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Category: IND AS/IGAAP - Interpretation & Practical Application

Accounting For Uncertainty Over Income Tax Treatments

Background

IAS 12 (Ind AS 12) Income
Taxes specifies requirements for   
current   and   deferred  
tax   assets  and  
liabilities. However, there was no
clarity with respect to recognition and  
measurement   of   uncertain  
tax   treatments.  An‘uncertain tax treatment’
is a tax treatment for which there is uncertainty over whether the relevant
taxation authority will accept the entity’s tax treatment under tax law. For
example,   an   entity’s  
decision   not to include
particular income in taxable profit,
is an uncertain tax treatment if its acceptability   is  
uncertain   under  tax 
law. IFRIC 23 Uncertainty over Income Tax
Treatments is an interpretation of IAS 12 that deals with recognition and
measurement of uncertain tax treatments. A corresponding interpretation is not
yet issued under Ind AS, but is expected shortly.

 

Uncertainty over Income Tax Treatments

In assessing whether
uncertainty over income tax treatments exists, an entity may consider a number
of indicators including, but not limited to, the following:

 

–    Ambiguity in the drafting of relevant tax
laws and related guidelines (such as ordinances, circulars and letters) and
their interpretations

–    Income tax practices that are generally
applied by the taxation authorities in specific jurisdictions and situations

–    Results of past examinations by taxation
authorities on related issues

–    Rulings and decisions from courts or other
relevant authorities in addressing matters with a similar fact pattern

–    Tax memoranda prepared by qualified in-house
or external tax advisors

–    The quality of available documentation to
support a particular income tax treatment.

 

Unit of Account

The Interpretation requires
an entity to determine whether to consider each uncertain tax treatment
separately or together with one or more other uncertain tax treatments. This
determination is based on which approach better predicts the resolution of the
uncertainty. In determining the approach that better predicts the resolution of
the uncertainty, an entity might consider, for example, (a) how it prepares its
income tax filings and supports tax treatments; or (b) how the entity expects
the taxation authority to make its examination and resolve issues that might
arise from that examination. 

 

The author believes that
interdependent tax positions (i.e., where the outcomes of uncertain tax
treatments are mutually dependent) should be considered together. Significant
judgement may be required in the determination of the unit of account. In
making the judgement, entities would need to consider the approach expected to
be followed by the taxation authorities to resolve the uncertainty. The
judgement required in the selection of a unit of account may be particularly
challenging in groups of entities trading in various jurisdictions where the
relevant tax laws or taxation authority treat similar elements differently.

 

Example 1 – Unit of account

Entity A is part of a
multinational group and provides intra-group loans to affiliates. It is funded
through equity and deposits made by its parent. Whilst the entity can show that
its interest margin earned on many loans is at an appropriate market rate,
there are loans where the rate is open to challenge by the taxation
authorities. However, Entity A determines that, across the loan portfolio as a
whole, the existence of rates above and below a market comparator results in an
overall interest margin that is within a reasonable range accepted by the
taxation authorities.

 

Depending on the applicable
tax law and practice in a specific jurisdiction, a taxation authority may accept
a tax filing position on the basis of the overall interest margin if it is
within a reasonable range. However, there might be other taxation authorities
that would examine the interest rate separately for each loan receivable. In
considering whether uncertain tax treatments should be considered separately
for each loan receivable or combined with other loan receivables, Entity A
should adopt the approach that better reflects the way the taxation authority
would examine and resolve the issue.

 

Detection risk

The Interpretation requires
an entity to invariably assume that a taxation authority will examine amounts
it has a right to examine and have full knowledge of all related information
when making those examinations.

 

In some jurisdictions,
examination by taxation authorities is subject to a time limit, sometimes
referred to as a statute of limitations. In others, examination by taxation
authorities might not be subject to a statute of limitations, which means the
authorities can examine the amounts at any time in the future. Some respondents
to the draft Interpretation suggested in their comment letter that an
assessment of the probability of examination would be relevant in this latter
case. However, the IFRS Interpretation Committee (IC) decided not to change the
examination assumption, nor to create an exception to it, for circumstances in
which there is no time limit on the taxation authority’s right to examine
income tax filings.

 

The IC also noted that the
assumption of examination by the taxation authority, in isolation, would not
require an entity to reflect the effects of uncertainty. The threshold for
reflecting the effects of uncertainty is whether it is probable that the
taxation authority will accept an uncertain tax treatment. In other words, the
recognition of uncertainty is not determined based on whether a taxation
authority examines a tax treatment.

 

The Interpretation does not
explain what is meant by ‘results of examinations’. The examination procedures
vary by jurisdiction and, in some jurisdictions, an examination can have
multiple phases. In the author’s view, the communication between an entity and
the taxation authorities during the course of such examinations may provide
relevant information that could give rise to a change in facts and
circumstances before the actual ‘results’ of the examination are formally issued.

 

Example 2 – Detection risk

Entity A is based in
Country B. It is generally known that the taxation authorities in Country B
have limited resources. As a consequence, their examination procedures are
usually limited to a summary assessment of the income tax filings. Scrutiny tax
examinations are only performed in very rare circumstances and if there is a
clear indication of a tax fraud. Entity A has never been subjected to such a
scrutiny examination by the taxation authorities.

 

Prior to the application of
IFRIC 23, Entity A argued that it was unlikely that the taxation authorities
would identify any key income tax exposures not already identified through
their summary assessment, because they could be identified only by analysing
the underlying accounting records. Therefore, Entity A did not recognise any
uncertain tax treatments.

 

With the adoption of IFRIC
23, Entity A would need to consider underlying tax positions even though
scrutiny by the taxation authorities is unlikely. Entity A should assume that
the taxation authority can and will examine amounts it has a right to examine
and have full knowledge of all related information when making those
examinations.

 

Recognition and Measurement

Under IFRIC 23, the key
test is whether it’s probable that the taxation authority would accept the tax
treatment used or planned to be used by the entity in its income tax filings.
If yes, then the amount of taxes recognised in the financial statements would
be consistent with the entity’s income tax filings. Otherwise, the effect of
uncertainty should be estimated and reflected in the financial statements. This
would require the exercise of judgement by the entity. The recognition of
current and deferred taxes including uncertain tax treatments continues to be
on the underlying principle of “probability”. The measurement requirements in
IFRIC 23 do not distinguish between a probability of 51% and a probability of
100%. This is consistent with the objective of IAS 12 (Ind AS 12) that refers
to a probable threshold and with the Conceptual Framework for Financial
Reporting which refers to a probability threshold for the recognition of
assets and liabilities in general. It should be noted that deferred tax assets
on carry forward of losses can be recognised only if there is convincing
evidence that it will be utilised in future years.

 

Example 3 – Current and deferred tax impact

 

Entity C, constructs and
leases wooden chalet at hill stations, and claims 100% depreciation on the
basis that they are temporary structures. However, the tax laws may not
consider them as temporary structures and therefore there is a risk that the
100% depreciation claim may be disallowed. On application of IFRIC 23, Entity C
should reflect the impact of such uncertainties in the measurement of current
and deferred tax assets and liabilities as at the reporting date.

 

An entity may need to apply
judgement in concluding whether it is probable that a particular uncertain tax
treatment will be acceptable to the taxation authority. An entity may consider
the following:

 

–  Past experience related to similar tax
treatments

–   Legal advice or case law related to other
entities

–  Practice guidelines published by the taxation
authorities

–   The entity obtains a pre-clearance from the
taxation authority on an uncertain tax treatment.

 

In defining ‘uncertainty’,
the entity only needs to consider whether a particular tax treatment is probable,
rather than highly likely or certain, to be accepted by the taxation
authorities. If an entity concludes it is probable that the taxation authority
will accept an uncertain tax treatment, the entity shall determine the taxable
profit or loss, deferred taxes, unused tax losses, unused tax credits or tax
rates consistently with the tax treatment used or planned to be used in its
income tax filings. If an entity concludes it is not probable that the taxation
authority will accept an uncertain tax treatment, the entity shall reflect the
effect of uncertainty in determining the related taxable profit or loss,
deferred taxes, unused tax losses, unused tax credits or tax rates. An entity
shall reflect the effect of uncertainty for a unit of uncertain tax treatment
by using either of the following methods, depending on which method the entity
expects to better predict the resolution of the uncertainty:

 

a)   the
most likely amount—the single most likely amount in a range of possible
outcomes. The most likely amount may better predict the resolution of the
uncertainty if the possible outcomes are binary or are concentrated on one
value.

 

b)   the
expected value—the sum of the probability-weighted amounts in a range of
possible outcomes. The expected value may better predict the resolution of the
uncertainty if there is a range of possible outcomes that are neither binary
nor concentrated on one value.

 

If an uncertain tax
treatment affects current tax and deferred tax (for example, if it affects both
taxable profit used to determine current tax and tax bases used to determine
deferred tax), an entity shall make consistent judgements and estimates for
both current tax and deferred tax.

 

Example 4 – Application of Expected Value Method

 

–  Entity A’s income tax filing in a
jurisdiction includes deductions related to transfer pricing. The taxation
authority may challenge those tax treatments.

 

–  Entity A
notes that the taxation authority’s decision on one transfer pricing matter
would affect, or be affected by, the other transfer pricing matters. Entity A
concludes that considering the tax treatments of all transfer pricing matters
in the jurisdiction together better predicts the resolution of the uncertainty.
Entity A also concludes it is not probable that the taxation authority will
accept the tax treatments. Consequently, Entity A reflects the effect of the
uncertainty in determining its taxable profit.

 

–  Entity A estimates the probabilities of the
possible additional amounts that might be added to its taxable profit, as
follows:

 

 

Estimated additional amount, INR

Probability, %

Estimate of expected value, INR

Outcome 1

–

15%

–

Outcome 2

200

5%

10

Outcome 3

400

20%

80

Outcome 4

600

10%

60

Outcome 5

800

30%

240

Outcome 6

1,000

20%

200

 

 

100%

590

 

           

–   Outcome 5 is the most likely outcome.
However, Entity A observes that there is a range of possible outcomes that are
neither binary nor concentrated on one value. Consequently, Entity A concludes
that the expected value of INR 590 better predicts the resolution of the
uncertainty.

 

–  Accordingly, Entity A recognises and measures
its current tax liability that includes INR 650 to reflect the effect of the
uncertainty. The amount of INR 590 is in addition to the amount of taxable
profit reported in its income tax filing.

Example 5 – Application of the Most Likely Outcome Method

 

–  Entity B acquires for INR 100 a separately
identifiable intangible asset that has an indefinite life and, therefore, is
not amortised applying IAS 38 (Ind AS 38) Intangible Assets. The tax law
specifies that the full cost of the intangible asset is deductible for tax
purposes, but the timing of deductibility is uncertain. Entity B concludes that
considering this tax treatment separately better predicts the resolution of the
uncertainty.

–   Entity B deducts INR 100 (the cost of the
intangible asset) in calculating taxable profit for Year 1 in its income tax
filing. At the end of Year 1, Entity B concludes it is not probable that the
taxation authority will accept the tax treatment. Consequently, Entity B
reflects the effect of the uncertainty in determining its taxable profit and
the tax base of the intangible asset. Entity B concludes the most likely amount
that the taxation authority will accept as a deductible amount for Year 1 is
INR20 and that the most likely amount better predicts the resolution of the
uncertainty.

–   Accordingly, in recognising and measuring its
deferred tax liability at the end of Year 1, Entity B calculates a taxable
temporary difference based on the most likely amount of the tax base of INR 80
(INR 100 – INR 20) to reflect the effect of the uncertainty, instead of the tax
base calculated based on Entity B’s income tax filing (INR 0).

–   Entity B reflects the effect of the
uncertainty in determining taxable profit for Year 1 using judgements and
estimates that are consistent with those used to calculate the deferred tax
liability. Entity B recognises and measures its current tax liability based on
taxable profit that includes INR 80 (INR 100 – INR 20). The amount of INR80 is
in addition to the amount of taxable profit included in its income tax filing.
This is because Entity B deducted INR 100 in calculating taxable profit for
Year 1, whereas the most likely amount of the deduction is INR 20.

 

Changes in facts and circumstances

An entity shall reassess a
judgement or estimate required by this Interpretation, if the facts and circumstances
on which the judgement or estimate was based change or as a result of new
information that affects the judgement or estimate. For example, a change in
facts and circumstances might change an entity’s conclusions about the
acceptability of a tax treatment or the entity’s estimate of the effect of
uncertainty, or both. An entity shall reflect the effect of a change in facts
and circumstances or of new information as a change in accounting estimate
applying IAS 8 (Ind AS 8) Accounting Policies, Changes in Accounting
Estimates and Errors. An entity shall apply IAS 10 (Ind AS 10) Events
after the Reporting Period to determine whether a change that occurs after the
reporting period is an adjusting or non-adjusting event.

 

Examples of changes in
facts and circumstances or new information that, depending on the
circumstances, can result in the reassessment of a judgement or estimate
required by this Interpretation include, but are not limited to, the following:

 

(a)  examinations
or actions by a taxation authority. For example:

(i)  agreement
or disagreement by the taxation authority with the tax treatment or a similar
tax treatment used by the entity;

(ii) information
that the taxation authority has agreed or disagreed with a similar tax
treatment used by another entity; and

(iii) information
about the amount received or paid to settle a similar tax treatment.

(b)  changes
in rules established by a taxation authority.

(c)  the
expiry of a taxation authority’s right to examine or re-examine a tax
treatment.

 

Example 6 – Change in facts and circumstances

Entity A claimed a
tax-deduction for a particular expense item. In the prior year, Entity A had
concluded that it was probable that the taxation authority would accept the tax
deduction. However, during the current year, Entity A is alerted by a similar
issue where a tax deduction was denied in a ruling by the Supreme Court. The
recent court ruling is considered a change in facts and circumstances. As a
result, Entity A has to reassess the uncertain tax treatment, taking into
account the recent Supreme Court decision.

 

Example 7 – Events after the reporting date

 

Scenario A

Entity C had claimed a tax
deduction for a particular expense item in its tax return related to the
financial year ending 31st December 2018. However, for the purpose
of recognising current and deferred taxes in that year, Entity C had concluded
that it is not probable that the taxation authorities will accept the tax
deduction. Accordingly, Entity C had recognised an additional tax liability
relating to the uncertainty. In February 2020, before the approval of the
financial statements for the year ending 31st December 2019, Entity
C receives the final tax assessment for 2018. The tax assessment confirms the
full deductibility of the expense item. The confirmation of tax deduction
received after the reporting period and prior to authorisation of the financial
statements for 2019 is considered as an adjusting event after the reporting
period. Accordingly, the additional tax liability that was recognised in 2018
relating to the uncertainty is released in the 2019 period.

 

Scenario B

Entity B claimed a
tax-deduction pertaining to interest expense on a loan granted by an affiliated
company, amounting to INR 500,000 in its tax return related to the financial
statements for the year ending 31st December 2018. However, for the
purposes of recognising current and deferred taxes for that year, Entity B had
concluded that the taxation authorities will only accept a deduction of INR 100,000.
In March 2020, before the approval of the financial statements for the year
ending 31st December 2019, Entity B learns from its tax advisor that
the taxation authorities have confirmed that they will accept, on a
retrospective basis, another method of determining interest rate at arm’s
length that would lead to a tax deduction of INR 300,000 in year 2018. In this
example, it appears that the taxation authorities have issued a new guideline
on deductibility of interest expenses relating to a loan from an affiliated
company. Accordingly, in contrast to Scenario A above, the information received
in March 2020 is considered as a non-adjusting event after the reporting period
for the 2019 financial statements.

 

Absence of an explicit
agreement or disagreement by the taxation authorities on its own is unlikely to
represent a change in facts and circumstances, or new information that affects
the judgements and estimates made. In such situations, an entity has to
consider other available facts and circumstances before concluding that a
reassessment of the judgements and estimates is required.

 

An uncertain tax treatment
is resolved when the treatment is accepted or rejected by the taxation
authorities. The Interpretation does not discuss the manner of acceptance
(i.e., implicit or explicit) of an uncertain tax treatment by the taxation
authorities. In practice, a taxation authority might accept a tax return
without commenting explicitly on any particular treatment in it. Alternatively,
it might raise some questions in an examination of a tax return. Unless such
clearance is provided explicitly, it is not always clear if a taxation
authority has accepted an uncertain tax treatment. An entity may consider the
following to determine whether a taxation authority has implicitly or
explicitly accepted an uncertain tax treatment:

 

–   The tax treatment is explicitly mentioned in
a report issued by the taxation authorities following an examination

–   The treatment was specifically discussed with
the taxation authorities (e.g., during an on-site examination) and the taxation
authorities verbally agreed with the approach; or

–   The treatment was specifically highlighted in
the income tax filings, but not subsequently queried by the taxation
authorities in their examination.

 

Disclosures

There are no new disclosure
requirements in IFRIC 23. However, entities are reminded of the need to
disclose, in accordance with existing IFRS (Ind AS) standards. When there is
uncertainty over income tax treatments, an entity shall determine whether to
disclose: judgements made in determining taxable profit (tax loss), tax bases,
unused tax losses, unused tax credits and tax rates; and information about the
assumptions and estimates made in determining taxable profit (tax loss), tax
bases, unused tax losses, unused tax credits and tax rates under IAS 1 (Ind AS
1) Presentation of Financial Statements. If an entity concludes it is
probable that a taxation authority will accept an uncertain tax treatment, the
entity shall determine whether to disclose the potential effect of the
uncertainty as a tax-related contingency under IAS 12 (Ind AS 12).

 

Effective date and transition

IFRIC 23 applies to annual
reporting periods beginning on or after 1st January 2019. Earlier
application is permitted. Entities can apply the Interpretation using either of
the following approaches:

 

–   Full retrospective approach: this approach
can be used only if it is possible without the use of hindsight. The
application of the new Interpretation will be accounted for in accordance with
IAS 8, which means comparative information will have to be restated; or

 

–    Modified retrospective approach: no
restatement of comparative information is required or permitted under this
approach. The cumulative effect of initially applying the Interpretation will
be recognised in opening equity at the date of initial application, being the
beginning of the annual reporting period in which an entity first applies the
Interpretation.

     It
is not clear as to when this interpretation will apply under Ind AS. It is most
likely that this Interpretation may apply from annual reporting periods
beginning on or after 1st April 2019.

 

Key challenges

–    Applying the Interpretation could be
challenging for entities, particularly those that operate in more complex
multinational tax environments.

 

–    It would be challenging for entities to
estimate the income tax due with respect to tax inspections, when tax
authorities examine different types of taxes together and issue a report with a
single amount due therein.

 

–   Entities may also need to evaluate whether
they have established appropriate processes and procedures to obtain
information, on a timely basis, that is necessary to apply the requirements in
the Interpretation and make the required disclosures.

 

–    IFRIC 23 requires an entity to assume a
detection risk of 100%. An entity should not take any credit for the
possibility that uncertain tax treatments could be overlooked by the taxation
authority. This is a different approach compared to existing practice that may
lead to changes when the Interpretation is first applied. This could be a
challenging task in some cases.

 

Frequently Asked Questions

 

Will this
Interpretation apply to uncertain treatments of other taxes, for example GST?

 

Although uncertainty exists
in the determination of GST liability, IFRIC 23 is not applicable since GST is
not a tax on income and not in the scope of IAS 12 (Ind AS 12)/IFRIC 23. Rather
they would be covered under IAS 37 (Ind AS 37) Provisions, Contingent
Liabilities and Contingent Assets. It may be noted that whilst the
underlying principle for recognition in both standards is “probability”, the
measurement basis under the two standards are significantly different.

 

In a
particular jurisdiction, if tax is not deducted at source with respect to
royalty payments to non-resident the entity is subjected to penalty and also
disallowance of the royalty expenses in computation of taxable income. Is the
penalty and disallowance of the royalty expense covered under IFRIC 23?

 

Penalty is not a tax on
income and hence are not covered under IFRIC 23. Rather they would be covered
under IAS 37 (Ind AS 37) Provisions, Contingent Liabilities and Contingent
Assets. The disallowance of royalty expenses which is included in the
taxable income will be subjected to the requirements of IAS 12 (Ind AS 12) and
IFRIC 23.

 

Will
Interest and penalties levied by Income tax Authorities be covered under this
Interpretation?

 

IAS 12 (Ind AS 12) does not
explicitly refer to interest and penalties payable to, or receivable from, a
taxation authority, nor are they explicitly referred to in other IFRS
Standards. A number of respondents to the draft Interpretation suggested in
their comment letter that the Interpretation explicitly include interest and
penalties associated with uncertain tax treatments within its scope. Some said
that entities account for interest and penalties differently depending on
whether they apply IAS 12 (Ind AS 12) or IAS 37 (Ind AS 37) Provisions,
Contingent Liabilities and Contingent Assets to those amounts.

 

The IC decided not to add
to the Interpretation requirements relating to interest and penalties
associated with uncertain tax treatments. Rather, the IC noted that if an
entity considers a particular amount payable or receivable for interest and
penalties to be an income tax, then that amount is within the scope of IAS 12
and, when there is uncertainty, also within the scope of this Interpretation.
Conversely, if an entity does not apply IAS 12 to a particular amount payable
or receivable, then this Interpretation does not apply to that amount,
regardless of whether there is uncertainty.

 

An entity
determines that an uncertain tax treatment is not probable but is possible and
hence disclosure as contingent liability is required. Whether the contingent
liability disclosure will also include the consequential interest and penalty
amount?

 

Interest amount will be
included in the contingent liability amount if there is no or very little
likelihood of waiver. On the other hand, penalty amount may be waived by the
tax authorities. If it is probable that the penalties may be waived by the tax
authorities, they are not included in the contingent liability amount.

 

In evaluating
the detection risk, should an entity consider probability of detection by the
Income-tax authorities rather than assuming an examination will occur in all
cases?

 

The IC decided that an
entity should assume a taxation authority will examine amounts it has a right
to examine and have full knowledge of all related information. In making this
decision, the IC noted that IAS 12 (Ind
AS 12) requires an entity to measure tax assets and liabilities based on tax
laws that have been enacted or substantively enacted.

 

A few respondents to the
draft Interpretation suggested that an entity consider the probability of
examination, instead of assuming that an examination will occur. These
respondents said such a probability assessment would be particularly important
if there is no time limit on the taxation authority’s right to examine income
tax filings.

 

The IC decided not to
change the examination assumption, nor create an exception to it for
circumstances in which there is no time limit on the taxation authority’s right
to examine income tax filings. Almost all respondents to the draft
Interpretation supported the examination assumption. The IC also noted that the
assumption of examination by the taxation authority, in isolation, would not
require an entity to reflect the effects of uncertainty. The threshold for
reflecting the effects of uncertainty is whether it is probable that the
taxation authority will accept an uncertain tax treatment. In other words, the
recognition of uncertainty is not determined based on whether a taxation
authority examines a tax treatment.

 

Will the
principles of “virtual certainty” apply for recognition of current and deferred
tax assets in cases where there is uncertainty of tax treatments?

 

When the key test of the
Interpretation would result in the entity recognising tax assets (i.e. based on
the probability that the taxation authorities would accept the entity’s tax
treatment), the entity is not required to demonstrate the ‘virtual certainty’
of the tax authority accepting the entity’s tax treatment in order to recognise
such a tax asset. The underlying principle of “probability” will apply for
recognition of current and deferred tax asset arising from uncertain tax
treatments. Consider the example below.

 

Example 8 – Measurement of tax positions

The management of Entity B
decides to undertake a group-wide restructuring and records a restructuring
liability of INR 1,000,000. Entity B has tax loss carry-forwards of INR
1,200,000. Excluding the restructuring liability, taxable profit for the
current year is INR 2,000,000. Entity B is uncertain whether the local taxation
authorities will accept a deduction for the restructuring costs. However, it
analyses all available evidence and concludes that it is probable that the
taxation authorities will accept the deduction of the INR 1,000,000 in the year
when it is recorded.

 

Entity B therefore
estimates its taxable profit to be INR 1,000,000 and that this will be fully
offset with tax loss carry-forwards from the INR 1,200,000 available. As a
consequence, there is no current income tax charge in the period and Entity B
determines a remaining tax loss carry-forward balance of INR 200,000. As
management has convincing evidence that Entity B will realise sufficient
taxable profits in the future, it records a deferred tax asset for the unused
tax losses of INR 200,000. Though convincing evidence is required to record a
deferred tax asset on carry forward losses (INR 200,000), the acceptability of
uncertain tax treatments (INR 1,000,000) by the tax authorities is based on the
principle of “probability”.

 

Conclusion

For many large sized
entities or those with significant income tax litigations or complications,
this Interpretation may well be a significant change. Management and Audit
Committees should ensure that the Interpretation is properly understood and
complied with. Tax advisors too need to get upto speed on the standard, since
this standard may have significant impact on income tax computation and
assessments. _

Voluntary Revision Of The Financial Statements

Background

With respect to voluntary
revision of financial statements, following is the provision of The Companies
Act, 2013 (as amended). 


131.(1)
If it appears to the directors of a company that— (a) the financial statement
of the company; or (b) the report of the Board, do not comply with the
provisions of section 129 or section 134, they may prepare revised financial
statement or a revised report in respect of any of the three preceding
financial years after obtaining approval of the Tribunal on an application made
by the company in such form and manner as may be prescribed and a copy of the
order passed by the Tribunal shall be filed with the Registrar…….


The MCA notified section
131 of the Act dealing with voluntary revision of financial statements on 1
June 2016 and the section is applicable from the notification date. In
accordance with the section, if it appears to the directors of a company that
its financial statement or the board report do not comply with the requirements
of section 129 (dealing with preparation of financial statements, including
compliance with accounting standards) or section 134 (dealing with aspects such
as signing of financial statements and preparation of the board report), then
directors may prepare revised financial statements or a revised report for any
of the three preceding financial years after obtaining the National Company Law
Tribunal (NCLT) approval. The section and related rules prescribe the procedure
to be followed in such cases. The procedure include:


– The company will make an application to the NCLT in prescribed
manner.

– Before passing any orders for revision, the NCLT will notify the
Central Government and the Income tax authorities and will consider
representations received, if any.

– The company will file a copy of the NCLT order with the
Registrar.

 –  Detailed reasons for revision of financial statements or report
will also be disclosed in the board’s report in the relevant financial year in which such revision is being made.


Ind AS 1 Presentation of
financial statement and Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors


A company may decide to
change one or more accounting policies followed in the preparation of financial
statements or change classification of certain items or correct an error in
previously issued financial statements. In these cases, Ind AS 8/ 1 requires
that comparative amounts appearing in the current period financial statements
should be restated.


In the case of an error,
there may be rare circumstances when the impact of error in financial
statements is so overwhelming that they may become completely unreliable. In
such cases, the company may need to withdraw the issued financial statements
and reissue the same after correction. The auditor may also choose to withdraw
their audit report. However, in majority of cases, the impact of error will not
be so overwhelming requiring withdrawal of already issued financial statements.
Rather, the company will correct the error in subsequent financial statements.
Ind AS 8 requires that comparative information presented in subsequent
financial statements will not be the same as originally published. Those
numbers will be restated/ updated to give effect to the correction of the
error. Similar treatment applies for change in accounting policy or
reclassification. The subsequent financial statements in which correction is
made will also include appropriate disclosures to explain impact of the
changes.


Issue


Whether restatement of
comparative amounts in subsequent financial statements is tantamount to
revision of financial statements? Consequently, whether such restatement will
trigger compliance with section 131 of the Act?


Author’s View


Section 131 of the Act is
triggered only in cases where the company needs to withdraw previously issued
financial statements and re-issue the same. For example, this will be required
when the impact of error on previously issued financial statements is so
overwhelming that they have become completely unreliable.


Section 131 will not be
triggered in cases related to restatement of comparative information appearing
in the current period financial statements. This view can be supported by the
following key arguments:


– Restatement of comparative information appearing in subsequent financial
statements is not tantamount to change or revision or reissuance of
previously issued financial statements. If one reads section 131 carefully, it
is about preparing (and consequently reissuing) revised financial statements,
at the behest of the board of directors. It cannot be equated to restating
comparative numbers for errors or changes in accounting policies where there is
no revision or reissuance of already issued financial statements. There
is a change in the comparative numbers in subsequent financial statements; but
there is no revision or reissuance of already issued financial
statements.


– Section 131 can be triggered only if
the previously issued financial statements were not in compliance with section
129. In the case of a change in accounting policy or reclassification, there
was no such non-compliance in previously issued financial statements. Hence,
section 131 does not apply. The Ind AS 8 requirement to restate an error in
subsequent financial statements is the same as change in accounting
policy/reclassification. Hence, section 131 should apply in the same manner for
correction of errors as well.

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 1st
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 23rd 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

Point  of Difference

Indian GAAP

ICDS

Delhi HC Decision/Judicial pronouncements

Revenue
during early stage of construction, when outcome cannot be estimated
reliably.

Revenue
recognised to the extent costs are recoverable. No threshold is prescribed
for early stage.

Same
as Indian GAAP. However, the early stage shall not extend beyond 25%
completion. (ICDS III – Construction Contracts).

No
change.

Retention
money.

Forms
part of contract revenue and POCM is applied to entire contract revenue.

Same
as Indian GAAP (ICDS III – Construction Contracts).

Retention
money accrues to the taxpayer only when the related performance conditions
are fulfilled, for eg. 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.

Export
incentive.

When
it is reasonably certain that all conditions will be fulfilled and the
ultimate collection will be made.

In
the year of making claim, if there is a reasonable certainty of ultimate
collection. (ICDS VII – Government Grants).

Income
will not accrue, till the time conditions attached to it are fulfilled and
there is corresponding liability on Government to pay the benefit. (SC in Excel
Industries case).

Revenue
from construction contracts.

POCM

POCM

Not
discussed.

Revenue
from service contracts.

POCM
or CCM

u  Only POCM for long duration contracts (>
90 days).

u   CCM permitted for short duration contracts (< 90 days) (ICDS
IV – Revenue Recognition).

Accounting
principles and Judicial precedents permit, both POCM and CCM.

Real
estate developers.

As
per Guidance Note on Accounting for Real Estate Transactions, only
POCM is allowed.

No
ICDS for real estate developers. 
Judicial precedents will apply. 
Therefore, POCM or CCM will be allowed per the method of accounting
regularly employed by the taxpayer. 
The acceptance of CCM by the tax authorities for real estate
developers is a contentious issue and generally resisted by the Tax
Department. There are also cases where CCM has been disallowed by courts.
Currently, if taxpayer is following POCM in books, it would be bound u/s.145,
which requires income to be computed as per method of accounting regularly
followed by the taxpayers in its books. Most corporate real estate developers
follow POCM. A few corporates and non-corporates that followed CCM had to
face severe litigations and an audit qualification from the auditor on the
financial statements.

Not
discussed.

Onerous
Contract.

Expected
losses are recognised as an expense immediately.

Losses
incurred on a contract will be allowed only in proportion to the stage of
completion (ICDS III – Construction Contracts).

Prudence
is inherent in section 37(1) and hence expected losses allowable as per
judicial precedents.

Borrowing
Cost capitalisation – whether substantial period of time is required.

Applies
only when assets require substantial period of time for completion.

No
condition w.r.t substantial period of time except for inventory and general
borrowing costs ( 12 months) (ICDS IX – Borrowing Costs).

No
change.

Capitalisation
of specific borrowing cost.

Actual
borrowing cost.

Actual
borrowing cost.

No
change.

Capitalisation
of general borrowing cost.

Weighted
average cost of borrowing is applied on funds that are borrowed generally and
used for obtaining a qualifying assets.

Allocation
is based on average cost of qualifying asset to average total assets (ICDS IX
– Borrowing Costs).

No
change.

Borrowings
– Income on temporary investments.

Reduced
from the borrowing costs eligible for capitalisation.

Not
to be reduced from the borrowing costs eligible for capitalisation. Thus, it
will be taxable income (ICDS IX – Borrowing Costs).

Accounting
principles and Judicial precedents permit reduction of incidental income
where it has close nexus with construction activity. (SC in Bokaro Steel).

Contingent
Assets.

Recognition
is based on virtual certainty.

Recognition
is based on reasonable certainty (ICDS X – Provisions, Contingent Liabilities
and Contingent Assets).

Test
of ‘reasonable certain’ is not in accordance with S. 4/5 of ITA. Hypothetical
income not creating enforceable right cannot be taxed.

Government
Grant
classification.

u   Income related grant

u   Assets related grant

u   Grant in the nature of promoter’s contribution (credited to
capital reserve).

u     Income related grant

u     Assets related grant

     (ICDS VII – Government Grant).

 

No
change.

Government
Grant – recognition.

Not
recognised until there is a reasonable assurance that the entity shall comply
with the conditions attached to them and the grants will be received.

Similar
to Indian GAAP, except recognition is not postponed beyond the date of actual
receipt. (ICDS VII – Government Grant).

Taxable
when conditions attached to the receipt of government grant are fulfilled
and, there is corresponding liability on Government to pay.

Capitalisation
of exchange differences on long term foreign currency monetary item for
acquisition of fixed assets
(AS 11.46A).

Paragraph
46/ 46A of AS 11 provides option for capitalisation.

u   On imported assets S43A allows capitalisation

u   On local assets S43A does not apply.

u     With respect to local assets, all MTM exchange differences are included
in taxable income (ICDS VI – Foreign Exchange)

Distinguish
between capital and revenue nature of exchange fluctuation (Sutlej Cotton Mills).  Thus, exchange
differences on local capital assets, are not revenue in nature; nor, are
capitalisable under 43A.

Forward
contracts under AS 11 for hedging purpose.

Premium/
discount to be amortised over the contract period. Spot-to-spot gains/ losses
are recognised in P&L.

Same
as Indian GAAP. (ICDS VI – Foreign Exchange).

No
change.

Foreign
currency risk of a firm commitment or a highly probable forecast transaction.

As
per Guidance Note on Accounting for Derivative Contracts (GN)
derivatives are measured at fair value through P&L, if hedge accounting
is not applied.

Premium,
discount or exchange difference, shall be recognised at the time of
settlement. (ICDS VI – Foreign Exchange).

ICDS
cannot override judicial precedents (which will implicitly include SC ruling
in Woodward Governor’s case (312 ITR 254) which upheld MTM treatment
as per accounting principles). Thus MTM losses/gains are deductible/taxable.

Foreign
currency risk on contract for trading or speculative purposes.

As
per GN, derivatives are measured at fair value through P&L.

Premium,
discount or exchange difference shall be recognised at the time of
settlement. (ICDS VI – Foreign Exchange).

MTM
losses are tax deductible

[SC
in Sutlej Cotton Mills].

MTM
gains – No clarity but on principles, it is taxable.

MTM
losses on commodity derivatives.

As
per GN, derivatives are measured at fair value through P&L, if hedge
accounting is not applied.

u   MTM losses are not tax deductible. (ICDS I – Disclosure of
Accounting Policies)

u     CBDT Circular – MTM Gains are not taxable.

u     Consequently, tax will apply on settlement.

ICDS
cannot override judicial precedents (which will implicitly include SC ruling
in Woodward Governor’s case (312 ITR 254) which
permitted MTM treatment as per accounting principles).  Thus MTM losses/gains are
deductible/taxable.

 

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. _

Impact of Ind AS 115 on Real Estate Companies

An Exposure draft namely Ind AS 115 Revenue from Contracts with
Customers is awaiting approval by the Ministry of Corporate Affairs.  There is uncertainty on the effective date of
the Standard, but it may apply as early as from accounting periods beginning on
or after 1 April, 2018.  In this article,
we discuss the impact of Ind AS 115 on real estate companies, particularly in
the context of development and sale of multi-unit residential or commercial
property before the entity constructs the property.

 

Ind AS 115 specifies the requirements an entity must apply to measure
and recognise revenue and the associated costs. The core principle of the
standard is that an entity will recognise revenue when it transfers control of
the underlying goods and services to a customer. The principles in Ind AS 115
are applied using the following five steps:

1.  Identify the contract with a customer

2.  Identify the performance obligations in the contract

3.  Determine the transaction price

4.  Allocate the transaction price to the performance obligations

5.  Recognise revenue when or as the entity satisfies each performance
obligation.

 

Ind AS 115 requires recognition of revenue when or as the entity
satisfies each performance obligation. This requirement is one of the key
hurdles for real estate companies. Currently, the Guidance Note on
Accounting for Real Estate Transactions (GN) requires real estate companies
to apply the percentage of completion method.

 

Under Ind AS 115, an entity will have to evaluate whether it satisfies
the performance obligation to its customer at the time of delivery of the real
estate unit or over time as the construction is in progress. If an entity
cannot demonstrate that the performance obligation is satisfied over time, it
will not be able to recognis e revenue over time. In simpler terms, the entity
will have to record real estate sales on the completed contract method, instead
of the percentage of completion method (POCM).

 

Satisfaction of
performance obligations

An entity recognises revenue only when it satisfies a performance
obligation by transferring control of a promised good or service to a customer.
Control may be transferred at a point in time or over time. Control of the good
or service refers to the ability to direct its use and to obtain substantially
all of its remaining benefits. Control also means the ability to prevent other
entities from directing the use of and receiving the benefit from a good or
service. The benefits of an asset are the potential cash flows (inflows or
savings in outflows) that can be obtained directly or indirectly in many ways,
such as by:

 

a)  using the asset to produce goods or provide services;

b)  using the asset to enhance the value of other assets;

c)  using the asset to settle liabilities or reduce expenses;

d)  selling or exchanging the asset;

e)  pledging the asset to secure a loan; and

f)   holding the asset.

 

The control model is different from the ‘risks and rewards’ model in
current Ind AS 18 and the GN. As per the GN, the completion of revenue
recognition process is usually identified when the following conditions are
satisfied.

 

a)  the entity has transferred to the buyer the significant risks and
rewards of ownership of the real estate;

b)  the entity retains neither
continuing managerial involvement to the degree usually associated with
ownership nor effective control over the real estate sold;

c)  the amount of revenue can be measured reliably;

d)  it is probable that the economic benefits associated with the
transaction will flow to the entity; and

e)  the costs incurred or to be incurred in respect of the transaction
can be measured reliably.

 

The differences in the model may result in different accounting
outcomes.

 

Performance
obligations satisfied over time

An entity transfers control of a good or service over time, rather than
at a point in time when any of the following criteria are met:

 

1)  The customer simultaneously receives and consumes the benefits
provided by the entity’s performance as the entity performs. For example, when
cleaning services are provided, the customer simultaneously receives and
consumes the benefits.

 

2)  The entity’s performance creates or enhances an asset that the
customer controls as the asset is created or enhanced. For example, an entity
constructs an equipment for the customer at the customer’s site.

 

3)  The entity’s performance does not create an asset with an
alternative use to the entity and the entity has an enforceable right to
payment for performance completed to date.

 

The first criterion is not applicable because the entity’s performance
creates an asset, i.e., the real estate unit that is not consumed immediately.
The second and the third criteria are discussed below. The Standard contains
requirements on when performance obligations are satisfied over time. When a
performance obligation is not satisfied over time, it will be deemed to have
been satisfied at a point in time.

 

Customer
controls asset as it is created or enhanced

The second criterion in which control of a good or service is
transferred over time, is where the customer controls the asset as it is being
created or enhanced. For example, many construction contracts contain clauses
indicating that the customer owns any work-in-progress as the contracted item
is being built. In many jurisdictions, the individual units of an apartment
block are only accessible by the purchaser on completion or near completion.
However, the standard does not restrict the definition of control to the
purchaser’s ability to access and use (i.e., live in) the apartment. In Ind AS
115.33, the standard specifies: The benefits of an asset are the potential cash
flows (inflows or savings in outflows) that can be obtained directly or
indirectly in many ways, such as by:

a)  using the asset to produce goods or provide services (including
public services);

b)  using the asset to enhance the value of other assets;

c)  using the asset to settle liabilities or reduce expenses;

d)  selling or exchanging the asset;

e)  pledging the asset to secure a loan; and

f)   holding the asset.

 

In some jurisdictions, it may be possible to pledge, sell or exchange
the unfinished apartment. Careful consideration will be required of the
specific facts and circumstances. The September 2017 Update of IFRIC, discusses
this issue in detail, and concluded that the second criterion is not fulfilled
in most developments of a multi-unit complex. Consequently, PCOM cannot be
applied in such cases. Particularly, the IFRIC emphasised the following:

 

1)  In applying the second criterion, it is important to apply the
requirements for control to the asset that the entity’s performance creates or
enhances. In a contract for the sale of a real estate unit that the entity
constructs, the asset created is the real estate unit itself. It is not, for
example, the right to obtain the real estate unit in the future. The right to
sell or pledge this right is not evidence of control of the real estate unit
itself.

 

2)  The entity’s performance creates the real estate unit under
construction. Accordingly, the entity assesses whether, as the unit is being
constructed, the customer has the ability to direct the use of, and obtain
substantially all of the remaining benefits from, the part-constructed real estate
unit. The Committee observed the following:

 

a)  although the customer can resell or pledge its contractual right to
the real estate unit under construction, it is unable to sell the real estate
unit itself without holding legal title to it;

b)  the customer has no ability to direct the construction or
structural design of the real estate unit as the unit is constructed, nor can
it use the part-constructed real estate unit in any other way;

c)  the customer’s legal title (together with other customers) to replace
the entity, only in the event of the entity’s failure to perform as promised,
is protective in nature and is not indicative of control.

d)  the customer’s exposure to changes in the market value of the real
estate unit may indicate that the customer has the ability to obtain
substantially all of the remaining benefits from the real estate unit. However,
it does not give the customer the ability to direct use of the unit as it is
constructed.

 

Thus, the customer does not control the part-constructed unit. In
simpler terms, the performance obligation is satisfied when the real estate
entity delivers the constructed unit to the customer. At that point in time the
real estate entity recognises revenue.

 

Asset with no
alternative use and right to payment

The third situation in which control is transferred over time has the
following two requirements that must both be met:

–The
entity’s performance does not create an asset with alternative use to the
entity.

–  The
entity has an enforceable right to payment for performance completed to date.

 

Asset with no
alternative use

An asset created by an entity has no alternative use if the entity is
either restricted contractually or practically from readily directing the asset
to another use (e.g., selling it to a different customer). A contractual
restriction on an entity’s ability to direct an asset for another use must be
substantive. In other words, a buyer could enforce its rights to the promised
asset if the entity sought to sell the unit to a different buyer. In contrast,
a contractual restriction may not be substantive if the entity could instead
sell a different unit to the buyer without breaching the contract or incurring
significant additional costs. Furthermore, a practical limitation exists if an
entity would incur significant economic losses to direct the unit for another
use. A significant economic loss may arise when significant costs are incurred
to redesign or modify a unit or when the unit is sold at a significantly
reduced price.

 

Enforceable
right to payment for performance completed to date

An entity has an enforceable right to payment for performance completed
to date if, at any time during the contract term, the entity would be entitled
to an amount that at least compensates it for work already performed. This
right to payment, whether by contract or by law, must be present, even in
instances in which the buyer can terminate the contract for reasons other than
the entity’s failure to perform as promised. The entity’s right to payment by
contract should not be contradictory to any law of the land.

 

Many real estate companies sell real estate on a small down payment,
followed by the rest of the payment being made at the time of delivery of the
real estate; for example, a 20:80 scheme, wherein 20% of the consideration is
paid upfront on booking, followed by 80% payment on delivery of the unit. The
customer can walk away without making the rest of the payment, if he is not
interested in taking delivery of the unit. Such real estate contracts do not
meet the criterion of enforceable right to payment for performance completed to
date.

 

To meet this criterion, the amount to which an entity is entitled must
approximate the selling price of the goods or services transferred to date,
including a reasonable profit margin. The standard clarifies that including a
payment schedule in a contract does not, by itself, indicate that the entity
has an enforceable right to payment for performance completed to date. The
entity needs to examine information that may contradict the payment schedule
and may represent the entity’s actual right to payment for performance
completed to date (e.g., an entity’s legal right to continue to perform and
enforce payment by the buyer if a contract is terminated without cause).

 

In some contracts, a customer may have a right to terminate the contract
only at specified times during the life of the contract or the customer might
not have any right to terminate the contract. If a customer acts to terminate a
contract without having the right to terminate the contract at that time
(including when a customer fails to perform its obligations as promised), the
contract (or other laws) might entitle the entity to continue to transfer to
the customer the goods or services promised in the contract and require the
customer to pay the consideration promised in exchange for those goods or
services. In those circumstances, an entity has a right to payment for
performance completed to date, because the entity has a right to continue to
perform its obligations in accordance with the contract and to require the
customer to perform its obligations (which include paying the promised
consideration).

 

Conclusion

In light of the requirements of Ind AS 115, many real estate companies
in India may not qualify for POCM. However, the third criterion discussed above
is a small window available for real estate companies in India to achieve POCM
recognition. To qualify for POCM recognition, real estate companies should
ensure that they have a contractual right to collect payment from the customer
for work completed to date and that the contractual right is not in
contradiction with any law of the land.  _

 

Ind AS 115 – Revenue From Contracts With Customers

Identifying the customer

Ind AS 115 defines a customer as a
party that has contracted with an entity to obtain goods or services that are
an output of the entity’s ordinary activities in exchange for consideration.
Beyond that, Ind AS 115 does not contain any definition of a customer. In many
transactions, a customer is easily identifiable. However, in transactions
involving multiple parties, for example, in the credit card business, it may be
less clear which counterparties are customers of the entity. For some
arrangements, multiple parties could all be considered customers of the entity.
However, for other arrangements, only some of the parties involved are
considered as customers. The identification of the performance obligations in a
contract can also have a significant effect on the determination of which party
is the entity’s customer.

 

Identifying the customer becomes
very important under Ind AS 115, because depending on who and how many
customers are identified, it will determine, the performance obligations in a
contract, the presentation and accounting of sales incentives, determination
and presentation of negative revenue, etc. The example below shows how the
party considered to be the customer may differ, depending on the specific facts
and circumstances.

 

Example — Travel Agents

An entity provides internet-based
airline ticket booking services. In any transaction, there are three parties
involved, the airline is the principal, the entity is an agent, and the
end-customer who purchases the ticket on the entity’s website. The entity gets
its majority of the income from the airline, to whom it charges a commission
(say INR 500 per ticket). The entity also receives a small convenience fee from
the end-customer (INR 20). To attract customers, the entity provides a cash
back of INR 120 to each end-customer.

 

If the entity considers, the
airline and the end-customer as two customers in a transaction, it will
determine revenue to be INR 400 (500+20-120). On the other hand, if the entity
had not received any convenience fees from the end-customer, and reduced the
cash back to INR 100, the entity will determine revenue to be INR 500. The
entity will also present INR 100 paid to third parties (end-customers) as a
selling cost.

 

Consideration paid to Customers’ Customer

Consideration payable to a customer
includes cash amounts that an entity pays, or expects to pay, to the customer.
Such amounts are reduced from revenue. This requirement also applies to
payments made to other parties that purchase the entity’s goods or services
from the customer. In other words, consideration paid to customers’ customer is
also reduced from revenue. For example, if a lubricant entity pays a
consideration to mechanics that purchases lubricants from the entity’s customer
(distributor), that amount will be reduced from the revenue of the lubricant
entity.

 

In some cases, entities provide
cash or other incentives to end consumers that are neither their direct
customers nor purchase the entities’ goods or services within the distribution
chain. One such example is depicted below. In such cases, the entity will need
to identify whether the end consumer is the entity’s customer under Ind AS 115.
This assessment could require significant judgment. The management should also
consider whether a payment to an end consumer is contractually required
pursuant to the arrangement between the entity and its customer (e.g., the
merchant in the example below) in the transaction. If this is the case, the
payment to the end consumer is treated as consideration payable to a customer
as it is being made on the customer’s behalf.

 

Example – Consideration paid to other
than customers

An entity provides internet-based
airline ticket booking services. In any transaction, there are three parties
involved, the airline is the principal, the entity is an agent, and the
end-customer who purchases the ticket on the entity’s website. The entity gets
its income from the airline, to whom it charges a commission (say INR 500 per
ticket). To attract users, the entity provides a cash back of INR 100 to each
end-customer on its own (i.e. without any contractual requirement from the
airline company).

 

If the entity considers, the
airline and the end-customer as two customers in a transaction, it will
determine revenue to be INR 400 (500-100). On the other hand, if the entity
determines that the end-customer is not its customer (because convenience fee is
not charge to the end-customer), the entity will determine revenue to be INR
500 and present INR 100 paid to third parties (end-customers) as a selling
cost. In case, the cash back to end user is paid because of a contractual
requirement between the airline and the entity, then such cash back paid will
be deducted from revenue, even when it is concluded that the end-user is not a
customer.  This is because, the entity is
making a payment on behalf of the customer as per agreement.

 

Both examples in the article are economically
the same; however, they provide different accounting consequences, based on how
a customer is identified. In the second example, a convenience fee is not paid
to end-customer, and hence it is concluded that the end-customer is not the
customer of the entity.