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

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