Companies Act 2013
Corporate social responsibility
- Companies act 2013: Corporate social responsibility
What the Companies Act 2013 states:
The 2013 Act requires that every company with net worth of`500 crore or more, or turnover of `1,000 crore or more or a net profit of `5 crore or more during any financial year will constitute a CSR committee.
The CSR Rules state that every company, which ceases to be a company covered under the above criteria for three consecutive financial years, will not be required to (a) constitute the CSR Committee, and (b) comply with other CSR related requirements, till the time it again meets the prescribed criteria.
Constitution of CSR committee
The 2013 Act requires a company, which meets the CSR applicability criteria, to constitute a CSR committee comprising three or more directors. The 2013 Act also states that outof these three directors, at least one director should be anindependent director.
The CSR Rules state that a non-listed public company or a private company, which is not required to appoint an independent director as per the 2013 Act/ Directors’Appointment Rules, can have its CSR Committee without an independent director. Also, a private company having only two directors on its board can constitute the CSR Committee with the two directors.
Some people argue that the CSR Rules are changing the requirements of the 2013 Act. Hence, an issue arises whether a subordinate legislation can override the main legislation. However, most people are likely to welcome the clarifications provided in the CSR Rules.
In accordance with the 2013 Act, the board of each company covered under the CSR requirement needs to ensure thatthe company spends, in every financial year, at least 2% of its average net profits made during the three immediately preceding financial years in pursuance of CSR policy. Neither the 2013 Act nor the CSR Rules prescribe any specific penal provision if a company fails to spend the 2% amount. However, the board, in its report, needs to specify the reasons for not spending the specified amount.
Section 135(1) of the 2013 Act, dealing with the applicability criteria for CSR requirements, refers to net worth/turnover/ net profit ‘during any financial year’. What is meant bythe phrase ‘during any financial year’? Does it require a company to consider its net worth/turnover/net profit for the immediately preceding financial year or the current financial year?
One view is that ‘financial year’ refers to completed period/year in respect of which the financial statements of a company are made-up. The supporters of this view refer the following:
- The definition of ‘net profit’ in the CSR Rules refers to net profit as per the financial statements.
- A proviso to the rule 3(1), dealing with CSR applicability to foreign companies, refers to net worth/turnover/net profit as per the balance sheet and P&L.
- A company cannot determine with certainty whether a criterion is met till the completion of a financial year. To illustrate, it may be possible that cumulative turnover ofa company breaches prescribed `1,000 crore limit at one point in time during the year. However, the position may change at a later date, say, due to significant sale return.
Thus, a company uses its financial statements for the immediately preceding financial year to determine CSR applicability.
The supporters of the second view emphasize on the use of the word ‘during’. They mention that dictionary meaning of the word ‘during’ is ‘throughout the course’ or ‘at one point within a period of time’3. Hence, this word is more connected with the concurrent evaluation or evaluation through-outthe period. Considering these arguments, the supportersof this view believe that a company considers its net worth/ turnover/net profit during the current year to determine CSR applicability. For example, none of the thresholds are currently met in the case of ABC Limited. They are likely to be met during the financial year 2015-16. ABC complies with the CSRrequirements as soon as it meets those criteria in 2015-16, and cannot delay it to 1 April 2016 and onwards.
A clarification from the MCA will help in settling this issue. Until such guidance or clarification is provided, our preferred approach is to apply the second view, i.e., a company considers its net worth/turnover/net profit during the current year to determine CSR applicability. Under this view, it may so happen that a company may meet the prescribed criteria toward the year-end. Thus, it may not be able to spend 2% of its average net profit on CSR activities during the current year. This may require the company to explain its factual position and reason for not spending in the board report.
Whilst two views seem possible for deciding the CSR applicability, the provisions for exit from the CSR requirements seem more clear. The rules state that a company can move out of CSR requirements only if the prescribed criteria are not met for three consecutive years.
Paragraph 3(1) of the CSR rules states as below:
“Every company including its holding or subsidiary, and a foreign company defined under clause (42) of section2 of the Act having its branch office or project office in India, which fulfils the criteria specified in sub-section (1) of section 135 of the Act shall comply with the provisions of section 135 of the Act and these rules.”
Does it mean that if a company is covered under the CSR requirements, its parent/subsidiary will also be automatically covered by the CSR requirements?
The reason for referring to holding/subsidiary company in the rule is not clear. Apparently, two views seem possible. The first view is that a parent/subsidiary company cannot claim exemption from the CSR applicability merely because itssubsidiary/parent company complies with the same. Although, the paragraph contains the phrase ‘including its holdingor subsidiary,’ it also states that ‘which fulfils the criteria specified in sub-section (1) section 135 of the 2013 Act’. Hence, each company in the group should evaluate whether it meets the prescribed criteria. If so, it will comply with the CSR requirements.
The second view is that if a company satisfies the prescribed criteria for CSR applicability, CSR requirements automatically become applicable to its holding and subsidiary companies. It does not matter whether they satisfy the prescribed criteria or not.
The former view seems a more plausible intention, which theMCA should confirm.
Do the CSR requirements also apply to the foreign companies, viz., Indian branch/project offices of foreign companies operating in India?
Neither section 135 of the 2013 Act nor sections 379 to 393 dealing with foreign companies nor the Foreign Companies Rules refer to applicability of the CSR requirements to foreign companies having Indian/branch project office.
However, paragraph 3(1) of the CSR Rules, as reproduced in the previous discussion, makes it clear that a foreign company having its branch/project office in India will comply with the CSR requirements, if the branch/project office fulfils the prescribed criteria.
Meaning of net profit
In accordance with section 135(1) of the 2013 Act, one of the criteria for the CSR applicability is that a company has a net profit of `5 crore or more during any financial year. The 2013Act does not specifically explain the meaning of net profit forthis purpose.
In accordance with section 135(5) of the 2013 Act, a company meeting the CSR applicability criteria needs to spend, in every financial year, at least 2% of its average net profits made during the three immediately preceding financial years, in pursuance of its CSR policy. An explanation to the section 135(5) states that for the purpose of this section,the average net profit will be calculated in accordance with section 198. Section 198 deals with calculation of profitfor managerial remuneration and requires specific addition/deduction to be made in the profit for the year.
In addition, CSR Rules define “net profit” as below. The CSR Rules do not refer whether the definition is relevant for the applicability criteria or CSR expenditure.
“’Net profit’ means the net profit of a company as per its financial statement prepared in accordance with the applicable provisions of the Act, but shall not include the following, namely:
- Any profit arising from any overseas branch or branches of the company, whether operated as a separate company or otherwise; and
- Any dividend received from other companies in India, which are covered under and complying with the provisions of section 135 of the Act.”
How should one resolve the above contradiction?
There may be two possible ways of looking at the definition of net profit in the CSR Rules. The first view is that the CSR Rules define net profit for the purposes of applicability as well as the amount to be spent on CSR activities. The supporters of this view argue that both under section 198 and the CSR Rules, starting point to make adjustments is net profit as per the financial statements. To reconcile two requirements, they believe that a company uses net profit as per the financial statements as starting point and make adjustment required under the CSR Rules to arrive at “net profit” under theCSR Rules. The company uses “net profit” so determined to make specific adjustments required under section 198. The supporters of this view argue that it better achieves the objective for which the term “net profit” was defined in theCSR Rules, i.e., a company can exclude dividends received from other companies covered under CSR from net profit so as to ensure that a group does not incur CSR expenditure on the same income twice. Also, it helps in ensuring that only income earned in India is subject to CSR expenditure.
The second view is that the CSR Rules define net profit in the context of the applicability criterion for CSR requirements. The amount that needs to be spent on CSR is based on the average net profitsdetermined in accordance with section 198. The supporters of this view believe that under section 198, debits and credits are allowed only for items specified in the section. If a company makes any debit/credit for any other item, including, items specified in the CSR Rules, net profit so determined is not as per section 198. Hence, if this view is taken, there will be no conflict between the 2013 Act and the CSR Rules. However, it implies that profit arising from overseas branches and dividend received from other Indian companies covered under the CSR requirement will not get excluded from the ‘average net profit’, for determining CSR spend.
It may be argued that the first view better reflects intention of including ‘net profit’ definition in the CSR Rules. Also, one may argue that it conforms to the harmonious interpretation of the 2013 Act and the CSR Rules. Hence, the first view ispreferred approach. However, this view is not beyond doubt and arguments can be made to support second views also. Sincethis is a legal matter, we suggest that a company consults the legal professionals before taking any final view on the matter.
CSR expenditure and its accounting
The 2013 Act requires the board of each company covered under the CSR to ensure that the company spends, in every financial year, at least 2% of its average net profits made during the three immediately preceding financial years in pursuance of its CSR policy. If a company fails to spend the2% amount, is there any legal/constructive obligation on companies to spend the shortfall in the subsequent years
Neither the 2013 Act nor the CSR Rules prescribe any specific penal provision if a company fails to spend the amount.Also, there does not appear to be any legal obligation on companies to make good short spend of one year in the subsequent years. This indicates that there is no legal obligation on companies to incur CSR expenditure. However, due to disclosure of short spend in the board report, many reputed companies can ill-afford not to spend the prescribed amount. Hence, the naming and shaming policy will create an implied pressure on companies to spend the requisite amount. Also, reputed companies, who have not been able to spend the requisite amount in one year, may try to spend the shortfall in subsequent years.
What is the appropriate accounting for CSR expenditure incurred? Is a company required to charge such amount asan expense to P&L? Alternatively, can a company take a view that CSR is not a mandatory expense and/or expense relating to business and therefore, it should be charged directly to equity?
The argument that CSR expense is a voluntary cost and/or expense not related to business does not appear to be tenable. A company needs to incur this expenditure under the governing law, viz., the 2013 Act. Non-incurrence of this expenditure may severely impact the reputation of a company.
Attention is drawn to paragraph 5 of AS 5 which states as below:
- “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.”
The Framework for the Preparation and Presentation of
Financial Statements defines the term “expense” as below:
- “Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.”
Considering the above, we believe that CSR expenditure is an item of expense for the company which needs to be charged to P&L. This approach may also support the company’s claim to a tax deduction.
Let us assume that a company has incurred lower amount on CSR activities in year 1. It expects to cover-up the short- spent amount in the subsequent years. Is the company required to create a provision toward such short-spent amount?
As discussed earlier, there is no legal obligation on a company to spend on CSR or cover for the shortfalls in the spend in subsequent years. It may so happen that a company does not spend the requisite amount, but discloses that it will cover the shortfalls in subsequent years, thereby creating a constructive obligation for itself.
Whilst there is no doubt that provision for constructive obligation is required under IFRS and Ind-AS; the answer to this question under Indian GAAP seems clear from the two EAC opinions. In both these opinions, the EAC seems to have taken a view that constructive obligation are not provided for. In the recent opinion published in The Chartered Accountant of July 2013, the EAC opined “Since as per Department of Public Enterprises Guidelines, there is no such obligation on the enterprise, provision should not be recognised. Accordingly, the committee is of the view that the requirement in the DPE Guidelines for creation of a CSR budget can be met through creation of a reserve as an appropriation of profits rather than creating a provision as per AS 29. On the basis of the above, the committee is of the view that in the extant case, it is not appropriate to recognise a provision in respect of unspent expenditure on CSR activities. However, a CSR reserve may be created as an appropriation of profits.”
Another opinion is contained in Volume 28, Query no 26. In this query EAC opined “A published environmental policy of the company by itself does not create a legal or contractual obligation. From the Facts of the Case and copies of documents furnished by the querist, it is not clear as to whether there is any legal or contractual obligation for afforestation, compensatory afforestation, soil conservation and reforestation towards forest land. In case there is any legal or contractual obligation, compensatory afforestation, felling of existing trees or even acquisition of land could be the obligating event depending on the provisions of law or the terms of the contract.”
Let us assume that a company incurs higher CSR expenditure during any financial year, say, 3% of its average net profit. Can it carry forward the benefit of higher expenditure and use the same to spend lower amount in the subsequent years?
Neither the 2013 Act nor CSR Rules provide any guidance on whether a company can carry forward the benefit of higher expenditure and use the same to spend lower amount in subsequent years.
Since there is no legal obligation for CSR expenditure in the first place, the question of carrying forward the benefit of higher expenditure in one year to spend lower amounts in subsequent years may not be so relevant. Also, from an accounting perspective, the excess expenditure may not meet the definition of an asset, exactly like the lower expenditure not meeting the definition of a liability. This requires a company to charge off the entire expenditure incurred during the year to its P&L.
Can a company incur capital expenditure on CSR related activities? If so, how such expenditure will be included in the 2% limit? Will the company include the entire amount in the year in which capital expenditure is incurred or only depreciation of the capital expenditure will be included in 2% limit for each year?
Paragraph 7 of the CSR Rules explains CSR expenditure in an inclusive manner. It states as below:
- “CSR expenditure shall include all expenditure including contribution to corpus, or on projects or programs relating to CSR activities approved by the Board on the recommendation of its CSR Committee, but does not include any expenditure on an item not in conformity or not in line with activities which fall within the purview of Schedule VII of the Act.”
Considering the above, one may argue that a company can incur both capital and revenue expenditure on CSR activities. However, no guidance is available on how capital expenditure will be included in the CSR limit. Many believe that if the contribution is made to a trust, then it does not matter whether the trust has spent it on capital assets or operating expenditure, and both would be counted in the 2% limit of the current year. However, if a company itself is incurring CSR expenditure, the capital assets will be owned by the company. Consequently, in such cases, one may argue that only depreciation on the capital asset will be counted as the CSR expenditure. Some income may be generated from use of the capital asset earmarked for CSR activity, say, fee collected from school run for poor children. The CSR Rules are clear that such income will not form part of the business profit for the company; rather, it needs to be incurred on CSR activities.
The MCA may consider clarifying this issue. Until such guidance is provided, it may be appropriate for a company to consult legal professionals before taking final view.
The rule 4(5) states that the CSR projects/programs/ activities, which benefit only the employees of a company and their families, will not be considered as CSR activity. Let us assume that a company is incurring expenditure on CSR activities which benefit both (i) general public, and (ii) employees of the company and their families. Will the expenditure on such activities be included in the 2% CSR expenditure limit?
A reading of the rule 4(5) indicates that employees of a company and their family should not be sole beneficiaries of the CSR activities being carried out by a company. However, it may be acceptable, if together with the general public, some employees also get benefit from the CSR activities of a company. In our view, to meet this requirement in substance, it needs to be ensured that employees and their families are not the most significant users.
To illustrate, assume that a company is operating a school for poor children. In the same school, children of some low paid workers of the company have also been granted admission. These children constitute 5-10% of the total school population. In this case, expenditure on running the school will qualify as the CSR activity. Consider another scenario. The company has a factory at a place which is very far from the city. To facilitate education for children of its employees, the company is operating a school near to its factory. In the school, the company has also granted admission to the children of some villagers staying close to the factory; however, the number of such children is relatively small, say, 5-10%. In this case, it may be difficult to argue that the expenditure qualifies as CSR expenditure.
A related issue arises in cases where a company is distributing its products at free of cost, purely as CSR activity. Let us assume that a pharmaceutical company distributes free medicine for treatment of poor people. It is also assumed that the activity qualifies as CSR under the 2013 Act read with the CSR Rules. The cost of production of medicine given free is `65 and their maximum selling price is `100. The 2013 Act or the CSR Rules do not provide any guidance on whether the cost or selling price of medicine should be included in the CSR expenditure. However, from common parlance perspective, it may be argued that actual cost is the expenditure incurred by a company and it may not include any opportunity cost. Hence, the preferred view is that actual cost of production (i.e., actual expenditure incurred) should be considered for this purpose and the amount spent by pharmaceutical company on CSR is `65
Let us assume that a company has created a trust to carry out its CSR activities. Should the company consolidate that trust under AS 21?
The ICAI has considered the issue regarding the consolidation of trust in the Guidance Note on Accounting for Employee Share-based Payment. The Guidance Note states that AS 21 requires consolidation of only those controlled entities which provide economic benefits to the company. Since an ESOP trust does not provide any economic benefit to the company in the form of return on the investment, it is not required be consolidated.
Typically, trusts created for CSR activities are independent and the company is not a beneficiary. One may argue that no economic benefits, in form of return on investment, flow back to the company. Hence, the CSR trust should not be consolidated.
A company makes payment to an implementation agency for carrying out CSR activities on its behalf. Should the company treat payment made to an implementation agency or actual expenditure incurred by the agency as CSR expenditure?
The implementation agency carries out the underlying activities on the company’s behalf. The rules require the CSR committee to monitor the activities of the agency. Further, the agency needs to provide periodic reports on the projects/activities undertaken and expenditure incurred to the company. These aspects suggest that any payment made by a company to the implementation agency does not discharge the company of its obligation. Rather, the agency is holding money on the company’s behalf and it needs to be ensured that the amount is actually spent on the stated purpose. Hence, one may argue that any amount paid by a company to the implementing agency is only an advance payment. It cannot be treated as CSR expenditure, until the expenditure is actually incurred by the agency.
How should a newly incorporated company comply with the requirement concerning 2% CSR expenditure? Let us assume that MNO Limited is incorporated during the financial year 2014-15. MNO met CSR applicability criteria in the first year of incorporation itself. How can MNO comply with the requirement concerning CSR expenditure @ 2% of average net profit for the three immediately preceding financial years?
Two views seem possible. The first view is that section 135(5) requires 2% of the average net profits made during three immediately preceding financial years to be spent on CSR activities. Since MNO was not in existence for the past three years and does not have profit/loss available for three preceding financial years, CSR expenditure requirement is not applicable to it. In other words, the CSR requirement for MNO will be met only after it has a history of three financial years.
The second view is that when a company is in existence for less than three years, the average of periods in existence should be considered. Just because the company is in existence for less than three years, does not make the requirement of CSR redundant.
It may be appropriate for the MCA to clarify this issue. Until such guidance or clarification is provided, one may argue that it is not necessary for a company to be in existence for 3 years to start incurring CSR expenditure. Hence, the second view seems to be the preferred approach.
Can a company incur expenditure on activities not covered under the Schedule VII and include the same in the 2% expenditure limit?
The CSR Rules are clear that only the expenditure incurred on activities mentioned in the Schedule VII is included in the 2% expenditure limit.
The requirements concerning CSR are applicable from 1 April 2014. For companies covered under the requirement, how does the requirement concerning 2% expenditure apply in the first year?
A reading of the 2013 Act and the CSR rules suggests that in the first year of application, a company covered under the requirement needs to incur 2% of its average net profit for past 3 years (i.e., financial year 2011-12, 2012-13 and 2013-14) on the CSR activities. Let us assume that a company covered under the CSR requirements has earned net profit of `50 crores, (`12 crores) (net loss) and `34 crores during the immediately preceding three years. In this case, the company’s average net profit is `24 crores i.e., one-third of (`50 crores - `12 crores + `34 crores). Hence, the company needs to spend 2% of its average net profit, i.e., 2% of `24 crores, on CSR activities.
For companies having other than 31 March year-end, an additional issue is whether they are required to apply the CSR requirements from 1 April 2014 or from the beginning of their next financial year. Will a company having 31 December year- end apply the requirement from 1 April 2014 or 1 January 2015 onward?
Interestingly, the CSR Rules state that reporting requirements of the 2013 Act will apply to financial years commencing on or after 1 April 2014. However, there is no such clear guidance on the constitution of CSR committee and/or CSR expenditure.
One view is that a company determines if it meets the thresholds specified in section 135(1) on a financial year basis. Once the applicability criteria is met, the company sets up a CSR committee and starts spending 2% of its average net profits determined in accordance with section 198 of the 2013 Act. Thus, a company with a calendar year end will examinethis requirement at 1 January 2015 and start spending for the calendar year 2015. Thus, it will not be required to spend on CSR for the year ended 31 December 2014.
The second view is that since the section is applicable from 1 April 2014, the intention is to make companies spend from that date onwards. The three years of average net profit for a calendar year company would comprise of calendar year 2011, 2012 and 2013.
The MCA may clarify this issue. Pending the issue of such guidance/clarification, it may be noted that CSR requirements of the 2013 Act are primarily driven by disclosure requirements. Since it is clear that disclosures will apply from the financial year beginning on or after 1 April 2014, it may be argued that other CSR requirements will also apply from the same date. Hence, view 1 is the preferred approach. This implies that a company, which has calendar year-end and meets the prescribed criteria, will apply CSR requirements from 1 January 2015 onward.