EY Tax Alert. Executive summary. Final report of Accounting Standards Committee of CBDT. 29 October 2012
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1 29 October 2012 EY Tax Alert Final report of Accounting Standards Committee of CBDT Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your Ernst & Young advisor. This Tax Alert summarizes the key recommendations in the final report issued in August 2012 by the Accounting Standards Committee (Committee) constituted by the Central Government (CG) in December The CG published the report on 26 October Section 145 of the Indian Tax Laws (ITL) gave the power, effective from tax year , to the CG to notify Tax Accounting Standards (Tax AS) to be followed by any class of taxpayers or in respect of any class of income. In view of significant developments in convergence to International Financial Reporting Standards (IFRS), the CG constituted the Committee in December 2010, comprising officials of the Tax Authority and professionals. The terms of reference of the Committee were to study harmonization of accounting standards issued by the Institute of Chartered Accountants of India (ICAI AS) with the ITL and to suggest accounting standards for tax compliance under the ITL and also to deal with the issue of the tax impact of convergence to IFRS. The Committee has recommended notification of 18 Tax AS for compliance with the ITL on the issue of harmonization of ICAI AS with the ITL and has also provided drafts of 14 Tax AS. The CG has invited comments/suggestions on the recommendations of the Committee and draft Tax AS by 26 November 2012.
2 Given the uncertainty surrounding convergence to IFRS, the Committee has recommended that the status of transition to IFRS should be carefully monitored and appropriate amendments in the ITL, especially relating to computation of Minimum Alternate Tax (MAT), should be considered based on developments in the future. Background Section 145 of the ITL provides that the taxable income of the taxpayer under the heads profit and gains of business or profession (Business head) or income from other sources (Other sources head) shall be computed in accordance with either cash or mercantile system of accounting that is regularly employed by the taxpayer. It further provides that the CG may notify in the Official Gazette, from time to time, Tax AS to be followed by any class of taxpayers or in respect of any class of income. The object behind introducing a provision to notify separate Tax AS was that ICAI AS provides flexibility of alternative accounting treatments, which make it possible for a taxpayer to avoid payment of correct taxes by choosing a particular system. Therefore, an urgent need was felt to standardize one or more of the alternatives in various standards so that income for tax purposes could be computed precisely and objectively. Since the introduction of this provision in the ITL, the CG has notified two Tax AS in 1996 [1] viz., (a) Accounting Standard I, relating to disclosure of accounting policies (b) Accounting Standard II, relating to disclosure of prior period and extraordinary items and changes in accounting policies. These standards are largely comparable to the corresponding ICAI AS [2]. Constitution of the Committee Vide an Order [3] dated 20 December 2010, the CG constituted the Committee, comprising officials of the Tax Authority and professionals, with the following terms of reference: To study the harmonization of ICAI AS with the ITL and to suggest accounting standards for tax compliance under the ITL, with relevant modifications. To suggest a method for determination of tax base (book profit) for the purpose of MAT in case of companies migrating to IND AS [4] in the initial year of adoption and thereafter. To suggest appropriate amendments to the ITL in view of transition to IND AS regime. Interim report of the Committee The Committee submitted its interim reports in August 2011 and May The first interim report of August 2011 and drafts of Tax AS on Construction Contracts and Government Grants were published for public comments in October [5] Final report of the Committee The Committee submitted its final report in August 2012 along with drafts of 14 Tax AS. After examining the existing set of 31 ICAI AS, the Committee has recommended an 3 Order No. 134/48/2010-SO(TPL) 4 Indian Accounting Standards converged to IFRS 1 Notification No dated 25 January AS-1 and AS-5 of the ICAI 5 Refer EY Tax Alert dated 20 October 2011 Central Government issues Discussion paper on Tax Accounting Standards as also EY Tax Alert dated 10 November 2011 Memorandum of Ernst & Young views on proposed Tax Accounting Standards
3 approach of notifying independent set of Tax AS with the object of bringing certainty and clarity, eliminating alternatives (to the extent possible) as also to ensure horizontal equity and uniformity. A summary of the significant recommendations of the Committee are as follows: General Since it is intended that Tax AS should be in harmony with the ITL, it should be expressly provided in the Tax AS that, in case of conflict, provisions of the ITL shall prevail over Tax AS [6]. Tax AS should be made applicable only to the computation of taxable income and a taxpayer need not maintain separate sets of books of account on the basis of Tax AS [7]. To set at rest any future controversy in this regard, appropriate amendments should be made to the ITL. Broadly, the governing principles while framing Tax AS are reduction of litigation, minimization of alternatives and giving certainty to issues. Tax AS should be made applicable to all classes of taxpayers, irrespective of quantum of turnover/income, with a view to bring certainty on the issues covered by Tax AS. Transitional provisions, wherever required, should also be notified along with Tax AS to ensure that there is no double taxation or non-taxation of any income in pre and post Tax AS period. 6 Incidentally, preamble of each draft Tax AS contains a clarification that, in case of conflict between provisions of the ITL and Tax AS, provisions of the ITL shall prevail 7 Incidentally, preamble of each draft Tax AS contains a clarification that it applies for computation of income chargeable under Business head or Other Sources head and not for the purpose of maintenance of books of accounts Appropriate modification should be made in the return of income to ensure compliance with Tax AS. For tax audit cases, the tax audit report should also be modified so that a tax auditor is required to certify that the computation of taxable income is made in accordance with the provisions of Tax AS. Given the uncertainty surrounding convergence to IFRS, the Committee has recommended that the status of transition to IFRS should be carefully monitored and appropriate amendments in the ITL, especially relating to computation of MAT, should be considered based on any such developments in the future. Amendments to the ITL on specific issues Suitable amendments be made to the ITL to provide certainty on the following issues: 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. Tax AS on areas not covered by ICAI AS To reduce litigation and provide certainty, Tax AS covering the following areas which are presently not covered by ICAI AS [8] may also be considered for notification under the ITL: Share-based payment. Revenue recognition by real estate developers. Service concession arrangements (e.g., Built Operate Transfer agreements). Exploration for and evaluation of mineral resources. 8 The ICAI has issued Guidance Notes on these matters. However, Guidance Notes are recommendatory in nature and do not have the same mandatory effect as accounting standards
4 Areas where separate Tax AS is not necessary Tax AS need not be notified in respect of 17 ICAI AS which are listed at Annexure A to this Tax Alert for reasons specified therein. Suggested drafts of Tax AS The Committee has suggested drafts of 14 Tax AS. A summary of significant changes made in each draft Tax AS vis-avis the corresponding ICAI AS, as explained by the Committee in its report, is provided in Annexure B to this Tax Alert. Comments The publication of the final report and draft Tax AS for inviting public comments represents the continuation of a commendable consultative approach adopted by the CG in the recent past before introducing any new significant tax law. This provides an opportunity to all stakeholders to make representations on the possible adverse impacts and/or for making improvements to address unintended consequences. It is necessary for all stakeholders to carry out an in-depth analysis of each Tax AS to assess impact on their taxable income and/or compliance burden and provide their recommendations with support reasons within the time allowed by the CG viz., 26 November Annexure A Areas identified by the Committee where separate Tax AS is not necessary A. ICAI AS which merely prescribe disclosure requirements not affecting computation of taxable income. Cash Flow Statements (ICAI AS-3). Segment Reporting (ICAI AS-17). Discontinuing Operations (ICAI AS-24). Earning Per Share (ICAI AS-20). Consolidated Financial Statements (ICAI AS-21). Accounting for Investments in Associates in Consolidated Financial Statements (ICAI AS-23). Interim Financial Reporting (ICAI AS- 25). B. ICAI AS whose subject matter is covered by specific provisions under the ITL Accounting for Amalgamations (ICAI AS- 14). Employee Benefits (ICAI AS-15). Segment Reporting (ICAI AS-17). Related Party Disclosures (ICAI AS-18). Depreciation Accounting (ICAI AS-6). Impairment of Assets (ICAI AS-28) C. ICAI AS issues whereof are covered by other Tax AS and/or not relevant under the ITL Financial Reporting of Interests in Joint Ventures (ICAI AS-27). Accounting for Taxes on Income (ICAI AS-22).
5 D. ICAI AS which are currently voluntary and primarily get covered by Tax AS on Disclosure of Accounting Policies [9] Financial Instruments (Recognition and Measurement, Presentation and Disclosure) (ICAI AS-30,31 and 32). Annexure B Summary of significant changes as explained in the report of draft Tax AS suggested by the Committee from ICAI AS. Tax AS for Accounting Policies (Corresponding to ICAI AS-1). To reduce litigation, Tax AS specifically incorporates the well-established principle that the value of inventory of a business as on the beginning of a tax year shall be the same as the value of inventory at the end of the immediately preceding tax year. Method of valuation of inventory once adopted by a taxpayer in any tax year shall not be changed without a reasonable cause. Inventory on the date of dissolution of a partnership firm, association of persons and body of individuals shall be valued at net realizable value. Tax AS for Events occurring after the End of Tax Year (Corresponding to ICAI AS-4) Expected losses or mark-to-market losses shall not be recognized unless permitted by any other Tax AS. Concept of materiality for selection of accounting policies is omitted as it is not recognized by the ITL for the purpose of computation of taxable income. Accounting policies shall not be changed without a reasonable cause. [10] Disclosures relating to events occurring after the end of the tax year do not directly impact the computation of income. Hence, these provisions have been removed in Tax AS. Tax AS for Prior Period Expense (Corresponding to ICAI AS-5) Tax AS for Valuation of Inventories (Corresponding to ICAI AS-2) Since ICAI AS-2 does not specifically prescribe the method of valuation of inventories of a service provider, the same should be incorporated in Tax AS based on international best practices. Use of standard cost method as a technique for measurement of cost is not recommended. The ITL does not distinguish extraordinary items from ordinary items. Hence, provisions relating to separate disclosure of extraordinary items are not included in Tax AS [11]. Prior Period Expense shall not be considered as an allowable deduction in the tax year in which it is recorded unless the taxpayer proves that such expense accrued during the said tax year [12]. Tax AS on Construction Contracts (Corresponding to ICAI AS-7) Retention money shall be recognized for computing revenue based on percentage of completion method. 9 The Committee has, however, recommended close monitoring of the mandatory status of these ICAI AS and notification of appropriate Tax AS based on any developments in the future. 10 ICAI AS-1 permits change if it is considered that the change would result in a more appropriate presentation 11 Currently, notified Tax AS-II requires such separate disclosure. 12 There is no Tax AS proposed to deal with treatment of prior period income.
6 Before reversal of revenue already recognized as income on account of uncertainty arising on realizability of contract revenue, the sum shall be written off in the books of account in line with the provisions of the ITL relating to bad debts. Pre-construction income in the nature of interest, dividend and capital gains shall not be reduced from the cost of construction but shall be taxed as income in accordance with the applicable provisions of the ITL. Contract costs relating to future activity shall be recognized as an asset and if such costs are not realizable then the same may be allowed under the provisions of the ITL. Condition of non-recognition of contract revenues, if it is not possible to reliably measure the outcome of a contract, is not incorporated in Tax AS since it is subjective in nature and has resulted in litigation and postponement of tax liability. Losses incurred on a contract shall be allowed only in proportion to the stage of completion. Future or anticipated losses shall not be allowed unless such losses are actually incurred. Once a contract crosses 25% of the completion stage, the revenue in respect of such contract shall be required to be recognized. Tax AS for Revenue Recognition (Corresponding to ICAI AS-9) Revenue from service transactions shall be recognised by following only percentage completion method. In view of specific provisions in the ITL for bad debts, the postponement of revenue recognition due to uncertainty in ultimate collection shall be restricted to claims for price escalation and export incentives. Tax AS for Tangible Fixed Assets (Corresponding to ICAI AS-10) In case of acquisition of an asset in exchange for another asset, shares or other securities, lower of the fair value of the asset/securities given up or the asset acquired shall be recorded as actual cost of the asset [13]. Revaluation of assets is not incorporated in Tax AS as the ITL does not recognize the concept of revaluation of assets. The ITL contains specific provisions relating to retirement and disposal of tangible fixed assets. Hence, same are not incorporated in Tax AS. Tax AS for Effects of Changes in Foreign Exchange Rates (Corresponding to ICAI AS-11) Initial and subsequent recognition of foreign currency transactions and resultant exchange differences will be subject to specific provisions of the ITL and Income-tax Rules, Since the ITL does not distinguish between integral and non-integral foreign operations, exchange differences on non-integral foreign operations shall be recognised for the purpose of computation of income [14]. Since mark-to-market gains or losses are unrealized in nature, all gains or losses on forward exchange or similar contracts entered into for trading or speculation contracts shall be recognized only on settlement Tax AS for Government Grants (Corresponding to ICAI AS-12) Government grants should either be treated as revenue receipt or should be reduced from the cost of fixed assets based on the purpose for which such grant or subsidy is given. Recognition of Government grants shall not be postponed beyond the date of actual receipt. 13 As against whichever value is more evident as per ICAI AS As against accumulation in foreign currency translation reserve in Balance Sheet as prescribed under ICAI AS-11
7 Tax AS for Securities (Corresponding to ICAI AS-13) Since Tax AS deals with computation of income under Business head or Other sources head, Tax AS only deals with securities held as stock-in-trade. Securities should be valued at lower of cost or net realizable value (NRV). Comparison of cost and NRV shall be done category-wise (and not for each individual security) for which securities shall be classified into the following categories: (a) Shares (b) Debt securities (c) Convertible securities (d) Any other securities not covered above. Unlisted or thinly traded securities shall be valued at cost. Cost which cannot be ascertained by specific identification shall be determined on the basis of first-in-firstout (FIFO) method. Tax AS for Borrowing Costs (Corresponding to ICAI AS-16) Borrowing cost will not include exchange differences arising from foreign currency borrowings [15]. As against the criterion of substantial period of time for classifying an asset as qualifying asset under ICAI AS-16, the definition of qualifying asset is modified under Tax AS to mean: Land, building, machinery, plant or furniture, being tangible assets; Know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature, being intangible assets; Inventories that require a period of 12 months or more to bring them to a saleable condition. Specific pro-ration formula is provided for capitalizing borrowing costs relating to general borrowings. Income on temporary investments of borrowed funds cannot be reduced from borrowing costs eligible for capitalization. Condition of suspension of capitalization during interruption of active development is removed in Tax AS. Tax AS for Leases (Corresponding to ICAI AS-19) For ensuring uniformity of classification of a lease as operating lease or finance lease by both lessor and lessee, Tax AS provides for uniformity of definitions and requires a joint confirmation regarding consistency of classification of lease between lessor and lessee. In the case of finance leases, depreciation will be allowed to the lessee even though the asset is owned by the lessor. The Committee has recommended amendment in the provisions of the ITL relating to depreciation, ownership, block of assets, transfer etc., to align with this requirement. The Committee has also recommended necessary amendment to address cases where after sale and lease back transaction, the resulting lease is an operating lease. Tax AS on Intangible Assets (Corresponding to ICAI AS-26) In case of acquisition of an intangible asset in exchange for another asset, shares or other securities, lower of fair value of the asset/securities given up or the asset acquired shall be recorded as actual cost of the asset [16]. 15 ICAI AS-16 includes such differences to the extent that they are regarded as an adjustment to interest costs 16 As against whichever value is clearly evident as prescribed under ICAI AS-26
8 As the ITL contains specific provisions relating to amortization, retirement and disposal of intangible assets (including those acquired on amalgamation), same are not incorporated in Tax AS. Tax AS for Provisions, Contingent Liabilities and Contingent Assets (Corresponding to ICAI AS-29) A provision can be recognized when it is reasonably certain that an outflow of economic resources will be required to settle an obligation [17]. A contingent asset can be recognized when the realization of related income is reasonably certain [18]. 17 As against condition of probable under ICAI AS As against condition of virtual certainty under ICAI AS-29
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