The provisions under Section 135 of the Companies Act, 2013(hereinafter referred to as “The Act”) and the Rules there under, are , in a manner of speaking, water under the bridge. Companies, both private and public alike, answering to the prescribed bench marks for compliance under Section 135 are now grappling with the reality of the law as it takes effect from the current financial year.
Compliance having now become an inevitability, it would be pertinent to look at the intricacies in the law relating to CSR which will stand up as potential road blocks ,thus make it difficult for companies to ensure compliance unless the rigors of the law are eased in the interregnum. In this exposition we shall deal with some contentious issues which need to be addressed urgently so that companies can embrace the provisions with the least trepidation.
Definition of “Net Profit”
The definition to the above term is provided under Rule 2(1)(f) of the companies (Corporate Social Responsibility Policy)Rules,2014 (hereinafter “the said Rules”).The term is defined to mean the net profit as per the company’s financial statement prepared in accordance with the applicable provisions of the Act. From the above, it follows that the financial statement should be drawn up pursuant to the requirements of Section 128 of the Act .However, two exclusions are to be made from the amount of net profit as stated in clauses (i) and (ii) to the above Rule 2. Profits emanating the activities of an overseas branch (es) irrespective of whether the branch operates as a separate entity or not are to be disregarded. The reason for this exclusion is intriguing. If a Branch operates as a separate Company there is no way its results could be dovetailed into the Books of the Indian Company, given the fact that overseas Branch would be a separate entity in the first place. The dividend income received by the company from other Indian Companies which are in compliance with the provisions of Section 135 is also to be excluded from the determination of the Net profit. This suggests that the Investor Company which receives the Dividend should go around asking all the Indian companies from whom it has received dividend whether they are CSR compliant under Section 135 or not .A weird inquiry indeed if we may say so, the rationale of which is hard to comprehend! Let us consider the unenviable plight of , say an Investment company which holds shares in numerous Indian companies and receives dividend income there from ,which has to ascertain whether all the investee companies which have paid dividend are Section 135 compliant or not. Surely a needless pain area , given the minimal impact it would otherwise have.
CSR Spends at 2% of average Net Profits
Section 135(5) provides that the Board of every company shall ensure that the company spends in every financial year at least 2 % of the average net profits of the company made during the three immediately preceding financial years in pursuance of its CSR policy. The Explanation under Section 135 stipulates that for the purposes of this Section,” average Net Profit” shall be calculated in accordance with the provisions of Section 198.
As the CSR provisions have kicked in from April 1, 2014, it obviously means that firstly the average net profits during the three preceding years will have to be considered. Hence profits made by the Company in the years 2011-12,2012-13 and 2013-14 will have to be considered and arrived at as per the financial statement for the relevant years in the manner stated in Rule 2(1)(f)referred to above. The proviso under Rule 2(1)(f) clarifies that in respect of the financial years that precede the financial year 2013-14, if the financial statements of those years have been prepared in accordance with the provisions of the 1956 Act, there would be no need to re-compute the Net Profit in accordance with the requirements of the 2013 Act.
It is pertinent to note that the computation of Net profit as per the requirements of Section 198 of the Act operates altogether on a different premise and is intended for an entirely different purpose. The methodology provided in Section 198 is used for the purpose of ensuring that the remuneration payable to Managerial personnel such as the Managing director, Whole Time Director and Manager does not exceed 11% of the Net profits of the company. We shall not elaborate on the method of computing net profits pursuant to the requirements of Section 198. Suffice to say that several additions and deductions need to be made for arriving at the Net profit with the central idea being that the Managerial personnel should not get any credit for capital profits arising from the sale of fixed Assets and other incomes such as that arising from sale of forfeited shares or incomes of such genre which are not exactly attributable to their efforts. In addition, adjustments would need to be made to the net profit figure on account of the differences in the computation of depreciation as per the Companies Act and the provisions of the Income Tax Act,1961.
In deference to the Explanation in Section 135 , the net profit as arrived as per Rule 2 ibid will have to be recast as per the prescription contained in Section 198.This recasting will have to be done not only for the financial year 203-14 but also for the preceding two financial years. Only after this can the quantum of the mandatory spend @ 2 % of the Net profit for CSR can be determined.
Readers will appreciate that surely that the above exercise involves recasting of the net profit in two distinct stages and as Accountants will aver, it is by no means an easy exercise. In our view, the law could have been simplified to provide merely that it would be incumbent upon a company which satisfies the prescribed benchmarks u/s 135 of the Act to expend at least 2% of its Net profit as appearing in its Statement of profit and loss effective from financial year 2013-14 instead of being called upon to make a jugglery of the genre elaborated above.
No Independent director in the CSR Committee for Private Companies and for certain unlisted public Companies-Whether the Rule is legally tenable
The provisions of Section 135 are applicable to every company ,both public and private, which satisfies any of the benchmarks laid down in the Section. Where a company is required to be CSR compliant , it is necessary for it to constitute a CSR Committee of the Board which should consist of at least one Independent director. On the other hand, Sub-section (4) u/s 149 of the Act mandates that listed companies and certain class of unlisted public companies shall have the minimum number of Independent directors. Public companies which do not comply with the requirements of Rule 4 in the companies (Appointment and Qualification)Rules 2014 need not appoint Independent Director. Section 135 therefore runs contrary to the provisions of Section 149 by thrusting, on the unlisted public companies and private companies not covered under Rule (4) of the above Rules , the obligation of having an Independent Director on its CSR Committee. Before being a member of any Committee constituted by the Board , a person has to necessarily be a Director of the Company in the first place.
That sub-section (1) to section 135 had given rise to an anomalous situation by making it obligatory even for private companies, must have been a late realization on the part of the powers that be as they sprung into action, to set right the above anomaly through suitable inserts in the CSR Rules. Rule 5(1)(i) was introduced to clarify that an unlisted public company or a private company covered under Section 135(1) which is not required to appoint an Independent director pursuant to sub-section (4) of section 149 shall have its CSR Committee without such Director.
Therefore private companies and unlisted public companies not covered by the requirements relating to appointment of Independent Directors can constitute a CSR Committee which does not consist of Independent directors.
Rule 5(1)(i) above has come as a major reprieve for unlisted public companies of a certain genre and private companies. However, there is, in our view, a grave doubt as to the legal sustainability of Rule 5 above. Firstly the Rule contradicts the mother legislation. It is a settled legal principle that sub-ordination legislation cannot dilute or over-ride the statutory provision. Secondly, Rule 5(1)(i) carves out a statutory exception for particular class of unlisted public companies and private companies. This brings into focus the provisions of Section 462 in the Act. Under this Section, the Central Govt is empowered ,inter alia, in the public interest, by notifying that any of the provisions of the Act shall not apply to such class or classes of companies. Before making such notification ,as per Section 462(2),a copy of every notification proposed to be issued should be laid before both Houses of parliament while it is in session for a period of thirty days and both Houses should either approve or disapprove of the same and the notification should be issued only in the form in which it has been approved by parliament. By inserting Rule 5(1)(i) ibid private and public companies have been spared from the requirements of Section 135 (1) in that they need not have independent directors in their CSR Board committees. A statutory exception has therefore been carved out through Rule 5(1) for the benefit of private companies which represent by themselves a class of companies. Therefore in our view Rule 5(1) ought to have been brought out only after due compliance with the procedure laid down in Section 462.We therefore hold that the legal validity of Rule 5(1) (i) is in grave doubt. Like we said before, no one is complaining on this score and hence ,as they say, it is par for the course!.
Rehabilitation and Resettlement(R&R) costs are not CSR spends –Separating chalk from cheese !
Vide General circular No.21/2014 dated June 18,2014, MCA have clarified that expenses incurred by companies for the fulfillment of any Act/Statute or Regulations (such as labour laws, Land Acquisition Act etc)would not count as CSR expenditure under the companies Act. When large projects involving use of substantial tracts of land are implemented which involves acquisition of both privately owned and Govt. allotted land by the company it results in displacement of people. The project affected people as they are called are required to be provided compensation against acquisition of land, alternative housing and employment/vocational opportunities in accordance with policies of both the Central and State govts. The benefits so provided are normally considered as Rehabilitation and Resettlement costs (R&R costs).Understandably as these expenses are incurred under the provocation of a Statute or state policy , such costs cannot be passed off as CSR spends which is acceptable. In the process of resettling the project affected persons, a company may incur costs beyond what is statutorily required. For instance, if the statutory requirement was merely that a school building be set up and if the company has gone much beyond this and created the necessary infrastructure as also provided free education to the children ,taken up the responsibility of running the school by deploying trained teachers etc, such costs cannot be considered as involuntary. They are in fact CSR costs. There would in such cases, be a very thin dividing line between what is mandatory and what is voluntary. It is unlikely that in many cases such costs could be easily distinguished and isolated. It would be analogous to separating chalk from cheese.
It is necessary that the statutory provision in such cases be liberally construed to the benefit of the company as opposed to running a fine tooth comb over the impugned costs.
No tax deductibility against CSR spends under Section 37- Some serious pointers
By the Finance Act, 2014 Explanation 2 has been inserted under Section 37(1) of the Income Tax Act,1961, with effect from 1.4.2015 to clarify that for the purposes of Section 37(1),any expenditure incurred by the Assessee on the activities relating to CSR referred to in Section 135 of the Companies Act,2013 shall not be deemed to be an expenditure incurred for the purposes of the business or profession. The above Explanation casts away any doubts as to the admissibility of CSR spends in tax assessments. The Explanation does not in our view operate as a blanket ban over the admissibility of the entire gamut of CSR spends.
It is pertinent to note that Section 37 is the residuary clause in the Income Tax Act, 1961 which provides that any expenditure not being of the nature described in Sections 30 to 36 shall be allowed as a deduction against Income from business or profession subject to the following three conditions being satisfied:
i).The expenditure should not be capital in nature.
ii).It should not represent personal expenditure of the Assessee.
iii).It should have been laid out or expended wholly and exclusively for the purposes of the Business.
From the above, it follows that any CSR spends which comes within the purview of Section 37 will not merit consideration as business expenditure. Having said that, we would submit that there would be a plethora of expenditure incurred on account of CSR which would be covered under Sections 30 to 36 of the Income Tax Act which should logically be admitted under the relevant provisions. For instance, if the Assessee sets up a School Building as part of its CSR initiative, the expenditure incurred for its upkeep would be allowable under Section 30 and the depreciation on the building would find refuge under Section 32 as a non-factory Building. Again suppose the Assessee, as part of its CSR drive, provides vocational training by providing computers, sewing machines etc , the upkeep thereon would be allowable under Section 31 and the depreciation on the equipments would be allowed under Section 32.Further as per Schedule VII of the Act, CSR spends could also be in the form of a donation to the Prime Minister’s National Relief fund. The donation should be allowed as a deduction under Section 80 G against the total income of the Assessee.
Continuing on the same vein, as per the circular dated June,18,2014,(Circular no.21/2014) issued by the MCA, salaries paid by companies to regular CSR staff as well as to volunteers can be factored into the CSR project cost as part of the CSR expenditure. Such expenditure would merit consideration as tax deductible not under Section 37 but under the specific provision of Section 36 of the Income Tax Act.
In the light of the above, we are of the firm view that expenditure of the genre described above should be admissible in tax assessments notwithstanding the insert of Explanation 2 under Section 37 by the finance Act, 2014. It would be appropriate if a suitable affirmation on this is issued by the CBDT to allay the apprehensions in the minds of companies which will have already started incurring CSR costs during the current fiscal in fulfillment of their obligations u/s 135 of the Act.
We believe that we have raised in the above discussion some pertinent questions the answers to which should soon be found out. Suffice to say that it is premature for the law relating to CSR to be cast in stone. These are early days yet and it is imperative that the decks are cleared and the potential road blocks some of which have been enumerated above are removed by appropriate changes in the legislature so that India Inc . can discharge its responsibilities towards CSR befittingly and become a partner in the process of achieving inclusive growth of the country.