CBDT releases revised draft of Income Computation and Disclosure Standards for public comments

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1 16 January 2015 EY Tax Alert CBDT releases revised draft of Income Computation and Disclosure Standards for public comments 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 key changes made in the revised draft of Income Computation and Disclosure Standards [1] (ICDS) released by the Central Board of Direct Taxes (CBDT) on 9 January 2015, as compared to an earlier draft of October Section 145 of the Indian Tax Laws (ITL) gave the power, effective from tax year , to the Central Government (CG) to notify ICDS to be followed by any class of taxpayers or in respect of any class of income. In view of significant developments in the convergence to International Financial Reporting Standards (IFRS), the CG constituted a 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 recommended notification of 18 standards for compliance with the ITL on the issue of harmonization of ICAI AS with the ITL and also provided drafts of 14 standards which were released for public comments by the CBDT in October After examining suggestions received from stake holders, the CBDT has released revised drafts of 12 ICDS on websites of the Ministry of Finance and the Income Tax Department for comments/suggestions from stakeholders and the general public, which may be submitted by 8 February 2015 by or hard copy. [1] Nomenclature changed from Tax Accounting Standards to ICDS by Finance (No. 2) Act, 2014 to clarify that ICDS are meant only for computation of taxable income and taxpayers are not required to maintain separate books of account.

2 Background Section 145 of the ITL provides that the taxable income of a taxpayer, under the head profit and gains of business or profession (Business head) or income from other sources (Other Sources head), shall be computed in accordance with either the 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, ICDS 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 ICDS was that ICAI AS provide 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 can be computed precisely and objectively. Since the introduction of this provision in the ITL, the CG has notified two ICDS in 1996 [2] 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 [3]. Constitution of the Committee Vide an Order [4] dated 20 December 2010, the CG constituted a 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 minimum alternate tax (MAT) in case of companies migrating to IND AS [5], in the initial year of adoption and thereafter. To suggest appropriate amendments to the ITL in view of transition to the IND AS regime. Final report of the Committee The Committee submitted its final report in August The Committee recommended notification of 18 standards for compliance with the ITL on the issue of harmonization of ICAI AS with the ITL and also provided drafts of 14 standards which were released for public comments by the CBDT in October 2012 [6]. A summary of significant recommendations of the Committee is provided in Annexure A. Revised drafts of ICDS The CBDT examined suggestions received from the stakeholders and revised the draft ICDS, which have been placed on websites of the Ministry of Finance and the Income Tax Department for comments from stakeholders and the general public, which may be submitted by 8 February 2015 by or hard copy. Summary of changes in revised draft of ICDS as compared to first draft of October 2012 The names of all standards have been changed from Tax Accounting Standards to Income Computation and Disclosure Standards, pursuant to amendment made by Finance (No. 2) [2] Notification No dated 25 January [3] AS-1 and AS-5 of the ICAI. [4] Order No. 134/48/2010-SO(TPL). [5] Indian Accounting Standards converged to IFRS. [6] Refer EY Tax Alert Final report of Accounting Standards Committee of CBDT dated 29 October 2012.

3 Act, 2014 to clarify that ICDS apply only to computation of taxable income and taxpayers are not required to maintain separate books of account to comply with ICDS. The first draft did not contain transitional provisions to deal with the impact of the first year of implementation of ICDS. Pursuant to the Committee s recommendations in its final report to ensure that there is no double taxation or non-taxation of any income in pre and post ICDS period, transitional provisions have been inserted in all ICDS (except ICDS on Securities). The transitional provisions broadly require recognition of the concerned contract/transaction, asset, income, expense, loss or provision existing as on or entered into on or after 1 April 2015 (i.e., tax year onwards) as per ICDS, after taking into account income, expense or loss, if any, recognized in respect thereof in earlier years [7]. The cut-off of 1 April 2015 provided in ICDS indicates that the CBDT is proposing to notify the ICDS effective from tax year onwards. Some significant changes made in the revised draft of ICDS are summarized in the table below: [7] Except in case of leases where leases undertaken on or before 31 March 2015 are proposed to be grandfathered

4 ICDS Particulars As per first draft published in October 2012 As per revised draft published in January 2015 Valuation of Inventories Valuation of inventories of services for service providers To be valued at cost To be valued at cost or net realizable value, whichever is lower Value of opening inventory where business has commenced during relevant tax year NIL Cost of inventory, if any, on the day of commencement of business Construction Contracts and Revenue Recognition Revenue recognition only when there is reasonable certainty of ultimate collection This aspect was not provided This has now been specifically provided Tangible Fixed Assets Cost of tangible fixed asset acquired in exchange for another asset or shares/securities Lower of (a) fair value of tangible fixed asset acquired or (b) fair value of asset given up/shares or securities issued Value of tangible fixed asset acquired Test for capitalizing/writing off improvements and repairs to tangible fixed asset Negative test i.e. Expenditure incurred for preserving or maintaining an already existing tangible fixed asset and which does not bring a new asset into existence or does not result in a new or different advantage that increases future benefits from the existing asset to be charged to revenue. Positive test (in line with ICAI AS-10) i.e. Expenditure that increases the future benefits from the existing asset beyond its previously assessed standard of performance to be added to actual cost. The Effects of Changes in Foreign Exchange Rates Use of weekly/monthly average rate for initial recognition This was not permitted This is now permitted (in line with ICAI AS-11) Use of likely realizable value in case of uncertainty of closing rates This was not permitted This is now permitted (in line with ICAI AS-11) Securities Cost of securities acquired in exchange for another asset Lower of (a.) fair value of securities acquired or (b.) fair value of asset given up Value of securities acquired Intangible Assets Cost of intangible asset acquired in exchange for another asset or shares/securities Fair value of asset given up/shares or securities issued Value of intangible asset acquired

5 Revision in capitalization formulae for borrowing costs: Earlier draft of ICDS on borrowing costs provided the following pro-ration formula for capitalizing borrowing cost relating to general borrowings: While the capitalization formula remains unchanged in the revised draft, the following situations are now also specifically covered: Borrowing cost on general borrowings X Average cost of qualifying asset appearing in Balance Sheet as on first day and last day Average amount of total assets appearing in Balance Sheet as on first day and last day For qualifying assets acquired and put to use during same year, capitalization shall be with reference to half the cost of qualifying asset. For qualifying assets brought forward from earlier year and put to use during the year, capitalization shall be with reference to average cost as on first day of tax year and date of completion. A summary of significant deviations of the revised draft of ICDS from ICAI AS is enclosed in Annexure B. Comments The revised draft of ICDS represents an improved version which addresses transitional impact and certain ambiguities in the original draft. Curiously, no revised drafts have been published for: (a.) Events occurring after the previous year and (b.) Prior period items. From the cut-off date of 1 April 2015 specified in transitional provisions in the revised draft, the intent appears to be to notify ICDS with effect from tax year onwards. This makes it imperative for all stakeholders to make representations on possible adverse impacts and/or for making improvements to address unintended consequences. This could probably be the last opportunity to make such representations which stakeholders should not miss.

6 Significant recommendations of the Committee in its final report of August 2012 Annexure A The Committee submitted its final report in August 2012 along with drafts of 14 ICDS. After examining the existing set of 31 ICAI AS, the Committee recommended an approach of notifying an independent set of ICDS 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 is as follows: General Since it is intended that ICDS should be in harmony with the ITL, it should be expressly provided in the ICDS that, in case of conflict, provisions of the ITL shall prevail over ICDS 8. ICDS 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 ICDS 9. To set at rest any future controversy in this regard, appropriate amendments should be made to the ITL 10. Broadly, the governing principles while framing ICDS are reduction of litigation, minimization of alternatives and giving certainty to issues. ICDS 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 ICDS. Transitional provisions, wherever required, should also be notified along with ICDS to ensure that there is no double taxation or non-taxation of any income in pre and post ICDS period 11. Appropriate modification should be made in the return of income to ensure compliance with ICDS. 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 ICDS. Given the uncertainty surrounding convergence to IFRS, the Committee 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 12 : 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. [8] This is incorporated in preamble of each draft ICDS. [9] Incidentally, preamble of each draft ICDS 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. [10] This was implemented by an appropriate amendment to Section 145 of ITL by Finance (No. 2) Act, 2014 with effect from 1 April [11] This is incorporated in the revised draft of ICDS. [12] This is yet to be implemented.

7 ICDS on areas not covered by ICAI AS To reduce litigation and provide certainty, ICDS covering the following areas which are presently not covered by ICAI AS 13,may also be considered for notification under the ITL 14 : Share-based payment. Revenue recognition by real estate developers. Service concession arrangements (e.g., Built Operate Transfer agreements) 15. Exploration for and evaluation of mineral resources. Areas where separate ICDS is not necessary ICDS need not be notified in respect of 17 ICAI AS which relate to disclosure requirements and/or are covered by specific provisions in the ITL and/or are covered by other ICDS. [13] 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. [14] The Revised draft of ICDS does not cover these items. [15] Refer EY Tax Alert on CBDT clarifies on tax treatment of expenditure for developing infrastructure facility under BOT arrangement dated 25 April 2014.

8 Summary of significant deviations of revised draft ICDS from ICAI AS Annexure B ICDS for Accounting Policies (corresponding to ICAI AS-1) Expected losses or mark-to-market losses shall not be recognized unless permitted by any other ICDS. 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 16. ICDS 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 ICDS, based on international best practices. (The revised draft of ICDS provides for valuation of inventory of securities at cost or net realizable value, whichever is lower) Use of standard cost method, as a technique for measurement of cost is not recommended. To reduce litigation, ICDS 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. Similarly, cost of inventory, if any, on the day of commencement of business will be opening inventory where business has commenced during the relevant 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. ICDS for Events occurring after the End of Tax Year (corresponding to ICAI AS-4) 17 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 ICDS. ICDS for Prior Period Expense (corresponding to ICAI AS-5) 18 The ITL does not distinguish extraordinary items from ordinary items. Hence, provisions relating to separate disclosure of extraordinary items are not included in ICDS 19. 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 20. [16] ICAI AS-1 permits change if it is considered that the change would result in a more appropriate presentation. [17] No revised draft has been released on this ICDS. [18] No revised draft has been released on this ICDS. [19] Currently, notified Accounting Standard II requires such separate disclosure. [20] There is no ICDS proposed to deal with treatment of prior period income.

9 ICDS on Construction Contracts (corresponding to ICAI AS-7) Retention money shall be recognized for computing revenue based on percentage of completion method. 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 ICDS, 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. ICDS for Revenue Recognition (corresponding to ICAI AS-9) Revenue from service transactions shall be recognized by following only percentage completion method. ICDS 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, value of tangible fixed asset acquired shall be recorded as actual cost of the asset 21. Revaluation of assets is not incorporated in ICDS 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 ICDS. ICDS 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 recognized for the purpose of computation of income 22. 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. [21] As against whichever value is more evident as per ICAI AS-10 [22] As against accumulation in foreign currency translation reserve in Balance Sheet as prescribed under ICAI AS-11

10 ICDS 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. ICDS for Securities (Broadly corresponding to ICAI AS-13) Since ICDS deals with computation of income under Business head or Other Sources head, ICDS 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-first-out (FIFO) method In case of acquisition of securities in exchange for issue of shares or other securities, lower of: (a) fair value of shares or securities acquired or (b) fair value of securities issued shall be recorded as actual cost of the securities 23. In case of acquisition of securities in exchange for another asset, value of securities acquired shall be recorded as actual cost of the securities 24. ICDS for Borrowing Costs (corresponding to ICAI AS-16) Borrowing cost will not include exchange differences arising from foreign currency borrowings 25. 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 ICDS 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. The revised draft of ICDS also addresses the circumstances of: (a) Assets acquired and put to use during same tax year and (b) Assets awaiting capitalization brought forward from earlier year and put to use during the relevant tax year. 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 ICDS. [23] As against fair value of securities issued as per ICAI AS-13 [24] As against whichever value is more evident as per ICAI AS-13 [25] ICAI AS-16 includes such differences to the extent that they are regarded as an adjustment to interest costs.

11 ICDS 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, ICDS 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. ICDS 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, value of intangible asset acquired 26 shall be recorded as actual cost of the asset. 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 ICDS. ICDS 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 27. A contingent asset can be recognized when the realization of related income is reasonably certain 28. [26] As against whichever value is clearly evident as prescribed under ICAI AS-26 [27] As against condition of probable under ICAI AS-29 [28] As against condition of virtual certainty under ICAI AS-29

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