ICDS – Post Delhi High Court Decision

The Central Government (CG)
has notified 10 Income Computation and Disclosure Standards (ICDS) u/s. 145(2)
of the Income-tax Act (ITA). Section 145 of the ITA provides that the taxable
income of a taxpayer falling under the heads “Profits and Gains from Business
and Profession” (PGBP) or “Income from Other Sources” (IFOS) shall be computed
in accordance with either the cash or mercantile system of accounting,
whichever is regularly employed by the taxpayer. Section145(2) grants power to
the CG to prescribe the ICDS to be followed by any class of taxpayers or in
respect of any class of income. The notified ICDS are applicable from 1^st
April, 2016, (financial year 2016-17) to taxpayers following the mercantile
system of accounting and for the computation of income chargeable under the
heads PGBP or IFOS. They do not apply to taxpayers who are individuals or Hindu
Undivided Families, which are not liable for tax audit under the provisions of
the ITA.

A writ petition was filed
by The Chamber of Tax Consultants (Chamber) on the constitutional validity of
section 145(2) as also the validity of notified ICDS, to the extent they are in
conflict with the principles laid down in binding judicial precedents rendered
prior to ICDS. The Chamber urged that while section 145(2) of the ITA permits
the CG, as a delegate of the Legislature, to notify ICDS, it cannot be read as
granting unfettered powers to the CG, in the guise of delegated legislation, to
notify ICDS modifying the basis of taxation which can, if at all, be done only
by the Parliament by amending the ITA. The notified ICDS, to the extent they
seek to unsettle binding judicial precedents and modify the basis of
chargeability and computation of taxable income, are ultra vires the ITA
and the Constitution of India.

The Chamber further argued
that “the accounting standards (AS) issued by the ICAI were applicable to all
corporate entities and non-corporate entities following the mercantile system
of accounting. ICDS was applicable only to taxpayers following mercantile
system of accounting (i.e. to all assesses except individuals and HUFs whose
accounts are not required to be audited u/s. 44B of the Act). There was no
reasonable basis on which such differentiation or classification can be made
for the applicability of the ICDS, since the Assessee following the cash system
of accounting would escape from the implications and compliance requirements of
the ICDS. This is violative of Article 14 of the Constitution.”

The Delhi High Court (HC)
upheld the constitutional validity of section145(2), but struck down several
contentious provisions of individual ICDS. In a landmark ruling, the HC held
that ICDS cannot override binding judicial precedents or statutory provisions.
It held that the force of judicial precedents can be overridden only by a valid
law passed by the Parliament. Such power cannot be exercised by the Executive.
The provisions of ICDS, being a delegated legislation, have to be so read down
such that they do not modify the basis for computation of taxable income as
recognised by the provisions of the ITA or the binding judicial precedents laid
down by the Supreme Court (SC) or High Courts.

In the following
paragraphs, we discuss the provisions of individual ICDS that are struck down
by the HC.

ICDS I on Accounting Policies

–  ICDS I provides that expected or mark to
market (MTM) losses are not to be allowed as deduction, unless specifically
permitted by any other ICDS and, thus, does away with the concept of
“prudence”, which was present in the earlier Tax Accounting Standard (TAS) I.

–  The provision of ICDS I is contrary to the
settled judicial position. Many High Court rulings have recognised the
principle of ”prudence” by allowing deduction for provision for expected losses
on contracts recognised in the books of account by the taxpayer in compliance
with GAAP.

–  The ITA also grants deduction for revenue
expenses “laid out” or “expended” for the purpose of business in which the
concept of “prudence” is inherent.

–   The removal of the concept of prudence is
also not consistent with the prudence principles inherent in other ICDSs. A few
examples are given below.

•    Inventory
valuation at lower of cost and market price (ICDS II).

•    Provision
for expected losses on contracts in ICDS III, with the only modification that
the said loss will be allowed in proportion of completion of the contract,
rather than allowing the same for the unfinished portion of the contract. This
was primarily for bringing horizontal equity of treating the contract profit
and contract loss on the same principle.

•    The
principle of reasonable certainty is adopted for recognising revenue in ICDS
IV.

•    Provision
for the losses on forward cover transactions in the nature of hedging (except
to the extent the same pertains to highly probable transactions or firm
commitment) in ICDS VI.

•    Valuation
of inventory (of investments) under ICDS VIII at lower of cost and market price

•    Recognising
provisions for present obligation of future liabilities in ICDS X.

–  Accepting the above contentions, the HC held
that non-acceptance of the “prudence” concept is contrary to the ITA and,
hence, ICDS I is unsustainable to that extent.

–   It may be noted that the CBDT Circular (No 10
dated 23^rd March, 2017) provides horizontal equity by not taxing MTM
gains.

ICDS II on Valuation of Inventory

–   As per the settled judicial position, if the
business of a partnership firm continues after dissolution of the firm, then
the inventory has to be valued at lower of the cost and the market price. On
the other hand, if the business is discontinued on dissolution of the firm,
then the inventory has to be valued at market price.

–   ICDS II requires that inventory, as on the
date of dissolution of the firm, is to be valued at market price, irrespective
of continuance or discontinuance of the business. This leads to notional
taxation of income contrary to the judicial position.

–   Furthermore, there is a specific provision of
the ITA [section 145A], which provides that the inventory shall be valued as
per the method of accounting regularly employed by the taxpayer.

–   The HC held that: (a.) It is not permissible
for ICDS II to override the settled judicial position. (b.) Where the taxpayer
follows a certain method of accounting for valuation of inventory, the same
shall override ICDS II by virtue of the specific provision in the ITA. Thus,
the HC held that ICDS II is ultra vires the ITA and, to that extent, it
is struck down.

ICDS III on Construction Contracts –
Retention money

–  ICDS III provides that retention money should
form part of the contract revenue and taxed on the basis of percentage of
completion method (POCM). The CBDT Circular reiterates this position.

–  However, as per the settled judicial
position, retention money accrues to the taxpayer only when the defect
liability period is over and the Engineer-in-Charge certifies that no liability
is attached to the tax payer. Retention money cannot form part of the revenue
unless the same has accrued as “income” as per the charging provisions of the
ITA.

–   The HC held that taxation of retention money
would need to be seen on a case-to-case basis depending upon the contractual
terms, conditions attached to such amount and keeping in mind the settled tax
principles of accrual of income. ICDS III, to the extent it seeks to bring
retention money to tax at the earliest stage even when the receipt is uncertain
or conditional, is contrary to the settled position. Therefore, to that extent
ICDS III was struck down.

–   Whilst as per law, retention money is taxable
on completion of defect liability period, in practice, many companies prefer to
offer it for tax on its recognition in the accounts, which is much earlier than
completion of the defect liability period. This is done predominantly because
it is the method of accounting regularly followed by the tax payer (section
145) and to avoid any possible litigation. Since the item involves mere timing
difference, tax payers find it convenient to offer retention money for tax as
per accounts, and thereby avoid cumbersome offline calculation for tax
purposes. It also meets the Tax Officers’ intent of taxing it at the earliest
point of time. Therefore, the risks and consequences to the tax payer of
continuing with its existing practice is very limited.

ICDS III on Construction Contracts –
Incidental income

–   The SC, in the case of CIT vs. Bokaro
Steel Ltd., held that receipts which are inextricably linked to the setting
up of plant or machinery can be reduced from the cost of asset.

–   However,
ICDS III, read with the provisions of ICDS IX on Borrowing Cost, provides that
incidental income earned cannot be reduced from the borrowing cost forming part
of the cost of the asset.

–   The
HC held that, to the extent the provisions of ICDS III are contrary to the settled
judicial position, they are not sustainable.

ICDS IV on Revenue Recognition – Export
incentives

–   As
per the SC ruling in the case of CIT vs. Excel Industries Ltd., export
incentives are taxable only in the year in which the claim is accepted by the
Government, as the right to receive the payment accrues in favour of the
taxpayer when the corresponding obligation to pay arises for the Government.

–   However,
ICDS IV requires recognition of such income in the year of making claim if
there is a reasonable certainty of ultimate collection.

–   ICDS
IV, being contrary to the SC ruling, is ultra vires the ITA provisions
and, hence, struck down to that extent.

–  In
the case of Excel Industries, exports were made in Year 1, which
entitled the tax payer to duty free imports. The benefit arising to the tax
payer on exports was recognised in the books in Year 1 and duty free imports
were made in Year 2. In other words, from an accounting parlance, the incentive
was earned in Year 1 and utilised in Year 2. Taxpayer claimed that for tax
purposes, the benefit is taxable in Year 2 when there is corresponding
liability on Government to pay which was upheld by the SC. In more complicated
export incentives or Government grants, the taxability will depend upon facts
and circumstances and may not be straight-forward. As already explained in the
context of retention monies, most tax payers may be offering these incentives
for tax in the year in which it is accrued in the accounts.

ICDS IV on Revenue Recognition –
Completed contract method (CCM)

–   Accounting
principles (AS-9) permit the taxpayer with respect to service related contracts
to follow either CCM or POCM for revenue recognition. As per AS-9, the choice between CCM and POCM is
dependent on whether there is only a single act in performance of service
contract or more than one act. It may be noted that the AS are not binding on
all categories of assesses, firms, etc. Such assessees are free to
follow any method of accounting.

–   Judicial
precedents have recognised both methods as valid for tax purposes under the
mercantile system of accounting.

–   ICDS
IV, which only permits POCM, is contrary to the above judicial position and,
hence, liable to be struck down to that extent.

–   It
may be noted that with respect to construction contracts (not service contracts,
covered under AS-9), AS-7, permits only POCM. ICDS III on Construction
Contracts also allows only POCM. The HC did not strike down ICDS III, on this
account, probably because the POCM method is the only acceptable method
provided under AS-7 for construction contracts.

ICDS IV on Revenue Recognition – Interest
Income

–   The
Chamber contended that under ICDS IV, interest income on non-performing assets
(NPAs) of Non-banking Financial Companies (NBFCs) would become taxable on time
basis even though such interest is not recoverable.

–  The
HC noted that the CBDT Circular clarifies that while interest income is to be
taxed on time basis alone, bad debt deduction, if any, can be claimed under the
provisions of the ITA. Furthermore, the Parliament has inserted a specific
provision in the ITA to grant bad debt deduction for incomes recognised under
ICDS (without recognition in the books) in the year in which they become
irrecoverable.

–  The
HC held that this provision of ICDS IV cannot be held to be ultra vires
since a corresponding bad debt deduction can be claimed by the taxpayer if the
amount of interest is irrecoverable. Also, the Chamber has not demonstrated
that ICDS IV is contrary to any ruling of the SC or any other Court.

–  The
HC further observed that once interest income is offered to tax on time basis
by claiming corresponding bad debt deduction, if the amount is not recoverable,
ICDS creates a mechanism to track unrecognised interest amounts for future
taxability, if so accrued.

ICDS VI on Foreign Exchange Fluctuations

–   The
SC held, in the case of Sutlej Cotton Mills Ltd .vs. CIT, that exchange
fluctuation gain/loss in relation to loan utilised for acquiring a capital item
would be capital in nature.

–   ICDS
VI provides that exchange fluctuation loss/gain in case of foreign currency
derivatives held for trading or speculation purposes shall be allowed on actual
settlement, and not on MTM basis. The HC held that this is not consonant with
the ratio laid down by the SC in the Sutlej Cotton Mills ruling and,
therefore, struck it down.

–   The
CBDT Circular clarifies that the opening balance of Foreign Currency
Translation Reserve Account as on 1 April 2016 (i.e., on the date ICDS first
became applicable), which comprises of accumulated balance of exchange
fluctuation gains/losses in relation to non-integral foreign operations, is
taxable to the extent it relates to monetary items.

–   In
line with the SC decision in the case of Godhra Electric Supply Company Ltd
vs. CIT, the HC held that valuation of monetary assets and liabilities of
the foreign operations as at the end of the year cannot be treated as real
income as it is only in the nature of notional or hypothetical income which
cannot be subjected to tax.

ICDS VII on Government Grants

–   ICDS
VII provides that recognition of government grants cannot be postponed beyond
the date of actual receipt. This is in conflict with the accrual system of
accounting since, many times, conditions are attached to the receipt of
government grant which need to be fulfilled in the future. In such instance, it
cannot be said that there is any accrual of income although the money has been
received in advance.

–   Therefore,
the HC struck down ICDS VII to that extent.

ICDS VIII on Securities held as Inventory

–   ICDS
VIII provides for valuation of securities held as inventory and is divided into
two parts.

–   Part
B of ICDS VIII, which applies to banks and public financial institutions,
provides that recognition of securities should be in accordance with the RBI guidelines.

–   Part
A applies to taxpayers other than banks and public financial institutions. It
requires valuation of inventory on “bucket approach” i.e., category-wise
application of lower of cost and market instead of individual valuation of each
security. However, this is different from the normal accounting principles and,
thus, taxpayers will need to maintain separate records for tax purposes every
year.

–  The
HC held that Part A of ICDS VIII, which prescribes “bucket approach”, differs
from ICDS II on valuation of inventory which, under similar circumstances, does
not prescribe the ”bucket approach”. This shows that ICDS has adopted separate
approaches at different places for valuation of inventory. This change is not
possible without a corresponding amendment in the ITA. Hence, to that extent,
Part A of ICDS VIII is ultra vires the ITA.

Comparison between Indian GAAP, ICDS and Delhi HC Decision

The Road Ahead

The ICDS has far-reaching implications on tax
liability of assessees, which are debilitating. The introduction of Ind AS
should have been tax neutral, with minimal or no impact on tax liability. It is
unfortunate that Ind AS was used as an excuse to introduce ICDS that had severe
tax consequences on tax payers, which were mostly negative. The standards were
framed by a part time committee and that too in a great hurry. The ICDS
standards appear to be one sided, determined to maximise tax collection, rather
than routed in sound accounting principles. Such a backhanded and concealed
manner of bringing in an important piece of legislation, many of the provisions
of which were in conflict with the ITA or judicial precedents was deservedly
struck down by the HC. To the extent, the provisions were in conflict with the
ITA, the ICDS itself provided that those would prevail over ICDS. However,
there was no such exemption for ICDS provisions that were in conflict with
judicial precedents. The CBDT’s clarification in the Circular that ICDS shall
prevail over judicial precedents on ‘transactional issues’ was also highly
unsatisfactory.

There were also many interpretative
challenges that could have created a very litigious environment. Consider this;
the preamble of the ICDS states that where there is conflict between the
provisions of the ITA and ICDS, the provisions of the ITA shall prevail to that
extent. If a company has claimed mark-to-market losses on derivatives as
deductible expenditure u/s. 37(1) of the ITA – Can the company argue that this
is a deductible expenditure under the ITA (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?

Some of the transitional provisions in ICDS
had significant unanticipated effect. For example, the ICDS requires contingent
assets to be recognised 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 recognised such claims as income, since it
did not meet the virtual certainty test under AS 29 Provisions, Contingent
Liabilities and Contingent Assets. Under the transitional provision, it
will recognise all such claims in the first transition year 2016-17. If the
claim amounts are significant, the tax outflow could be devastating. 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.

The struck down ones of some contentious
provisions of ICDS by the HC is a huge relief to tax payers. It will not only
bring fairness and tax neutrality but will also avoid a litigious environment,
provided the HC decision is upheld by the SC and not contested by the
Government.

Taxpayers which have already filed returns
for tax year 2016-17 can explore revising their returns on the basis of the law
laid down by the present ruling. While there may be no difficulty in case of
the SC ruling which is binding on all lower Courts in India, there could be
difficulties in the case of a High Court ruling. A High Court ruling would be
binding on a lower judicial authority in the jurisdictional area of the High
Court. Whether a High Court ruling would bind lower judicial authority in other
jurisdictional areas is a highly contentious and debatable matter.

In this respect, different High Courts have
taken different views. If other High Courts step into this issue, the situation
can get very muddy and complicated, particularly if they take a conflicting
position from that taken by the Delhi HC. Therefore, it is natural to expect
that the CG may intervene, either by filing a special leave petition with the
SC for stay of the HC decision or alternatively, incorporating the ICDS as part
of the Act. _