TeDiouS compliances under GST Law

The Government has notified 1st October 2018 as the date for implementation of provisions for deduction of tax at source (TDS) under the GST Law. The concept of TDS is an inherent part of direct tax collection mechanism wherein it aims to collect tax from the very source of income. Similarly, under the provisions of GST Law, the specified recipients of supplies (i.e., deductors) are required to deduct tax from the payment made or credited to the supplier of taxable goods and/ or services (i.e., deductee), where the total value of such supply, under a contract, exceeds rupees 2.50 lakh. TDS mechanism under the GST Law aims to collect tax at the time of payment. Also, it seeks to provide an additional trail of taxable supplies to the Government especially in case of B2C transactions to ensure disclosure of taxable supplies by suppliers so as to curb tax evasion. However, given the state of responsiveness of GST Portal and difficulties faced by the industry in adhering to existing compliances, practically, the implementation of TDS provisions now would only add to the compliance burden.

The TDS mechanism under GST may not prove to be very effective for certain reasons such as (i) TDS under GST would not significantly advance the flow of taxes to the Government as otherwise also the supplier is required to deposit tax by 20th of next month irrespective of the receipt of the consideration towards such supplies, (ii) the persons specified as deductors, except Public sector undertakings (PSUs) are mainly the final consumers, who are otherwise not liable for GST registration, for TDS compliances, such persons (final consumers) shall have to bear the burden of entire set of compliances like registration, determination and deduction of tax, depositing the same through e-payment, issue the necessary certificate & filing of returns, (iii) instances of non-compliances and mis-matches in TDS are likely to occur and (iv) there is no need of TDS mechanism in case of supplies to PSUs as the supplies shall be automatically verified while availment of input-tax credit thereon by the PSUs.

In view of the above, the difficulties posed by the TDS mechanism under the GST Law seems to outweigh the expected benefits. The Government should therefore, seriously reconsider the implementation of TDS provisions under the GST law.

 

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GST Implementation: The Indian Experience

Goods and Services Tax (GST) marked its beginning on the midnight of July 1, 2017, with the sound of gong in the historic Central Hall of Parliament House, reminiscent of India’s tryst with destiny on the midnight of August 15, 1947, releasing Indian Economy from the web of multiple indirect taxes and bringing in the largest tax reform since independence.

The implementation of GST on completion of its first year seems to be largely effective and efficient from the standpoint of various stakeholders, (i) consumers, for whom GST unlike international experience, it has not shown any initial inflationary trend in India, (ii) for industry, the subsuming of multiple central and state levies into one GST along with seamless input-tax credit has been a boon and (iii) for Government, GST regime has resulted in significant increase in the tax base and tax collections thereof. Besides, the highs the GST bag contains some lows also viz. (i) business were saddled with compliance burden which was in stark contrast to ‘ease of doing business’ being propagated by the Government (ii) The number of amendments and tweaking in law by way of circulars, notifications, press release, clarifications, orders etc. have added to the complexity of GST Law (iii) carrying forward of legacy of interpretation and classification disputes which is further worsened by contrary advance rulings pronounced by Authority for Advance Rulings of various states.

In its present avatar GST is only a Good but not a Simple Tax. If the Government actually wants to make it into a Good and Simple Tax then it should look at making the law simpler in terms of the compliance burden and start trusting the tax payers.

DISCOUNT NOT EQUAL TO CAPITAL EXPENDITURE

Is discount equal to capital expenditure? My answer is a big NO.

DISCOUNT  ff CAPITAL EXPENDITURE

It was reported in the leading newspapers that Flipkart has recently lost an appeal wherein the income tax department has held that the heavy discounts offered by the e-marketing companies, which are at present classified as marketing expenditure are in the nature of capital expenditure. Flipkart along with other big e-commerce companies have been classifying such expenditure as marketing expenses and have been claiming it as a deduction from revenue, resulting in losses for tax purposes on a year on year basis.  The tax authorities have taken a view that discounts offered by Flipkart are in the nature of capital expenditure as the heavy discounts being offered is nothing but a brand building exercise which has an enduring benefit. On the other hand, Flipkart claims that discount offered by them is the cost to company and must be therefore deducted from the total revenue.

The moot question here is whether discounts being offered result in brand building and can discounts be characterised as capital expenditure which results in a benefit that is of an enduring nature. Discounts are given to achieve high volumes and thus directly hit the revenue for the period in which discount is given and depending upon the accounting treatment followed it could be accounted for as a separate line item of expenditure or netted off from revenue. The tax authorities cannot sit in the chair of the businessman to decide as to what price should a product be sold at. This principle is judicially very well settled, and it is unfortunate that the officers at the lower level do not follow the decisions of the higher courts.

When examining the question, whether expenditure is capital or revenue in nature, one has to be guided by commercial considerations and only when the advantage is in the capital field, the expenditure can be disallowed applying the enduring benefit test. If the advantage consists of merely facilitating trading operations or increasing profitability or enabling the management to conduct business more efficiently, while leaving the fixed capital untouched, the expenditure is still on revenue account. In the instant case the discounts given by Flipkart are unequivocally on the revenue account.

One also needs to bear in mind that the enduring benefit is not a conclusive test for holding an expenditure as capital expenditure. The Supreme court in the case of Empire Jute Co. limited had held that there can be an expenditure which gives enduring benefit, but the expenditure can still be classified as revenue expenditure. What is material to consider is the nature of the advantage in a commercial sense and it is only where the advantage is in the capital field that the expenditure would be disallowable.

Thus, in my view the stand taken by the income tax department in Flipkart’s case is erroneous and based on a myopic view. On one hand the Government is trying to increase its position on index of ‘Ease of doing business’ and on the other hand the tax department is ensuring that the tax payer is harassed and drawn into needless litigation. It is very unlikely that the reasoning given by the tax department would stand the test of judicial scrutiny in higher courts.

 

Steps that the Government should take to make GST actually a Good and Simple Tax

It has been 4 months since the GST legislation was thrust upon the taxpayers. I use the word ‘thrust upon’ because the Government did not heed to the suggestions to make the law simple. The whole scheme of the Act and the associated compliances are based on the notion that all taxpayers are dishonest and therefore full control must be kept by the respective department. Numerous extensions have taken place in filing of all returns which has added to the confusion. No doubt the Government has issued many FAQ’s and held seminars but that was too little and too late. The damage has already been done. Across various states traders and service providers have started various methods to evade tax. This will continue to happen till the time the law is made simple and less complex for the taxpayers. As a concept GST is great but its implementation in India has caused the mess where we all find ourselves. This is what the Government needs to do:

  1. Reverse charge

Section 5(4) of the Integrated Goods and Services Tax(IGST) and section 9(4) of the Central Goods and Services Tax Act need to be deleted permanently. This only adds to the compliance burden. There is no revenue loss to the Government. A registered person has to first raise a self-invoice if he takes a supply from an unregistered person, pay the tax and then claim the input credit. Continuing with this will force businesses to buy from registered persons and make small shopkeepers redundant who are not liable to register because of the exemption linked to turnover.

  1. Multiplicity of Rates

Multiple rates add to the confusion. Selling a product in loose quantity attracts a different rate, if packed will attract a different rate. Why have these distinctions? It is but obvious that tax payers will find loopholes in drafting and try to fit the product in another rate than what the Government wishes it to be. The end result-more litigation. The judiciary is already burdened, and multiplicity of rates will further increase litigation.

  1. Multiple returns

The tax payer has to file 3 returns in a month. GSTR-1, GSTR-2 and GSTR-3 for outward, inward and payment of taxes for the month respectively. In GSTR-1, the tax payer is obliged to file invoice wise details of his outward supply. In GSTR-2, the taxpayer is supposed to match all his input as per his records with the outward supply details filed by his vendors/suppliers. This is the most complex part in the entire GST compliances. Every month the tax payer will reconcile all his inputs invoice by invoice and report to the same to the Government. Imagine the time, effort and money spent in doing this unproductive compliance.

The Government should keep it simple and ask the taxpayers to only file its outward supply details on a quarterly basis and trust the taxpayers in so far as claiming of input tax credit is concerned. There is no harm in learning the best practices from other countries where compliance has been made simple. Let the form GST 3B be made the only form to be filed on a quarterly basis.

  1. High rates of tax

Higher the rates, higher the incentive to evade tax. India is already a highly taxed and compliance driven economy and the high rates in GST will hurt the economy more than by doing any good. Taxing goods at 28% or 43% (including cess) is not the way going forward. Majority of the population buys cars only because the Government has miserably failed to provide effective public transport. Yes there are Metros to commute but given the population size is the Metro enough? The answer is an emphatic No.

  1. One Nation One Tax

This concept is a misnomer. The current legislation is far from one tax. If that were it, then why can’t the taxes paid in one State be adjusted the output of other States. Therefore, there are still 29 SGST’s and CGST’s credit for which cannot be claimed by a taxpayer in another State. The law should allow input credit in respect of tax paid anywhere in India and these artificial barriers should be removed. How the revenue collected has to be distributed is for the Government to decide. Why should the tax payer be made to suffer on this account. To claim credit again entities will be set up in different jurisdictions which will only increase litigation. Therefore the Government should permit set off of input credit of all states with the output tax of any State.

Good & Simple Tax-A Myth or Reality?

It has been two months since the Goods and Service Tax (GST) has been in operation. Termed as the biggest reform in Indirect Taxes, GST has been showcased by the Government as a Good and Simple Tax. No doubt, conceptually GST is the good tax. However, the implementation and the complexity in the Indian variant of GST as detailed below, does not make this law either good or simple. The GSTN portal has not been able to cope with the pressure of filing returns by business entities and dates for filing of returns have had to be extended multiple times.

1. Multiplicity of Rates

Multiplicity of rates goes against the concept of a good and simple tax. Five rates of tax, one special rate for Gold and cess for certain goods is going to result in classification disputes. This would increase the load on the already overburdened judiciary with unnecessary litigation. Across the world there is no country where five rates of GST / VAT are in effect. But as always, our Government believes in making laws which are complex and cumbersome. The rationale behind bucketing of goods and services under various rates was that the new rate would be in line with the aggregate rate of VAT & Excise being levied under the erstwhile law. While for some commodities this has been possible but for many goods and for services the rates of tax have increased thereby raising the cost for the ultimate consumer.

2. Dual GST

The very concept of a dual GST, wherein the supplier of goods and services has to determine whether he has to levy CGST, SGST or IGST goes against the basis of ‘One Nation One Tax’. The present form of GST is not ‘One Nation One Tax’. It is One Nation but 29 taxes, as each State has its own law and credit for tax paid in one State cannot be claimed as credit in the other State. If the intent were to keep the law simple then there should not have been Dual GST in the first place. The Supplier would deposit the GST collected and the allocation or bifurcation of tax between the Centre and States would be done at the level of the Government as opposed to what is being expected out of the taxpayers today. Also, the input CGST cannot be used to set off the output SGST and vice-versa.

3. Blockage of Credit

As long as any Goods or Service are used for the purpose of business, the entity paying for such Goods and Service should be permitted to claim input credit in respect of taxes paid on receipt of such goods or service. In various cases however, the Government has expressly denied allowance for the input credit. This goes against the concept of seamless credit which is fundamental to GST. Further, the Government has also clarified that CGST of one State cannot be set off as an input against the output liability of CGST of another State. While, there is no express prohibition in the Act, the view therefore taken by the Government on this matter is strange. As long as taxes have been paid anywhere in India by an entity that entity should be allowed to take credit of the taxes paid subject to the condition that the Goods and Services are used for the purpose of business.

4. Complex Returns

The law in its present form expects tax payers to file invoice wise details while filing the returns under GST which would then be matched at an invoice level against the inputs of that payer resulting in differences for the tax payer to sort out in a given period of time. Under the existing indirect tax laws there was no requirement of invoice wise matching of credits. This requirement is cumbersome and unnecessary. This is a mammoth task leading to huge compliance cost for companies. This is clear example of the Government not trusting its tax payers and trying to procedurally complicate the law instead of making it simple for the tax payers. The lower the tax rates, the simpler the compliance mechanism higher will be the compliance by the tax payers.

5. Blockage of working capital

Implementation of GST has resulted in huge blockage of working capital especially for start-up or small exporters where furnishing of bond or payment of tax is mandatory before exporting.

I sincerely hope that the Government considers all the above aspects and actually makes GST truly a good and simple tax in letter and spirt for the tax payers.

Composite Supply & Mixed Supply

As per section 2(27) of the CGST/SGST Act, “composite supply” means a supply made by a taxable person to a recipient comprising of two or more supplies of goods or services, or any combination thereof, which are naturally bundled and supplied in conjunction with each other in the ordinary course of business, one of which is a principal supply. To illustrate this consider purchase of a laptop. When you buy the laptop you get a bag alongwith the laptop. Therefore this becomes a composite supply wherein the supply of laptop is the principal supply and the bag is incidental to the principal supply.

On the other hand ‘mixed supply’ as per section 2(66) means two or more individual supplies of goods or services, or any combination thereof, made in conjunction with each other by a taxable person for single price where such supply does not constitute composite supply. For eg. A supply of a package consisting of canned foods, sweets, chocolates, cakes, dry fruits, aerated drink and fruit juices when supplied for a single price, is mixed supply. Each of these items can be supplied separately and is not dependent on any other.

“Composite supply” and “mixed supply” are mutually exclusive concepts. The answers to the following questions would help to distinguish between the two types of supplies:

(a) Are the supplies involving supply of different types of goods or services which are made for a single price ‘naturally bundled’ and supplied in conjunction with each other in the ordinary course of business.
(b) Are different supplies provided as a package in a single contract
(c) What is the intention of the parties

Every composite supply presupposes an existence of principal supply and therefore, a composite supply shall be deemed to be a supply of that principal supply. The end use test should also be applied to see which part would be the predominant supply and which would be an ancillary supply. For example: In a contract involving supply of software and customisation thereof, if the intention of the parties was to acquire a customised software, and the basic software without such customisation is of no use to the customer, then such contract can be said to be a naturally bundled contract.

If a contract of supply falls under the category of a mixed supply then a mixed supply shall be deemed to be a supply of that particular supply which attracts higher rate of tax. In some cases involving composite supply of goods as well as services, it may be difficult to identify whether the principal supply is a supply of goods or supply of services, as in such cases both the elements may be equally predominant. In such cases, legislature by a deeming fiction has decided whether such supplies shall be treated as ‘supply of goods’ or ‘supply of services’. Such cases are enumerated in Schedule II of the CGST/SGST Acts.

Goods and Service Tax – A New Beginning

Considered to be the biggest tax reform in the Country, the implementation of Goods and Service Tax Law (GST) is now a reality. The date of its implementation though has been postponed but all contentious issues have been sorted out by the GST Council. There is a paradigm shift in the basis of taxation under GST. The taxation moves from collecting tax at the point of origin to a destination based consumption tax. GST is a dual tax i.e. Central GST/State GST (CGST/SGCT) and Integrated GST (IGST). The fundamental basis of levy of GST is ‘Supply’. If there is an intra State supply of goods and/or services then a CGST and SGST would be charged, whereas if there is an inter State supply of goods and/or services then IGST would be charged.

 

Section 2(57) of CGST/SGST Acts defines “intra-state supply of goods” to mean supply of goods in the course of intra-state trade or commerce in terms of Section 4(1) of IGST Act. Section 2(58) of CGST/SGST Act defines “intra-state supply of services” to mean supply of services in the course of intra-state trade or commerce in terms of Section 4(2) of IGST Act. Thus, what constitutes an intra-state trade or commerce is contained in Section 4, of the IGST Act.

 

Two factors namely (i) the location of the supplier and (ii) the place of supply will determine whether the supply is intra-state or interstate. If both are in the same State, then it will be intra-state supply. If both are in different States, then it will be an interstate supply. Supply, in the course of import into territory of India, shall be deemed to be an inter-state supply. Similarly supply of goods / services when the supplier is located in India and the place of supply is outside India (i.e. exports), shall be deemed to be an interstate supply. Besides, import and exports, supply of goods/service to or by a SEZ developer or a SEZ unit, shall also be deemed to be an inter-state supply.

 

 

As per section Section 3(1)(a) of the CGST/SGST Law, “Supply” includes all forms of supply of goods and services such as sale, transfer, barter, exchange, license, rental, lease or disposal, made or agreed to be made for a consideration, by a person, in the course or furtherance of business. The said section makes importation of service for a consideration a supply whether or not such importation is under ordinary course of business.

 

In the context of transaction involving goods, supply would mean alienation (temporary or otherwise) of goods by one person and possession/custody thereof by another person. In the context of service, it means carrying out an activity by one person and enjoyment of deliverables of such activities by other person. From the above, it would be clear that there has to be contract for ‘supply’ between ‘two distinct persons’, consensus-ad-idem as to the ‘identity of goods or services’ and ‘consideration’ identified with the supply. Further, the transaction should be in the course or furtherance of business or commerce. This fourth condition is to be examined from the perspective of the person making the supply. Hence, even if the person receiving a supply is not a business entity such supplies would still attract GST.

 

In the subsequent posts various aspects of Supply would be covered in greater detail.

Income Declaration Scheme, 2016

The Income Declaration Scheme, 2016 (referred to here as ‘the Scheme’) is contained in the Finance Act, 2016, which received the assent of the President on 14th of May 2016.The Scheme provides an opportunity to persons to declare their undisclosed income and pay tax thereon at the rate of 30% of such undisclosed income, surcharge at the rate of 25% of such tax and penalty at the rate of 25% of such tax, totaling in all to 45% of such undisclosed income. The aforesaid payment of taxes, surcharge and penalty shall not be refundable under any circumstances. It has been clarified vide CBDT Circular No. 24/2016 dated 27th June 2016, that in case of part payment, the entire declaration made under the aforesaid scheme shall be invalid.

The Scheme has been brought into effect from 1st June 2016 and is available to every person, whether resident or non-resident. The Scheme is applicable in respect of undisclosed income of any financial year upto FY 2015-16.

Meaning of Undisclosed Income: Undisclosed income means any income or income in the form of investment in any asset located in India and acquired from income chargeable to tax in India under the Income-tax Act, 1961 (the Act), for which the declarant had either failed to furnish a return under section 139 of the Act or failed to disclose such income in its return or such income had escaped assessment. Where the undisclosed income is in the form of investment in any asset located in India, the fair market value (FMV) of such asset as computed in accordance with Rule 3(1) of Income Declaration Scheme Rules, 2016 (Rules) shall be deemed to be the undisclosed income. Where the investment in any asset is partly from an income which has been assessed to tax prior to AY 2017-18, the FMV of the asset, determined in accordance with Rule 3(2) of the Income Declaration Scheme Rules, 2016, shall be reduced by an amount which bears to the value of the asset as on 1st June 2016, the same proportion as the assessed income bears to the total cost of the asset (i.e., FMV as on 1.6.2016 X Assessed Income / Total cost of asset)

Time limit for declaration and making payment:

  • The scheme shall remain in force for a period of 4 months from 01.06.2016 to 30.09.2016 for filing of declarations. CBDT has, in this regard, clarified vide circular no. 27/2016 dated 14th July 2016 that a revised declaration can also be filed on or before 30.9.2016 provided the undisclosed income in the revised declaration is not less than the undisclosed income declared originally.
  • Payment towards taxes, surcharge and penalty must be made latest by 30.11.2016.
  • A declaration under the Scheme shall be made in Form 1 and shall be furnished either (a) electronically under digital signature or (b) electronically under electronic verification or (c) manually in print form to the concerned Principal CIT/ CIT. After such declaration has been furnished, the jurisdictional principal CIT/ CIT will issue an acknowledgement in Form 2 to the declarant within 15 days from the end of the month in which the declaration under Form 1 is made. The declarant shall not be liable for any adverse consequences under the Scheme in respect of any income which has been duly declared but has been found ineligible for declaration. However, such information may be used under the provisions of the Act. The declarant shall furnish proof of payment made in respect of tax, surcharge and penalty to the jurisdictional Principal CIT/CIT in Form 3 after which the said authority shall issue a certificate in Form 4 within 15 days of submission of proof of payment by the declarant.

Declaration is not eligible in the following cases:

  • For those assessment years in respect of which notices have been issued under section 142(1) or 143(2) or 148 or 153A or 153C of the Act and served on the declarant on or before 31st May 2016, or
  • Where a search or survey has been conducted and the time for issuance of notice under the relevant provisions of the Act has not expired. However, he can make a declaration in respect of undisclosed income of any other previous year, or
  • For those assessment years for which the proceeding is pending with the Settlement Commission
  • Cases covered under the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015, or
  • Persons notified under Special Court Act, 1992, or
  • Cases covered under Indian Penal Code, the Narcotic Drugs and Psychotropic Substances Act, 1985, the Unlawful Activities (Prevention) Act, 1967 and the Prevention of Corruption Act, 1988

Consequences/ Effect of valid declaration as per clarifications by CBDT:

  • The amount of undisclosed income declared by the declarant shall not be included in his total income under the Income-tax Act for any assessment year. Further, the value of the asset declared by the declarant shall not be chargeable to Wealth-tax for any assessment year or years.
  • The contents of the declaration shall not be admissible in evidence against the declarant in any penalty or prosecution proceedings under the Act and the Wealth Tax Act, 1957.
  • Immunity from Benami Transactions (Prohibition) Act, 1988 shall be available in respect of the assets disclosed in the declarations subject to the condition that benamidar shall transfer to the declarant or his legal representative the asset in respect of which the declaration of undisclosed income is made on or before 30th September, 2017.
  • Declaration of undisclosed income will not affect the finality of completed assessments.
  • Under normal circumstances, the capital gain is computed by deducting cost of acquisition from sale price. However, when the asset which is disclosed under the scheme is sold, since the asset will be taxed at its fair market value, the cost of acquisition for the purpose of capital gains shall be the fair market value as on 01.06.2016 and the period of holding shall start from the said date (i.e. the date of determination of fair market value for the purpose of the scheme).
  • It has been clarified by the CBDT that it is not mandatory to file the valuation report, along with the declaration, of the undisclosed income represented in the form of investment in asset. However, while filing the declaration on the e-filing website, a facility for uploading the document will be available.
  • In case of amalgamation or conversion of a company to LLP, the declaration is to be made in the name of the amalgamated company or LLP, as the case may be, for the year in which the amalgamation or conversion takes place.
  • The CBDT, vide circular no. 25/2016 dated 30.6.2016, has clarified that the department will not make any enquiry in respect of the source of income, payment of tax, surcharge and penalty. However, this created a doubt as to whether the payment of tax, surcharge and penalty can be made out of the undisclosed income, thereby bringing down the effective rate of tax, surcharge and penalty to around 31%. The CBDT, vide circular no. 27/2016 dated 14.7.2016, has clarified that if a person declares Rs. 100 Lakhs as undisclosed income and pays tax, surcharge, penalty of Rs. 45 Lakhs out of his other undisclosed income, he will not get immunity under the Scheme in respect of undisclosed income of Rs. 45 Lakhs which has been utilized towards payment of tax, surcharge and penalty. Immunity will be granted if the person declares the entire Rs. 145 Lakhs as undisclosed income and pays tax, surcharge and penalty @ 45% amounting to Rs. 62.25 Lakhs.

Deeming provisions under the Scheme

Section 197(c) of the Scheme provides that

A careful reading of the same would show that the aforesaid provision of the Scheme goes beyond the provisions of section 149 of the Act. At present a notice for re-assessment cannot be issued beyond 6 years of the end of any assessment year. By virtue of this deeming fiction any income of any preceding previous year shall deemed be to the income of the year in which a notice under the aforesaid sections is issued. For eg. if the undisclosed income pertains to financial year 2001-02 for which no declaration is filed under this Scheme and particulars of such income become available to the tax department in financial year 2017-18. Under, the normal provisions of the Act, this undisclosed income would not be taxed but considering the wording of section 197(c) of the Scheme such undisclosed income can be taxed in any year in which a notice is sent.

Whether, this provision of the Scheme would stand the test of judicial scrutiny or not is a question but the reason for such a provision in the Scheme is clearly to give a message to all persons who have undisclosed income to take benefit of this Scheme.

ICDS III relating to Construction Contracts

Scope of ICDS
The said ICDS is based on Accounting Standard-7 (AS-7) on Construction Contracts notified by the Companies (Accounting Standard) Rules 2006. The ICDS has made significant changes in treatment of certain items of contract revenue which would have far reaching implications. This ICDS also seeks to override settled legal position on many aspects which are explained in detail in the subsequent paragraphs.

Issues
AS-7 does not deal with recognition of revenue by Real Estate Developers. However, there is separate Guidance Note on the same issued by the ICAI. The ICDS is silent on this aspect but the treatment provided for by the Guidance Note on this aspect is being accepted by the tax authorities. In my opinion as the ICDS is silent on this aspect, the accounting treatment prescribed by the Guidance note should continue to be followed for tax purposes as well.

Under AS-7, contract revenue is to be recognized if it is possible to reliably estimate the outcome of the contract. The criteria “if it is possible to reliably measure the outcome of a contract” has been omitted in the ICDS. This omission would result in taxing of the contract revenue earlier as compared to it being accounted for as income for accounting purposes.

Contract revenue and contract costs as per AS-7 are to be recognized as revenue or expenses by reference to the percentage of completion method (POCM) if the outcome of the contract can be estimated reliably. If it is not possible to do so, revenue should be recognized only to the extent of contract costs incurred. AS-7 does not provide for any threshold for determining the stage of completion. On the other hand, the ICDS takes a position whereby recognition of revenue cannot be postponed once the contract has reached 25% completion stage. If the contract has not reached the 25% completion stage, contract revenue would be equal to contract costs.

Another significant difference between AS-7 and ICDS is regarding accounting and taxation of Retention money. As per AS-7, retention money would be taxed when the right to receive is established. Under the ICDS, retention money is also taxed on POCM basis. This seeks to override settled legal position wherein it has been held that retention money can be taxed only when the right to receive the same is established.

Under AS-7, recognition of actual loss and forseeable loss is permitted. Under the ICDS, there is no provision for recognition of forseeable loss and actual loss would be allowed on POCM basis. The position taken by the ICDS again seeks to unsettle the settled legal position. Some of the cases where the judiciary had allowed deduction of anticipated losses are CIT vs. Triveni Engineering & Industries Ltd. (336 ITR 374) (Delhi HC), CIT vs. Advance Construction Co. Pvt. Ltd. (275 ITR 30) (Gujarat HC), Jacobs Engineering India Pvt. Ltd. (14 taxman.com 186) (Mumbai Tribunal). On account of non-allowbility of forseeable loss in Year 1 or preponing of revenue in year 1 as per the ICDS, a situation may arise which would lead to double taxation as in year 2 when the revenue is recognised for books of account, MAT would be applicable.

The ICDS provides that any pre-construction income in the nature of interest, dividends and capital gains shall not be reduced from the cost of construction. Accordingly, preconstruction income (like interest from advances given to sub-contractors, etc.) could get taxed as income in the year of accrual. AS-7 permits reduction of incidental income from the contract costs as long as the income is not in the nature of contract revenue. The authorities seem to have based their view on the decision of the Apex Court in the case of Tuticorin Alkali Chemicals and Fertilizers Ltd. v CIT 227 ITR 172 ignoring the subsequent decision of the Apex Court in the case of CIT v Bokaro Steel Ltd. 236 ITR 315.

As compared to other ICDS, the impact for taxpayers under this ICDS is significant. Apart from corporate tax payers who would be following the POCM method, there would be many tax payers in the category of partnerships and proprietorships where the completed contract method would be followed uptill now. The application of this ICDS would result in early taxation of income for such class of tax payers. Time will tell whether the stated objective of the ICDS i.e. to reduce litigation will be achieved with this ICDS

ICDS II relating to Valuation of Inventories

SCOPE OF ICDS

The said ICDS is based on Accounting Standard-2 (AS-2) on Valuation of Inventories notified by the Companies (Accounting Standard) Rules 2006. The ICDS however, has made some departures from the accounting treatment prescribed for preparation of financial statements. The intent behind the change seems to be to address certain matters which have been subject to litigation. As explained earlier in case of conflict between the provisions of Income-tax Act 1961 (the Act) and this ICDS, the provisions of the Act shall prevail.

Definition

Inventories under the ICDS is defined as 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.

From the above definition of ‘inventories’, it would be clear that the ICDS requires measurement of inventory even in case of service providers. This aspect is not covered under AS-2. The ICDS further provides that the method of valuation for service providers would also be cost or NRV whichever is lower, which is the prescribed method for all other types of inventories.

NRV is defined as the estimated selling price in the ordinary course of business less estimated costs of completion and the estimated costs necessary to make the sale. This definition is similar to the definition given in AS-2.

Measurement

As stated hereinabove, the ICDS adopts the accepted accounting measurement criteria for Inventories i.e. cost for NRV whichever is lower. Changes have however been made in the definition of costs. AS-2 defines the costs of purchase as consisting of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase.

The ICDS has modified the said definition inasmuch as words “other than those subsequently recoverable by the enterprise from the taxing authorities” has been deleted. This implies that cost of purchase would necessarily include the element of duty for which cenvat credit is available. For accounting purposes a company is required to follow the exclusive method of accounting wherein taxes which are recovered subsequently are not included as cost of purchase. This ICDS however seems to follow the inclusive method of accounting. The ICAI in its Guidance Note on Tax Audit has taken a view that the adjustments envisaged by section 145A of the Act will not have any impact on the trading account of the assessee. In other words both under exclusive method of accounting and inclusive method of accounting, the gross profit in the trading account will remain the same. The view taken by the Guidance Note has also been affirmed by a Mumbai ITAT judgment in the case of Raj Petro Speciality Pvt. Ltd. vs ACIT (2013) 34 taxman.com 76.

In respect of valuation of services, the ICDS provides that the cost of services should include the cost of labour and other costs of personnel directly engaged in providing the service including supervisory personnel and attributable overheads. This could lead to a difficult situation as it may not be possible to prescribe value for certain type of service revenues. For example, commission income.

Value of opening inventory

The ICDS specifically provides guidance on value of inventory as on the beginning of the previous year so as to put to rest litigation on this aspect. The ICDS provides that the value of opening inventory shall be –

  • the cost of inventory available, if any, on the day of the commencement of the business when the business has commenced during the previous year, and
  • the value of inventory as on the close of the immediately preceding previous year in any other case.

Thus, if during the course of assessment proceeding the value of inventory is increased by the Assessing Officer then the said amount would have to be taken as the value of opening inventory in the subsequent assessment year. The guidance provided on this aspect would certainly help in reducing litigation.

Change of method of valuation of inventory

The method of valuation of inventories once adopted by a person in any previous year shall not be changed without reasonable cause. What constitutes ‘reasonable cause’ has not been defined. According to AS 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies a change in an accounting policy should be made only if the adoption of a different accounting policy is required by statute or for compliance with an accounting standard or if it is considered that the change would result in a more appropriate presentation of the financial statements of the enterprise. This should be used as a guiding principle to determine “reasonable cause”.

Valuation of inventory in place of dissolution

The ICDS provides that in case of dissolution of a partnership firm, or AOP or a BOI notwithstanding whether business in discontinued or not, the inventory on the date of dissolution shall be valued at the net realisable value. This decision adopted by the ICDS seems to overrule the decision of Hon’ble Supreme Court in the case of Sakthi Trading Co. vs. CIT (2001) 118 Taxman 301 (SC).

The Hon’ble Supreme Court in the said case had held that where a firm got dissolved due to death of a partner and business was reconstituted and continued without any interruption with the remaining partners, the closing stock was to be valued at cost or market price, whichever was lower, and not at market value. The ICDS overrules this decision by providing that in all cases of dissolution of partnerships, the inventory shall be valued at NRV on the date of dissolution.

Conclusion

ICDS II has tried to provide guidance on a few aspects which would certainly reduce litigation but the requirement to follow the inclusive method of accounting is not correct. This unnecessarily requires the taxpayer to make complex reconciliations which goes against the intent of the Government to make the law simple.