Demystifying Revised ICDS

Demystifying Revised ICDS
Dhinal Shah Chartered Accountant June 2018

Contents Background ICDS - General principles
Revisions in ICDS II - Valuation of inventory Revisions in ICDS IV - Revenue recognition Revisions in ICDS VI - Foreign exchange fluctuations Revisions in ICDS VIII - Securities Revisions in ICDS IX - Borrowing Cost Concluding thoughts

Background in brief ICDS notified by Central Government (CG) as a delegated legislation u/s 145(2) w.e.f. AY Applicable for computation under the heads PGBP and IFOS Applicable to all taxpayers following mercantile method of accounting Not applicable to individuals and HUFs not liable to tax audit Revised ICDS notified in September 2016 and FAQs released by the CBDT in March 20172 The Delhi HC in The Chamber of Tax Consultants3 read down power granted to notify ICDS u/s.145(2) to preserve constitutional validity and struck down several contentious ICDS provisions Finance Act 2018 (FA 2018) In order to provide legitimacy and bring certainty, new provisions inserted in the Act, in line with ICDS Retrospective amendment from AY to regularize compliance by large number of taxpayers and to prevent any further inconvenience to them ________________________________________ Postponed by one year from AY in view of implementation difficulties faced by taxpayers Circular No. 10/ 2017 dt 23 Mar 2017 (2017) 159 DTR 313 (Del)

FA 2018 amendments seek to override Delhi HC ruling
Delhi HC ruling on ICDS and positions prior to FA 2018 Delhi HC: ICDS cannot override judicial precedents on chargeability and computation of total income ICDS cannot override charging provisions Taxability of retention money or government subsidies before fulfilment of attached conditions ICDS cannot override judicial precedents on computational aspects MTM loss on derivatives not allowed Foreseeable loss on contract not allowed Service contract revenue recognition on POCM basis FA 2018 amendments seek to override Delhi HC ruling ________________________________________

Impact of retrospective amendments
Justification in Explanatory Memorandum to Finance Bill 2018 for retrospective amendment : Most taxpayers would have relied upon ICAI Technical Guide ICDS cannot override charging provisions but can modify the computational methodology Taxpayers will need to revisit positions adopted prior to FA 2018 amendment Forex gain/ loss on domestic assets neither taxable not deductible Retention money or government subsidies not taxable till fulfillment of attached conditions Pre-amended s. 145A overrides “category-wise” valuation of securities as per ICDS VIII While there can be retrospective levy of tax, arguably, levy of penalty or interest u/s.234B/ 234C is defensible

Bird’s eye view of ICDS amendments in FA 2018
Section Provision 36(1)(xviii) Marked to market (MTM) loss/ expected loss will be allowed as deduction only to the extent permissible under the ICDS 40A(13) Any MTM loss/ expected loss not to be allowed as deduction, except as specified u/s.36(1)(xviii) 43AA Foreign exchange fluctuation gain or loss in respect of specified foreign currency transactions shall be treated as income or loss and computed in accordance with ICDS (subject to s.43A) 43CB Profit arising from construction contracts and service contracts shall be computed as per Percentage of Completion Method (POCM) in accordance with ICDS, except: Service contract with duration < 90 days (completed contract method) Service contract where indeterminate acts are performed (SLM basis) For POCM purposes, contract revenue includes retention money and contract cost shall not be reduced by incidental income in the nature of interest, dividends or capital gains

Bird’s eye view of ICDS amendments in FA 2018
Section Provision 145A Inventory shall be valued at lower of actual cost or NRV computed in accordance with ICDS subject to addition of any tax, duty, cess etc. Inventory being unlisted securities, or listed securities but not quoted with regularity, shall be valued at actual cost initially recognised in accordance with ICDS Other listed securities shall be valued at lower of actual cost or NRV in accordance with ICDS on a category-wise basis Inventory being securities held by a scheduled bank or public financial institution shall be valued in accordance with ICDS after taking into account extant RBI Guidelines in this regard 145B Export incentives or claims for price escalation shall be taxable in the year in which reasonable certainty of its realisation is achieved Subsidy/ grants received from Government shall be taxed on receipt basis, if not charged to tax in any earlier tax year Notable items on which no amendments made (since not directly dealt by Delhi HC) Treatment of expenses between trial run and commercial production To be treated as capital expenditure as per CBDT FAQ 15 Taxation of contingent assets on “reasonable certainty” basis

ICDS – Principles of construction
Provisions of ITA to prevail in case of conflict with ICDS Amendment to Income Tax Act by retrospective effect Undefined words/expression take their meaning from ITA No clarity as yet on interplay with tax jurisprudence Hierarchy of ICDS Specific statutory provisions (ITA) & ICDS Income tax rules Real income theory Tax jurisprudence on above Commercial principles of accounting

ICDS – Transitional Provisions
Committee’s intent – ICDS should not result in double taxation or escape from taxation Complete grandfathering for construction and service contracts commenced prior to 1 April 2016 No ‘grandfathering’ for any other items – ICDS to be applied after reckoning incomes/ deductions recognised prior to 1 April 2016

Transitional Provisions – Grandfathering of construction and service contracts
Date of commencement of contract Book treatment Tax treatment Key difference amongst others Prior to 1 April 2016 IGAAP/ Ind-AS IGAAP/Ind- AS Foreseeable loss on onerous contract can be recognised On or after 1 April 2016 ICDS III Foreseeable loss on onerous contract cannot be recognised

Revised ICDS II - Valuation of inventory

WIP in case of ‘service provider’
ICAI AS-2 Excluded 2015 ICDS Ambiguous ‘Cost of services’ refers to ‘service provider’ 2016 ICDS Ambiguity continues But ‘service provider’ reference omitted

Standard costing technique
ICAI AS-2 Permissible 2015 ICDS Ambiguous in view of omission 2016 ICDS Permitted if standard cost approximates actual cost

Average % for each retail department under retail method
ICAI AS-2 Permissible (‘is often used’) 2015 ICDS Ambiguous in view of omission 2016 ICDS Mandatory (‘is to be used’) Specific provisions of s.145A (which requires inventory to be valued at book value and further increased by tax, duties, etc.) will override ICDS

General spares (not specific to any capital asset)
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 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 View 1 – Depreciate over useful life as per books View 2 – Treat it as inventory as per ICDS II/V Issue How does s.145A impact conclusion?

Revised ICDS IV – Revenue Recognition

Treatment of construction and service contracts prior to FA 2018
Sr Nature of income/ expense Book treatment Tax position prior to ICDS Treatment as per ICDS Delhi HC ruling 1. Revenue recognition POCM mandatory for construction contract (AS- 7) Both POCM and completed contract method (CCM) permitted for service contracts (AS- 9) Both POCM and CCM permitted POCM mandatory (except where duration of service contract < 90 days or it involves indeterminate acts) ICDS III/ IV is ultra vires on this aspect and hence struck down 2. Retention money May be included as part of total contract revenue Not taxable till attached conditions are fulfilled – even if recognised in books Contract revenue includes retention money Profits to be computed on POCM basis Not taxable unless it accrues to the taxpayer Timing of taxation to be determined on case-to-case basis 3. Foreseeable loss on contracts Recognised as an expense immediately Allowable as per HC rulings Not allowable as deduction (ICDS I) ICDS III requires recognition on POCM basis Prudence is inherent in s.37 ICDS cannot override binding judicial precedents which have permitted deduction of foreseeable loss

Text of s. 43CB “S. 43CB. (1) The profits and gains arising from a construction contract or a contract for providing services shall be determined on the basis of percentage of completion method in accordance with the income computation and disclosure standards notified under sub-section (2) of section 145: Provided that profits and gains arising from a contract for providing services,— (i) with duration of not more than ninety days shall be determined on the basis of project completion method; (ii) involving indeterminate number of acts over a specific period of time shall be determined on the basis of straight line method. (2) For the purposes of percentage of completion method, project completion method or straight line method referred to in sub-section (1)— (i) the contract revenue shall include retention money; (ii) the contract costs shall not be reduced by any incidental income in the nature of interest, dividends or capital gains.”

Taxation of profits from construction and service contracts [s
Taxation of profits from construction and service contracts [s. 43CB] [w.r.e.f AY ] Methodology under ICDS III/ IV now codified u/s 43CB Profits from service contracts (duration > 90 days not involving indeterminate acts) and construction contracts to be computed as per POCM “in accordance with” ICDS Recognise contract revenue if there is reasonable certainty of ultimate collection Mandatory to recognize profit/loss on POCM basis beyond 25% stage of completion Foreseeable loss allowed only to the extent of proportion of work completed Service contracts with duration < 90 days to recognize as per completed contract method Service contracts with indeterminate number of acts to recognize on straight line basis Contract revenue shall specifically include retention money as per s. 43CB Whether s. 43CB is a charging provision?

Service Contracts ICAI AS-9
Provides choice between Percentage of Completion Method (POCM) and Completed contract method 2015 ICDS Mandatory to follow POCM without any time or value threshold Stage of completion to be determined w.r.t Cost incurred or Survey or Physical proportion 2016 ICDS Mandatory to follow POCM only if contract duration > 90 days Permits straight line method (SLM) for time based contracts (like AMC)

Illustration – Service Contracts
Particular Service contracts < 90 days Service contracts > 90 days Book treatment (assumed) Completed contract method Completed contract method Tax treatment (2016 ICDS) As per books WIP to be recognised at year end? POCM is mandatory No WIP since revenue is recognised on POCM basis Revenue for work completed till 31 March 2016 but unbilled?

Interest on tax refunds
ICAI AS-9 No special treatment; Time basis 2015 ICDS Same as ICAI AS-9 2016 ICDS Receipt basis

Revised ICDS VI – Foreign exchange fluctuations

Treatment of MTM loss/ expected loss prior to FA 2018
Pre-amendment position Nature of income/ expense Book treatment Tax position prior to ICDS Treatment as per ICDS Delhi HC ruling MTM loss on derivatives (not covered by ICDS VI) As per ICAI Guidance of March 2008, MTM loss is recognised but MTM gain is ignored Allowable as per SC ruling in Woodward Governor’s case (312 ITR 254) Not allowable as deduction (ICDS I) Prudence is inherent in s.37 of the Act

Whether s. 36(1)(xviii) will cover capital loss?
Treatment of MTM loss/ expected loss [s. 36(1)(xviii), 40A(13)] [w.r.e.f AY ] “S. 36(1)(xviii): marked to market loss or other expected loss as computed in accordance with the income computation and disclosure standards notified under sub-section (2) of section 145” “S. 40A(13): No deduction or allowance shall be allowed in respect of any marked to market loss or other expected loss, except as allowable under clause (xviii) of sub-section (1) of section 36” ICDS I prohibits MTM/ expected loss, unless permitted by any other ICDS ‘MTM’ or ‘expected loss’ undefined, to be understood in commercial sense – unlikely to cover: Already incurred loss which requires quantification on best estimate basis (eg. Pension obligation valued actuarially, loss by fire) Probability of paying damages/ compensation pursuant to law suit against the taxpayer (covered by ICDS X) Once MTM loss is disallowed, loss to be claimed on actual settlement u/s 37(1) S. 37(1) will now cover only real, actual or crystallised loss; S. 40A(13) overrides s. 37(1) Loss allowable as per s. 36(1)(xviii) subject to s. 43B (eg. Disputed statutory dues) At par with MTM loss, arguably, MTM gains not chargeable to tax by relying on CBDT FAQ 1 Whether s. 36(1)(xviii) will cover capital loss?

Treatment of forex fluctuation on capital monetary items
Pre-amendment position Nature of income/ expense Book treatment Tax position prior to ICDS Treatment as per ICDS Delhi HC ruling Forex gain/ loss on borrowings for domestic capital assets Requires recognition in P&L A/c One-time irrevocable option of capitalization provided u/s. 211(3C) of Cos Act 1956 Neither taxable nor deductible Cannot be adjusted against cost of asset To be treated as gain/ loss on MTM basis (ICDS VI) No specific observation on this issue

Taxation of foreign exchange fluctuation not governed by s. 43A [s
Taxation of foreign exchange fluctuation not governed by s. 43A [s. 43AA] [w.r.e.f AY ] “S. 43AA. (1) Subject to the provisions of section 43A, any gain or loss arising on account of any change in foreign exchange rates shall be treated as income or loss, as the case may be, and such gain or loss shall be computed in accordance with the income computation and disclosure standards notified under sub-section (2) of section 145. (2) For the purposes of sub-section (1), gain or loss arising on account of the effects of change in foreign exchange rates shall be in respect of all foreign currency transactions, including those relating to— (i) monetary items and non-monetary items; (ii) translation of financial statements of foreign operations; (iii) forward exchange contracts; (iv) foreign currency translation reserves.”

Taxation of foreign exchange fluctuation not governed by s. 43A [s
Taxation of foreign exchange fluctuation not governed by s. 43A [s. 43AA] [w.r.e.f AY ] Subject to s.43A, any forex gain/ loss arising on all the following foreign currency transactions “shall be treated as income or loss” and computed in accordance with ICDS: Monetary and non-monetary items Translation of financial statements of foreign operations Forward exchange contracts Foreign currency translation reserve Is s. 43AA both charging and computation provision? No amendment to s. 2(24) or s. 28 Whether forex gain/ loss on loans related to domestic assets taxable/ deductible on MTM basis?

Distinction between integral & non-integral foreign operations
ICAI AS-11 Yes 2015 ICDS 2016 ICDS No (Non-integral FO to be treated as integral FO)

Illustration – Independent foreign branch
ICAI AS-11 Translated at year end rate and accumulated in FCTR ICDS 2016 Capital Items like building, furniture, fixtures etc. Working capital items like Drs, Crs, Bank balances etc No translation Related loan liability translation covered by s.43A – to be capitalised on settlement basis Translated at year end rate and recognised as income/expense Recognition of opening FCTR balance as on 1 April 2016?

Exchange rate for converting non-monetary items valued at cost/ NRV
ICAI AS-11 Rate which existed when cost or NRV was determined 2015 ICDS No translation 2016 ICDS

Revised ICDS VIII – Securities (held as stock in trade)

Valuation of inventory, including securities [s. 145A] [w. r. e
Valuation of inventory, including securities [s. 145A] [w.r.e.f AY ] Pre- amendment position S.145A (i.e. method of accounting regularly employed) overrides anything to the contrary under ICDS Eg. ICDS VIII providing category-wise valuation of securities overridden by book valuation Supported by Del HC ruling which struck down category-wise valuation of securities Such change not possible without corresponding amendment in the Act FA 2018 amendment Amended s. 145A mandates valuation of inventory (including securities held as inventory) in accordance with ICDS provisions Method of accounting regularly adopted by taxpayer no more relevant Since ‘inventory’ not defined, guidance may be drawn from ICDS As per the ICAI Technical Guide, ‘inventory’ as per ICDS II does not include ‘services’

Text of s. 145A “S. 145A. For the purpose of determining the income chargeable under the head “Profits and gains of business or profession”, (i) the valuation of inventory shall be made at lower of actual cost or net realisable value computed in accordance with the income computation and disclosure standards notified under sub-section (2) of section 145; (ii) the valuation of purchase and sale of goods or services and of inventory shall be 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 or services to the place of its location and condition as on the date of valuation; (iii) the inventory being securities not listed on a recognised stock exchange, or listed but not quoted on a recognised stock exchange with regularity from time to time, shall be valued at actual cost initially recognised in accordance with the income computation and disclosure standards notified under sub-section (2) of section 145; (iv) the inventory being securities other than those referred to in clause (iii), shall be valued at lower of actual cost or net realisable value in accordance with the income computation and disclosure standards notified under sub-section (2) of section 145: Provided that the inventory being securities held by a scheduled bank or public financial institution shall be valued in accordance with the income computation and disclosure standards notified under sub-section (2) of section 145 after taking into account the extant guidelines issued by the Reserve Bank of India in this regard Provided that the comparison of actual cost and net realisable value of securities shall be made category-wise. …PTO

Text of s. 145A (contd.) Explanation 1.—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. Explanation 2.—For the purposes of this section,— (a) "public financial institution" shall have the meaning assigned to it in clause (72) of section 2 of the Companies Act, 2013; (b) "recognised stock exchange" shall have the meaning assigned to it in clause (ii) of Explanation 1 to clause (5) of section 43; (c) "scheduled bank" shall have the meaning assigned to it in clause (ii) of the Explanation to clause (viia) of sub-section (1) of section 36.

Valuation of inventory, including securities [s. 145A] [w. r. e
Valuation of inventory, including securities [s. 145A] [w.r.e.f AY ] Post-amendment, s.145A overview: Sr. Category Inventory valuation 1 Valuation of purchase and sale of goods Valuation of purchase and sale of services Valuation of inventory Adjusted to include the amount of any tax, duty, cess or fee 2 Valuation of items of inventory (other than (3) to (5) below) Lower of actual cost or NRV computed in accordance with ICDS 3 Unlisted securities or listed securities but not quoted with regularity from time to time Actual cost initially recognised in accordance with ICDS 4 Listed securities Comparison to be done category-wise i.e. bucket approach (categories as per ICDS VIII include shares, debt securities, convertible securities and others) 5 Securities held by a scheduled bank1 or public financial institution1 In accordance with ICDS after taking into account extant RBI Guidelines in this regard2 ________________________ Scheduled bank and public financial institution defined in Expl 2 to s. 145A Inserted at enactment stage of FA 2018

Shares of closely held company
ICAI AS No specific standard 2015 ICDS No specific inclusion in the definition of ‘Securities’ 2016 ICDS Specifically included in the definition of ‘Securities’ Conflict with CBDT Instruction dt. 2 May 2016 which directs Tax Authorities to treat unlisted shares as Capital asset

Weighted average method for valuation of securities
ICAI AS No specific standard 2015 ICDS Not permitted 2016 ICDS Permissible

Securities held by Banks/PFIs (including derivatives)
ICAI AS Governed by RBI Guidelines 2015 ICDS Scope exclusion 2016 ICDS Valuation as per RBI Guidelines to be recognised for tax purposes Overrides ICDS VI (to the extent relating to forward exchange contracts) By implication, permits recognition of MTM loss on forward contracts offered to constituents, cross currency swaps, interest rate swaps etc. if permitted by RBI Guidelines

Revised ICDS IX - Borrowing Cost

Qualifying capital asset for the purposes of capitalisation of general borrowing costs
ICAI AS-16 Which takes ‘substantial period’ of time (generally > 1 year) to get ready for use/ sale 2015 ICDS No threshold period 2016 ICDS Which takes > 12 m to get ready for use/ sale (relevant for general purpose borrowing only) But no threshold for specific borrowings The words “for extension of existing business or profession” was omitted from the proviso to section 36(1)(iii) by F.A w.e.f. A.Y – This proviso was inserted from A.Y,

Cessation of capitalisation of general borrowing costs
ICAI AS When asset is ready for use/ sale 2015 ICDS Ambiguity existed on interpretation of normative formula whether period multiplier to be considered 2016 ICDS When asset is put to use/ ready for sale Clarifies applicability of period multiplier

Revised ICDS VII – Government Grant

Taxation of Government grant [s. 145B] [w.r.e.f AY 2017-18]
Pre-amendment position FA 2018 amendment As per s. 145B(3), government grant shall be deemed to be taxable on receipt basis, if not charged to tax in earlier years Reference to “in accordance with ICDS” missing in s. 145B(3) Nature of income/ expense Book treatment Tax position prior to ICDS Treatment as per ICDS Delhi HC ruling Government grants received pending compliance of attached conditions Recognition of government grants on reasonable certainty of fulfilment of attached conditions Taxable only upon fulfilment of attached conditions as per SC ruling in Excel Industries Recognition of government grants cannot be postponed beyond date of actual receipt (ICDS VII) ICDS VII is ultra vires the Act on this aspect and hence struck down “S. 145B(3). The income referred to in sub-clause (xviii) of clause (24) of section 2 shall be deemed to be the income of the previous year in which it is received, if not charged to income-tax in any earlier previous year.” Direct Tax Litigation School - ICDS

Case study – Government grant received in advance
Facts ICo receives land worth Rs. 10 Cr. in Year 1 in backward area pursuant to Govt.’s packaged scheme of incentives Obligation to set up industrial unit & provide certain employment over a period of 5 years. If it does so, ICo doesn’t have to pay anything to Govt. towards land cost If ICo defaults, liable to pay pro-rata cost of land to Govt. Issues for consideration Issue 1: Whether taxation can be triggered in Year 1 on receipt basis due to s.145B(3) despite absence of perfected entitlement? Issue 2: Assuming taxation is triggered in Year 1 on receipt basis, whether grant can be recognised on spread over basis as per Paras 5 to 9 of ICDS VII? ICo Land Land allotment in backward area with employment condition Govt. Year of Receipt Year 1 (FY ) Year of Accrual Years 2 to 6 (FY to FY )

Summary Issues View 1 View 2 K&S View Issue 1:
Whether taxation can be triggered in Year 1 on receipt basis ahead of perfected entitlement due to s.145B(3)? No taxation on receipt basis as s. 145B(3) cannot be considered as a charging provision in absence of amendment to s. 4/5 Grant can be taxed in the year of receipt in view of clear language of s. 145B(3) which can regulate the timing of recognition of government grant which is an income as per s. 2(24)(xviii) Highly debatable and litigative Fact specific evaluation required Issue 2: If taxation triggered on receipt basis, whether the grant can be recognised on spread over basis as per Paras 5 to 9 of ICDS VII? If charge is not conceded, issue becomes academic Without prejudice, since S.145B(3) is intended to legitimize ICDS VII, S.145B(3) needs to be read harmoniously with paras 5 to 9 of ICDS VII which require spread over treatment S.145B(3) clearly provides for full taxation in year of receipt. Once charge is conceded, upfront taxation cannot be avoided Once charged is conceded u/s. 145B(3), View 2 is better view

Concluding thoughts

Tax Audit Report Form 3CD
No. Particulars Para 13(d) Any adjustment required in view of ICDS u/s 145(2) Para 13 (e) Details of Adjustment as under: Increase in Profit, Decrease in Profit, Net Effect Para 13 (f) Disclosure as per ICDS Para 14(b) Compliance to section 145A

ICDS Disclosures in ITR 5 and ITR 6
Schedule (Column) Particulars Part A – OI (3a) and BP (25) Increase in profit or decrease in loss because of deviations, if any, as per ICDS notified u/s 145(2) Part A – OI (3a) and BP (34) Decrease in profit or increase in loss because of deviations, if any, as per ICDS notified u/s 145(2) ICDS Effect of ICDS adjustment on profit (standard wise)

Other issues Mismatch of effective date for taxation of capital subsidies Amendment in ITA – F.Y onwards ICDS VII – F.Y onwards Omission of ‘materiality’ as a consideration for selection & application of accounting policy MTM loss on derivatives not permitted (except for scheduled banks/PFIs) Mismatch with MAT due to timing differences between book profit and tax profit

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Demystifying Revised ICDS

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