New CSR Regime – Is it a philanthropy or a tax levy?

The Ministry of Corporate Affairs (“MCA”), Govt of India, notified the amendments to Section 135 of the Companies Act, 2013 (“the Act”), (dealing with CSR contribution), by the Companies (Amendment) Act, 2019 (“2019 Amendment”), and the Companies (Amendment) Act, 2020 (“2020 Amendment”), on January 22, 2021. The MCA has also notified the Companies (CSR Policy) Amendment Rules, 2021 (“new CSR Rules”), which has made some fundamental changes to the CSR Rules, 2014.

Prior to the notification of the new CSR regime, Section 135 of the Act was based on the principle of ‘comply, or explain’ ‑‑ where a company could either spend the minimum CSR amount in accordance with Section 135(5) [2% of the average net profit of the three immediately preceding financial years], or disclose the reasons for failing to do so. The new regime has departed from ‘comply or explain’ and has made CSR a mandatory obligation of the company. The new regime has also imposed onerous obligations on the CSR Committee and the Board, and Section 135(7) now imposes stringent monetary penalties for non-compliance with the CSR mandate.

Despite making CSR mandatory, no amendments have been made to Section 37(1) of the Income Tax Act, 1961, which states that CSR expenditure is not tax deductible. Further, companies shall also have to provision for their CSR liability under Accounting Standard Ind AS 37 –  as and when they undertake their CSR activities during the financial year (“FY”).

CSR expenditure is not tax-deductible

Explanation 2 of Section 37(1) of the Income Tax Act states that – “For the removal of doubts, it is hereby declared that for the purposes of sub-section (1), any expenditure incurred by an assessee on the activities relating to corporate social responsibility referred to in section 135…..shall not be deemed to be an expenditure incurred by the assessee for the purposes of the business or profession”. This Explanation was inserted by the Finance Act, 2014, with effect from April 1, 2015.

Through Circular No. 01/2015[1], the Central Board of Direct Taxes (“CBDT”) clarified that as CSR expenditure “is not incurred for the purposes of carrying on business”, such expenditure cannot be allowed as a deduction. However, the CBDT Circular also stated that if the CSR expenditure falls within any of the categories of expenditure covered under Sections 30-36 of the Income Tax Act, it can be claimed as a deduction, subject to fulfilment of the conditions specified in Sections 30-36.

In this regard, the High-Level Committees on CSR (“HLC 2015” and “HLC 2019”)[2] observed that certain categories of CSR expenditure permitted under Schedule VII of the Act are eligible for deduction under various provisions of the Income Tax Act. For instance, Section 35CCC allows deductions on expenditure incurred on notified agricultural extension projects, and Section 80G allows deductions for donation to the National Children’s’ Fund.

The HLC 2019 observed that as only certain kinds of CSR expenditure are eligible for tax benefit, CSR funds may disproportionately flow to those activities which enjoy tax incentives. To avoid such distortions, the Committee recommended that all categories of CSR expenditure under Schedule VII of the Act should be made eligible for uniform tax deduction.

It is also pertinent to note that the rationale given in the CBDT Circular was under the ‘comply or explain’ regime. This rationale is no longer relevant today, as CSR is now a mandatory levy for every profit-making company. Companies should hence be allowed to deduct this legitimate expenditure from their taxable income.

Ind AS 37 – Provisioning of CSR liability during the FY

Ind AS 37 prescribes the Accounting Standard for “provisions, contingent liabilities, and contingent assets”. Appendix C of Ind AS 37 defines a “levy” as an “outflow of resources embodying economic benefits that is imposed by governments on entities in accordance with legislation”. This does not include:

  • Outflows of resources that are within the scope of other Accounting Standards.
  • Fines/penalties imposed for breaches of legislation.

Paragraph 10 of Ind AS 37 defines an “obligating event” as an “event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation”. It may be argued that CSR expenditure is a “levy” under Appendix C, as it is an outflow of resources in accordance with Section 135 of the Act. Further, Paragraph 17 provides that “a past event that leads to a present obligation is called an obligating event. For an event to be an obligating event, it is necessary that the entity has no realistic alternative to settling the obligation created by the event”.

Through an FAQ issued by the Accounting Standards Board (“ASB”) of the Institute of Chartered Accountants of India (“ICAI”), it has been clarified that the “obligating event” for the CSR liability shall arise as and when the CSR activities are undertaken during the FY. Hence, as the CSR liability shall accrue as and when the CSR budget is spent during the FY, companies shall not have to provision for the full CSR liability on the first day of the financial year. This implies that the CSR liability can be provisioned across four quarters, and companies need not provision for the full CSR liability in Q1.

Further, if the company has not spent the 2% CSR budget during the FY, another “obligating event” shall arise on the determination of the ‘unspent CSR amount’ at the end of the FY. This obligating event shall arise in both situations covered under Section 135 i.e. – (i) if the Unspent CSR amount relates to an “ongoing project” under Section 135(6), which mandates that the amount should be transferred to the “Unspent CSR Account” to be opened by the company; and (ii) If the unspent CSR amount does not relate to an “ongoing project”, and should accordingly be transferred to a Schedule VII Fund, in accordance with the second proviso to Section 135(5).

Practical Challenges

Transfer of capital assets ‘owned or acquired’ out of CSR funds

Under Rule 7(4), the CSR amount may be spent by the company for ‘creation or acquisition’ of a capital asset. The capital assets ‘created or acquired’ out of CSR funds cannot be held directly by the company. It can only be held by the entities prescribed under Rule 7(4)(a) to 7(4)(c), which includes a Section 8 company, registered public trust, a public authority, etc.

Under the proviso to Rule 7(4), any capital asset ‘created or acquired’ out of CSR funds, prior to January 22, 2021, should also be transferred to any of the entities prescribed under Rule 7(4). Rule 7(4) is accordingly applicable with retrospective effect, and has given rise to multiple practical difficulties:

  • The transfer of capital assets such as land and buildings will have stamp duty implications, which casts an additional financial burden on the company. The stamp duty and registration fees liability will vary, basis the location of such capital assets and the applicable stamp duty and registration fee provisions.
  • This provision will affect those companies which do not undertake their CSR activities through implementing partners. Such companies would not have executed arrangements with the implementing entities covered under Rule 7(4). As transfer of capital assets is mandatory, such companies will be forced to execute arrangements with the entities covered under Rule 7(4).

Further, it is a well-established rule that a delegated legislation can be applicable with retrospective effect, only if the parent statute authorises the same either expressly or by necessary implication.[3] Hence, Rule 7(4) can be made applicable with retrospective effect, only if the parent statute (i.e. Section 135 read with Section 469[4] of the Act) expressly, or by necessary implication authorises a retrospective operation. As Sections 135 and 469 do not expressly (or by necessary implication) authorise the enactment of retrospective subordinate legislation, it could be argued that the proviso to Rule 7(4) goes beyond the ambit of Sections 135 and 469, and is ultra vires the parent statute.

Creation of Unspent CSR Account

Under Section 135(6), the unspent CSR amount (for a particular FY), pursuant to an “ongoing project”[5], shall be transferred to an “Unspent CSR Account”, which is to be opened by the company. This provision has affected companies which disburse their CSR funds to implementing partners.

As the “Unspent CSR Account” cannot be opened by implementing partners, the company may be forced to claw back the unspent CSR amount from the implementing partner. Clawing back such funds becomes more difficult if the company has engaged multiple implementing partners or vendors.

CFO certification

Under Rule 4(5) – “The Board of a company shall satisfy itself that the funds so disbursed have been utilised for the purposes and in the manner as approved by it and the Chief Financial Officer or the person responsible for financial management shall certify to the effect”. This provision creates practical difficulties for companies that have engaged implementing partners, as the CFO has an obligation to ensure that the implementing partners have also utilised CSR funds in accordance with Board approvals.

In many situations, the implementing partners may engage multiple sub-partners and vendors for last-mile implementation of CSR activities. In such situations, the CFO will have an onerous responsibility of ensuring proper utilisation of funds at the last-mile. This provision may also require companies to amend the agreements executed with implementing partners and insert clauses which would grant the Board an absolute right to inspect the books of accounts and the CSR vouchers of the implementing partner.

Concluding Thoughts

Apart from casting onerous legal obligations on the company, the new CSR regime provides for the imposition of stringent monetary penalties for non-compliance with the CSR mandate. Under Section 135(7), stringent penalties can be imposed on the company, and every officer in default. Although Section 135(7) has been ‘decriminalised’, it is among the few provisions of the Act where the quantum of ‘penalty’ has not been significantly reduced.

Within a span of eight years, there has been a major departure from the original objective of CSR, which was envisaged to encourage corporate philanthropy. During the parliamentary debate on the Companies Bill, the then Minister for Corporate Affairs had given a categorical assurance to Parliament that CSR expenditure shall only be voluntary. With the notification of the new CSR regime, the CSR obligation is now akin to an additional tax liability imposed on companies.

Obligating companies to spend 2% of net profits on CSR, but not allowing tax deductibility of such legitimate expenditure is harsh and unfair to companies – particularly when such expenditure could be availed as a tax deduction under various provisions of the Income Tax Act, prior to the introduction of Section 135. The CSR obligation is applicable only when one carries on business through a company registered under the Act. Other forms of business organizations like partnerships, LLPs and sole proprietorships do not have to fulfill this obligation even if they have bumper profits. One could argue that this is arbitrary and unreasonable. It is doubtful whether this provision will pass the test of judicial scrutiny, if one were to challenge its constitutional validity under Article 14 and 19(1)(g) of the Constitution.

[1] Explanatory Notes to the provisions of the Finance Act, 2014, Central Board of Direct Taxes Circular No.       01/2015, issued on January 21, 2015.

[2] The MCA had set-two High Level Committees on to examine the CSR framework, in 2015 and 2019.

[3] State of Rajasthan v. Basant Agrotech (India) Limited, (2013) 15 SCC 1; Mahabir Vegetable Oils Private Limited v. State of Haryana, (2006) 3 SCC 620; M.D. University v. Jahan Singh, (2007) 5 SCC 77; State of Madhya Pradesh v. Tikamdas, (1975) 2 SCC 100.

[4] Under Section 469(1), the Central Government may, by notification, make rules for carrying out the provisions of this Act. Section 469(2) states as follows – “Without prejudice to the generality of the provisions of sub-section (1), the Central Government may make rules for all or any of the matters which by this Act are required to be, or may be, prescribed or in respect of which provision is to be or may be made by rules”.

[5] The term “ongoing project” defined under Rule 2(1)(i) of the CSR Rules (as amended on January 22, 2021). Under Rule 2(1)(i), – “Ongoing Project” means a multi-year project undertaken by a Company in fulfilment of its CSR obligation having timelines not exceeding three years excluding the financial year in which it was commenced, and shall include such project that was initially not approved as a multi-year project but whose duration has been extended beyond one year by the board based on reasonable justification.