Tax Accounting Standards - Income Computation & Disclosure Standards (ICDS)

1. Tax Accounting Standards - Income Computation & Disclosure Standards (ICDS) Ameya Kunte – Taxsutra 30 April 2016 www.taxsutra.com

2. 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 www.taxsutra.com

3. 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 www.taxsutra.com

4. 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 www.taxsutra.com

5. ICDS Background • March 2015 – 10 ICDS notified by the Government applicable from FY 2015-16 • 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 www.taxsutra.com

6. 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 www.taxsutra.com

7. Simplification Committee on ICDS ! • Simplification Committee – 1st 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 www.taxsutra.com

8. 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 www.taxsutra.com

9. Analysis of ICDS www.taxsutra.com

10. 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. www.taxsutra.com

11. ICDS II - Valuation of inventory 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. ICDS definition • a “Inventories” are assets:   • iheld 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  process or in the rendering of services.   Most clauses in ICDS 2 and AS 2 are similarly worded. www.taxsutra.com

12. 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’ includingdirectlyrelatedservicecontract • Shares, debentures and other financial instrumentsheld as stock-in-trade  • Producers’ inventories of livestock, agriculture and forest  products, mineraloils, ores& gases to the extent that they are measured at net realisablevalue;  • Machinery spares www.taxsutra.com

13. 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  acquisition. 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 overheads 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.  www.taxsutra.com

14. 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 www.taxsutra.com

15. 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  labour  and  other costs  of  personnel  directly  engaged  in  providing  the service including supervisory personnel and attributable overheads. www.taxsutra.com

16. 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? www.taxsutra.com

17. Case Study 2 • 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 2016. 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 31st March? www.taxsutra.com

18. 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 31st March? www.taxsutra.com

19. 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 www.taxsutra.com

20. 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. www.taxsutra.com

21. 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. www.taxsutra.com

22. 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

23. 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”? www.taxsutra.com

24. 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.” www.taxsutra.com

25. 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. www.taxsutra.com

26. 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. 2015-16? • 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.” www.taxsutra.com

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