing Costs, state as follows:
“5 Borrowing costs are interest and other costs that an entity incurs in connection with the borrowing of funds.
6 Borrowing costs may include:
(a) interest expense calculated using the effective interest method as described in Ind AS 109, Financial Instruments;
With regard to the recognition of dividend declared on financial instruments, paragraphs 35 and 36 of Ind AS 32 reproduced here under may be noted:
“35 Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability shall be recognized as income or expense in profit or loss. Distributions to holders of an equity instrument shall be recognized by the entity directly in equity. Transaction costs of an equity transaction shall be accounted for as a deduction from equity.
36 The classification of a financial instrument as a financial liability or an equity instrument determines whether interest, dividends, losses and gains relating to that instrument are recognized as income or expense in profit or loss. Thus, dividend payments on shares wholly recognized as liabilities are recognized as expenses in the same way as interest on a bond. Similarly, gains and losses associated with redemptions or refinancings of financial liabilities are recognized in profit or loss, whereas redemptions or refinancings of equity instruments are recognized as changes in equity. Changes in the fair value of an equity instrument are not recognized in the financial statements.”
In view of the above, if a financial instrument is classified as debt, the dividend or interest thereon is in the nature of interest which is charged to profit or loss.
Further, paragraph 8 of Ind AS 23 states that, “An entity shall capitalize borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. An entity shall recognize other borrowing costs as an expense in the period in which it incurs them.”
Paragraphs B5.4.4 and B5.4.8 of Ind AS 109, Financial Instruments, state as follows:
“B5.4.4 When applying the effective interest method, an entity generally amortizes any fees, points paid or received, transaction costs and other premiums or discounts that are included in the calculation of the effective interest rate over the expected life of the financial instrument ”
The Guidance Note on Ind AS Schedule III provides following guidance in respect of dividend on redeemable preference shares:
Dividend on preferences shares, whether redeemable or convertible, is of the nature of ‘Interest expense’, only where there is no discretion of the issuer over the payment of such dividends. In such case, the portion of dividend as determined by applying the effective interest method should be presented as ‘Interest expense’ under ‘Finance cost’. Accordingly, the corresponding Dividend Distribution Tax on such portion of non-discretionary dividends should also be presented in the Statement of Profit and Loss under ‘Interest expense’.
In the given case, assuming that the requirements of paragraph 8 of Ind AS 23 for capitalization are met then the dividend on the preference shares that are classified as a liability, in accordance with the principles of Ind AS 32, Financial Instruments: Presentation would be treated as interest and DDT paid thereon will be treated as cost eligible for capitalization. Thus, in the given case, DDT is in the nature of incremental cost that an entity incurs in connection with obtaining the funds for qualifying asset. Hence DDT should be capitalized along with interest. Further, dividend distribution tax paid on such dividend will form part of the effective interest rate calculation (EIR) to compute the effective interest expense to be capitalized with the qualifying asset.
[Issue 2: Company A Ltd., applied for a term loan from Bank B for business purposes. As per the loan agreement, the loan required a personal guarantee of one of the directors of A Ltd. to be executed. In case of default by A Ltd, the director will be required to compensate for the loss that Bank B incurs. Mr. P, one of the director had given guarantee to the bank pursuant to which the loan was sanctioned to Company A. Company A does not pay premium or fees to its director for providing this financial guarantee.
Whether Company A is required to account for the financial guarantee received from its director?
Response: Ind AS 109 Financial Instruments, defines a financial guarantee contract as ‘a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument.’
Based on this definition, an evaluation is required to be done to ascertain whether the contract between director and Bank B qualifies as a financial guarantee contract as defined in Appendix A to Ind AS 109. In the given case, it does qualify as a financial guarantee contract as:
Ind AS 109 provides principles for accounting by the issuer of the guarantee. However, it does not specifically address the accounting for financial guarantees by the beneficiary. In an arm’s length transaction between unrelated parties, the beneficiary of the financial guarantee would recognize the guarantee fee or premium paid as an expense.
It is also pertinent to note that the entity needs to exercise judgment in assessing the substance of the transaction taking into consideration relevant facts and circumstances, for example whether the director is being compensated otherwise for providing guarantee. Based on such an assessment, an appropriate accounting treatment based on the principles of Ind AS should be followed.
In the given case, Company A Ltd, is the beneficiary of the financial guarantee and it does not pay a premium or fees to its director for providing this financial guarantee (subject to discussion above). Accordingly, Company A will not be required to account for such financial guarantee in its financial statements considering the unit of account as being the
Ind AS Transition Facilitation Group (ITFG) Clarification
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