This second article is again an attempt to discuss some of the FAQs issued by the CBDT and to highlight some of the potential tax issues emanating therefrom. In the previous article we discussed some of the clarifications issued by the CBDT pertaining to revenue recognition. This time we have first analysed the merits of capitalisation of expenses incurred prior to commencement of commercial production; then marked to market (“MTM”) gain to have same treatment as of MTM loss and followed by clarifications on computation of closing stock of securities held as stock-in-trade and overriding effect of Income Tax Rules, 1962 (“Rules”) on ICDS.

Capitalisation of expenses prior to commencement of business

Income Computation and Disclosure Standard (“ICDS”) V relating to “Tangible Fixed Assets” states that “expenditure incurred on start-up and commissioning of the project including test runs and experimental production, shall be capitalised. The expenditure incurred after the plant has begun commercial production, that is, production intended for sale or captive consumption, shall be treated as revenue expenditure”. Doubts arose in the minds of the taxpayer regarding the treatment of expenditure incurred after the test run/ experimental production but before commercial production on which CBDT in its recent circular on ICDS clarified that till the plant has begun commercial production i.e. production intended for sale or captive consumption, shall be treated as capital expenditure. It further inherently raises an issue that what will be the treatment of interest incurred/paid before commencement of commercial production which is governed by ICDS IX and provides for capitalisation of borrowing costs incurred for acquisition of assets up to the date the asset is first put to use.  

Hence, in light of the law laid down by Central Government and CBDT, one needs to re-look that how the provisions of the Income Tax Act, 1961 (the “Act”) deal with such expenses and how the courts have interpreted it as ICDS itself provides that in case of conflict between ICDS and a provision in the Act, the provision of the Act shall prevail.

Expenses incurred by a company for business purposes is a deductible expense under section 37(1) of the Act which provides that “expenses laid out or expended wholly and exclusively for purposes of business shall be allowed in computing Profits and Gains from Business and Profession (“PGBP”).” Further, proviso to section 36(1)(iii) of the Act provides for “capitalisation of interest paid for acquisition of an asset from the date on which funds were borrowed till the date such asset is put to use”. Furthermore, as per Explanation 8 to section 43(1), interest paid shall be added in the actual cost of the asset till the asset is first put to use for claiming depreciation.   

It has been a common issue before Courts to determine the difference between setting up of business and commencement of business and consequential determination of deductibility of expense as revenue expenditure under the Act.

Various Courts such as by Bombay High Court in the case of Western India Vegetable Products Ltd v. CIT [TS-3-HC-1954(BOM)-O] held that setting up means ready to commence while actual commencement is when the business activity actually commences and expenses incurred during the gap between set up and commencement are allowable deductions. Further in another case of CIT v. Forging and Stamping Pvt. Ltd. [TS-5079-HC-1979(BOMBAY)-O], Bombay High Court held that mere trial run of the machines would not be sufficient to conclude that the business had set up. Furthermore, Calcutta Tribunal in the case of ACIT v. Paharpur Cooling Towers P. Ltd [TS-5437-ITAT-1992(CALCUTTA)-O] held that assessee had not only set up its business but also commenced production when it started its trial production and hence allowed the expenses on trial production i.e. after setting up of business but prior to commercial production.

Therefore, it can be said that there is no straight jacket formula to determine the date of setting up of business for deductibility of expenses and hence it is a combination of both factual and legal analysis.

Moreover, various Courts including Punjab & Haryana High Court in the case of CIT vs. Piccadily Agro Industries Ltd [TS-5693-HC-2007(PUNJAB)-O] has held that trial production would amount to use of machinery for the purpose of business and the assessee would be entitled to claim depreciation.

Hence, due to similar determinative factor of “put to use” in ICDS IX, proviso to 36(1)(iii) and explanation 8 to section 43(1) of the Act, it can be said that interest paid after the asset has been put to use even for test runs before the commencement of commercial production can be claimed as revenue expenditure.

However, in the absence of explicit mention in the Act relating to deduction in respect of expenses before commercial production and now guidance provided by ICDS V including the recent clarification on ICDS V and previous judicial precedents getting overruled, should it be said that expenses prior to commercial production shall be treated as capital expenditure? One should await the developments in this regard.  Given the way ICDS has been drafted, it is expected that there could be huge ramifications especially manufacturing sector and sectors that have heavily invested on plant and machinery.

Mark to Market loss / gain

Currently, MTM losses / gains are treated as an expense / income for tax purposes, in appropriate cases, based on existing jurisprudence. However, ICDS I states that MTM loss or expected loss shall not be deductible unless it has been recognized in accordance with any other ICDS. However, no ICDS has been notified as on date for MTM transactions, expect for forward exchange contracts, the exchange fluctuations for some of which are to be recognised year-on-year and some to be recognised on settlement, however as per Accounting Standards such contracts are marked-to market on each balance sheet date. CBDT in its recent clarification has provided that the principle of MTM loss shall apply mutatis mutandis to MTM gains or expected profit. Hence, MTM gains in respect of forward contracts that are to be recognised on settlement, will not be recognised as income as per ICDS and for other types of MTM gains (expect forward contracts) will not be recognised as income until any ICDS is prescribed in this regard.

The FAQ’s further clarifies that ICDS shall not apply to computation of Minimum Alternate Tax (MAT) under section 115JB of the Act, however ICDS is applicable for Alternate Minimum Tax (AMT) under section 115JC of the Act, as the same is a computation methodology under regular provisions of the Act. Hence, it appears that MTM transactions (other than certain forward contracts as discussed above) will not be considered for normal provisions of the Act and also for AMT calculation, however will be considered for the purpose of MAT provisions.

Various Tribunals held that MAT is levied on real working results of the company and only real profits are taxed under MAT and while holding so it has upheld that notional / capital transactions, in appropriate cases, should not be included for the purpose of MAT computation. Hence, it may be possible to that argue that MTM transactions which do not meet the test of real profits to be excluded while calculating MAT liability based on existing jurisprudence, and that that ICDS does not govern MAT provisions. However, one should await the ICDS that are going to be notified in respect of other MTM transactions for normal provisions of the Act / AMT provisions.

Valuation of Closing Stock of listed securities

Generally shares held as stock-in-trade are valued scrip wise. Paragraphs 9 and 10 of ICDS VIII provide measurement criteria for computing the closing stock of shares held as stock-in-trade, for listed stock and that are quoted with regularity from time to time. It has been further clarified by CBDT in its recent circular by way of an illustration.

Pre-ICDS

In pre-ICDS scenario, the above diminution (i.e.,70(1160-1090) is recognised as provision for diminution in value of asset and written off in profit and loss account when the value permanently declines

Post-ICDS 

Hence, as per ICDS closing stock value shall be valued each year lower of cost or NRV and hence as per above example 1135 will be value of closing stock and amount to be recognised in profit and loss account will be 25 i.e., (1160-1135).

Further, ICDS VIII mentions that this ICDS is not applicable to banks but carves out the applicability to scheduled banks and public financial institutions and says that they will be governed by the valuation rules prescribed by Reserve Bank of India (“RBI”) and any excess claim over and above the said guidelines by RBI will not be acceptable. As per Reserve Bank guidelines securities classified as Held for Trading (“HFT”) and Available for Sale (“AFS”) will be marked to market scrip wise and aggregated category wise under HFT / AFS and only net depreciation if any will be provided for in the books of accounts. The same also has been re-iterated by CBDT through instruction no. 17/2008.

The issue valuation for securities for Banks has already been dealt by various Courts including Bangalore Tribunal in the case of ING Vysya Bank Ltd v. ACIT [TS-5085-ITAT-2015(BANGALORE)-O] wherein it was held that assessee is entitled to value all the securities which are part of trading stock at cost price or market value and claim depreciation due to diminution in value of each such share and not category wise as it could lead to recognition of appreciation thereof which is in the nature of notional income. Therefore, the questions that arises is that whether the above jurisprudence would still hold good as the same overrides Reserve Bank guidelines, however, whether the specific mention in the ICDS that excess claim over the RBI guidelines will not be acceptable will have any ramifications is to be decided by the courts, if CBDT does not provide any further guidance on the same.

Conflict between ICDS and Rules

The FAQ’s have clarified that in case of conflict between ICDS and Rules governing specific circumstances, the latter shall prevail eg., Rule 9A and 9B that deals with special provisions of deduction of expenditure on production of feature films / acquisition of distribution rights.  However, the future interplay between certain Rules such as Rule 10 which provides general principles for determination of income of a non-resident in certain cases and the ICDS which provides general principles for computation of income, would be interesting to look-forward.