In the road sector, the government is aggressively following the public-private partnership (PPP) model, in which the private developer would construct the highway on its own and recover the cost?and make a profit?by collecting toll from the users for a specified period. This arrangement is referred to as a concession arrangement. For private developers, a vital factor in evaluating any project is the certainty of a reasonable rate of return on their investment. The expected payback period, associated traffic risk, possibility of cost and time over- runs, income-tax liability and expected post-tax returns are key factors that guide the evaluation process.
The income-tax liability mostly depends on the treatment of various items of income and expenditure in the books of accounts. On this front, a typical concession arrangement involves many unanswered complexities and debatable issues, some of which would assume importance only in the future.
Here, a key accounting challenge is the unavailability of any specific accounting standard/ guideline. Though there are guidelines to account for construction contracts, a typical concession arrangement is materially different from a construction contract. In the absence of specific guidance, there is considerable subjectivity on the treatment of construction expenditure incurred by the developer. In such a scenario, the industry tends to take cues from accounting practices being followed overseas, which is largely based on the Guidance Note issued by the International Accounting Standards Board. The Guidance Note postulates that, in cases where the developer is entitled to collect toll from users of a highway, expenditure incurred in thje construction of the highway, plus a mark-up of reasonable profit margin, should be recorded as an asset in the books of the developer. This treatment is referred to as the fair market value of accounting.
However, such treatment assumes much significance in the light of existing and the proposed tax and regulatory structures in India. On the regulatory front, the method of accounting prescribed by the Guidance Note is at variance with the accounting norms prescribed by the statute. The accounting norms followed in India are based on the historical cost concept as opposed to the fair market value method. Also, the profit margin on construction varies with each project, depending on the scope and extent of work, the duration of project, terms and conditions of the contract and the like. The challenge is that each developer may estimate a different profit margin, leading to inconsistency in measurement of financial statements.
The apex regulator of accounting standards in India, the Institute of Chartered Accountants of India (ICAI), has issued an Exposure Draft on the accounting issues concerning a typical concession agreement. The guidelines prescribed in the Exposure Draft are similar to the Guidance Note issued by the International Accounting Standards Board. However, the Exposure Draft is under the process of finalisation for the last two years, and in the absence of any enforceable regulation, there is considerable ambiguity over treatment of construction expenditure. Some major road sector players have already applied the fair value method of accounting?which may be followed by other developers, too.
On the tax front, the fair market value method leads to recognising hypothetical income (to the tune of mark-up on the construction cost) on which the developer may be liable to pay an income tax?without actually earning that income. Such treatment also implies a notional increase in the cost of asset in the books of accounts as the asset is recognised at a higher value. Critically, this may result in a higher tax liability under the proposed Direct Taxes Code, which proposes to levy a minimum alternate tax (MAT) on the value of assets?higher asset value means higher tax outflow.
Further, there are diverse views on the treatment of such expenditure for income tax purposes. The expenditure can be subject to different depreciation rates, depending on its characterisation as a tangible or an intangible asset. The difference in tax liability in the two alternatives is likely to be substantial, given that the size of investment is usually huge and any variance in the depreciation rates makes a sizable difference in the ultimate tax outflow of the investor. The courts have held divergent views on this matter and it will be some time before a settled position is arrived at on the issue.
Availability of tax holiday is another factor impacting the business model. Although, the infrastructure sector, including the road sector, is said to enjoy ?tax holiday? for an initial 10 years, the income from such projects are subjected to MAT at about 20% of profits. Such tax liability on the book profits of the company may substantially dilute the tax holiday benefits.
The government has clarified that widening of highways would also be eligible for the tax holiday. However, such projects start generating toll revenue during the construction phase itself. Though the recent clarification is good news for the industry, treatment of toll received during the construction phase is, from accounting and tax perspective, still ambiguous and the availability of tax holiday on such income is also questionable.
A simple and unambiguous tax structure would go a long way in boosting investor confidence in the road sector, and all PPP projects the government may float in other sectors in the future.
The writer is a senior manager at BSR & Co