DEFINITION OF CAPITAL PROFIT

Capital profit is any profit which is not a revenue profit. However this is an indicative/guiding definition which does not clarify as to what are the transactions results in to capital profit. To understand capital profit better, capital profit arises due to the following :

– an asset is sold for more than the cost,
– write back of certain capital receipts like loan received are no more payable and hence written back in the profit and loss account.
– upward revaluation of assets/downward revaluation of long term liability
– profit on forfeiture of shares.

The specific definition of capital profit is given in the Guidance note on terms used in Financial Statements issued by Institute of Chartered Accountants of India (‘ICAI’) which reads as under : –

Capital Profit – Excess of proceeds realized from the sale, transfer or exchange of the whole or a part of a capital asset over its cost. When the result of this computation is negative it is referred to as capital loss. 

The next question is what should be the accounting treatment of the capital profit in the books. There are two views, one transfer the same to capital reserves and second transfer the same to profit and loss account if permitted by accounting standards notified under the Companies Accounting Standard rules, 2000 (as amended) (‘Rules’). To understand the first view we need to know what is the definition of capital reserve?

Let us now explore the meaning of capital reserve. Capital reserve is the transfer of capital profit to reserve as mandated in certain cases by the regulation governing the entity. E.g. in case of redemption of preference shares an amount equal to face value of preference share capital is to be transferred from free reserve to capital redemption reserve (capital redemption reserve is type of capital reserve). There are certain other transactions where the capital profit is transferred directly to capital reserve without routing the same through the profit and loss account. However when we look at specific definition of the capital reserve the guidance can be drawn from the Guidance note on terms used in Financial Statements (‘GN’) issued by ICAI and part III of schedule VI of the Companies Act, 1956 which reads as under:

CAPITAL RESERVES AS PER GN
Capital Reserve – A reserve of a corporate enterprise which is not available for distribution as dividend. Capital reserve as per Part III of schedule VI of the Companies Act, 1956 gives the “interpretation”-of Capital reserve “the expression capital reserve shall not include an amount regarded as free for distribution through the profit and loss account.”

The implication of profit being capital in nature or revenue in nature can have far-reaching implications in terms of its impact on availability of profit for payment of managerial remuneration, its availability for distribution to the shareholders as dividend and its taxability. Hence the question of any profit being of capital in nature or revenue in nature and further its accounting treatment warrants special attention.
 

CONSIDERATION OF CAPITAL PROFIT WHILE CALCULATING THE PROFIT TO BE CONSIDERED FOR MANAGERIAL REMUNERATION
Under the Companies Act sub-section (3) of section 349 reads as under :

“In making the computation aforesaid, credit shall not be given for the following sums : –
(a) profits, by way of premium, on shares or debentures of the company, which are issued or sold by the company;
(b) profits on sales by the company of forfeited shares;
(c) profits of a capital nature including profits from the sale of the undertaking or any of the undertakings of the
company or of any part thereof,
(d) profits from the sale of any immovable property or fixed assets of a capital nature comprised in the undertaking or any of the undertakings of the company, unless the business of the company consists, whether wholly or partly, of buying and selling any such property or assets :

Provided that where the amount for which any fixed asset is sold exceeds the written-down value thereof referred to in section 350, credit shall be given for so much of the excess as is not higher than the difference between the original cost of that fixed asset and its written-down value.”

Thus the Companies Act very specifically states (through the above proviso) that the profit on sale of asset resulting in capital profit need to be deducted for computing the managerial remuneration. However one need to be very careful about the interpretation of capital profit here. As already explained, capital profit is the profit over the original cost which sometimes misinterpreted as the profit on sale of asset while calculating the managerial remuneration resulting in lower profit available for managerial remuneration. Following is an example explaining the concept of capital profit, revenue profit and profit of capital nature to be
 

deducted in calculating the managerial remuneration :

Original cost of an asset                                Rs. 100
WDV at the end of 6 years                           Rs. 40
                                                             Scenario 1                   Scenario 2
Sale proceeds at the end                            Rs. 120                       Rs. 80
of six years
Profit on sale of asset                                  Rs. 80                        Rs. 40
                                                          (Rs. 120-Rs. 40)            (Rs. 80-Rs. 40)
Capital profit incl in above                           Rs. 20                        Rs. Nil
profit                                                   (Rs. 120-Rs. 100)
Revenue profit                                             Rs. 60                        Rs. 40
Profit to be deducted for                              Rs. 20
arriving at the profit to be                          (and not Rs. 80)
considered for the
Managerial remuneration

AVAILABILITY OF PROFIT (CAPITAL PROFIT) FOR DISTRIBUTION AS DIVIDEND
Section 205 of the Companies Act deals with the profit available for dividend. It reads as under : No dividend shall be declared or paid by a company for any financial year except out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-section (2) or out of the profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with those provisions and remaining undistributed or out of both or out of moneys provided by the Central Government or a State Government for the payment of dividend in pursuance of a guarantee given by that Government :
 

Provided that –(a) if the company has not provided for depreciation for any previous financial year or years which falls or fall after the commencement of the Companies (Amendment) Act, 1960 it shall, before declaring or paying dividend for any financial year provide for such depreciation out of the profits of that financial year or out of the profits of any other previous financial year or years;
(b) if the company has incurred any loss in any previous financial year or years, which falls or fall after the commencement of the Companies (Amendment) Act, 1960 then, the amount of the loss or an amount which is equal to the amount provided for depreciation for that year or those years whichever is less, shall be set off against the profits of the company for the year for which dividend is proposed to be declared or paid or against the profits of the company for any previous financial year or years, arrived at in both cases after providing for deprecation in accordance with the provisions of subsection (2) or against both;
(c) the Central Government may, if it thinks necessary so to do in the public interest, allow any company to declare or pay dividend for any financial year out of the profits of the company for that year or any previous financial year or years without providing for depreciation :

Provided further that it shall not be necessary for a company to provide for depreciation as aforesaid where dividend for any financial year is declared or paid out of the profits of any previous financial year or years which falls or fall before the commencement of the Companies (Amendment) Act, 1960.

As dividend can be distributed from net profits of the current year after providing for aforementioned items including depreciation, we need to understand the meaning of profits for the year. Guidance can be drawn from Para 5 of Accounting Standard (‘AS’) 5. All items of income and expense which are recognised in a period should be included in the determination of net profit or loss for the period unless an Accounting Standard requires or permits otherwise. Anything which is credited to the profit and loss account of the current year is included in the profit for the year in terms of the definition given in the AS 5 issued by ICAI. Further, AS 10 (Accounting for fixed assets) vide para 14.3 provides that in historical cost financial statements, gains or losses arising on disposal are generally recognised in the profit and loss statement.

This clearly indicates that irrespective of whether the profit on disposal of assets is revenue or capital in nature the same has to be credited to profit and loss account. (In the example given in the table above in both scenario Rs 80 and Rs 40 will be credited to profit and loss account)

Now the question is, even though the above forms part of net profit for the year is there any restriction in the Companies Act which restrict the distribution of capital profit to shareholders? (like it does have for managerial remuneration as explained in the earlier section). The answer to that is, that the Companies Act is silent as to whether capital profit is distributable as dividend or not. However courts have adopted liberal view in this regard. In Lubbock v Bank of South America Ltd., the Court expressed the view that capital profit on sale of assets is distributable as dividend. However questions as to appreciation of value in assets is also capital profit and hence distributable as dividend has been discussed in various decisions and finally the same has been settled by concluding that the unrealized gain is not distributable as dividend. Hence though realized capital profit is distributable as dividend, the unrealized profit is not distributable as dividend.

Taxability
The dividend so declared will be exempt in the hands of recipient of the dividend. However the companies distributing the same will have to pay dividend distribution tax @15% plus surcharge.1 Further, under provisions of income tax sale proceeds have no connection to the taxability of profit due to block of asset concept which is being followed in the Income tax. (However the block of assets and related issues are not covered in this article but interested reader may refer section 32, 43 of Income-Tax Act, 1961.)

Another aspect which needs consideration of Indian companies going forward while revaluing their assets is as to whether the capital profit arising from such revaluation will be available or not for distribution to shareholders. The same will be considered for the purpose of calculation of Minimum alternate tax liability in terms of proposed DTC. As per proposed DTC, MAT will be calculated as 2% of total assets. This means that higher tax will have to be paid if the book assets are upward revalued though the same is not realized.

CONCLUSION
The capital profit can be classified in to realizable and non realizable profit. Non realizable capital profit can never be distributed as dividend to shareholders unless the same is realized. In respect of realizable capital profit if it is permitted to credit the same to the profit and loss account in the light of prevalent AS being notified under the Rules, the same can be distributed as dividend. For managerial remuneration computation, capital profit being explicitly excluded in terms of sec 349 from profit available for managerial remuneration the same will need to be excluded.

Notes:

1. Raised to 18 per cent vide Finance Act 2010 

(Published in Chartered Secretary October 2010 - ICSI)
Kevin Daftary, Manager, S.R. Batliboi & Co., Mumbai.