Study Circle Meeting ICDS I, II and IV - · PDF fileICDS applies only to taxpayers following...

CA Ravikant Kamath

17 August 2017

Study Circle Meeting

ICDS I, II and IV

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Page 2 August 2017CTC Study Circle – ICDS I, II & IV

Contents

► ICDS – General principles

► ICDS I – Accounting Policies

► ICDS II – Valuation of Inventories

► ICDS IV – Revenue Recognition

Page 3

ICDS – General principles


ICDS - General principles

► Broad principles which internally guided the Committee while formulating ICDS

are:

► Reduction of litigation

► Minimization of alternatives

► Certainty to issues

► ICDS applies from A.Y. 2017-18 (F.Y. 2016-17)

► ICDS applies only to taxpayers following mercantile method of accounting

► Applicable for two heads of income viz. ‘Profits & Gains of Business & Profession’ and

‘Income from other sources’

► Taxpayers who predominantly follow mercantile method but adopt cash method for

small/ insignificant streams of income may not be able to presume non-application of

ICDS1

► Non resident taxpayers may also have concern on computation of income of PE/branch

► Does not apply to Individuals and HUFs not liable to tax audit1 ICDS application to small streams recognized on cash basis will require fact based analysis and is litigation prone



► ICDS to be given effect in computation of taxable income (FAQ 1 of Circular No.

10/2017)

► No two sets of books required to be maintained as clarified by Preamble of each ICDS

► Practically, will necessitate maintenance of memorandum records (including changes in

ERP wherever necessary)

► Tax Audit Report (Form 3CD) amended to include ICDS disclosures (Refer

Notification No. 88/ 2016 dated 29 September 2016)

► Each ICDS has both ‘computation’ and ‘disclosure’ requirements

► Disclosure required in Tax Audit Report; not applicable if taxpayer is not liable for tax

audit (FAQ 25 of Circular)

► MAT will continue to be governed by books of account prepared as per applicable GAAP

(FAQ 6 of Circular)



► ICDS is based on pre-2016 ICAI AS subject to deviations/ carve-outs as

suggested by Committee

► IFRS / Ind-AS are notified to become effective from F.Y. 2016-17 in phased manner

► Differences of ICDS with Ind-AS will require independent evaluation (eg. BOT project,

Revaluation of PPE, Deferred revenue recognition for loyalty points or deferred

payment terms, Financial instruments, etc)

► Some ICAI AS revised w.e.f F.Y. 2016-17

► Revenue/ expense on which there is no ICDS will continue to be governed by AS/

Ind-AS

► E.g. ESOP cost

► Unlike ICAI AS, ICDS contains only main principles; no Explanations or

Illustrations provided


ICDS – Principles of construction

► Provisions of the Income-tax Act, 1961 (ITA) to prevail in case of conflict with ICDS

► Undefined words/ expression take their meaning from ITA

► FAQ 2 states that ICDS shall apply to ‘transactional issues’ dealt therein for A.Y. 2017-18 onwards

over judicial pronouncements rendered in absence of authoritative guidance under the Act

► ICAI Technical Guidance classify judicial rulings in three categories (Para 15, pg 15-17)

► ICDS supporting specific amendments (s.2(24)(xviii), 36(1)(iii) & 36(1)(vii)) shall override earlier judicial precedents

► ICDS shall override judicial precedents based on extant GAAP

► But ICDS cannot override judicial precedents on basic principles of tax (eg. real income theory in context of

interest on NPAs)

Hierarchy of ICDS

– Specific statutory provisions (ITA)

– Income tax rules

– Real income theory

– Tax jurisprudence on above

– ICDS

– Commercial principles of accounting

Page 8

ICDS I – Accounting Policies


Fundamental Accounting Assumptions and Materiality

► Going concern, consistency and accrual are fundamental accounting assumptions –

disclosure required if any of the assumptions not followed

► Accrual of income takes place when there emerges a debt in favour of taxpayer which is

enforceable in law [E.D. Sassoon & Co. Ltd. (26 ITR 27) (SC)]

► As per ICAI TG, ICDS does not alter or impinge upon supremacy of s.5 over s.145 (para 4.19,

pg 35)

► S.145 permits cash method as a choice. Also, judicially, it is recognized that if no method is

discernible, default choice is cash method

► Concept of ‘materiality’ which was relevant in selecting and applying accounting policy

omitted

► No likely significant tax impact, but possible litigation on small value items if Tax Authority

insists on strict application of ICDS

► ICAI TG also states that omission of ‘materiality’ is unlikely to impact income computation


Prudence

Concept of ‘prudence’ is modified by ICDS

► Prior to ICDS, prudence understood to mean non-recognition of anticipated profits

but recognition of known liabilities and losses on best estimate basis (e.g. ICAI’s

guidance on derivatives in March 2008)

► As per Committee, prudence led to differential treatment for income and loss

► ICDS prohibits recognition of marked to market (MTM) or expected loss unless

permitted by any other ICDS

► MTM gain at par with MTM loss – Taxable only at the time of realization (FAQ 1 of

Circular)

► ICDS I covers derivatives not covered under ICDS VI /VIII (FAQ 10 of Circular)


Prudence

► ‘Expected loss’ is different from actually incurred loss recognised on best estimate

basis (eg. loss by fire, theft, etc) or actuarially valued liabilities (eg. pension

obligation)

► ICDS prohibits deduction in respect of “expected loss” – but, does not impact actual loss

though may have been estimated on a scientific basis


► Accounting policy shall be such to represent true and fair view of state of affairs and income of

the business, profession or vocation

► As per ICAI TG, ‘accounting policy’ should be read as ‘computation policy’ (para 3.6, pg 25)

► As per FAQ 1 of Circular, accounting policies are ‘fundamental’ in nature

► All significant accounting policies adopted by taxpayer need to be disclosed

► As per ICAI TG, ‘significant’ infers of such magnitude as may influence readers/users of financial statements (para

3.3, pg 25)

► Accounting policy can be changed for any ‘reasonable cause’

► ‘Reasonable cause’ is not defined in ICDS; an existing concept, to be governed by judicial precedents

(FAQ 9 of Circular)

► ‘Reasonable cause’ means a reason which appeals to a person of average intelligence and ordinary

prudence; probable cause (Refer, illustratively, Woodward Governor India (P) Ltd (Del) (253 ITR 745),

Azadi Bachao Andolan (Del) (252 ITR 471))

► Earlier, change permitted if required by statute; or for compliance with AS; or considered as

resulting in more appropriate presentation

Disclosure of ‘accounting policy’


Change in Accounting Policy

► Upon change in accounting policy, disclosure required in the year of change if it

has material effect

► If no material effect in current year, disclosure also required in first year of material

impact.

► Enhanced disclosure requirement and compliance burden

► Default of sheer non disclosure unlikely to have any adverse impact on best

judgement assessment.


Transitional Provision- ICDS-I

► Extract of transitional provision

“10. All contract or transaction existing on the 1st day of April, 2016 or

entered into on or after the 1st day of April, 2016 shall be dealt with in

accordance with the provisions of this standard after taking into account the

income, expense or loss, if any, recognised in respect of the said contract or

transaction for the previous year ending on or before the 31st March, 2016.”

► ICDS I does not permit recognition of MTM losses or expected losses unless

permitted by other ICDS

► Transitional provisions arguably does not require reversal of MTM losses recognised in

earlier years (Refer ICAI TG para 8.2, page 38)


Case study – Modifying ‘Prudence’

MTM recognition of gain/loss on derivative (Interest Rate

Swaps) for hedging purposes (not covered by ICDS VI on Foreign Exchange Rates)

ICo Facts

► ICo has entered into derivative contract

with bank for hedging exposure to

fluctuating interest rate risk on loan having

floating rate interest

► Derivative contract is in compliance with

RBI Guidelines

► ICo is able to demonstrate that loss/gain

on derivative offsets corresponding

gain/loss on underlying interest outflow on

loan

Commercial Impact

Higher interest

cost

(Rs. 1 Cr)

MTM gain on

derivative

Rs. 1 Cr

Net commercial

income

NIL


Case study – Modifying ‘Prudence’ (…contd)

Income/Loss Amount ICAI 2008 GN ICAI 2015 GN Ind-AS ICDS I

Higher

interest cost

(1 Cr) Recognise as

per AS-16

Recognise as

per AS-16

Recognise as

per effective

interest rate

Recognise as

per ICDS IX

MTM Gain

on IRS

1 Cr Ignore MTM

Gain

Recognise

MTM Loss

Recognise

MTM gain/loss

Recognise

MTM

gain/loss

Ignore MTM

gain/loss

Recognise in

year of

realisation

Net income NIL (1 Cr) NIL NIL (1 Cr)

Page 17

ICDS II - Valuation of inventory


Valuation of inventory – tangible assets

► Includes assets

► Held for sale in the ordinary course of business

► In the process of production for such sale

► In the form of materials or supplies to be consumed in the production process or in the

rendering of services

► Valuation at lower of cost or NRV

► Akin to ICAI AS-2, ICDS permits FIFO, weighted average, specific identification,

standard cost or retail method

► If taxpayer adopts standard cost method, ICDS requires disclosure confirming that

standard cost approximates actual cost

► Will include unconsumed items for construction contract at year end (Refer ICAI TG, para

2.2(a), page 40)

Specific provisions of s.145A may override anything to contrary in ICDS


Valuation of inventory – service WIP

► Definition of ‘inventory’ is ambiguous on inclusion of service inventory within its scope

► Cost of inventories includes cost of services and para 6 of ICDS II defines “cost of

services” as labor and other direct personnel cost and attributable overheads

► Revised ICDS has deleted reference to ‘service providers’

► As per ICAI TG

► ICDS-II is not applicable to service inventory (para 7, pg 46)

► ICDS II include derivatives held as inventory but not covered by ICDS VI/VIII (para

2.4, pg 41)


Valuation of inventory

► S.145A overrides provisions of s. 145 r.w. ICDS

“145A. Notwithstanding anything to the contrary contained in section 145,—

(a) the valuation of purchase and sale of goods and inventory for the purposes of

determining the income chargeable under the head "Profits and gains of business or

profession" shall be—

(i) in accordance with the method of accounting regularly employed by the

assessee; and

(ii) further adjusted to include the amount of any tax, duty, cess or fee (by whatever

name called) actually paid or incurred by the assessee to bring the goods to the place

of its location and condition as on the date of valuation.

Explanation.—For the purposes of this section, any tax, duty, cess or fee (by whatever

name called) under any law for the time being in force, shall include all such payment

notwithstanding any right arising as a consequence to such payment;

(b)…..”

* CIT v Knight Frank (India) Pvt. Ltd. (2016) (242 Taxman 313) (Bom HC)

S.145A does not apply to service inventory*



► In case of newly commenced business, cost of inventory on day of

commencement of business shall be opening inventory

► In case of conversion of capital asset into stock-in-trade for commencing business, FMV

as on date of conversion is cost to the business (ICAI TG, para 13.4, pg 57-58)

► If business is commenced by acquiring a running business from another, consideration

paid (whether slump price or itemised value) constitutes cost to the business of opening

inventory

► No specific guidance about basis of determination of cost to business of firm

where partners contribute assets as stock-in-trade

► S.45(3) does not apply

► Value credited in books may arguably constitute the cost?

► Valuation of opening inventory to be the same as closing inventory in preceding

year – regardless of change in method of valuation of closing inventory



► On dissolution of firm, AOP or BOI, inventory to be valued at NRV regardless of

whether business is discontinued

► In ALA Firms (189 ITR 285)(SC), SC upheld valuation at NRV since business was

discontinued on dissolution

► Whether SC ruling in Shakthi Trading’s case (250 ITR 871) where SC upheld lower of

cost or NRV considering that business was continued post dissolution may no more

apply ?

► In Shakti Trading’s case (supra), ALA Firms (supra) was held not applicable as business was

continued on a going concern basis upon takeover

► Method of valuation once adopted shall not be changed without reasonable

cause

► Courts have permitted bonafide change where changed method is as per GAAP and

followed regularly thereafter (e.g. from cost to lower of cost or NRV)


Treatment of general machinery spares as per revised AS-2/ 10 and ICDS II/ V

Revised ICAI

AS-2/ 10

Treated as Property, Plant & Equipment (PPE) if

useful life > 12 m

Else, treated as Inventory

ICDS II and V Treated as inventory, irrespective of useful life

Charged to revenue as and when consumed

Illustration

X Co purchased general machinery spares with useful life > 12 m on 15th April 2016

Book treatment as per

revised ICAI AS-2/10

PPE to be depreciated over useful life

Tax treatment Alternative 1 – Depreciate over useful life as per books

Alternative 2 – Treat it as inventory as per ICDS II/V

Issue How does s.145A impact conclusion?


Transitional Provision- ICDS-II


“25. Interest and other borrowing costs, which do not meet the criteria for recognition

of interest as a component of the cost as per para 11, but included in the cost of the

opening inventory as on the 1st day of April, 2016, shall be taken into account for

determining cost of such inventory for valuation as on the close of the previous year

beginning on or after 1st day of April, 2016 if such inventory continue to remain part of

inventory as on the close of the previous year beginning on or after 1st day of April,

2016.”

► Transitional provision explicit only for interest component

► Overriding impact of s.145A on valuation of inventories needs to be considered before

application of ICDS II

Page 25

ICDS IV – Revenue Recognition


POCM

Transfer of

property or

significant

risks &

rewards of

ownership to

buyer

As per contractual

terms, unless some

other systematic /

rational basis as

per substance of

transaction

Ordinarily, POCM

If contract duration <

90 days, permits

completed contract

method

If services by

indeterminate

number of acts,

permits straight line

method

Receipt

basis for

interest

on tax

refund

Time

basis for

other

Revenue recognition

criteria as per ICDS

Construction

contract

(including

services

directly related

to construction

like architect)

Sale of

goods

Rendering of services Interest Royalty (as defined

by ITA)

Broad Overview

As per ITA

Dividend


Revenue recognition – Sale of goods

► Revenue from sale of goods recognised upon transfer of property or upon transfer

of significant risk/ rewards of ownership to buyer

► In case of timing mismatch between transfer of property vs. significant risks/ rewards;

revenue to be recognised on transfer of significant risks/ rewards

► No change in position for lessor in finance lease (ICAI TG, para 4.4, pg 89-90)

► Revenue to be recognised only if there is reasonable certainty of its ultimate

collection

► ICDS not materially different from AS-9

► ICDS is in line with current judicial thinking which aligns also with real income theory

► Reasonable certainty test is different from concept of accrual u/s. 5 of ITA (ICAI TG para

4.8, pg. 91)


Revenue recognition – Rendering of services

► Distinction between sale of goods v. rendering of services should be based on

predominant aspect (ICAI TG, para 5.8, pg. 93)

► Revenue recognition criteria for services

► Real estate developer not covered by ICDS IV (FAQ 12 of Circular) – draft ICDS

published for public comments

Features of service Less than or equal to 90

days

More than 90 days

Service contract specifying

indeterminate number of acts

Taxpayer can follow completed

contract method

Taxpayer can follow Straight Line

Method

Service contract with specified

milestones

Taxpayer can follow completed

contract method

Taxpayer shall follow Percentage

of Completion Method


Revenue recognition – Interest

► Interest income to be recognized on time basis (including discount or premium on securities)

► As per FAQ 13 of Circular, test of reasonable certainty of ultimate collection does not apply to interest

and royalty income; subsequent non-recovery can be claimed as deduction u/s. 36(1)(vii)

► Specific provisions of the Act (e.g. s. 43D, 145A) override ICDS

► As per settled legal position, interest income not taxable (unless contractually due) in absence of real

income

► Accrual and reasonable test certainty applicable to interest income (ICAI TG, para 6.5, pg. 95)

► Onus on taxpayer to prove that there is no reasonable certainty of realization

► Alternatively, taxpayers can claim bad debt deduction under second proviso to s.36(1)(vii)

► Broken period interest income on securities to be reduced in capital gains computation (FAQ 18 of

Circular)

► Taxation of interest/royalty in hands of NR on paid/ actual basis as per treaty and favourable judicial

decisions – remains unaffected by ICDS (ICAI TG, para 6.23, pg. 99)

► Interest on refund of any tax, duty or cess to be taxable on receipt basis


Royalty income

► Royalty to be recognized in accordance with the terms of the relevant agreement

unless having regard to the substance of the transaction, it is more appropriate to

recognize it on some other systematic and rational basis.

► ‘Royalty’ definition to be borrowed from Exp 2 to 5 to s.9(1)(vi)

► Includes equipment royalty (excluding those covered by s.44BB)

► Includes services incidental to royalty transaction (ICAI TG, para 6.26, pg. 101)

► Beneficial provisions of applicable DTAA shall override ICDS (ICAI TG, para 6.23,

pg. 99)


Revenue recognition – Applicability to special sectors

► Circular No. 10/2017

► Rules 9A, 9B (film production/distribution) shall override ICDS (FAQ 4)

► ICDS applicable to presumptive taxation schemes for determining turnover, receipts

(FAQ 3)

► Sector specific provisions in ITA shall override ICDS (FAQ 7) (eg. ICDS VIII – Securities

has special provisions for banks/FIs, Insurance governed by Schedule I of ITA)

► No specific ICDS for real estate developers, BOT projects and leases (FAQ 12)

► ICAI Technical Guidance

► Logically ICDS would not apply to taxpayers governed by presumptive taxation schemes

(ICAI TG, para 9.3, pg 10)

► ICDS not applicable to Insurance companies (para 10, pg 11)


Applicability of ICDS to taxpayers governed by presumptive tax provisions

► As per FAQ 3 &14 of Circular, ICDS applies even to taxpayers opting for

presumptive tax provisions for determining “receipt” or “turnover” and also for

computation of income on gross basis u/s 115A

Incomes taxed on gross basis

u/s.115A

■ S.115A merely prescribes rate

of tax and quantifies tax

lability after income is

computed

■ Thus, income covered by

S.115A necessarily gets

subjected to ICDS

Presumptive sections like s.44B/ BBA/

BBB specify presumptive tax base as

amount paid/ payable or received/

deemed to be received

■ These presumptive tax provisions

are self-contained and complete

code in itself

■ Thus, taxation cannot be as per

ICDS

Presumptive sections like

s.44AD/ ADA do not define

gross receipt/ turnover

■ Taxpayers governed by

s.44AD/ ADA not liable to

tax audit

■ Thus, individual and HUF

continue to remain outside

the ICDS net

■ However, if taxpayers opt out of presumptive provision and offer lower

income, they are governed by normal tax provisions and also liable for

tax audit. ICDS will also apply in that case


Transitional Provision - ICDS IV


“11. The transitional provisions of Income Computation and Disclosure Standard on

construction contract shall mutatis mutandis apply to the recognition of revenue and the

associated costs for a service transaction undertaken on or before the 31st day of March,

2016 but not completed by the said date.

12. Revenue for a transaction, other than a service transaction referred to in Para 10,

undertaken on or before the 31st day of March, 2016 but not completed by the said date

shall be recognised in accordance with the provisions of this standard for the previous year

commencing on the 1st day of April, 2016 and subsequent previous year. The amount of

revenue, if any, recognised for the said transaction for any previous year commencing on

or before the 1st day of April, 2015 shall be taken into account for recognising revenue for

the said transaction for the previous year commencing on the 1st day of April, 2016 and

subsequent previous years.”

► ICDS III ‘grandfathers’ construction/service contracts commenced prior to 1 April 2016

► No grandfathering for other revenue streams – to be recognized as per ICDS after considering revenue already recognized in earlier years


Disclosure requirements

► Taxpayer needs to make following disclosures:

► In case of sale of goods, unrecognized revenue amount due to lack of

reasonable certainty of its ultimate collection and nature of uncertainty

► In case of service contracts, similar disclosure requirements as under ICDS III

► Arguably, no disclosure requirements for :-

► grandfathered service contracts (ICAI TG, para 11.1, pg 84)

► Service contracts < 90 days (ICAI TG, para 8.4, pg 104)


Case study – Recognition of ‘service’ revenue

Facts

► ICo is engaged in providing management

consulting services and it undertakes numerous

assignments which typically last over 3-4 years

► Invoices are raised as per milestones agreed in

service contracts

► Services rendered till balance sheet date but not

invoiced are not recognized either as ‘unbilled

revenue’ or as ‘inventory’

ICo

(Project Management Consulting)

Customers

Service contracts

Issues Position for books of

account

ICDS

impact

► Non-recognition of

unbilled revenue

No reasonable certainty

of receipt

?

► Non-recognition of

service inventory

AS-2 does not cover

service WIP

?

Thank you !“This Presentation is intended to provide certain general information existing as at the time of

production. This Presentation does not purport to identify all the issues or developments. This

presentation should neither be regarded as comprehensive nor sufficient for the purposes of decision-

making. The presenter does not take any responsibility for accuracy of contents. The presenter does

not undertake any legal liability for any of the contents in this presentation. The information provided is

not, nor is it intended to be an advice on any matter and should not be relied on as such. Professional

advice should be sought before taking action on any of the information contained in it. Without prior

permission of the presenter, this document may not be quoted in whole or in part or otherwise.”

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