For the purpose of this article, tax modeling will refer to income tax modeling for a corporate. Before we get into the intricacies of tax modeling, it is important to understand the following three concepts:
Concept 1 – The reporting requirements of the Companies Act and Income Tax Act:
- Every company has to pay tax to the government for the profits they make.
- Financial statements of the companies are prepared in accordance with the Companies Act. While preparing ledgers of accounts, tax is calculated as per the Companies Act. The Companies Act specifies the Tax rate and the methodology to be used to calculate tax.
- The tax calculated as per the Companies Act is only for reporting purposes.
- The actual tax that a company pays is determined by the Tax rate and methodology defined by the Income Tax Act.
- The major difference in the methodology specified by Companies Act and Income Tax Act is the way depreciation is calculated.
Concept 2 – Minimum Alternate Tax (“MAT”):
- There were a large number of companies who had profits as per books but were not paying any tax because income computed as per IT Act was either nil or negative or insignificant.
- In such cases, although the companies were showing book profits and declaring dividends to the shareholders, they were not paying any income tax.
- In order to bring such companies under the income tax act net, MAT was introduced.
- As per MAT, if the income-tax payable, computed as per the Income Tax Act, is less than MAT Liability (MAT Rate X Income as per Companies Act), then the tax payable for that year shall be the MAT Liability. MAT Rate includes the base tax rate, any surcharge and cess thereon.
- After the introduction of MAT, sometimes companies have to pay excess Taxes when compared to the Tax computed as per the IT Act.
- The excess Tax paid is allowed to be carried forward as MAT credit.
- The MAT credit can be set off against tax, payable in subsequent years up to ten assessment years immediately succeeding the assessment year in which the MAT credit was earned. The set off rule and period may be different in different geographical locations.
Concept 3 – Carry Forward Loss
- Losses made by the company are carried forward to subsequent years.
- Whenever the company makes profits, the carry forward losses are set off against the profits made and the tax is adjusted accordingly.
- Losses can be carried forward up to a finite number of years. There are different timeframes for carrying forward different types of losses.
- With this in mind, let us undertake tax modeling step by step:
Step 1: Calculation of PBT for IT purposes
- We need to restate the PBT for Book purposes to PBT for IT purpose. For this, pick up PBT from P&L and add back book depreciation and subtract IT depreciation.
- Any income which is exempted and/ or any expense in the books which is disallowed under IT Act must be adjusted at this stage while calculating the PBT for IT purpose. (For the sake of simplicity, we have assumed that there is no such income or expense in the case presented below.)
Step 2: Calculation of MAT
1. MAT liability is calculated by multiplying Income as per companies act with MAT Rate ( MAT Rate * (1+ Surcharge)*(1+ Education Cess)
Step 3: Calculation of Tax as per IT Act
1. PBT as per IT Act calculated in Step 1 above should now be adjusted for carry forward losses, if any. For doing so, we need to roll out a schedule for carry forward losses.
2. Carry Forward Losses schedule will have following components:
2A. Opening Balance = 0 for first year of operation and for the rest of the years it is equal to the carry forward loss of previous year.
2B. Addition during the Year = Loss made by the company in the current year and it will be zero if the company makes profit.
2C. Utilization during the Year = Loss Set Off.
2C.i. If the company is, making loss or if the carry forward loss opening balance is zero then the loss set off will be zero
2C.ii. If the company is making profit and the loss carry forward opening balance is greater than zero, then the loss set off is equal to the
2C.ii.1. Profit made by the company if the loss carry forward from previous year is greater than the profit
2C.ii.2. Carry forward loss opening balance, otherwise.
2D. Lapse at the end of year = losses carried from previous year that lapses after a fixed number of years if not set off
2E. Closing Balance = Opening balance + Addition during the year – Utilization during the year – Losses lapsed at the end of the year
3. Net PBT for calculating tax liability = PBT calculated in step 1 + Losses Utilization during the year calculated in point 2(c) above.
4. The Tax Liability as per Income Tax Act is calculated by applying Corporate Tax Rate on Net PBT calculated above. The Corporate Tax Rate should be inclusive of base rate, any surcharge and cess thereon.
Step 4: Calculation of Current Tax (This can’t be modeled in isolation; it has to be modeled along with MAT Credit Modeling explained in step 5)
- If MAT Liability is more than the payable Tax as per the IT Act, then current tax = MAT and MAT credit earned is the difference between the two. Accounting of MAT credit is explained in Step 5 below.
- If MAT Liability is less than the Tax Payable as per the IT ACT then the TAX Liability will be equal to the Tax payable as per the IT Act less the MAT credit available in that year. However, if this figure turns out to be lower than MAT liability, then Current Tax = MAT Liability. MAT credit utilized during the year will be adjusted. There will not be any MAT Credit earned for that year.
Step 5: Modeling MAT Credit (This can’t be modeled in isolation; it has to be modeled along with Calculation of Current Tax explained in step 4)
1. MAT Credit Modeling will have the following components:
a. Opening Balance = 0 for the first year of operation and for the following years it is equal to the carry forward loss of the previous year.
b. Addition During the Year = Current Tax calculated in step 4 in excess of Tax Liability as per IT Act if it is positive, otherwise 0.
c. Availed During the Year = Tax Liability as per IT Act in excess of Current Tax calculated in step 4 if it is positive, otherwise 0. MAT credit availed is the amount of Tax that has been set off against the MAT credit Carry forward from previous year.
Step 6: Modeling Deferred Tax Liability
1. Deferred Tax Liability for the year = Corporate Tax Rate x (IT Depreciation – Book Depreciation). This should appear in P&L below Current Tax and can take positive or negative values. This simply measures how much tax you ought to have paid this year as per your books less the tax calculated under IT Act on account of timing differences.
2. Deferred Tax Liability(net) = Accumulation of all the deferred tax liabilities till the current period, appears on the balance sheet.
1. MAT credit cannot be used if there if there is no MAT credit carry forward from previous year
2. MAT credit will be zero for all years where the tax payable as per IT Act is more than the MAT Liability
3. Current Tax should be at least equal to MAT Liability in all years. This simply strengthens the concept of Minimum Alternate Tax.
4. Please note that MAT Credit is not reflected anywhere on the balance sheet.
I am pretty sure that after reading so many plausible conditions, you must be desiring to work out an example. I am attaching a calculation below where I have modeled the taxes as per the discussion above or at least I have tried to do so. While modeling this, I have assumed that carry forward losses lapse at the end of 7th year if left unused. Choice of this period of 7 years allows me to show at least 2 instances of lapse in the model below. I might have run out of columns had I chosen a longer period and introduction of more columns would have distorted the aspect ratio of the screenshot making it illegible or unclear. Depending upon the nature/ type of losses, the lapse time frame may vary. In case there is no provision for lapse in your location, this line item should be deleted. Since, the concept of “lapse” is explained in this step, I have not complicated things by modeling lapse of MAT credit if left unused after 10 years.
If you have understood the various concepts thus far and also the example below, you will be able to model the lapse of MAT credits yourself.
I have highlighted column “J” and the formula for each of the cells in the column has been displayed in column N. Please note that figures for Book PBT, Book Depreciation and IT Depreciations had been assumed in a way such that I could display all the permutations and combinations of sign and magnitude of Book PBT and PBT for IT purposes.
I understand that mathematical or excel modeling of taxation is quite complicated and the example above should help. It may take you a series of errors and regression for correction purposes before the model sinks in. As stated at the beginning of the article, it took me at least 5 – 6 modeling assignments to get it correct.
Please share your thoughts and comments after going through the example. For any further clarifications, please start a discussion thread.
Please note that MAT Credit is not reflected anywhere on the balance sheet.