Tax Accounting Standards - Income Computation & Disclosure Standards (ICDS) Ameya Kunte – Taxsutra 30 April

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 Finance Act 2014 amended Sec 145(2) and (3) to include ICDS 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 2

ICDS Background Accounting scenario – ICAI has notified 32 accounting standards 39 - IND-AS (India’s effort to converge with International Financial Reporting Standard - IFRS !) December 2010 – Government committee to study harmonization accounting standards with Income Tax 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 3

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. No TAS in respect of 17 ICAI AS 4

ICDS Background March 2015 – 10 ICDS notified by the Government applicable from FY No ICDS for : Leases Intangible assets Events occurring after the End of Tax Year Prior Period Expense ICDS apply to all taxpayers following mercantile accounting system Notified ICDS 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

ICDS Concept ICDS relevant only for income computation No separate books of account necessary Minimum Alternate Tax (MAT) shall apply on book profits (as per GAAP) Income Tax Act to prevail where ICDS is in conflict SC judgment is law of the land Best judgment assessment u/s 144 if ICDS not followed 6

Simplification Committee on ICDS ! Simplification Committee – 1 st report of 15 Jan 2016 suggests deferment of ICDS Taxpayers grappling with regulatory changes of the Companies Act, 2013, Ind-AS and GST Industry should be allowed more time to deal with another change of this nature Taxpayers feel that many of the provisions of the ICDS are capable of generating a legal debate about which at present there is no clarity. Multiple accounting methods - for accounts and other for tax purposes, creates confusion, interpretation issues, multiplicity of records and additional compliance burden These outweigh gains to be obtained by ICDS application ICDS at best brings timing difference on recognition of income or expense Fuller study of ICDS implications necessary before it is implemented 7

High level impact areas Prescriptive approach No harmony sought in Accounting and Tax Delegated legislation on ICDS Immediate impact on tax cash flow No likely impact on EPS due to deferred tax 8

Analysis of ICDS 9

ICDS I - Accounting Policies Concept of prudence modified and Concept of materiality removed 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 Materiality - No likely significant tax impact - In absence of materiality concept, considerable time and cost will be involved making trivial adjustments in net profit as per books of accounts to arrive at PGBP since authorities may insist on strict application of ICDS even on small value items. 10

ICDS II - Valuation of inventory ICDS DEFINITION a “Inventories” are assets: i held for sale in the ordinary course of business; ii in the process of production for such sale; iii in the form of materials or supplies to be consumed in the production pro cess or in the rendering of services. AS 2 DEFINITION 3.1. Inventories are assets: (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services Most clauses in ICDS 2 and AS 2 are similarly worded.

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, minera l oils, ores & gases to the extent that they are measured at net realisable value; Machinery spares 12

ICDS II - Valuation of inventory Cost of Inventory shall comprise of cost of purchase, cost of services, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of purchase shall consist of purchase price including duties and taxes, freight inwards and other expenditure directly attributable to the acquisi tion. Trade discounts, rebates and other similar items shall be deducted in determining the costs of purchase. The costs of conversion shall include costs directly related to the units of production and a systematic allocation of fixed and variable production over heads that are incurred in converting materials into finished goods. The allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion shall be based on the normal capacity of the production facilities. 13

ICDS II - Valuation of inventory ICDS II permits FIFO and Weighted Average Cost formula for inventory valuation Retail method permitted in specified situations ICDS does not permit standard cost method for the purpose of inventory valuation Method of valuation once adopted shall not be changed without reasonable cause Inventory cost exclusions : Abnormal wastages Storage costs Administrative overheads Selling Costs 14

ICDS II – Service contracts Definition of inventory – does not include services ? Valuation of service inventory to be the lower of cost or NRV. The costs of services in the case of a service provider shall consist of l abour and other costs of personnel directly engaged in providing the service including supervisory personnel and attributable overheads AS- 2ICDS AS-2 does not include work in progress (WIP) arising in the ordinary course of business of service providers. Specifies that it does not apply to WIP which is dealt with by other ICDS.

Case Study 1 Zukerburg Pvt Limited is a software company engaged in providing customised software development services. The software development service contracts are on a “time and material” basis. As per the terms of the contract, billings for the services performed during the month is raised at the end of the month. Is there any impact post ICDS on inventory valuation? 16

Case Study 2 Sikkha Pvt Ltd is Software Company engaged in building software products. A Bank appoints Sikkha Pvt Ltd to develop a banking product. The contract is effective on Jan 1,2016 and is expected to be complete by July The development cost is Rs 10 crores. The contract envisaged advance payments from Bank to Sikkha Pvt Ltd. Accordingly, as at 31 March 2016, Sikkha Pvt Ltd received an advance of Rs 3 crores. Sikkha Pvt Ltd needs to complete the product within timeframe to complete its obligations under the contract. Sikkha Pvt Ltd has a team of 10 engineers working on this project with an estimate of 1000 an hours. Upto 31 March 2016, around 400 hours have been spent by the team. How should the service inventory be recognised as at 31 st March? 17

Case Study 3 Kalyani Contracting Services acts as a sub-contractor to Bajaj Auto Ltd. It received semi-finished scooters from Bajaj Auto for processing on March 25. The job work involves application of labour, machinery work and some components. The processing was complete on April 5 and finished goods were returned to Bajaj Auto. Kalyani Contracting Services raised an invoice for processing charges on April 5. How should the service inventory be recognised as at 31 st March? 18

ICDS II – Opening inventory issues Value of opening inventory should be same as preceding year’s closing inventory. Valuation – closing and opening conflict due to indirect taxes – Sec 145A Opening service inventory on April 1, 2015 In case of a newly commenced business, the value of the opening inventory shall be the cost of the inventory 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 If business is commenced with acquisition of running business on slump sale, price paid will be ‘cost’ of opening inventory 19

Sec 145A Method of accounting in certain cases. 145A. 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. 20

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. 21

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. 22

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. However, as per AS-29, provision is recognized when outflow of resources is “probable” and not when it is ‘reasonably certain’. Is “reasonably certain” same as “probable”? 23

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.” 24

ICDS X – Obligations & onerous contracts Provisions made on obligations recognized out of customary business practices or voluntary obligations may be disputed. e.g. informal refunds policy to dissatisfied customers, employee welfare, etc. Deduction for the accrued liabilities on onerous contracts in books will be allowed in a year in which liability to pay arises. AS 29ICDS Obligations may be legally enforceable and may also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. No specific guidance on meaning of ‘obligation’ Upfront recognition of liabilities under onerous contracts No clarity on onerous contracts 25

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. However, as per AS-29, contingent asset is recognized when inflow of resources is “virtually certain” and not when it is ‘reasonably certain’ Whether transitional provision requires recognition of all past accumulated contingent assets in first year i.e ? What does ICDS say ? – “All the provisions or assets and related income shall be recognised for the previous year commencing on or after 1 day of April, 2015 in accordance with the provisions of this standard after taking into account the amount recognised, if any, for the same for any previous year ending on or before 31st day of March, 2015.” 26

Thank you Ameya Kunte Executive Editor and Co-founder - Taxsutra Views are personal. 27