Income computation and disclosure standards – Impact on tax liability – Income Tax

Income computation and disclosure standards – Impact on tax liability :

Under section 145(1), income chargeable under the heads “Profits and gains of business or profession” or “Income from other sources” shall be computed in accordance with either the cash or mercantile system of accounting regularly employed by the assessee. Section 145(2) empowers the Central Government to notify in the Official Gazette from time to time, income computation and disclosure standards to be followed by any class of assessees or in respect of any class of income. Accordingly, the Central Government has, in exercise of the powers conferred under section 145(2), notified ten income computation and disclosure standards (ICDSs) to be followed by all assessees, following the mercantile system of accounting, for the purposes of computation of income chargeable to income-tax under the head “Profit and gains of business or profession” or “ Income from other sources”. This notification shall come into force with effect from 1st April, 2015, and shall accordingly apply to the A.Y. 2016-17 and subsequent assessment years.

All the notified ICDSs are applicable for computation of income chargeable under the head “Profits and gains of business or profession” or “Income from other sources” and not for the purpose of maintenance of books of accounts. In the case of conflict between the provisions of the Income‐ tax Act, 1961 and the notified ICDSs, the provisions of the Act shall prevail to that extent.

The salient features and text of ICDSs have been given as an Annexure to this chapter.

There are significant deviations between the notified ICDSs and Accounting Standards which are likely to have the effect of advancing the recognition of income or gains or postponing the recognition of expenditure or losses under tax laws and consequently, impacting the computation of tax liability under the Income-tax Act, 1961. These deviations would also increase the timing differences between taxable income and accounting income. Further, the ICDSs, at many places, differ significantly from decisions pronounced by the Supreme Court and High Courts. Some of the deviations are briefed hereunder:

ICDS I : Accounting Policies

(1) Non-consideration of the concepts of Prudence and Materiality ICDS I on Accounting Policies, while recognizing the fundamental accounting assumptions of going concern, consistency and accrual, does not recognize the concepts of “materiality” and “prudence” in selection and application of accounting policies.

The concept of prudence requires that provisions should be made for all known liabilities and losses even though the amount cannot be determined wi th certainty and represents only a best estimate in the light of available information. Non-consideration of prudence in selection and application of accounting policies may have the impact of earlier recognition of income and gains or later recognition of expenses or losses for tax computation.

Examples of non-consideration of prudence in the ICDSs:

(i) The requirement in ICDS VII on Government Grants that recognition of a Government grant shall not be postponed beyond the date of actual receipt, even if conditions attached to the grant are not fulfilled.

(ii) Absence of requirement of “reasonable certainty of ultimate collection” for recognition of revenue from service transactions and use of resources by others yielding interest, royalties and dividends in ICDS IV on Revenue Recognition.

(iii) Non-recognition of expected losses on construction contracts and contract costs, recovery of which is not probable, as an expense immediately, in ICDS III on Construction Contracts.

(iv) Non-recognition of provision for loss on onerous contracts.

(2) Requirement of “reasonable cause” for change in accounting policy AS 5 vis-à-vis ICDS I

AS 5 which deals with changes in accounting policies, permits change in accounting policies if adoption of different accounting policies is required by –

(a) statute; or

(b) for the purpose of compliance with an accounting standard; or

ICDS I, however, states that an accounting policy should not be changed without any ‘reasonable cause‘.

The term “reasonable cause” has not been defined and would involve exercise of judgement by management and tax authorities. A clarification as to the meaning and scope of “reasonable cause” would help avoid litigation.

ICDS II : Valuation of Inventories

(1) Standard cost method not recognized for measurement of cost of inventories AS 2 vis-à-vis ICDS II

The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs. Further, cost of inventories, other than such inventories, should be assigned using the First-in First-out or weighted average cost formula. The formula should reflect the fairest possible approximation to the cost incurred in bringing the items of inventory to their present location and condition. These requirements are the same in AS 2 and ICDS II on Valuation of Inventories.

However, whereas AS 2 permits standard cost method as one of the techniques for the measurement of the cost of inventories, for convenience if the results approximate the actual cost, there is no enabling clause or para in ICDS II permitting adoption of standard cost as a technique for measurement of the cost of inventories.

(2) Valuation of inventory on the date of dissolution of a firm, where the business is continued by a partner(s)

In case of dissolution of a partnership firm or association of persons or body of individuals, Paragraph 24 of ICDS II on Valuation of Inventories requires the inventory on the date of dissolution to be valued at the net realisable value, notwithstanding whether business is discontinued or not.

This requirement in ICDS II is in deviation from the Supreme Court ruling in Shakti Trading Co. vs. CIT (2001) 250 ITR 871, where it was held that if the firm is dissolved due to death of a partner and the surviving partners reconstitute the firm and continue the business as before, the firm is entitled to adopt cost or market price, whichever is lower.

ICDS III: Construction Contracts

(1) Point in time of recognition of expected loss on construction contracts AS 7 vis-à-vis ICDS III:

AS 7 permits recognition of expected loss on construction contract as well as contract costs, recovery of which is not probable, as an expense immediately. It also permits recognition of expected loss immediately as an expense, when it is probable that total contract costs will exceed total contract revenue.

The absence of specific requirement in ICDS III to recognize such expected losses on construction contracts immediately as expense represents a significant deviation from AS 7 as well as judicial rulings permitting immediate recognition of such losses as long as the same are in accordance with the accounting standard or justified by the principle of prudence or by the nature and circumstances of the contract.

By implication, such losses are also to be recognized on Percentage of Completion Method as per ICDS III. Consequently, recognition of losses for tax purposes is postponed.

(2) Treatment of penalties arising from delays caused by the contractor in completion of the contract AS 7 vis-à-vis ICDS III:

Paragraph 11 of AS 7 permits decrease in contract revenue as a result of penalties arising from delays caused by the contractor in the completion of the contract. However, ICDS III does not permit such reduction in contract revenue.

Non-recognition of decrease in contract revenue as a result of such penalties would have the effect of inflating the taxable income and consequent tax liability.

(3) Point in time of recognition of retention money AS 7 vis-à-vis ICDS III:

ICDS III requires retention money to be treated as part of contract revenue and recognized on percentage of completion method. As per paragraph 10 of ICDS III,
“Contract Revenue” shall comprise of the initial amount of revenue agreed in the contract, including retentions. However, as per paragraph 10 of AS 7, contract revenue should comprise the initial amount of revenue agreed in the contract. While there is a specific requirement in paragraph 10 of ICDS III to include retentions, there is no such requirement in paragraph 10 of AS 7.

Deviation from judicial precedents:

In CIT v. Associated Cables (P) Ltd. (2006) 286 ITR 596 (Bom.) and CIT v. Ignifluid Boilers (I) Ltd. (2006) 283 ITR 295 (Mad), it was held that the payment of retention money in the case of contract is dependent on satisfactory completion of contract work. The right to receive the retention money accrues only after the obligations under the contract are fulfilled and, therefore, it would not amount to income of the assessee in the year in which the amount is retained.

The requirement in ICDS III to recognize retention money on percentage of completion method marks a significant deviation from the decisions pronounced by the Courts.

ICDS IV: Revenue Recognition

(1) Revenue recognition in case of rendering of services and use by others of person’s resources yielding interest, dividend or royalty, where there is significant uncertainty as to collectability

AS 9 vis-à-vis ICDS IV:

AS 9 requires recognition of revenue only if no significant uncertainty exists regarding the amount of consideration that will be derived from sale of goods, rendering of services or use by others of enterprise resources yielding interest, royalties and dividends.

ICDS IV also requires revenue from sale of goods to be recognized when there is reasonable certainty of its ultimate collection. However, “reasonable certainty for ultimate collection” is not a criterion for recognition of revenue from rendering of services or use by others of person‘s resources yielding interest, royalties or dividends. By implication, revenue recognition cannot be postponed in case of uncertainty regarding collectability of consideration to be derived from rendering of services or use by others of person‘s resources yielding interest, dividend or royalty.

Deviation from judicial precedents:

In this regard, ICDS IV is also in deviation with the Supreme Court ruling in UCO Bank v. CIT (1999) 237 ITR 889, where it was held that interest on sticky loans would not accrue if the same was not recoverable and the Delhi High Court ruling in DIT v. Brahmaputra Capital Financial Services Ltd. (2011) 335 ITR 182 (Del.), where it was held that interest on non-performing assets which is not received with no possibility of recovery may not be recognized.

(2) Recognition of revenue from service transactions AS 9 vis-à-vis ICDS IV:

AS 9 permits revenue from service transactions to be recognised as the service is performed, either by the proportionate completion method or by the completed service contract method, whichever relates the revenue to the work accomplished.

ICDS IV requires revenue from service transactions to be recognised only on the basis of percentage completion method, which may, however, not be appropriate in case of all service transactions. For example, in case of courier services, revenue is recognized only when the goods are delivered at the specified destination.

Deviation from judicial precedent:

This requirement in ICDS IV is also not in line with the Madras High Court ruling in CIT v. Coral Electronics P Ltd. (2005) 274 ITR 336, where it was held that the amount received as service charges for services to be rendered in future could not be considered as an income and was not exigible to tax. It is only when the service is done, does the assessee have a right over the amount that was deposited. Till then, he has no right over the same. Hence, it cannot be considered as income of the assessee.

ICDS VI: Effects of changes in Foreign Exchange Rates

(1) Treatment of exchange differences in translation of financial statements of nonintegral foreign operations AS 11 vis-à-vis ICDS VI:

AS 11 requires the resulting exchange differences in translating the financial statements of a non-integral foreign operation to be accumulated in a foreign currency translation reserve until the disposal of the net investment.

ICDS VI on the other hand requires such exchange differences to be recognized as income or as expenses in that previous year.

It is noteworthy that the requirements in AS 11 and ICDS VI as regards translation of assets and liabilities and income and expenses items of the non-integral foreign operation in the financial statements are aligned. However, the treatment of resultant exchange differences are different. The requirement as per ICDS VI to recognize such exchange differences as income or expenses would result in volatility in tax liabilit y due to currency fluctuations.

ICDS VII: Government Grants

(1) Recognition of Government Grants AS 12 vis-à-vis ICDS VII:

AS 12 provides that Government Grants should not be recognized until there is a reasonable assurance that the enterprise will comply with the conditions attached to them and the grants will be received.

Paragraph 4(1) of ICDS VII also provides that Government Grants should not be recognized until there is a reasonable assurance that the enterprise will comply with the conditions attached to them and the grants will be received. This requirement is in line with AS 12. However, Paragraph 4(2) of ICDS VII goes on to provide that recognition of government grant shall not be postponed beyond the date of actual receipt.

Therefore, as per ICDS VII, initial recognition of government grants cannot be postponed beyond the date of actual receipt even in a case where all the recognition conditions in accordance with AS 12 are not met.

(2) Treatment of Government Grants of capital nature and Government Grants in the nature of promoter’s contribution AS 12 vis-à-vis ICDS VII:

AS 12 permits government grants in the nature of promoters‘ contribution, i.e., grants given with reference to the total investment in an undertaking or by way of contribution towards its total capital outlay (for example, central investment subsidy scheme) to be treated as capital reserve which can neither be distributed as dividend nor considered as deferred income.

ICDS VII, however, does not contain specific requirement to capitalize government grants in the nature of promoter‘s contribution. Except in case of government grant relating to a depreciable fixed asset, which has to be reduced from written down value or actual cost, all other grants have to be recognized as upfront income or as income over the periods necessary to match them with the related costs which they are intended to compensate.

Deviation from judicial precedent:

The requirement in ICDS VII to recognize such grants as upfront or deferred income is not in line with the rationale of the Supreme Court that the purpose of the grant would ultimately determine its nature. The Supreme Court in, CIT v Ponni Sugar Mills (2008) 306 ITR 392, observed that it is the object for which the subsidy/assistance is given which determines the nature of the incentive subsidy. If the object of the subsidy scheme was to enable the assessee to run the business more profitably then the receipt is on revenue account. On the other hand, if the object of the assistance under the subsidy scheme was to enable the assessee to set up a new unit or to expand the existing unit then the receipt of the subsidy was on capital account.

In line with the requirement in ICDS VII, new sub-cluase (xviii) has been inserted in the definition of income under section 2(24) to provide that assistance in the form of a subsidy or grant or cash incentive or duty drawback or waiver or concession or reimbursement, by whatever name called, by the Central Government or a State Government or any authority or body or agency in cash or kind to the assessee would be considered as income. It is only the subsidy or grant or reimbursement which has been taken into account for determination of the actual cost of the asset in accordance with Explanation 10 to section 43(1) which would not be considered as income.

ICDS VIII: Securities

(1) Manner of comparison of cost and NRV for valuation of securities held as stock-intrade

ICDS VIII requires securities held as stock-in-trade to be valued at lower of actual cost initially recognized or net realizable value at the end of the year, whichever is lower. Further, such comparison has to be done category-wise and not for each individual security.

Deviation from judicial precedents:

This requirement in the ICDS deviates from the judicial position that anticipated profit should not be taken into consideration for valuation of stock-in-trade. The Supreme Court, in the case of UCO Bank Ltd. v CIT 240 ITR 355, observed that it is not proper to take into account anticipated profit in the shape of appreciated value of closing stock, as no prudent trader would show increased profit before actual realization. This is the theory underlying the valuation of closing stock at the lower of cost or market price.

The requirement in ICDS VIII to compare the actual cost and net realizable value category-wise, in effect, results in recognition of anticipated profits since rise in value of some securities will absorb the decrease in value of the remaining securities in the same category.

(2) Valuation of unlisted or irregularly traded securities at actual cost initially recognized.

ICDS VIII requires valuation of the following securities at actual cost initially recognized –

(i) Securities not listed on a recognized stock exchange; or

(ii) Securities listed but not quoted on a recognized stock exchange with regularity from time to time.

This requirement in ICDS VIII to value such securities at cost would also impact computation of taxable income and consequent tax liability.

ICDS IX: Borrowing Costs

(1) Minimum period for classification of an asset as a qualifying asset AS 16 vis-à-vis ICDS IX:

As per AS 16, “qualifying asset” has been defined to mean an asset that necessarily takes a substantial period of time to get ready for its intended use or sale. AS 16 clarifies that ordinarily a period of 12 months is considered as substantial period of time unless a shorter or longer period can be justified on the basis of facts and circumstances of the case.

ICDS IX, however, does not provide any minimum period for treating an asset as a qualifying asset (except in the case of inventories). Consequently, borrowing costs in respect of assets have to be capitalized even if the asset, say, land or building or plant or machinery, does not take a substantial period of time to get ready for intended use.

(2) Treatment of income earned from temporary investment of borrowed funds AS 16 vis-à-vis ICDS IX:

Paragraph 11 of AS 16 permits income earned on temporary investment of borrowed funds pending their expenditure on the qualifying asset to be deducted from borrowing cost incurred. ICDS IX however, does not permit such reduction from borrowing costs.

This deviation between AS 16 and ICDS IX would result in increase in taxable income.

(3) Suspension of capitalization of borrowing costs AS 16 vis-à-vis ICDS IX:

Paragraph 17 of AS 16 permits suspension of capitalization of borrowing costs during extended periods in which active development is interrupted. ICDS IX does not permit suspension of capitalization of borrowing costs in such cases.

This deviation between AS 16 and ICDS IX would result in increase in taxable income.

ICDS X: Provisions, Contingent Liabilities & Contingent Assets

(1) Condition for recognition of Provision AS 29 vis-à-vis ICDS X:

AS 29 requires recognition of a provision when it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation.

ICDS X requires recognition of a provision only when it is reasonably certain that an outflow of resources embodying economic benefits will be required to settle the obligation.

The requirement of “reasonable certainty” in ICDS X to recognize a provision is more stringent as compared to the requirement of “probability” in AS 29. This will have the effect of postponing the recognition of provision for tax purposes and consequently, result in earlier payment of taxes.

(2) Condition for recognition of Contingent Asset AS 29 vis-à-vis ICDS X:

Both AS 29 and ICDS X provide that a contingent asset should not be recognized. Further, both AS 29 and ICDS X require contingent assets to be assessed continually.

Thereafter, recognition of contingent assets and related income is required in –

AS 29, if inflow of economic benefits is “virtually certain”;

ICDS X, if inflow of economic benefits is “reasonably certain”.

The requirement of “reasonable certainty” in ICDS X to recognize a contingent asset and the related income is more stringent as compared to the requirement of “virtual certainty” in AS 29. This deviation between AS 29 and ICDS X would have the effect of advancing recognition of income for tax purposes and consequently, result in earlier payment of taxes.

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