Income Computation Disclosure Standards ICDS Ameya Kunte Taxsutra

Income Computation & Disclosure Standards (ICDS) Ameya Kunte – Taxsutra 5 th August 2017 WWW. TAXSUTRA. COM

Agenda • Evolution of ICDS • Important ICDS Concepts • CBDT’s FAQs • ICAI Technical Guide • Impact of ICDS on rulings • ICDS to presumptive taxation…and more • Analysis of ICDS 1, 2 and 10 WWW. TAXSUTRA. COM

Evolution of ICDS WWW. TAXSUTRA. COM

ICDS – Background • Section 145 of the Income Tax Act, 1961 gives power to Government to notify accounting standards to be followed by any class of taxpayers or in respect of any class of income • Two prescribed tax accounting standards notified since 1996 • Disclosure of Accounting Policies and • Disclosure of Prior Period and Extraordinary Items and Changes in Accounting Policies • December 2010 – Government committee to study harmonization AS with IT Act and • To suggest method for addressing MAT issue in transitional year of convergence to IFRS • To suggest appropriate amendments to the ITA in view of transition to Ind-AS regime WWW. TAXSUTRA. COM

2012 Draft TAS Report • August 2012 – 14 draft standards announced • Suitable amendments to IT Act to provide certainty on the following issues: • Depreciation on goodwill arising on amalgamation. • Allowability of the provision made for the payment of pension on retirement or termination of an employee. • Separate Tax Accounting Standards covering the areas not covered by ICAI AS • Share-based payment. • Revenue recognition by real estate developers. • Service concession arrangements (e. g. , BOT agreements). • Exploration for and evaluation of mineral resources. WWW. TAXSUTRA. COM

ICDS Background • March 2015 – 10 ICDS notified by the Government applicable from FY 2015 -16 • No ICDS on: • Leases • Intangible assets • Events occurring after the End of Tax Year • Prior Period Expense WWW. TAXSUTRA. COM 10 Notified ICDS I - Accounting Policies ICDS VI - Foreign exchange fluctuations ICDS II - Valuation of inventory ICDS VII - Government grants ICDS III - Construction Contracts ICDS VIII - Securities ICDS IV - Revenue recognition ICDS IX - Borrowing Cost ICDS V - Tangible fixed assets ICDS X – Provisions, Contingent liabilities and Contingent assets

Revised ICDS from AY 2017 -18 • September, 2016: Earlier notification dated March 31, 2015 rescinded • CBDT issued new notification for 10 ICDS, to be applicable from AY 2017 -18. • Changes introduced in 7 of the 10 ICDS in the revised notification • No changes in ICDS 1 (Accounting Policies), ICDS 7 (Government grants) and ICDS 10 (Provisions, contingent liabilities and contingent assets) • CBDT vide Circular No. 10 of 2017 has clarified vexed issues in ICDS notified u/s 145(2) by issuing 25 clarifications in the form of FAQs. WWW. TAXSUTRA. COM

Important ICDS Concepts WWW. TAXSUTRA. COM

ICDS – Key Aspects • ICDS apply to all taxpayers following mercantile accounting system • ICDS is 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. • FAQ 1 : CBDT clarifies that ICDS is not meant for maintenance of books of account or preparing financial statements (which is required to be done as per requirements of Companies Act 2013) and ICDS is to be applied only for computation of income. • ICDA applicable to trusts reporting business income (Para 14. 6 of ICAI Guidance Note) • Taxpayer following cash and mercantile system for different sources of income permissible – ICDS to apply only where mercantile system is followed (ICAI Guide Para 7. 7) WWW. TAXSUTRA. COM

ICDS – Key Aspects • Income Tax Act to prevail where ICDS is in conflict • The risk of best judgment assessment u/s 144 if positions adopted as per ICDS which is contrary to rulings. • For various purposes other than computation of income under two heads of income, provisions of ICDS would not apply. • For instance, ICDS would not apply for determining the time of credit of income for deduction of tax at source. (Para 14. 1) • However, in some cases, the ICDSs may indirectly apply to the applicability aspect of the TDS. (Para 14. 4) WWW. TAXSUTRA. COM

ICDS & Tax Rulings • ICDS and Tax Rulings • FAQ 2 : The ICDS have been notified after due deliberation and after examining judicial views for bringing certainty on the issues covered by it. Certain judicial pronouncements were pronounced in the absence of authoritative guidance on these issues under the Act for computing Income under the head “Profits and gains of business or profession” or Income from other sources. Since certainty is now provided by notifying ICDS under section 145(2), the provisions of ICDS shall be applicable to the transactional issues dealt therein in relation to assessment year 2017 -18 and subsequent assessment years. WWW. TAXSUTRA. COM

ICDS & Tax Rulings – ICAI Technical Guide (Para 15) Category 1 • 3 specific amendments by the Finance Act, 2015, to ensure that the provisions of the Act are in line with the provisions of ICDS. Eg subsidy or bad debts • ICDS read along with the amended Act, would override the earlier judicial rulings. WWW. TAXSUTRA. COM Category 2 • Judicial rulings which are based on the relevant GAAP • These judicial rulings would now have to be considered as being subject to the requirements of ICDS, Category 3 • Courts have laid down basic principles of taxation • Such rulings continue to apply and override ICDS. • See next slide…

ICDS & Tax Rulings View from ICAI Technical Guide on ICDS: 15. 6 For instance, various judicial rulings have propounded the real income theory. The Delhi High Court, in the case of CIT v Vasisth Chay Vyapar Ltd. [2011] 330 ITR 440 (Delhi) has held, based on the real income theory, thatinterest accrued on nonperforming assets of non-banking financial companies cannot be taxed until such time as such interest is actually received. Would the contrary provisions of ICDS IV on revenue recognition change the position? It would appear that the ruling will still continue to hold good even after the introduction of ICDS. WWW. TAXSUTRA. COM

Imp ICDS FAQs • FAQ 3 : . ICDS shall also apply to the persons computing income under the relevant presumptive taxation scheme (eg Sec 44 AD, 44 AE, 44 ADA, 44 BB, 44 BBA). • Example – partnership firm computing income under presumptive basis will need to apply ICDS on revenue recognition for determining receipts/turnover. • FAQ 4 : In a case of conflict between provisions of Income Tax Rules and ICDS, provisions of Rules (eg rules 9 A, 9 B dealing with film distributors), which deal with specific circumstances, shall prevail. • FAQ 5 : ICDS shall also apply to companies preparing its accounts under IND-AS. • FAQ 14: ICDS provisions would apply to computation of income on gross basis (e. g. interest, royalty etc. ) u/s 115 A. WWW. TAXSUTRA. COM

Imp ICDS FAQs • FAQ 6 : ICDS shall not apply to computation of Minimum Alternate Tax (MAT) under section 115 JB of the Act. CBDT however added that the provisions of ICDS shall apply for computation of AMT u/s 115 JC (as it is computed on adjusted total income which is derived by making specified adjustments to total income computed as per the regular provisions of the Act). • FAQ 7 : General provisions of ICDS shall apply to all persons (including for example Banks, Non-banking financial institutions, Insurance companies, Power sector) unless there are sector specific provisions contained in the ICDS or the Act. • FAQ 25 : Disclosures required under ICDS shall be made in the tax audit report in Form 3 CD and no separate disclosures are required for persons not liable to tax audit. WWW. TAXSUTRA. COM

Important Developments • FAQ 6 CBDT released draft ICDS on "Real Estate Transactions" for public consultation – ICDS not finalized yet. • Changes in draft ICDS vis-a-vis ICAI Guidance Note proposed in five areas viz. definition of project & project cost, revenue recognition, application of percentage of completion method (POCM) for real estate projects and transferable development rights (TDRs) • Draft ICDS proposes doing away with the condition of obtaining all 'critical approvals' for revenue recognition in view of the newly enacted RERA • Chamber of Tax Consultants (‘CTC’) has filed writ petition before Delhi HC challenging constitutional validity of ICDS • Hearing scheduled on Aug 28 WWW. TAXSUTRA. COM

Analysis of ICDS 1, 2 and 10 WWW. TAXSUTRA. COM

ICDS 1 – Accounting Policies • Prescription under ICDS 1 – Para 4 - Accounting policies adopted by a person shall be such so as to represent a true and fair view of the state of affairs and income of the business, profession or vocation. For this purpose, (i) the treatment and presentation of transactions and events shall be governed by their substance and not merely by the legal form; and (ii) marked to market loss or an expected loss shall not be recognised unless the recognition of such loss is in accordance with the provisions of any other Income Computation and Disclosure Standard. • ICAI Technical Guide: The term “accounting policies” in ICDS I should be read as “computation policies”. (Para 3. 6) WWW. TAXSUTRA. COM

ICDS I - Accounting Policies • Concept of ‘prudence’ modified and concept of ‘materiality’ removed • Expert Committee stated that “concept of materiality not recognised by the Income Tax Act” • ICDS prohibits marked to market or expected loss recognition • Exceptions - marked to market forex loss on monetary items, inventory valuation etc. • ICDS silent on MTM gains • FAQ 8 : Principles as contained in ICDS-I relating to marked to market (‘MTM’) losses or an expected loss shall apply mutatis mutandis to MTM gains or an expected profit. • No likely significant tax impact - In absence of materiality concept WWW. TAXSUTRA. COM

Double Whammy Year Loss Anticipated Income Computation Income Tax Remarks Books of Accounts 1 Expected loss = (5000) Anticipated Income = 1, 000 (5, 000) Foreseeable loss is not allowed as deduction in Year 1 as per ICDS but anticipated profit is taxed and thus tax is required to be paid as per Normal Provisions on 1, 000. 2 Actual loss = (5, 000) Actual Income = 1, 000 (5, 000) 1, 000 As per ICDS, the actual loss will now be allowed in year 2 and actual gain will be regarded as income in accounts. However, MAT will apply and tax is required to be paid as per the provisions of MAT. Deferred Tax Asset (DTA) / Deferred Tax Liability (DTL) as the case may be as per AS 22 would arise.

Transition Impact • Para 10 prescribes that all contracts or transactions entered into by the assessee on or after 1. 4. 2016 shall be in accordance with this ICDS. This recognition should be carried out after considering the income, expense or loss (if any) which have already been recognised on or before 31. 3. 2016. • Para 8. 2 of ICAI Technical Guide : • Migration from income computation under IT-AS 1 to ICDS could result in change of accounting policies such as ‘non-recognition of MTM losses’. Such change however should not impact the recognition of the MTM losses of earlier year. • a view is possible that recognition of losses relating to earlier years should remain intact, and would not result in a reversal of loss during the transitional year due to the transitional provisions. WWW. TAXSUTRA. COM

ICDS I - Accounting Policies • FAQ 10 - Derivatives which are not covered within the scope of ICDS – VI (which deal with accounting for derivative contracts such as forward contracts and other similar contracts), ICDS - I provisions would apply. • Examples – Commodity hedge WWW. TAXSUTRA. COM

ICDS II - Valuation of inventory • Inventories shall be valued at cost or net realizable value, whichever is lower • ICDS II permits FIFO and Weighted Average Cost formula for inventory valuation • Retail method permitted in specified situations • ICDS now permits standard cost method for the purpose of inventory valuation • Method of valuation once adopted shall not be changed without reasonable cause • FAQ 9 : Under the Act, 'reasonable cause' is an existing concept and has evolved well over a period of time conferring desired flexibility to the tax payer in deserving cases. WWW. TAXSUTRA. COM

ICDS II - Valuation of inventory • In case of newly commenced business, cost of inventory on day of commencement of business shall be opening inventory. • Valuation of opening inventory to be the same as closing inventory in preceding year – regardless of change in method of valuation of closing inventory. WWW. TAXSUTRA. COM

ICDS II - Valuation of inventory • Inventories shall be valued at cost or net realizable value, whichever is lower • NRV = estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. • NRV to be determined item – by- item basis • Exclusions from application of ICDS • WIP arising under ‘construction contract’ including directly related service contract • Shares, debentures and other financial instruments held as stock-in-trade • Producers’ inventories of livestock, agriculture and forest products, mineral oils, ores & gases to the extent that they are measured at net realisable value; • Machinery spares WWW. TAXSUTRA. COM

ICDS II – Service contracts AS- 2 ICDS • AS-2 does not include work in progress • Specifies that it does not apply to WIP (WIP) arising in the ordinary course of which is dealt with by other ICDS. business of service providers. • Cost of services – Para 6 of the recent ICDS notification: • The costs of services in the case of a service provider shall consist of labour and other costs of personnel directly engaged in providing the service including supervisory personnel and attributable overheads. • Inventories definition not been modified to cover WIP of service providers WWW. TAXSUTRA. COM

ICDS II – Service contracts Para 7. 7. of ICAI Technical Guide: Considering this, in case of service providers ICDS II will not have application and value of service not fully rendered need not be computed under this ICDS. This is also indicated by the scope of the ICDS, which excludes work-in-progress which is dealt with by other ICDS. WWW. TAXSUTRA. COM

ICDS II – Opening inventory issues • Valuation – closing and opening conflict due to indirect taxes – Sec 145 A • Opening service inventory on April 1, 2015 • Cases of conversion of capital asset into stock-in-trade with intent to commence business may remain unaffected due to overriding provisions of Section 45(2) of the Act • Para 13. 4 of ICAI Technical Guide – FMV on the date of conversion to be taken as inventory cost • If business is commenced with acquisition of running business on slump sale, price paid will be ‘cost’ of opening inventory WWW. TAXSUTRA. COM

Sec 145 A Method of accounting in certain cases. 145 A. Notwithstanding anything to the contrary contained in section 145, — (a ) the valuation of purchase and sale of goods and inventory for the purposes of determining the income chargeable under the head "Profits and gains of business or profession" shall be— (i) in accordance with the method of accounting regularly employed by the assessee; and (ii) further adjusted to include the amount of any tax, duty, cess or fee (by whatever name called) actually paid or incurred by the assessee to bring the goods to the place of its location and condition as on the date of valuation. Explanation. —For the purposes of this section*, any tax, duty, cess or fee (by whatever name called) under any law for the time being in force, shall include all such payment notwithstanding any right arising as a consequence to such payment; (b) interest received by an assessee on compensation or on enhanced compensation, as the case may be, shall be deemed to be the income of the year in which it is received. WWW. TAXSUTRA. COM

ICDS II – Valuation in dissolution cases • In case of dissolution of a partnership firm or association of person or body of individuals, notwithstanding whether business is discontinued or not, the inventory on the date of dissolution shall be valued at the net realizable value. • No specific provision for allowing such NRV as the cost to the successor of the business. • Also this is contrary to law settled by Apex court in the case of Sakthi Trading Co. v. CIT • Sakthi Trading (250 ITR 871) (SC) – Regular method of accounting to be followed, hence inventory to be valued at cost or NRV, which ever is lower WWW. TAXSUTRA. COM

ICDS – Inventory and borrowing costs • ICDS IX – Qualifying asset for ‘Borrowing Cost’ capitalisation purposes include inventories • Inventories – that require 12 months or more to bring them to saleable condition • Capitalisation means addition of borrowing cost to the cost of inventory (para 4) • Cessation of capitalisation for inventory - when substantially all activities necessary to prepare it for its intended sale are complete • Construction of qualifying asset is completed in part and a completed part is capable of being used while construction continues for the other parts , capitalisation of borrowing costs shall cease in relation to a part , when substantially all the activities to prepare such part of inventory for its intended sale are complete. WWW. TAXSUTRA. COM

ICDS X – Provisions, Contingent liabilities and Contingent assets • A provision should be recognized when – A person has a present obligation as a result of a past event; – It is “reasonably certain” that an outflow of resources embodying economic benefits will be required to settle the obligation; and – A reliable estimate can be made of the obligation amount. • ICDS - Para 12 – Amount of a provision cannot be discounted to its present value. • As per AS-29, provision is recognized when outflow of resources is “probable” and not when it is ‘reasonably certain’. • FAQ 25: Provisions of employee post retirement benefits which are otherwise covered by AS 15 (like provident fund, gratuity, etc. ) shall continue to be covered by specific provisions of the Act and shall not be dealt with by ICDS - X. WWW. TAXSUTRA. COM

ICDS X – Provisions • Provision for Warranty is allowed as an expenditure upholding the test of ‘probable’ warranty obligation in many judgments. • Rotork Controls India P. Ltd. (2009) 314 ITR 62 (SC) “A provision to qualify for recognition, there must be a present obligation arising from past events, settlement of which is expected to result in an outflow of resources and in respect of which a reliable estimate of amount of obligation is possible. ” “If historical trend indicates that in past large number of sophisticated goods were being manufactured and defects existed in some of items manufactured and sold, then provision made for warranty in respect of army of such sophisticated goods would be entitled to deduction from gross receipts under section 37(1), provided data is systematically maintained by assessee. ” Warranty provision deduction should be available under ICDS WWW. TAXSUTRA. COM

ICDS X – Obligations & onerous contracts • Provisions made on obligations recognized out of customary business practices or voluntary obligations may be disputed. • AS 29 ICDS Obligations may be legally No specific guidance enforceable and may also on meaning of arise from normal ‘obligation’ business practice, custom • e. g. informal refunds policy to dissatisfied and a desire to maintain customers, employee welfare, etc. good business relations or act in an equitable Deduction for the accrued liabilities manner. on onerous contracts in books will be allowed in a year in which liability to pay arises. WWW. TAXSUTRA. COM Upfront recognition of liabilities under onerous contracts Not applicable to “executory contracts”, but no clarity on onerous contracts

ICDS X –Contingent liabilities and assets • Contingent liability not to be recognized • Contingent asset must be assessed continually and if it becomes “reasonably certain” that inflow of economic benefit will arise, the asset and the income are recognized in previous year in which the change occurs. • As per AS-29, contingent asset is recognized when inflow of resources is “virtually certain” and not when it is ‘reasonably certain’ WWW. TAXSUTRA. COM

ICDS X – Transition • FAQ 23 - Paragraph 20 of ICDS X (Transitional Provision ) provides that all the provisions or assets and related income shall be recognized for the previous year commencing on or after April 1, 2016 in accordance with the provisions of ICDS X after taking into account the amount recognized, if any, for the same for any previous year ending on or before March 31, 2016. Explaining the intent of transitional provision CBDT stated that its aim is “that there is neither 'double taxation' of income due to application of ICDS nor there should be escape of any income due to application of ICDS from a particular date. ” WWW. TAXSUTRA. COM

Concluding comments • Prescriptive approach • No harmony sought in Accounting and Tax • Delegated legislation on ICDS • Immediate cash flow impact • No likely impact on EPS due to deferred tax WWW. TAXSUTRA. COM

Thank you Ameya Kunte Executive Editor and Co-founder - Taxsutra +91 9823038088 ameya. kunte@taxsutra. com Views are personal. WWW. TAXSUTRA. COM