EY Tax Alert. Delhi HC substantially dilutes ICDS by striking down to the extent of conflict with binding judicial precedents.

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1 9 November 2017 EY Tax Alert Delhi HC substantially dilutes ICDS by striking down to the extent of conflict with binding judicial precedents 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 EY advisor. Executive summary This Tax Alert summarizes a Delhi High Court (HC) ruling, dated 8 November 2017, on a writ petition [1] filed by The Chamber of Tax Consultants (Chamber) where the HC was concerned with the constitutional validity of Section 145(2) (S. 145(2)) of the Indian Tax Laws (ITL) authorizing the Central Government (CG) to notify Income Computation and Disclosure Standards (ICDS), as also the validity of 10 ICDS notified by the CG, to the extent they are in conflict with the principles laid down in binding judicial precedents rendered prior to ICDS. In a landmark ruling, the HC read down S.145(2) of the ITL to hold that the CG cannot notify ICDS that seek to override binding judicial precedents or statutory provisions. It held that the force of judicial precedents can be overridden only by a validation law passed by the Parliament, which removes the defect that the Courts had found in the existing law. Such power cannot be exercised by the Executive. The HC further held that if S.145(2) is not read in such restrictive manner, it would be ultra vires the ITL, as also the Constitution of India. [1] W.P.(C) 5595/ 2017

2 The HC also struck down several contentious provisions of each individual ICDS. It held that doing away with the concept of prudence (ICDS I), valuation of inventory at market value in case of dissolution of a partnership firm even when business is continued (ICDS II), taxation of unaccrued retention money (ICDS III), prohibition of reduction of incidental interest income from borrowing cost (ICDS III read with ICDS IX), recognition of export incentive as revenue before acceptance by the Government (ICDS IV), prohibition of completed contract method for revenue recognition from rendering of services (ICDS IV), prohibition of recognition of markedto-market (MTM) losses on forward contracts held for trading or speculation (ICDS VI), recognition of government grants on the basis of receipt prior to accrual (ICDS VII) and valuation of inventory of securities at variance with GAAP [2] (Part A of ICDS VIII) are all ultra vires the ITL and, hence, struck them down to that extent. However, it held that the mandate of ICDS IV to recognize interest income on time basis, even in the absence of reasonable certainty of realization, is a valid provision since it is backed up by a statutory provision under which the taxpayer can claim bad debt deduction for such unrealizable incomes. Background S. 145 of the ITL provides that the taxable income of a taxpayer falling under the Profits and Gains from Business and Profession (PGBP) or Income from Other Sources (IFOS) heads shall be computed in accordance with either the cash or mercantile system of accounting, whichever is regularly employed by the taxpayer. S.145(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. Based on the recommendations of an Expert Committee (Committee) constituted by the Central Board of Direct Taxes (CBDT) [3] and public consultation, the CBDT notified 10 ICDS under S. 145(2) of the ITL, covering diverse items like Accounting Policies, Inventories, Revenue Recognition, Tangible Fixed Assets etc [4]. The notified ICDS are applicable from tax year to taxpayers following the mercantile system of accounting and for the computation of income chargeable under the PGBP or IFOS heads. 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 ITL. Having regard to concerns raised by stakeholders in the implementation of ICDS, the CG issued Circular No. 10/2017 dated 23 March 2017 (Circular) providing clarifications on 25 issues, in the form of FAQs, for the smooth implementation of ICDS [5]. However, some of the provisions of the ICDS, as well as clarifications provided in the FAQs, were directly in conflict with the settled judicial positions under the ITL. In this regard, the Chamber, a voluntary non-profit organization with tax and legal professionals as its members, filed a writ petition before the HC challenging the constitutional [6] validity of S. 145(2) to the extent it requires compliance of the ICDS and the Circular issued thereunder, in conflict with binding judicial precedents rendered prior to ICDS. The Chamber urged that while S. 145(2) of the ITL 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 ITL. 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 ITL and the Constitution of India. On the other hand, the CG sought to defend the validity of ICDS by urging that they were aimed at codifying the law and give complete guidance to the Tax Authorities and, at the same time, act as a check on Tax Authorities not to deviate from the guiding principles. The CG argued that ICDS were aimed at bringing uniformity and clarity in computation of taxable income. Issues for consideration before the HC Are ICDS an instance of excessive delegation of legislative powers to the CG and, thus, constitutionally invalid. Whether the ICDS are in direct conflict with the settled judicial positions under the ITL and, therefore, liable to be struck down. HC s ruling Constitutional validity of ICDS The HC upheld the constitutional validity of ICDS but ruled that the CG, being a delegate of the Legislature, cannot override any statutory provisions or any binding judicial decision. The Legislature alone has the power to amend the provisions of the ITL to overcome defects/loopholes in the existing law as pointed out by the judicial precedents. [2] Generally Accepted Accounting Principles [3] The apex administrative body for direct taxes in India [4] Refer EY Tax Alert dated 3 October 2016, Government of India amends Income Computation and Disclosure Standards and also defers them by one year to tax year [5] Refer EY Tax Alert dated 24 March 2017, CBDT issues clarifications for smooth implementation of Income Computation and Disclosure Standards [6] The Constitution of India guarantees certain fundamental rights to every citizen of India, such as Article 14 providing for equality before law, Article 19(1)(g) providing for freedom to practise any trade, business or profession with any reasonable restrictions that may be imposed by the CG etc.

3 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 recognized by the provisions of the ITL or the binding judicial precedents laid down by the Supreme Court (SC) or HCs. It is, thus, clear that ICDS are not meant to overrule the provisions of the ITL, the Rules thereunder and the settled judicial positions. Accordingly, the HC dealt with each ICDS that was challenged by the Chamber and struck down some of the contentious provisions, which are discussed below. A snapshot of ICDS provisions struck down by the HC is provided at Annexure A. ICDS I on Accounting Policies Absence of prudence concept is in conflict with the ITL provisions and, hence, unsustainable ICDS I provides that expected or 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. The Chamber contended that this provision of ICDS I is contrary to the settled judicial position since the Delhi and Gujarat HC rulings [7] have recognized the principle of prudence by allowing deduction for provision for expected losses on contracts recognized in the books of account by the taxpayer in compliance with GAAP. The ITL also grants deduction for revenue expenses laid out or expended for the purpose of business in which the concept of prudence is inherent. Accepting the above contentions, the HC held that nonacceptance of the prudence concept is contrary to the ITL provisions and, hence, ICDS I is unsustainable to that extent. ICDS II on Valuation of Inventory - ICDS II is contrary to the settled judicial positon As per the settled judicial position [8], 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 [9]. 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. [7] CIT v. Triveni Engineering & Industries Ltd. [(2011) (49 DTR 253) (Del.HC)] and CIT v. Advance Construction Co. Pvt. Ltd. [(2005) (275 ITR 30) (Guj. HC)] [8] Shakti Trading Co. v. CIT [(2001) 250 ITR 871 (SC)] [9] ALA Firm v. CIT [(1989)(189 ITR 285)(SC)] Furthermore, there is a specific provision of the ITL [10], which overrides S. 145 and 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. Thus, the HC held that ICDS II is ultra vires the ITL and, as such, it is struck down. ICDS III on Construction Contracts - Taxability of retention money depends on contractual terms, conditions attached to such amount and settled principles of accrual of income 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 Circular reiterates this position. However, as per the settled judicial position [11], retention money accrues to the taxpayer only when the related performance conditions are fulfilled. Retention money cannot form part of the revenue unless the same has accrued as income as per the charging provisions of the ITL. 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 and, therefore, ultra vires the ITL. ICDS III on Construction Contracts - Incidental income not allowed as reduction from borrowing cost is contrary to the settled judicial position and is unsustainable to that extent [12], 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. [10] S.145A [11] CIT v. Simplex Concrete Piles India (P) Ltd. [(1988) (179 ITR 8) (Cal)], CIT v. P & C Constructions (P) Ltd. [(2009) (318 ITR 113) (Mad)], Amarshiv Construction (P) Ltd v. DCIT [(2014) (367 ITR 659) (Guj)], DIT v. Ballast Nedam International [(2013) (355 ITR 300) (Guj)] [12] [(1999) (236 ITR 315)]

4 ICDS IV on Revenue Recognition Export incentives are taxable only in the year of acceptance of claim by the Government As per the SC ruling in the case of CIT v. Excel Industries Ltd. [13], 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 favor of the taxpayer when the corresponding obligation to pay arises for the Government. 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 ITL provisions and, hence, struck down to that extent. ICDS IV on Revenue Recognition Both POCM and completed contract methods are permissible for revenue recognition from service contract Accounting principles permit the taxpayer to follow either completed service contract method or POCM for revenue recognition. Judicial precedents [14] have recognized 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. ICDS IV on Revenue Recognition Recognition of interest income, in the absence of reasonable certainty of ultimate collection, is not ultra vires since corresponding bad debt deduction can be claimed ICDS IV provides that interest income is to be taxed on time basis, irrespective of reasonable certainty of ultimate collection. 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 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 ITL. Furthermore, the Parliament has inserted a specific provision in the ITL to grant bad debt deduction for incomes recognized under ICDS (without recognition in the books) in the year in which they become irrecoverable. [13] [(2015) (358 ITR 295) (SC)] [14] CIT v. Bilhari Investment Pvt. Ltd. [(2008) 299 ITR 1 (SC)], CIT v. Manish Buildwell Pvt. Ltd. [(2011) 245 CTR 397 (Del)], Paras Buildtech India Pvt. Ltd. v. CIT [(2016) 382 ITR 630 (Del)]. 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 [15]. offered to tax on time basis by claiming corresponding bad debt deduction, if the amount is not recoverable, ICDS creates a mechanism to track unrecognized interest amounts for future taxability, if so accrued. ICDS VI on Foreign Exchange Fluctuations ICDS VI not allowing MTM loss/gain in case of foreign currency derivatives held for trading or speculation purpose and taxation of opening balance of Foreign Currency Translation Reserve (FCTR) pertaining to monetary items is contrary to the settled judicial decision The SC, in the case of Godhra Electric Supply Company Ltd v. CIT [16], held that hypothetical income cannot be taxed. Furthermore, it held, in the case of Sutlej Cotton Mills Ltd v. CIT [17], that exchange fluctuation gain/loss in relation to loan utilized for acquiring a capital item would be capital in nature. 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, ultra vires the ITL and, as such, struck it down. The Circular clarifies that the opening balance of FCTR 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. However, 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. [15] It seems several rulings like CIT v. Vasisth Chay Vyapar Ltd. [(2011)(330 ITR 440)(Del)] laying down the principle that there can be no taxation of interest on NPAs not permitted to be recognized by prudential guidelines of the Reserve Bank of India (RBI), were not noticed by the HC. [16] [(1997)(225 ITR 746)(SC)] [17] [(1979)(116 ITR 1)(SC)]

5 ICDS VII on Government Grants Taxation of unaccrued subsidy on the date of actual receipt is ultra vires the ITL 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 and, hence, the amount may not have accrued to the taxpayer. Therefore, the HC held that ICDS VII is ultra vires the ITL to that extent. ICDS VIII on Securities held as Inventory Part A of ICDS VIII which prescribes bucket approach applicable to taxpayers other than banks and public financial institutions is ultra vires the ITL ICDS VIII provides for valuation of securities held as inventory and is divided into two parts. Part A applies to taxpayers other than banks and public financial institutions. It requires valuation of inventory on bucket approach i.e., category-wise valuation of securities 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. 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 [18] guidelines. 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 ITL. Hence, to that extent, Part A of ICDS VIII is ultra vires the ITL. Comments This HC ruling is a landmark ruling which addresses several controversies which had arisen on interpretation of ICDS. It provides clarity on the interplay between ICDS and binding judicial precedents. It also provides a welcome relief to taxpayers by striking down several contentious provisions of ICDS, which had raised apprehensions of taxation of unrealized/notional incomes. Taxpayers which are yet to file returns for tax year can consider the impact of the present ruling in their tax computations. Taxpayers which have already filed returns for tax year can explore revising their returns on the basis of the law laid down by the present ruling. While the ruling has addressed majority of the concerns of taxpayers, to the extent that the ruling has upheld the validity of taxation of unrealizable interest, it may have a significant impact on certain sectors like NBFCs, in relation to interest on NPAs. Those taxpayers will need to take care to offer such incomes in their tax computation (even if not recognized in the books) and claim bad debt deduction as per the specific provision in the ITL. However, even on this issue, there is a silver lining for taxpayers in the form of the Tax Authority s admission before the HC that ICDS does not, in any way, seek to alter the well-laid principles of real income by the SC, but merely ensures that there is a trace available of the income which is not taxed. Therefore, if there is an unrealizable interest income, it can be written off by the taxpayer for tax purposes and claimed as bad debt deduction in the same year under the specific provision inserted in the ITL for this purpose. The Tax Authority s clarification that the process is intended to obtain information, rather than tax unrealizable income, should offer a sigh of relief to taxpayers. [18] The central bank of India

6 Annexure A List of ICDS provisions struck down by the HC The application of the principle laid down by the HC on the overriding impact of binding judicial precedents over ICDS may throw up some interesting issues. For example, 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 conflicting rulings of different HCs or where an issue is covered by a decision of the Income Tax Appellate Tribunal (which is lower in status than the HC). Taxpayers may also need to note that the present ruling does not impact adjustments required by ICDS which have not been specifically struck down by the HC. For example, ICDS IX requires capitalization of general borrowing costs as per the normative formula, which is at variance with GAAP. Furthermore, the impact of the present ruling on companies which have adopted or are in the process of adopting Indian Accounting Standards (Ind-AS ) [19] will need to be specifically evaluated. ICDS Particulars ICDS I Non-acceptance of the concept of prudence ICDS II Valuation of inventory at market price in case of dissolution of firm if firm s business is continuing ICDS III Taxation of retention money at the earliest possible stage even when the receipt of such money is conditional/uncertain Incidental income not allowed to be reduced from the borrowing cost even if it is inextricably linked to the setting up of project ICDS IV Taxation of export incentives on reasonable certainty of ultimate collection even if not admitted by the Government Completed contract method not permissible for recognition of service revenue ICDS VI MTM gain/loss in case of foreign currency derivatives entered into for trading or speculation purposes not allowed for tax purposes Upfront taxation of opening balance of FCTR as on 1 April 2016 pertaining to monetary items in tax year ICDS VII Taxation of government grants on the date of actual receipt even though not accrued ICDS VIII Bucket approach applicable for valuation of securities held as inventory in case of taxpayers other than banks and public financial institutions [19] Converged form of International Financial Reporting Standards

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