In our previous article, we had covered the approach for formulation of the Tax Accounting Standards by the CBDT Committee (the Committee), final recommendations of the Committee and some of the important implications of the TAS around areas such as accounting policies, inventories, prior period expenses, construction contracts, revenue recognition and fixed assets. In this article, we will cover some other important areas which would be impacted and lead to different taxable incomes under the proposed TAS regime.
The effects of changes in foreign exchange rates
• Unlike AS 11, under TAS all foreign currency transactions will have to be recorded at the exchange rate prevalent on the date of the transactions. TAS eliminates the option for entities to recognise foreign currency transactions at an average rate for a week or month when the exchange rate does not fluctuate significantly. This may lead to practical challenges with no significant benefits in reporting.
• Unlike AS 11 wherein exchange differences on translation of non-integral foreign operations are required to be recorded in reserves i.e. foreign currency translation reserve account, TAS requires these exchange differences to be recognised in the profit and loss account as income or expense. This treatment appears to be based on the analysis that the Income Tax Act, 1961 (‘the Act’) does not distinguish between the tax treatment of incorporating the results of branches that may qualify as non-integral from those that qualify as integral. However, as per TAS, there is a measurement difference in quantification of impact of exchange differences between integral and non-integral foreign operation.
For instance, fixed assets and other non-monetary assets of non-integral foreign operations are measured at closing rates whereas such assets are not re-measured in case of integral operations. Prior to the TAS, where the foreign currency exposures on existing monetary items were hedged through options, any exchange loss on the foreign currency monetary item was claimed as a deduction, but any corresponding unrecognised gain on the option contract may have been ignored, if the company determined that such contracts were not directly covered by AS 11.
However, the TAS now includes foreign currency option contracts and other similar contracts within the ambit of forward exchange contracts. When these contracts are entered into for hedging recognised assets or liabilities, the premium or discount is amortised over the life of the contract and the spot exchange differences are recognised in the computation of taxable income. Although this treatment may not be in line with current accounting and tax practices, it brings in uniformity in the treatment of foreign currency options and forward contracts to the extent that they seek to hedge a recognised asset or liability.
• The premium, discount or exchange differences on all foreign currency derivatives that are intended for trading or speculation purposes or that are entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction are to be recognised only at the time of settlement of the contract. This is consistent with other provisions of the TAS to not recognise unrealised gains and losses.
• As per TAS, exchange differences on foreign currency borrowings, other than those specifically covered u/s. 43 A will be allowed as a deduction or will be taxed based on translation at the year-end spot rate.
Borrowing costs
• Unlike AS 16, TAS requires capitalisation of borrowing costs for all covered assets irrespective of the period of construction. The only exception to this rule is for inventories, where the TAS requires capitalisation of borrowing costs to inventories that require more than 12 months to complete. In comparison, AS 16 defines a qualifying asset as an asset that necessarily takes a substantial period of time (generally understood as 12 months) to be ready for its intended use or sale. This could result in significant practical challenges to compute capitalisation of borrowing costs in all such cases. Under the TAS, the actual overall borrowing cost (other than borrowing costs on loans taken specifically for a qualifying asset) is allocated to qualifying asset (other than those funded through specific borrowings) based on the ratio of their average carrying value to the average total assets of the company. It should be noted that, while this allocation approach may be simple to apply, it may result in unintended consequences.
For example, assume that construction on a qualifying asset commences on 2nd April and the asset is put to use on 30th March of a previous year. Under the proposed approach, since the qualifying asset is not under construction either on the first day or the last day of the previous year, the average cost may be determined to be Nil. This could result in no allocation of borrowing costs to such an asset.
• Under TAS, in the case of loans borrowed specifically for acquisition of qualifying asset, capitalisation of borrowing costs commences from the date on which the funds are borrowed. Whereas under AS 16, capitalisation of borrowing cost commences only if all three conditions are satisfied (a) expenditure on qualifying asset is being incurred (b) borrowing costs are being incurred and (c) activities that are necessary to prepare the asset for its intended use or sale are in progress.
• Currently, there is inconsistency in treatment of income from temporary deployment of unutilised funds from specific loans (to be considered as an adjustment to borrowing costs incurred or considered as a separate income). The TAS now provides that in case of specific loans, any income from temporary deployment of unutilised funds shall be treated as income. Along with the provision relating to capitalisation of borrowing costs on specific loans even in period prior to the construction activity, this may have a significant impact on the practices currently followed.
• TAS requires capitalisation of borrowing costs even if the active development is interrupted. Under AS 16, the capitalisation of borrowing cost is suspended during extended periods in which active development is interrupted. However, this provision in the TAS seems to clarify the requirements that already exist in the Act.
Leases
• Under the TAS, the lessor would not be entitled to depreciation on assets that are given on finance lease. TAS now provides that assets covered by a finance lease shall be capitalised and depreciated by the lessee like any other owned asset. Presently, the Act permits depreciation only on those assets that are owned by the assessee. As such, for a finance lease arrangement, it is generally the lessor that is entitled to the depreciation deduction and the lease rentals are taxed as income in the hands of the lessor. Since the Act overrides the TAS, suitable amendments may be required to the Act to facilitate this provision of the TAS.
• Similarly, assets given on finance lease by the manufacturer lessor would be considered as sold by lessor with a corresponding recognition of revenues and profits. The finance income component of the lease rental would be recognised as income over the lease term.
• The consequential impact of the above changes under various other provisions such as Tax Deduction at Source and benefits under Double Taxation Avoidance Agreements would need to be considered prior to implementation of the TAS.
• Under the TAS, same lease classification shall be made by the lessor and lessee for the lease transaction. A joint confirmation to that extent will have to be executed in a timely manner, in the absence of which the lessee would not be entitled to a depreciation deduction on such assets. It is currently unclear on whether the lessor would be eligible for a depreciation deduction in such cases.
• AS 19 requires a lease to be classified as a finance lease, if there is a transfer of substantial risks and rewards relating to the ownership of the leased asset. AS 19 accordingly provides several indicators for finance lease classification that have to be considered in totality based on the substance of the arrangement. These indicators do not necessarily individually result in classification as a finance lease. However, the TAS considers the existence of any one of the specified indicators as sufficient evidence for finance lease classification. This may result in a change in lease classification as compared to current practice, with a greater number of lease arrangements meeting the finance lease classification criteria.
• Under the TAS, the definition of minimum lease payment does not include residual value guaranteed by any party other than the lessee. This is to ensure that there is a uniform lease classification. Whereas under AS 19, in case of a lessor, the definition of minimum lease payment (which affects the lease classification into operating or finance lease) includes residual value guaranteed by the lessee or any other party. However, in case of the lessee, the definition of minimum lease payment includes only the residual value guaranteed by the lessee. This difference may at times result in different lease classification for lessor and lessee under AS 19.
• Unlike AS 19 where initial direct costs incurred in negotiating and arranging a lease can be recognised upfront or over time, under TAS the upfront recognition of initial direct cost for the lessor is not permitted. Prior to TAS, in the absence of specific guidance under the Act, the tax treatment was in line with the requirements of the accounting standards.
Intangible assets
• TAS excludes goodwill from its scope, whereas AS 26 includes goodwill arising on acquisition of a group of assets that constitute a business (for example, slump sale). In the absence of specific provisions in the TAS, the current practice in this area (that has emerged based on judicial pronouncements) may prevail.
• For internally developed intangible assets, TAS does not provide any guidance on scenarios, where the development phase of a project cannot be distinguished from the research phase. Hence, the assessee would need to establish clearly whether the costs relate to the research phase or the development phase. Unlike TAS, AS 26 provides that in case the development phase of a project cannot be distinguished from the research phase, then the entire costs are recognised as part of research phase and consequently charged as expense.
• Under the TAS, development costs cannot be expensed merely on grounds of uncertainty around the commercial feasibility. If other criteria for capitalisation are met, the same should be capitalised. Unlike TAS, AS 26 requires companies to establish commercial feasibility of the project for determining capitalisation of development costs.
• Under the TAS, in the case of acquisition of an intangible asset in exchange for another asset, shares or other securities, the actual cost shall be the lower of the fair market value of the asset acquired or the fair value of the asset given up/securities issued. Unlike TAS, AS 26 provides that in such cases, the fair value of the asset/securities given up or fair value of the asset acquired, whichever is more clearly evident, should be recorded as actual cost.
Provisions, contingent liabilities and contingent assets
• AS 29 provides for recognising losses on onerous executory contracts, when the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. TAS excludes all executory contracts, including onerous contracts, from its scope. Accordingly, such unavoidable future losses cannot be currently recognised under the TAS. This is consistent with the general provisions under the TAS, which preclude recognition of unrealised gains and losses.
• Under the TAS, provision is required to be recognised if its existence is reasonably certain. In comparison, AS 29 requires the recognition of a provision if its existence is considered probable (more likely than not). This change from ‘probable’ to ‘reasonably certain’ may result in new interpretation issues.
• Under AS 29, contingent assets are not recognised unless the virtual certainty criteria is met. This is a very high threshold and generally such assets are not recognised until realised. However, under TAS, contingent assets are recognised when it is reasonably certain that an inflow of economic benefits will arise. Thus, the provisions of the TAS may accelerate the recognition of contingent assets and related income. This provision seems to have been inserted to bring in parity between the treatment of provisions for contingencies and treatment of contingent assets.
Summary
The final report of the Committee along with the draft TAS, represents a significant move towards providing a uniform basis for computation of tax-able income. Many of the differences between the TAS and the AS are intended to harmonise the basis for computation of taxable profits with the existing provisions of the Act. Companies would therefore have a comprehensive framework based on which adjustments may be made each year to their accounting profits to determine taxable income.
Some of the provisions of the TAS also represent a significant change or clarification in the tax position as compared to currently prevailing practices. These are broadly intended to cover aspects that have historically been a subject matter of litigation and diversity. Depending on the practices currently followed, a company may be affected significantly by these changes.
The report also indicates that additional guidance would be provided through TAS where there is currently no guidance, including areas such as real estate accounting, service concessions, financial instruments, share based payments and exploration activities. This will further strengthen the TAS framework in the future.
The draft TAS will also remove one of the significant impediments to adoption of Ind AS, since the TAS provides an independent framework for computation of taxable income, regardless of the accounting framework adopted by companies (Indian GAAP or Ind AS). However, an important consideration for adoption of Ind AS is the impact it will have on computation of the Minimum Alternate Tax (MAT), which is based on the accounting profits. The Committee did not address this issue in its Final Report. The main reasons cited were the uncertainty around the implementation date for Ind AS as well as the forthcoming changes in IFRS. The Committee has recommended that transition to Ind AS should be closely monitored and appropriate amendments relating to MAT should be considered in the future based on these developments.
The real benefit of providing a uniform framework for computing taxable income will only be achieved through a uniform and impartial implementation of TAS by the tax authorities and the judiciary. The tax authorities may consider issuance of internal implementation guidelines and training to ensure that the TAS are correctly applied and implemented at the field level.
