Background

Section 145(2) of the Income Tax Act was amended by Finance (No.2) Act, 2014 in order to provide that the Central Government may notify from time to time Income Computation and Disclosure Standards to be followed by any class of assessees or in respect of any class of income.

Income Computation and Disclosure Standards (ICDS)

The Central Government has notified ICDS vide Notification No.SO.892(E) dated 31.03.2015 and the standards will have to be followed by all assessees following the mercantile system of accounting for computation of income under the heads ‘profits and gains of business or profession’ or ‘income from other sources’. Currently, the Government has notified 10 Income Computation and Disclosure Standards which are effective from 01.04.2015 and applicable from assessment year 2016-2017.

Construction Contracts

ICDS-III is applicable to determination of income for a construction contract of a contractor. The key features of this standard are given below:-

(i) Contract revenue and contract costs associated with the construction contract should be recognized as revenue and expenses respectively by reference to the stage of completion of the contract activity at the reporting date. ICDS thus refers to percentage of completion method (POCM). Completed contract method is no longer relevant.

(ii) The stages of completion of contract has to be determined with reference to

       (a) Cost incurred for work performed upto the reporting date as they bear to the estimated total contract costs; or

       (b) Surveys of work performed; or

       (c) Completion of a physical proportion of the contract work.

(iii) Progress payments and advances received from customers are not determinative of the stage of completion of the contract.

(iv) Contract revenue shall be recognized when there is reasonable certainty of its ultimate collection. This is in one sense a relief.

(v) Contract revenue shall comprise of

• Initial amount of revenue agreed in the contract including retentions;
• Variations in contract work, claims and incentive payments to the extent are probable that it will result in revenue and to the extent it can be reliably measured.

(vi) During the early stages of a contract where the outcome of the contract cannot be estimated reliably, contract revenue is recognized only to the extent of costs incurred. The early stage of contract shall not extend beyond 25% of the stage of completion.

(vii) Where contract revenue that is already recognized as income is subsequently written-off in the books of accounts as uncollectable, the same shall be recognized as an expense and not as an adjustment of the amount of contract revenue.

Key Issues

(i) Retention money. AS-7 which deals with construction contract is silent with reference to retention money but under ICDS-III, retention money is also considered as contract revenue. Without an amendment to the Income Tax Act, ICDS attempts to nullify the decisions of the Bombay High Court in the case of Associated Cables; Calcutta High Court in the case of Simplex Concrete Pipes; and the Madras High Court in the case of P&C Constructions / East Coast Constructions. The crux of these decisions was to the effect that retention money is contingent upon satisfactory completion of contract work. Therefore, it would not amount to income in the year in which the amount is retained. The principles laid down in these decisions and the concept of real income will now have to be debated once again in the light of ICDS.

(ii) Compliance. There would be practical difficulties in complying with ICDS as it is applicable to all tax payers following mercantile system of accounting for the purpose of taxable income under ‘business or profession’ or ‘other sources’. Non-corporates such as partnership, sole proprietors, LLPs who had been following completion contract method would now have to mandatorily follow percentage of completion method.

(iii) Anticipated losses. The Delhi High Court in the case of CIT Vs. Triveni Engineering & Industries Ltd. (2011) 336 ITR 374 [TS-24-HC-2010(DEL)] had held that where completed method of accounting is followed which is consistent with the accounting standards, provision for anticipated losses is justified. There is no provision in ICDS for recognizing anticipated losses. This is clearly in conflict with the concept of prudence. In ICDS only actual losses would be allowed on percentage of completion basis.

(iv) Existing contracts. Para 22 of ICDS-III provides that contract revenue and contract costs associated with construction contracts which commenced on or before 31.03.2015 but not completed by the said date shall be recognized as revenue and costs respectively in accordance with this standard. The amount of contract revenue, contract costs or expected loss if any recognized for the said contract for any previous year commencing on or before 01.04.2014 shall be taken into account for recognizing revenue and costs for the said contract for the previous year commencing from 01.04.2015 and subsequent previous year. This is likely to have a significant impact on assessees following completed contract method since they would now be required to compute taxable income for all contracts for the Assessment Year 2016-2017 (Financial year 2015-2016). In the year of transition there could be an early recognition of income based on the stage of completion.

(v) Incidental income. AS-7 allows income such as interest, dividend, capital gain earned during the pre-construction stages to be reduced from the cost of construction.   ICDS provides that contract costs shall be reduced by incidental income not being in the nature of interest, dividends or capital gains that is not included in contract revenue.