Tax Accounting Standards: A New Framework for Computing Taxable Income

The provisions of the
Income Tax Act, 1961 (‘the Act’) presently govern the computation of
taxable profits; however, the Act does not comprehensively specify the
accounting principles to be followed for this purpose. In this context,
the Central Government, empowered u/s. 145(2) of the Act, notified only
two accounting standards, on ‘Disclosure of Accounting Policies’ and
‘Disclosure of Prior Period Items and Extraordinary Items and Changes in
Accounting Policies’.

Litigation pertaining to various
accounting related matters continues between the tax authorities and
companies that seek to follow the guidance in Accounting Standards (AS)
issued by the Institute of Chartered Accountants of India (ICAI) and the
Ministry of Corporate Affairs (MCA). There is consequential
uncertainty. With the impending convergence with International Financial
Reporting Standards in India (Ind AS), this issue assumes greater
importance. In this context, the Central Board of Direct Taxes (CBDT)
constituted the Accounting Standard Committee (the Committee) in
December 2010, with the following terms of reference:

1 To study
the harmonisation of Accounting Standards issued by the ICAI with
regard to the direct tax laws in India, and suggest Accounting Standards
which need to be adopted u/s. 145 (2) of the Act, along with relevant
modifications;

2 To suggest a 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

3 To suggest appropriate amendments to the Act in view of transition to Ind AS regime.

The
Ministry of Finance subsequently issued a Discussion Paper on Tax
Accounting Standards on 17th October, 2011 with draft recommendations by
the Committee and draft Tax Accounting Standards (TAS) on ‘Construction
Contracts’ and ‘Government Grants’. Key matters are discussed below.

Approach for Formulation of Tax Accounting Standards

On
deliberation by the Committee on whether all the standards issued by
ICAI should be considered for harmonisation, it observed that some
standards were not relevant from the perspective of computing taxable
income, because the Act contains specific requirements for matters
covered by these standards or these standards mainly relate to
disclosures in financial statements. Also accounting standards
pertaining to consolidated financial statements i.e. AS 21, 23 and 27
were not relevant, since consolidated financial statements are not
relevant under the Act.

Further, accounting standards such as AS
30, 31 and 32 relating to financial instruments, have not been notified
under the Companies Act, 1956 and are therefore not currently mandatory
in nature, were also not considered for harmonisation. Other reasons
for not evaluating these standards were the uncertain status of these
standards and their limited application to the area of derivatives and
hedge accounting. The accounting issues related to derivatives are
partly covered by the TAS on Accounting Policies.

The Committee
also recommended TAS for the areas where currently no accounting
standards have been issued by ICAI and guidance for computation of
taxable income is required. Consequently, TAS may be issued in the
future for areas such as: i) Share based payment ii) Revenue recognition
by real estate developers iii) Service concession arrangements iv)
Exploration for and evaluation of mineral resources.

Following are various other considerations and recommendations by the Committee:

•  TAS to be applicable only to those taxpayers that follow the mercantile system for tax purposes; 1

•  Return of income and Form 3CD to be modified to determine whether the
  taxable income is computed in accordance with TAS. This could be
  achieved by requiring reconciliation between the income as per the
  statutory financial statements and the income as computed per TAS;

•  Disclosure requirements prescribed in individual TAS and their inclusion in the return of income;

•  Transitional provisions, wherever required, to be notified along with
  TAS to avoid situations wherein income arising from a particular
  transactions is taxed neither in the pre-TAS period nor in the post-TAS
  period or may be taxable in both the periods. For example, if the
  assessee has claimed lease rentals as a deduction in the pre-TAS period
  for assets obtained on finance lease, basis for claiming deduction of
  depreciation and interest cost in the post-TAS period will need to be
  clarified by the transition guidance.

Final recommendations
The
final recommendations of the Committee are included in a report that
was issued for public comment on 26th October, 2012 which also contains
drafts of 14 individual TAS (including TAS on Construction Contracts and
Government Grants that were initially issued in October 2011).

The Committee recommended that:

•  TAS needs to be in harmony with the provisions of the Act;

•  TAS needs to lay down specific rules to enable computation of taxable income with certainty and clarity;

•  TAS to remove alternatives, to the extent possible;

•  AS issued by ICAI could not be notified under the Act without modification and hence, the TAS to modify AS;

•  TAS should be applicable only to computation of taxable income and
  taxpayers will not be required to maintain separate books of accounts on
  the basis of TAS;

•  TAS to apply to all taxpayers without
  specifying any thresholds relating to turnover/income in order to bring
  uniformity in computation of taxable income;

•  In case of a conflict between the Act and TAS, the provisions of the Act will prevail;

•  Transition provisions to be notified with each TAS as relevant, in order to prevent any tax leakage or any double taxation;

•  Appropriate modifications be made to the return of income to monitor
  TAS compliance. Modification of Form 3CD so that tax auditor is required
  to certify computation of taxable income in compliance with TAS;

•  Amendments to be made to the Act to provide certainty on issue of
  allowability of depreciation on goodwill arising on amalgamation,
  allowability of the provision made for the payment of pension on
  retirement or termination of an employee.

Significant impact areas
A
few of the important implications around accounting policies,
inventories, prior period expenses, construction contracts, revenue
recognition and fixed assets are covered below. Impacts for other areas
such as the effects of changes in foreign exchange rates, government
grants, securities, borrowing costs, leases, intangible assets and
provisions, contingent liabilities and contingent assets will be covered
in our next article.

Accounting policies

•  AS 1
  considers prudence as an important factor in selection and application
  of accounting policies and requires provisions for all known liabilities
  and losses on best estimate basis. Unlike AS 1, TAS eliminates the
  concept of prudence and disallows recognition of any such provisions of
  expected losses or mark to market (MTM) losses, unless specifically
  provided under TAS. Consequently, fair valuation gain/loss provisions on
  derivatives or other instruments would not be allowed under TAS.

•  Unlike AS 1, TAS does not permit a change in accounting policy merely
  on account of ‘more appropriate presentation’ and requires reasonable
  cause to do so. What constitutes ‘reasonable cause’ would require
  judgement by management and tax authorities.

•     TAS does not provide any specific guidance on how the impact of any such change in policies should be included in the computation of income.

Valuation of inventories

•     Under current practice, on conversion of capital asset into stock-in-trade, the fair value on the date of conversion is deemed to be consideration and accordingly treated as the cost of stock-in-trade. The definition of cost for valuation of inventory per TAS does not specifically address this situation and it is possible that such deemed cost may not be allowed post implementation of the TAS;

•     TAS specifies that opening stock will be valued as at the close of the immediately preceding previous year. This nullifies the impact of judicial decisions which provided that opening stock should be valued on the ‘same basis’ as closing stock, in cases where there is a change in policy for inventory valuation during the year;

Events occurring after the end of the previous year

•     Similar to AS 4, TAS also allows adjustment for events till the date of approval of the financial statements by the Board of Directors or other approving authority for a non-corporate entity. This may result in a change in current practice where such adjustments are permitted for events till the date of filing the return of income.

Prior period expense

•     No specific guidance is provided on prior period income in TAS. This seems to be in line with the current practice, whereby prior period income is subjected to tax in the current year.

•     Prior period expenses are explicitly covered under TAS and provide that no deduction can be allowed in the current year. In line with the current practice, even if the prior period expense can be claimed as a deduction for the year to which it pertains (pursuant to a revised return), there are practical limitations on filing a revised return in all such cases e.g. a revised return can be filed only for the two immediately preceding previous years.

Construction contracts

•     Percentage of completion method for revenue recognition is mandatory under TAS and accordingly, use of the completed contract method is no longer permitted.

•     Although TAS permits non-recognition of margins during the early stages of a contract, it prohibits such deferral if the stage of completion exceeds 25 %.

•     Unlike AS 7, TAS does not permit recognition of expected losses on onerous contracts.

•     Under TAS, any incidental income in the nature of interest, dividend or capital gains cannot be reduced from the contract cost; however, other incidental income can be reduced from the costs.

•     Unlike AS 7, TAS does not permit non-recognition of revenue due to uncertainty in collection. If other conditions for revenue recognition per TAS are met, revenue needs to be recognised. A corresponding bad debt expense deduction can be claimed in accordance with the provisions of the Act.

Revenue recognition

•     Unlike AS 9, TAS does not require revenue to be measurable or collectible at the time of sale (there is an exception for price escalation claims and export incentives). As such, revenue will have to be recognised even if the sales proceeds are not collectible. A corresponding bad debt expense deduction can be claimed in accordance with the provisions of the Act.

•     Unlike AS 9, TAS requires revenue recognition for all services based on percentage of completion method. As such, completed contract method as per AS 9 is no longer permitted under TAS. Though the TAS does not clarify whether expected losses on onerous service contracts should be recognised on a proportionate basis or in their entirety, given the provisions in the TAS on Construction Contracts and Accounting Policies, it is likely that such expected losses cannot be provided.

•     AS 9 contains certain illustrations that provide more clarity on application of revenue recognition principles to specific types of transactions. For example, a sale and repurchase agreement may be in substance a financing arrangement, or an upfront membership fee may be consideration for future discounted products or services. Since similar illustrations are not included in TAS, the position around such specific transactions may be unclear.

•     Unlike AS 9, TAS does not contain guidance on recognition of revenue as a principal or as an agent (gross vs. net). This may impact turnover determination u/s. 44AB, coverage under presumptive taxation and other similar cases where determination of gross turnover is relevant under the Act.

•     A separate TAS for revenue recognition for real estate developers is supposed to be issued as per Committee recommendation. Until that time, inconsistent practices may continue to exist in the manner in which real estate developers apply the principles of TAS.

Tangible fixed assets

•     AS 16 provides for capitalisation of exchange differences along with the underlying asset to the extent that such exchange differences qualify as borrowing costs or when the company has adopted the notifications on AS 11 issued by the Ministry of Corporate Affairs that permit such capitalisation. TAS reiterates the fact that capitalisation of exchange differences relating to fixed assets shall be in accordance with section 43A of the Act that states that any increase/ decrease in the liability in Indian currency shall be recognised only at the time of payment, which could be materially different from the provisions of AS 10, AS 16 and AS 11.

•     TAS provides that the actual cost in cases where an asset is acquired in exchange for another asset, shares or securities shall be the lower of the fair market value of the asset acquired or the assets/securities given up/issued. However AS 10 requires that its actual cost shall be determined by reference to the fair market value of the consideration given or asset acquired whichever is more clearly evident.

•     TAS prescribes maintenance of a Fixed Asset Register with specific disclosures. Currently, non-corporate assessees may not be maintaining Fixed Asset Registers in the prescribed format.

Conclusion

The Final committee report with draft TAS will provide a comprehensive framework for companies to determine their taxable income each year, by adjusting their accounting profits as many of the difference between AS and TAS will harmonise the computation basis for taxable profits with the existing provisions of the Act. This represents a significant progress in providing a consistent basis for computation of taxable income.

Some of the changes could extensively impact certain companies, as the TAS provisions would provide guidance on areas that are subject matters of considerable litigation and areas where there is no guidance under the current tax provisions. Depending upon the tax positions taken by a company these provisions would have an impact on the taxable profits under TAS regime.

Although TAS purports to remove one of the hurdles to implementation of Ind AS by providing independent framework regardless if GAAP followed (Indian GAAP or Ind AS), the issue of impact on computation of the Minimum Alternate Tax (MAT), which is based on the accounting profits still remains open, due to uncertainty around the adoption of Ind AS.

Finally, the key challenge lies in thorough implementation of the TAS framework by the tax authorities and the judiciary. This would go a long way in achieving tax uniformity and consistency across different companies.

Editor’s Note: One of the authors is a member of the Accounting Standards Committee.