Government of India amends Income Computation and Disclosure Standards and also defers them by one year to tax year

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1 3 October 2016 EY Tax Alert Government of India amends Income Computation and Disclosure Standards and also defers them by one year to tax year 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 EY advisor. This Tax Alert summarizes amendments to 10 Income Computation and Disclosure Standards (the ICDS) as notified by Central Government (CG) vide Notification No. 87/2016 dated 29 September 2016 (Notification). The CG had earlier notified [1] ICDS (old ICDS), effective from tax year , for compliance by all taxpayers following the mercantile system of accounting for the purposes of computation of income chargeable to income tax under the head profits and gains of business or profession (Business) or income from other sources (Other Sources). Having regard to concerns raised by stakeholders on challenges arising from implementation of old ICDS and pending revision of tax audit form to capture disclosures required in terms of ICDS, the Central Board of Direct Taxes (CBDT) had announced deferment of the effective date of old ICDS by one year i.e., to be applicable from tax year [2]. The Press Release had also clarified that an appropriate notification shall be issued shortly. In deference to this, vide the Notification [3], CG rescinded old ICDS and has now notified ICDS (amended ICDS) to be effective from tax year and onwards. These amended ICDS also are for compliance by the taxpayers following the mercantile system of accounting and for the purposes of [1] Refer EY Tax Alert dated 2 April, 2015 Indian Government notifies 10 Income Computation and Disclosure Standards effective from tax year onwards [2] Refer EY Tax Alert dated 7 July Government of India defers effective date of Income Computation and Disclosure Standards by one year to tax year [3] Vide Notification No. 86/ 2016 dated 29 September 2016

2 computation of income chargeable to income tax under the Business head or Other Sources head. However, the amended ICDS do not apply to taxpayers being individuals and Hindu Undivided Family (HUF) who are not liable for tax audit under the provisions of the Indian Tax Laws (ITL). The amendments aim to bring the amended ICDS closer to Accounting Standards issued by the Institute of Chartered Accountants of India (ICAI). Some of the key amendments made to old ICDS include: (a) permitting standard costing method for inventory valuation; (b) making the amended ICDS applicable to service and construction contracts commencing after 1 April 2016 and thus providing complete grandfathering to such contracts commenced prior to 31 March 2016 from applicability of ICDS; (c) permitting straight line method for revenue recognition if services are provided by an indeterminate number of acts over a specific period of time; (d) revenue from service contracts whose duration does not exceed 90 days may be recognized when rendering of services is complete or substantially complete (e) interest on refund of any tax, duty or cess taxable in the year in which such interest is received (f) borrowing cost incurred on general purpose borrowings needs to be capitalized to the cost of qualifying assets as per normative formula prescribed in ICDS IX only if qualifying assets require 12 months or more for their acquisition, construction or production. Changes have also been introduced in Tax Audit Report [4] for including ICDS related disclosure requirements and for quantifying adjustment to profits or loss for complying with the ICDS. Background Section 145 of the ITL provides that taxable income of a taxpayer falling under the heads Business or Other Sources, shall be computed in accordance with either cash or mercantile system of accounting which is regularly employed by the taxpayers. It further provides that the CG may notify, from time to time, ICDS to be followed by any class of taxpayers or in respect of any class of income. Based on the recommendations of the Expert Committee (Committee), which formulated ICDS, and post public consultation on draft ICDS, the CG had earlier notified [5] old ICDS, effective from tax year , for compliance by all taxpayers following the mercantile system of accounting for the purposes of computation of income chargeable to income tax under the Business head or Other Sources head. However, several concerns were raised by various stakeholders on the implementation of old ICDS, which resulted in hardships for the taxpayers and created uncertainty on tax treatment of several incomes and expenses, including transitional impact of ICDS. Vide Press Release dated 26 November 2015, the CG announced that issues raised by stakeholders for clarification/ guidance for proper implementation had been referred to the Committee. The Press Release also invited comments from stakeholders on implementation issues in old ICDS. Having regard to concerns raised by stakeholders on challenges arising from implementation of old ICDS and pending revision of Tax Audit Report to capture disclosures required in terms of ICDS, the CBDT had announced deferment of the effective date of old ICDS by one year [4] Statement of particulars to be furnished in relation to tax audit carried out under the provisions of the ITL [5] Refer EY Tax Alert dated 2 April, 2015 Indian Government notifies 10 Income Computation and Disclosure Standards effective from tax year onwards

3 and, accordingly, shall be applicable from tax year (assessment year ) and onwards [6]. The Press Release also clarified that an appropriate notification shall be issued shortly. Amendments in general The Notification provides that the amended ICDS are to be applicable from tax year and onwards. Accordingly, the CG vide Notification No. 86/2016 rescinded earlier notification [7] which introduced old ICDS. Consequently, transitional provisions of the respective ICDS [8] have also been amended. Amended ICDS is applicable to all taxpayers, excluding certain individuals and HUFs Old ICDS were applicable to all taxpayers following mercantile method of accounting for the purposes of computation of income chargeable to income tax under the Business head or Other Sources head. Amendments to old ICDS Following are the key amendments in relation to amended ICDS as notified: ICDS II relating to valuation of inventories Permitting techniques for measurement of cost in addition to first-in-first out (FIFO), weighted average and retail method Old ICDS permitted only FIFO, weighted average and retail method as a technique for measurement of cost. Amended ICDS II specifically permits use of standard cost method for convenience if the results approximate the actual cost [9]. This is largely in alignment with ICAI AS-2. If standard cost method is used, taxpayer needs to disclose details of such inventory and provide a confirmation that standard cost approximates the actual cost. Amendment to retail method In respect of retail method of measuring inventory, cost is determined by reducing appropriate percentage of gross margin from the sales value. It is now provided that an average percentage for each retail department is to be used [10]. ICDS III relating to construction contracts However, the amended ICDS are not applicable to individuals and HUFs who are not liable for tax audit under the provisions of the ITL. Contract revenue and contract costs from construction contracts which commenced on or after 1 April 2016 shall be recognised as per ICDS III. As per amended ICDS III, revenue and costs in respect of construction contract need to be recognized on percentage of completion method (POCM). But, if during the early stages of a contract [11] the outcome of the contract cannot be estimated reliably, then contract revenue is recognized only to the extent of costs incurred. [6] Refer EY Tax Alert dated 6 July 2016 Government of India defers effective date of Income Computation and Disclosure Standards by one year to tax year [7] Notification No. 33/2015 [8] Except ICDS VIII on Securities which does not have a transitional provision [9] Standard costs take into account normal levels of consumption of materials and supplies, labour, efficiency and capacity utilisation. They are regularly reviewed and, if necessary, revised in the light of current conditions [10] However, language used in ICAI AS-2 is as follows An average percentage for each retail department is often used. [11] Early stage of a contract shall not extend beyond 25% of the stage of completion

4 Contract revenue and contract costs from construction contracts which commenced on or before 31 March 2016 but not completed by the said date shall be recognized based on the method regularly followed by the taxpayer prior to 31 March Transitional provisions now provide for complete grandfathering in respect of construction contracts which commenced on or before 31 March 2016 but not completed by the said date. ICDS IV relating to revenue recognition Revenue recognition criteria for service contracts Old ICDS IV mandated adoption of POCM for recognition of revenue from service transactions irrespective of time threshold or duration of such contracts. In case of service contracts with duration of not more than 90 days, amended ICDS IV permits recognition of revenue when the rendering of services under that contract is completed or substantially completed. Further, in line with ICAI AS-9, when services are provided by an indeterminate number of acts over a specific period of time, revenue may be recognized on a straight line basis over the specific period. Other service contracts shall continue to be governed by POCM method. Since transitional provision of amended ICDS IV is linked to transitional provision of ICDS III, service contracts which commenced on or before 31 March 2016 but not completed by the said date shall be recognized based on the method regularly followed by the taxpayer prior to 31 March ICDS VI relating to the effects of changes in foreign exchange rates Amended ICDS VI removes distinction between integral and non-integral foreign operation as was provided under old ICDS VI. Accordingly, it now requires that financial statements of a foreign operation should be translated as if the transactions of the foreign operation are that of the taxpayer himself, irrespective of whether foreign operations are integral or non-integral. All non-monetary items were required to be converted by using the exchange rate as on the date of transaction. Amended ICDS VI provides that non-monetary item, being inventory, which is carried at net realizable value shall be converted by using the exchange rate that existed when such value was determined. This is in line with ICAI AS-11. ICDS VIII relating to securities Applicability to taxpayers other than scheduled banks and public financial institutions ICDS VIII deals with securities held as stock-in-trade. Under old ICDS VIII, securities was given a meaning assigned to it under Securities Contract (Regulation) Act, 1956 (SCRA) [12]. The definition of securities is amended to include share of a company in which public are not substantially interested. Like old ICDS VIII, securities need to be valued at lower of cost or net realizable value (NRV) [13] and cost which could not be ascertained by specific identification was determined on the basis of FIFO method. In addition to FIFO method, amended ICDS VIII now also permits weighted average method for ascertainment of cost. Revenue recognition criteria for interest income Under old ICDS IV, interest income arising from any source was required to be recognized on time basis. As per amended ICDS IV, interest on refund of any tax, duty or cess shall be taxable in the year in which such interest is received. [12] Excluding derivatives referred to u/s. 2(h)(ia) of SCRA [13] 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

5 Applicability to scheduled banks and public financial institutions The amended ICDS VIII introduces new Part B to deal with the securities held by a scheduled bank [14] or public financial institution [15]. The provisions of this part are as follows: i. Securities to have the same meaning as defined in SCRA and also includes share of a company in which public are not substantially interested. Derivatives as defined u/s 2(h)(ia) of SCRA are also included. ii. Classification, recognition and measurement of securities shall be in accordance with the extant guidelines issued by the Reserve Bank of India in this regard. Any claim by the taxpayer for deduction in excess of the said guidelines shall not be permissible. iii. To this extent, provisions of ICDS VI relating to forward exchange contracts shall not be applicable. ICDS IX relating to borrowing costs Old ICDS IX prescribed a normative formula for computing the amount of borrowing cost which is required to be capitalized to the cost of qualifying assets funded out of general purpose borrowings, irrespective of the time taken for acquisition, construction or production of such qualifying assets. Amended ICDS IX continues to provide that borrowing cost incurred on general purpose borrowings and as computed by prescribed normative formula needs to be capitalized to the cost of qualifying assets. However, for this purposes, qualifying assets shall be such assets that necessarily require a period of > 12 months for their acquisition, construction or production. Like old ICDS IX, capitalisation of borrowing cost incurred on funds borrowed specifically for the purposes of acquisition, construction or production of any qualifying asset is required during pre-construction period irrespective of the time period required for their acquisition, construction or production 16]. Changes in Tax Audit Report in relation to ICDS The CG vide Notification No. 88/ 2016 dated 29 September 2016 amends Tax Audit Report form and specifically requires following supplemental information to be provided: Whether any adjustment is required to be made to the profit or loss for complying with the provisions of ICDS. If yes, Tax Audit Report is to give information for each of the ICDS to reflect information about increase in profit, decrease in profit and the net impact. A specific clause is introduced providing for disclosures which are required in terms of the respective ICDS. To illustrate, in terms of ICDS II relating to Inventories, the taxpayer is required to give information about the accounting policies adopted in measuring inventories including the cost formulae used and the total carrying amount of inventories and its classification appropriate to a person. [14] Scheduled Bank shall have the same meaning as assigned under the provisions of the ITL (Explanation (ii) to s.36(1)(viia) [15] Refers to institutions form under a Central or a State Act or so declared under the Companies Act of 1956 or 2013 [16] Except qualifying assets being inventories which require a period of 12 months or more to bring them to a saleable condition

6 Comments Issuance of appropriate notification for deferral of ICDS as promised by the CG by way of Press Release clears the ambiguity with respect to the binding nature of the Press Release which preceded the Notification and provides certainty to the taxpayers, which is also the focus of the present Government. Further, some of the amendments to ICDS such as grandfathering for outstanding construction and service contracts, permitting project completion method for service contract of < 90 days, taxability of interest on refunds of tax, duty, cess etc. on receipt basis do address concerns of the taxpayers. However, there are some unaddressed concerns. For example, there is ambiguity on non-recognition of foreseeable losses on contracts and mark-tomarket losses on derivatives, valuation of inventory of work-inprogress of service providers, ambiguity on double taxation of benefit arising from concessional loans from the Government or exemption from taxes/duties which are already recognized in books by recording corresponding expenditure at net amount etc. It may also assist the taxpayers and tax administrators if guidance is provided with the help of examples. Likewise, restricting capitalization of interest on general borrowing to the assets, which necessarily require period of 12 months or more for its acquisition, construction or production, providing same tax treatment in respect of forex fluctuation for integral and nonintegral operations is also welcome.

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