Income Computation & Disclosure Standards Malad Goregaon CPE Stude Circle May 10, 2015 By: CA Shardul D Shah

Background The Indian Accounting Standards (Ind AS), the Indian version of International Financial Reporting Standards, will have significant impact on financial statements for many entities. Ind AS’s are meant to primarily serve the needs of investors and hence are not suitable for the purposes of tax computation. A clear need was felt for tax accounting standards that would guide the computation of taxable income.

Background The Central Government (CG) constituted a Committee in December 2010, to draft Income Computation and Disclosure Standards (ICDS). Section 145 of the Indian Income tax Act bestows the power to the CG to notify ICDS to be followed by specified class of taxpayers or in respect of specified class of income.

Background In August 2012, the Committee provided drafts of 14 standards which were released for public comments by the CG. After revisions, the CG has now notified 10 ICDS effective from the current tax year itself (viz. tax year ) for compliance by all taxpayers following mercantile system of accounting for the purposes of computation of income chargeable to income tax under the head “Profits and gains of business or profession” or “Income from other sources”.

Background Earlier, the CG had notified two standards in 1996 viz., (a.) Accounting Standard I, relating to disclosure of accounting policies. (b.) Accounting Standard II, relating to disclosure of prior period and extraordinary items and changes in accounting policies. They now stand superseded. These standards were largely comparable to the current AS corresponding to AS 1 & AS 5.

Background ICDS are meant for the normal tax computation. ICDS has no impact on minimum alternate tax (MAT) for corporate taxpayers which will continue to be based on “book profit” determined under current AS or Ind AS.

Background ICDS shall apply to all taxpayers whether corporate or otherwise. Further, there is no income or turnover criterion for applicability of ICDS. An entity need not maintain books of accounts to compute income under ICDS. However, if the differences between ICDS and Ind AS/current AS as the case may be are several, an entity may need to evolve a more sophisticated system of tracking them.

Background It is possible that the current tax audit requirements will be enhanced to require auditors to report on the correctness of tax computation under ICDS. Noncompliance of ICDS gives power to the Tax Authority to assess income on “best judgement” basis and also levy penalty on additions to returned income.

List of ICDS Following is the list of 10 ICDS notified w.e.f. 1 April 2015: 1. ICDS I relating to accounting policies 2. ICDS II relating to valuation of inventories 3. ICDS III relating to construction contracts 4. ICDS IV relating to revenue recognition 5. ICDS V relating to tangible fixed assets 6. ICDS VI relating to the effects of changes in foreign exchange rates 7. ICDS VII relating to government grants 8. ICDS VIII relating to securities 9. ICDS IX relating to borrowing costs 10. ICDS X relating to provisions, contingent liabilities and contingent assets

ICDS 1 – ACCOUNTING POLICIES Para 1 – This ICDS deals with significant accounting policies. (corresponds to para 1 of AS – 1 issued by ICAI. Para 2 – Corresponds to para 10 of AS-1 issued by ICAI. Para 3 – Corresponds to para 11 Para 4 - Corresponds to para 16 Para 4 (I,ii) & para 5 - Corresponds to para 17 (b)

ICDS 1 – ACCOUNTING POLICIES Para 6 – Corresponds to para 18 & para 24 of AS-1 issued by ICAI. Para 7 – Corresponds to para 22 & para 26 Para 8 – Corresponds to para 23 Para 9 – Corresponds to para 27

ICDS 2 – VALUATION OF INVENTORIES Para 1(a,b,c,d) – Corresponds to para 1 of AS-2 issued by ICAI. Para 1(e) corresponds to para 4 of AS-2 Para 2(1) - Corresponds to para 3. Para 2(1a) Corresponds to para 3.1, Para 2(1b) Corresponds to para 3.2. Para 2(2) no corresponding para in AS-2. Para 3 – Corresponds to para 5 Para 4 – Corresponds to para 6

ICDS 2 – VALUATION OF INVENTORIES Para 5 – Corresponds to para 7 Para 6 – no corresponding para in AS-2 Para 7 – corresponds to para 8 Para 8 – corresponds to para 9 Para 9 – corresponds to para 10 Para 10 – corresponds to para 11 Para 11 – corresponds to para 12 Para 12 – corresponds to para 13 Para 13 – corresponds to para 14 Para 14 & 15 corresponds to para 15 Para 16, 17 corresponds to para 16 & 17 Para 18 – corresponds to para 19 Para 19 – corresponds to para 21 Para 20 – corresponds to para 22 Para 21 – corresponds to para 24 Para 22,23,24,25 – corresponds to para 25 Para 26 – corresponds to para 26

ICDS 3 – CONSTRUCTION CONTRACTS Para 1 – corresponds to para 1of AS7- Construction Contracts issued by ICAI Para 2[1(a)(i)] corresponds to 2.1A & para 4 Para 2[1(b)] corresponds to 2.2A Para 2[1(c)] corresponds to 2.3A Para 2[1(d,e,f)] corresponds to para 40 Para 2(2) – no corresponding Para 3 – corresponds to para 3 Para 4 – corresponds to para 5 Para 5 – corresponds to para 6 Para 6 – corresponds to para 7 Para 7 – corresponds to para 8 Para 8 – corresponds to para 9 Para 9 – corresponds to para 11 Para 10 – corresponds to para 10 Para 11 – corresponds to para 27 Para 12 – corresponds to para 15, 16 Para 13 – corresponds to para 19 Para 14 – corresponds to para 20 Para 15 – corresponds to para 26 Para 16 – corresponds to para 21 Para 17 – corresponds to para 24

ICDS 3 – CONSTRUCTION CONTRACTS Para 18 – corresponds to para 29 Para 19 – corresponds to para 30 Para 20 – corresponds to para 32 Para 21 – corresponds to para 37 Para 22 – no corresponding para Para 23 – corresponds to para 38 Para 24 – corresponds to para 39

ICDS 4 – REVENUE RECOGNITION Para 1(1) – corresponds to para 1 of AS9 – Revenue Recognition issued by ICAI Para 1(2) – corresponds to para 2 Para 2(1) – corresponds to para 4 Para 2(1)(a) corresponds to para 4.1 Para 2(2) – no corresponding para Para 3 – corresponds to para 11 Para 4 – corresponds to para 9.1 and para 11(2) Para 5 – corresponds to para 9.2 and para 10

ICDS 4 – REVENUE RECOGNITION Para 6 – corresponds to para 7.1, para 12 Para 7 – corresponds to para 8.2 and para 13(i) Para 8 – corresponds to para 8.3 and para 13(ii) Para 9 – corresponds to para 8.4 and para 13(iii) Para 10, 11 – no corresponding para Para 12 – corresponds to para 14

ICDS 5 – TANGIBLE FIXED ASSETS Para 1 – corresponds to para 1 of AS-10 – Accounting for fixed assets issued by ICAI Para 2(i)(a) – corresponds to para 6.1 and para 18 Para 2(i)(b) – corresponds to para 6.2 Para 2(ii) – corresponds to para 6.3 and para 19 Para 3 – corresponds to para 8.1 Para 4 – corresponds to para 8.2 Para 5 – corresponds to para 9.1 Para 6 – corresponds to para 9.1 Para 7 – corresponds to para 9.2

ICDS 5 – TANGIBLE FIXED ASSETS Para 8 – corresponds to para 9.3 Para 9 - corresponds to para 10 and 21 Para 10 - corresponds to para 11.1 and 22 Para 11 - corresponds to para 11.2 Para 12 - corresponds to para 12.1 and 23 Para 13 - corresponds to para 12.2 Para 14 - corresponds to para 15.2 Para 15 - corresponds to para 15.3 and 35 Para 16, 17 – no corresponding para Para 18 - corresponds to para 14.1 and 25 Para 20 - corresponds to para

ICDS 6 – THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES Para 1 - corresponds to para 1 of AS11 – The effects of changes in foreign exchange rates Para 2 - corresponds to para 7 Para 3 - corresponds to para 9 Para 4 - corresponds to para 11 Para 5 - corresponds to para 13 Para 6 – no corresponding para Para corresponds to para 17 Para corresponds to para 20 Para 8 - corresponds to para 21 Para 9 corresponds to para 24 Para 10 corresponds to para 33 Para 11 corresponds to para 36 Para 12 – no corresponding para

ICDS 7 – GOVERNMENT GRANTS Para 1 - corresponds to para 1 of AS12 – Accounting for government grant issued by ICAI. Para 2 - corresponds to para 2 Para 3 - corresponds to para 3 Para 4(1) - corresponds to para 13 and para 6.1 Para 4(2) – no corresponding para Para 5 - corresponds to para 8.3 and 14 Para 6 - corresponds to para 8.4 and 14 Para 7 – no corresponding para Para 8 - corresponds to para 18 and 6.4 and 6.5 Para 9 - corresponds to para 15 and 9.1 Para 10 - corresponds to para 7.1 and 17 Para 11 - corresponds to para 11.2 and 21 Para 12 - corresponds to para 11.3 and 21 Para 13 – no corresponding para Para 14 - corresponds to para 12.1 and 23

ICDS 8 - Securities Para 1 - corresponds to para 1 of AS13 – Accounting for Investment issued by ICAI Para 2 - corresponds to para 2 Para 3 - corresponds to para 3 Para 4 - corresponds to para 9 Para 5 - corresponds to para 28 Para 6 - corresponds to para 10 and 29 Para 7 - corresponds to para 11 and 29 Para 8 - corresponds to para 12 Para 9 - corresponds to para 14 Para 10 - corresponds to para 15 and 31 Para 11,12,13 – no corresponding para

ICDS 9 – Borrowing Cost Para 1(1) – corresponds to para 1 of AS16 – Borrowing cost issued by ICAI Para 1(2) corresponds to para 2 Para 2(1)(a) - corresponds to para 3, 3.1 and para 4 Para 2(1)(b) - corresponds to para 3.2 and para 5 Para 2(2) – no corresponding para Para 3 - corresponds to para 6 Para 4 - corresponds to para 7 Para 5 - corresponds to para 10 Para 6 - corresponds to para 12

ICDS 9 – BORROWING COST Para 7 - corresponds to para 14 Para 8 - corresponds to para 19 and para 20 Para 9 - corresponds to para 21 Para 10 – no corresponding para Para 11 - corresponds to para 23

ICDS 10 – PROVISIONS, CONTINGENT LIABILITY AND CONTINGENT ASSETS Para 1 - corresponds to para 1 of AS29 – Provisions, contingent liabilities and contingent assets issued by ICAI Para 2 - corresponds to para 6 Para 3 - corresponds to para 7 Para 4 - corresponds to para 10 Para 5 - corresponds to para 14 Para 6 - corresponds to para 17

ICDS 10 – PROVISIONS, CONTINGENT LIABILITY AND CONTINGENT ASSETS Para 7 – corresponds to para 18 Para 8 - corresponds to para 21 Para 9 - corresponds to para 26 Para 10 - corresponds to para 30 Para 11 - corresponds to para 34 Para 12 - corresponds to para 35 Para 13 – no corresponding para Para 14 - corresponds to para 46 Para 15 - corresponds to para 50 Para 16 - corresponds to para 51

ICDS 10 – PROVISIONS, CONTINGENT LIABILITY AND CONTINGENT ASSETS Para 17 – corresponds to para 52 Para 18 – no corresponding para Para 19 - corresponds to para 53 Para 20 – no corresponding para Para 21(1) - corresponds to para 66 Para 21(2) - corresponds to para 67

Key differences between ICDS and current AS ICDS I prohibits recognition of expected losses or mark-to-market losses unless permitted by any other ICDS. During the early stages of a contract, where the outcome of the construction contract cannot be estimated reliably contract revenue is recognised only to the extent of costs incurred. This requirement is contained both in AS 7 and ICDS III. However, unlike AS 7, ICDS III states that the early stage of a contract shall not extend beyond 25 % of the stage of completion.

Key differences between ICDS and current AS AS 7 requires a provision to be made for the expected losses on onerous construction contract immediately on signing the contract. Under ICDS III, losses incurred on a contract shall be allowed only in proportion to the stage of completion. Future or anticipated losses shall not be allowed, unless such losses are actually incurred.

Key differences between ICDS and current AS Under AS 9 revenue from service transactions is recognized by following “percentage completion method” or “completed contract method”. Under ICDS IV only percentage of completion method is permitted.

Key differences between ICDS and current AS Under AS 11, all mark-to-market gains or losses on forward exchange or similar contracts entered into for trading or speculation contracts shall be recognized in P&L. In contrast, ICDS VI requires gains or losses to be recognized in income computation only on settlement.

Key differences between ICDS and current AS Under AS 11, exchange differences on a non- integral foreign operation are not recognized in the P&L, but accumulated in a foreign currency translation reserve. Such a foreign currency translation reserve is recycled to the P&L when the non-integral operation is disposed. Under ICDS VI, exchange differences on non-integral foreign operations shall also be included in the computation of income.

Key differences between ICDS and current AS Under AS 12, government grants in the nature of promoter’s contribution are equated to capital and hence are included in capital reserves in the balance sheet. Under ICDS VII government grants should either be treated as revenue receipt or should be reduced from the cost of fixed assets based on the purpose for which such grant or subsidy is given.

Key differences between ICDS and current AS Under AS 12 recognition of government grants shall be postponed even beyond the actual date of receipt when it is probable that conditions attached to the grant may not be fulfilled and the grant may have to be refunded to the government. Under ICDS VII, recognition of Government grants shall not be postponed beyond the date of actual receipt.

Key differences between ICDS and current AS Under AS 16 in the case of borrowings in foreign currency, borrowing costs include exchange differences to the extent they are treated as an adjustment to the interest cost. Under ICDS IX borrowing cost will not include exchange differences arising from foreign currency borrowings

Key differences between ICDS and current AS AS 16 requires the fulfillment of the criterion “substantial period of time” for treating an asset as qualifying asset for the purposes of capitalization of borrowing costs. ICDS IX retains substantial period condition (i.e. 12 months) only for qualifying assets in the nature of inventory but not for fixed assets and intangible assets. Therefore, ICDS requires capitalisation of borrowing costs for tangible and intangible assets even when they are completed in a short period.

Key differences between ICDS and current AS Under ICDS IX, capitalisation of specific borrowing cost shall commence from date of borrowing. Under AS 16, borrowing cost is capitalized from the date of borrowing provided the construction of the asset has started. Unlike AS 16, income on temporary investments of borrowed funds cannot be reduced from borrowing costs eligible for capitalization in ICDS IX. Unlike AS 16, requirement to suspend capitalization of borrowing costs during interruption of active construction of asset is removed in ICDS IX.

Key differences between ICDS and current AS Under ICDS X a contingent asset is recognized when the realization of related income is “reasonably certain”. Under AS 29 the criterion is “virtual certainty”.

Impact of ICDS The notification of ICDS was imperative to ensure smooth implementation of Ind AS, and therefore should have maintained a tax neutral position. Unfortunately ICDS are not tax neutral vis-à-vis the current Indian GAAP and tax practices currently followed and may give rise to litigation. For example, based on AS 7 Construction Contracts, the current practice is to recognise any expected loss on a construction contract as expense immediately. In contrast, ICDS will require expected losses to be provided for using the percentage of completion method.

Impact of ICDS ICDS I lays out the “accrual concept” as a fundamental accounting assumption. The prohibition on recognizing expected or mark-to-market losses appears to be inconsistent with the accrual concept. Though mark-to-market losses are not allowed to be recognized, there is no express prohibition on recognizing mark-to-market gains. The ICDS therefore appear to be one sided, determined to maximize tax collection, rather than routed in sound accounting principles. Matters such as these are likely to create litigious situations despite the Supreme Court decision in the Woodword Governor case where the status of ICDS is upheld.

Impact of ICDS The preamble of the ICDS states that where there is conflict between the provisions of the Income-tax Act, 1961 and ICDS, the provisions of the Act shall prevail to that extent. Consider that a company has claimed mark-to-market losses on derivatives as deductible expenditure under section 37(1) of the Income-tax Act. Can the company argue that this is a deductible expenditure under the Income-tax Act (though the matter may be sub judice) and hence should prevail over ICDS which prohibits mark-to-market losses to be considered as deductible expenditure?

Impact of ICDS Consider that a company receives a government subsidy for non-depreciable asset. Hitherto, it was accepted that it is a capital receipt not falling within the definition of ‘income’ and did not impact business income computation. Can the company argue that such receipt cannot be taxed in absence of amendment to definition of ‘income’ and hence should prevail over ICDS which requires such receipt to be recognized as income over the period of meeting related obligations? These are untested areas, and could be litigated.

Impact of ICDS All ICDS (except ICDS VIII relating to Securities) contain transitional provisions. These transitional provisions are designed to avoid double jeopardy. For example, if foreseeable loss on a contract is already recognized on a contract at 31 March 2015, those losses will not be allowed as a deduction again on a go forward basis using the percentage of completion method. On the other hand, if only a portion of the loss was recognized, the remaining foreseeable loss can be recognized using the percentage of completion method. The detail mechanism of how this will work is not clear from the ICDS.

Impact of ICDS The transitional provisions are not always absolutely clear. In the case of non-integral foreign operations, e.g., non-integral foreign branches, ICDS requires recognition of gains and losses in the P&L (tax computation), rather than accumulating them in a foreign currency translation reserve. It is not absolutely clear from the transitional provision whether the opening accumulated foreign currency translation reserve, which could be a gain or loss, will be ignored or recognised in the first transition year Since the amounts involved will be huge, particularly for many banks, the interpretation of this transitional provision will have a huge impact for those who have not already considered the same in their tax computation in past years.

Impact of ICDS Some of the transitional provisions are also expected to have a material unanticipated effect. For example, the ICDS requires contingent assets to be recognized based on reasonable certainty as compared to the existing norm of virtual certainty. Consider a company has filed several claims, where there is reasonable certainty that it would be awarded compensation. However, it has never recognized such claims as income, since it did not meet the virtual certainty test under AS 29. Under the transitional provision it will recognize all such claims in the first transition year If the amounts involved are material, the tax outflow will be material in the year This could negatively impact companies that have these claims. The interpretation of “reasonable certainty” and “virtual certainty” would also come under huge stress and debate. This may well be another potential area of uncertainty and litigation.

Impact of ICDS Taxpayers working on retainership basis or professionals would be worst hit, if they don’t follow cash basis of accounting. They have to compute their work in progress, which consists of cost of labour and staff, and appropriate overhead expenses, and offer that to tax. Besides, they have to make various disclosures, such as the method used to determine the stage of completion of service.

ICDS and TDS Ensuring proper credit for TDS in the year in which the relevant income is offered to tax. Tax is deducted in the year of credit or accrual, and credit for TDS is to be given in the year that the income is offered to tax. The tax department has still not been able to ensure a smooth and proper credit in cases where tax is deducted in one year and credit is to be given in another year. Innumerable rectification applications for such incorrect tax credit are pending.

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