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In the recent past, the corporate sector has seen the much needed refinement of the accounting and tax frameworks, with Notification of several new accounting standards and pronouncements under Indian GAAP, Notification of 35 accounting standards (Ind AS) that are converged with IFRS, and discussions around introduction of the Direct Tax Code (DTC) and the Goods and Services Tax (GST).
While the changes in the accounting and tax frameworks will have a substantial impact on the Indian industry, there was a need for more clarity on the tax implications of the accounting adjustments pursuant to adoption of Ind AS. Further, one of the common criticisms for implementation of Ind AS has been that the differences in recognition and measurement principles between Ind AS and the tax frameworks would potentially lead to additional efforts of maintaining different accounting records — one for accounting purposes and the other for tax purposes.
Background to accounting standards for tax purposes
For the purpose of enabling more clarity on accounting treatment for certain transactions for tax purposes and to standardise the alternative accounting options as contained in the financial accounting standards, the Income-tax Act, 1961 (the Act) permits the Central Government to notify accounting standards that shall be mandatorily applied by the assessees for determining accounting income for income-tax purposes.
Since the introduction of these provisions, two accounting standards relating to disclosure of accounting policies and disclosure of prior period and extraordinary items and changes in accounting policies have been notified.
In 2003, a committee on formulation of accounting standards under the Act submitted its report, recommending that the accounting standards issued by the Institute of Chartered Accountants of India (ICAI) be notified under the Act. The recommendation acknowledged that it would be impractical for the assessee to maintain two sets of books of accounts (i.e., for financial reporting as well as for tax purposes) in case the accounting standards for tax purposes differed significantly from financial accounting standards.
However, the said recommendation could not be effected at that time as new financial accounting standards were evolving and some of the existing standards were under revision. Further, the tax authorities believed that the Notification of the accounting standards issued by ICAI under the Act would require extensive revision to the Act in order to avoid complexity and litigation.
Accounting standard committee
In December 2010, the Central Board of Direct Taxes (CBDT) constituted an Accounting Standard Committee (the Committee) comprising of officers from the Income-tax Department and other professionals. The terms of reference of this Committee were as follows:
(a) to study the harmonisation of accounting standards issued by the ICAI with the direct tax laws in India, and suggest accounting standards which need to be adopted u/s.145(2) of the Act along with the relevant modifications;
(b) to suggest method for determination of tax base (book profit) for the purpose of Minimum Alternate Tax (MAT) in case of companies migrating to IFRS (Ind AS) in the initial year of adoption and thereafter; and
(c) to suggest appropriate amendments to the Act in view of transition to IFRS (Ind AS) regime. On 17 October 2011, based on the recommendation of the Committee, the Ministry of Finance issued a Discussion Paper on Tax Accounting Standards. This paper discusses the key recommendations of the Committee on point (a) above.
Main recommendations of the Committee
(a) As the accounting standards to be notified under the Act are required to be in conformity with provisions of the Act, the standards notified by ICAI cannot be adopted without modification. Further, the accounting standards notified under the Act should also eliminate the alternative accounting treatment permitted by the ICAI standards in order to ensure uniformity;
(b) The accounting standards notified under the Act may be termed as Tax Accounting Standards (TAS); such TAS shall be applicable only to those assessees who follow mercantile system of accounting (rather than cash system of accounting);
(c) TAS are intended to be in harmony with the provisions of the Act. As such, in case of conflict, the provisions of the Act shall prevail over TAS;
(d) The starting point for computing the taxable income under the Act would be the income computed based on TAS, instead of net profit as per the financial statements;
(e) The assessee need not maintain separate books of accounts based on TAS. Instead, the assessee should prepare a reconciliation of income computed based on financial accounting standards and TAS.
If the recommendations in the Discussion Paper are eventually accepted and incorporated into the Act, income for tax purposes (to which a set of allowances and disallowances would be adjusted to derive taxable income) would be computed based on provisions of TAS, irrespective of the accounting standards followed for the preparation of the financial statements.
This would partially address the issue relating to the impact of transition of Ind AS on taxation, as taxes payable (other than MAT) would be computed based on TAS, irrespective of whether a company follows the currently applicable accounting standards or Ind AS.
Further, though taxpayers will not be required to maintain separate books of account as per TAS, they would need to maintain and present the reconciliation between the profits per the financial statements and per the provisions of TAS.
So far, the Ministry of Finance has also issued the Draft TAS on Construction Contracts and Government Grants for comments and suggestions. Draft of other TAS will also be issued at a later date.
Draft TAS on construction contracts
Though the draft TAS on construction contracts is substantially similar to Accounting Standard 7 (AS-7) on Construction Contracts, the following modifications merit consideration:
Uncertainty relating to ultimate collection
In line with paragraphs 21 and 22 to AS-7, the revenue from the construction contract cannot be recognised unless it is probable that the ultimate collection of the consideration shall be made from the customer. As such, the revenue recognition in such cases is postponed until such collection is probable.
The draft TAS does not seem to have directly incorporated the above principles, thereby leading to an interpretation that contract revenue to be recognised based on percentage of completion method, even if the ultimate collection is not probable. As such, the company needs to recognise revenue even if at inception the collection does not seem probable, and subsequently write off the receivables as bad debts. This modification may lead to higher income for taxation purposes and may lead to higher income taxes in the initial phase of the contract as compared to the current practice.
Provision for loss-making contracts
AS-7 and Ind AS-11 requires that on construction contracts where the total contract costs exceed the total contract revenue, a provision for such loss should be made immediately. The draft TAS has not incorporated the said requirement of recognising a provision for the said loss immediately. As such, while computing income based on provisions of TAS, such provision for expected losses is not permitted for recognition. Consequently, the income computed based on TAS may be higher than that reported in the financial statements. However, one needs to watch the development of TAS equivalent to Ind AS-37 and AS-29 on Provisions, Contingent Liabilities and Contingent Assets closely, as Ind AS-37 and AS-29 require a provision for onerous contracts for an amount equivalent to lower of the expected loss in case of fulfilment and penalties in case of termination.
Method of computing the stage of completionAS-7 and Ind AS-11 do not require any particular method for the purpose of computing the stage of completion of the construction contract, but prescribes an illustrative list of the following methods:
(a) the proportion that contract costs incurred for work performed up to the reporting date bear to the estimated total contract costs; or
(b) surveys of work performed; or
(c) completion of a physical proportion of the contract work.
As such, for accounting purposes, the company could follow any of the above methods or any other method if that would lead to more reliable computation of stage of completion.
However, the draft TAS seems to have restricted the alternatives to the ones mentioned above and does not provide flexibility to adopt any other method. As such, modification is more in line with the objective of the committee to eliminate the alternate accounting practices permitted under the financial accounting standards.
Even though TAS permits non-recognition of margins during the early stages of a contract, it prohibits such deferral if the stage of completion exceeds twenty-five percent. Varied practices are currently prevailing on the point of time from which margin is recognised by different companies. This will be aligned under TAS to some extent.
Incidental income to be reduced from costs
AS-7 requires the contract costs be reduced by any incidental income that is not included in contract revenue. The draft TAS clarifies that such incidental income cannot be in the nature of interest, dividends or capital gains.
Need for some more clarity on draft TAS on construction contracts
(A) Combining and segmenting contracts
The draft TAS on construction contracts has retained the guidance on combining and segmenting contracts that requires the assessee, based on the substance of the arrangement, to:
(i) combine two or more contracts, or
(ii) split one contract into multiple components.
Based on the current draft, two specific areas within the combining and segmenting contracts that may require more clarity includes allocation of consideration to identified components within an arrangement and whether the said principles on combining and segmenting contracts shall also extend to accounting for arrangements that are not construction contracts, and commonly referred to as linked transactions and multiple element arrangements.
(a) Allocation of consideration to components
In cases where a single contract is required to be split into components, the draft TAS does not clarify a methodology for such allocation of consideration under a single contract into components.
On adoption of Ind AS, the companies generally allocate the consideration to each component based on either residual method (where the fair value of undelivered components is deferred and residual consideration is allocated to delivered components) or relative fair value method (where the consideration is allocated to each component in the ratio of their fair values). This has not been specifically addressed in TAS.
(b) Extension of principles to arrangements that are not construction contracts
The principles of combining and segmenting contracts are sometimes applied in case of arrangements that may not be a construction contract, but the commercial substance may be established by either combining or segmenting the contract(s) and are commonly referred to as linked transactions or multiple element arrangements, respectively. This may be further clarified in the corresponding TAS of AS-9 or Ind AS-18 on revenue recognition.
As a general principle based on current practices, the taxes are usually levied based on contractually agreed prices for the agreed deliverables and there may not be any need for allocation or aggregation of sale consideration for tax purposes.
(B) Discounting of retention money as per Ind AS
As TAS is based on AS-7, the new concepts in Ind AS that may impact accounting for construction contracts (for example, discounting of retention receivables) have not been incorporated into TAS. Accordingly, companies that transit to Ind AS may need to make certain additional adjustments to comply with TAS.
Draft TAS on government grants
Though
TAS is based on Accounting Standard 12, Accounting for Government Grants (AS-12), there are some fundamental modifications to AS-12, which require consideration:
- TAS does not permit the capital approach for recording government grants. Accordingly, the current practice of recording grants in the nature of promoters’ contribution or grants related to non-depreciable assets, directly in shareholders’ funds as a capital reserve will not be permitted under TAS;
- Under TAS, all grants will either be reduced from the cost of the asset; or recorded over a period as income; or recorded as income immediately; depending on the nature of the grant; and
- Unlike AS-12, TAS provides that the initial recognition of the grant cannot be postponed beyond the date of actual receipt. AS-12 specifically provides that mere receipt of a grant is not necessarily conclusive evidence that conditions related to the grant will be fulfilled.
Further, as TAS is derived from AS-12, the new concepts in Ind AS that impact accounting for government grants (for example, recognition of non-monetary grants at fair value) have not been incorporated into the TAS. Accordingly, companies that transition to Ind AS may need to make certain additional adjustments to comply with TAS.
Conclusion
The proposal to issue separate TAS will represent a significant change for taxpayers. Taxpayers would need to evaluate the requirements of the draft TAS proposed from time to time, and determine the specific areas of impact.
The recommendations in the current Discussion Paper will partially address one of the key stated bottlenecks for implementation of Ind AS, by requiring computation of taxable income using a uniform basis. It is likely that recommendations by the Committee on points (ii) and (iii) of their terms of reference will further facilitate the adoption of Ind AS in India.
