The Central Board of Direct taxes (“CBDT”) constituted a committee of tax experts to draft Tax Accounting Standards (“TAS”) with an intention to reduce litigation around contentious tax issues. The committee submitted its report in August 2012, which was put in public domain for their comments. The proposed TAS were replaced with the Income Computation and Disclosure Standards (“ICDS”) in 2015. The ICDS, apart from prescribing the standard on accounting policies, have also introduced nine standards, covering valuation of inventory, construction contracts, revenue recognition, tangible fixed assets, effects of changes in foreign exchange rates, government grants, securities, borrowing costs and provisions, contingent liabilities and contingent assets. Some of the salient features of ICDS are a) no need to maintain separate books of accounts, b) in case of conflict, provision of the Income-tax Act would prevail, c) mandated to be followed by taxpayers following mercantile basis of accounting under section 145 of the Act, d) applicable for computing income under the head “Profits and Gains from Business or Profession” and “Income from other sources” and e) individuals and HUF not required to undergo tax audit are excluded.

While ICDS were originally introduced in March 2015 to be applicable for FY 2015-16, various stakeholders raised concerns on interpretation and application of the ICDS. Considering this, its implementation was deferred by one year to FY 2016-17 and the CBDT again referred these issues to an expert committee. Based on their recommendations, the revised ICDS were released in September 2016 and on the issues requiring clarifications, the CBDT issued a Circular No. 10/2017 dated March 23, 2017 containing 25 clarifications in the form of FAQ’s with the aim to tackle some of the ambiguities arising in the minds of the taxpayer due to ICDS.

This article is the first in a 3 article series, to discuss FAQs issued by the CBDT and to highlight some of the potential tax issues emanating therefrom. In this article we have discussed clarifications issued by the CBDT pertaining to revenue recognition aspects. In this context, we have first analysed the overriding effect of ICDS on established judicial precedents, followed by other specific clarifications on aspects relating to revenue recognition.

In the Question 2 of the circular, the CBDT was posed with a question that where ICDS provisions are inconsistent with judicial precedents, whether these judicial precedents would prevail over ICDS? In the regard, the CBDT clarified that the ICDS have been notified after due consideration of judicial views, which were pronounced in the absence of authoritative guidance on those issues. Hence, considering the authoritative view has now been given in ICDS under Section 145(2) of the Act, the view given in ICDS shall be applicable to those issues.

In this regard, it is pertinent to note that ICDS have been notified under Section 145(2) of the Act. Thus, one can argue that by virtue of its incorporation in Section 145(2) ICDS attains the status of a statute. However, this position is diluted within ICDS itself, which provides that in case of conflict between ICDS and a provision in the Act, the provision of the Act shall prevail. Further, in response to Question 4 of the circular, which talks about conflict between ICDS and Income-tax Rules, it has been clarified that ICDS provides general principles for computation of income and in case of conflict, provision of Rules shall prevail. Thus, one can infer that ICDS though incorporated in the Act through Section 145(2) are guiding principles which do not override provisions of the Act as well as Rules.

Considering above position of ICDS, where a judicial pronouncement interprets a provision of the Act, the debate would be whether, overriding such pronouncement conflicts with the provision of the Act. In the context of revenue recognition, Section 5 of the Act provides that total income shall include income accruing or arising during the year. In this regard, Hon’ble Supreme Court in the cases of E.D. Sassoon & Co. Ltd v. CIT [TS-1-SC-1954-O], Godhra Electricity Co. Ltd v. CIT [TS-5046-SC-1997-O], etc. and various High Courts such as by Delhi High Court in Saraswati Insurance Co. Ltd v. CIT [TS-5033-HC-2001(DELHI)-O], etc. have held certain principles such as a) The accrual of any income is to be determined in light of the contractual terms under which such income arises, and b) a mere accounting entry or the following of the mercantile system of accounting is not conclusive of the accrual of income etc. which are required to be fulfilled before an “income” can be said to have “accrued or arisen” under section 5 of the Act. Thus, where ICDS prescribes for revenue recognition in contradiction with these principles, whether it can be argued that these jurisprudence read with Section 5 of the Act should override provisions of ICDS?

A case in point is ICDS III, which define “retentions” as part of contract price, which is paid upon satisfaction of conditions specified in the contract. Further, ICDS III includes such retentions in the contract revenue even when such receipts are contingent in nature on the satisfaction of certain performance criterion. The circular vide Question 11 has clarified that retention money being part of contract revenue shall be recognised when there is reasonable certainty of its ultimate collection.

The issue whether retention money needs to be treated as a part of contract revenue has been a subject matter of interpretation before various courts. For instance, Calcutta High Court in the case of CIT vs. Simplex Concrete Piles India (P) Ltd [TS-5643-HC-1988(CALCUTTA)-O] while interpreting Section 5 in this context has held that retention money shall be included in taxable income when the money became legally due and taxpayer has a right to receive the same i.e. on the satisfactory execution of the contract. Thus, reading Section 5 along with the judicial precedents, one can argue that inclusion of retention money in contract revenue and its taxation prior to its becoming legally due, is in conflict with Section 5 of the Act and thus, judicial interpretation of Section 5 should prevail over ICDS.

Similarly, in response to Question 13 on whether interest, royalty and dividend can accrue even if collection thereof is uncertain, it is clarified that interest accrues on time basis and royalty accrues on the basis of contract terms and any subsequent non-recovery can be claimed as a bad debt. Various courts have applied the real income theory for taxability of interest income. Where recovery of interest is contingent or uncertain, courts have held that interest income does not accrue under Section 5 of the Act. For instance, High Court of Delhi in the case of CIT vs. Vasisth Chay Vyapar Ltd. [TS-5864-HC-2010(DELHI)-O] applying real income theory for the purpose of Section 5 of the Act, held that interest income on non-performing assets cannot be taxed unless it is realised. This position of the circular disregarding realisability of an income seems to be in contradiction with well-established principles of accrual of income. Thus, whether ICDS can change these principles would be a subject of extensive debate and litigation.

The circular further provides clarification on determination of turnover by non-corporate taxpayers covered under presumptive taxation like Sections 44AD, 44AE, 44ADA, 44B, 44BB, 44BBA, etc. In this regard, in response to Question 3 on this topic, it has been clarified that ICDS shall also apply to persons computing income under presumptive taxation schemes. To illustrate this position, it is clarified that in case of taxation of a partnership firm under Section 44AD of the Act provision of ICDS on construction contract or revenue recognition shall apply for determination of its receipt or turnover.

Section 44AD of the Act provides that “Notwithstanding anything to the contrary contained in sections 28 to 43C, in the case of an eligible assessee engaged in an eligible business, a sum equal to eight per cent of the total turnover or gross receipts of the assessee in the previous year on account of such business or, … shall be deemed to be the profits and gains of such business chargeable to tax under the head "Profits and gains of business or profession".”. Thus, it mandates taxation of specified assessees @ 8% of the turnover or gross receipt. In this regard, the only variable is the amount of turnover i.e. whether the turnover should be considered as per the accounts or any adjustment can be made to it before applying presumptive tax rate of 8% on it. For instance, where a taxpayer covered within the ambit of Section 44AD is engaged in the construction business, which requires determination of turnover as per Percentage of Completion Method (PoCM) both under accounts and ICDS. However, under ICDS III, retention money is included in contract revenue while under AS 7 this may not be the case. Thus, the revenue recognised as per books of accounts and ICDS would vary. In this context, it has been clarified that revenue as per ICDS III would be considered for the purpose of applying presumptive tax rate under Section 44AD of the Act. However, whether same principle would apply for determining turnover in other provisions such as for maintenance of books of account under section 44AA or applicability of audit under Section 44AB, is yet to be seen.

A similar clarification has been provided vide Question 14 on taxation of interest, royalty and technical services under Section 115A of the Act. Section 115A provides for rate of taxation of income from interest, royalty and technical service accruing to a non-resident on gross income. In the context of interest and royalty, in response to Question 13 it has been clarified that interest accrues on time basis and royalty accrues on the basis of contract terms. Thus, where revenue authorities take a position that interest / royalty accrue as per ICDS IV, determination under Section 115A would be a natural consequence. In the context of taxation of services, ICDS IV mandates recognition of service revenue as per PoCM. Though a lee way has been provided for services requiring not more than 90 days for completion, where taxation can take place on completion of contract. Thus, in case of long term off-shore service contracts undertaken by non-residents, one would consider applying PoCM for determination of their revenues.

In the above context, since the income recipient is a non-resident, one would need to evaluate articles of relevant tax treaty and whether ICDS requirements can be imported for determination of income under the treaty provisions. Further, one would also need to evaluate whether it can be argued that since Section 115A forms part of Chapter XII of the Act, which provides for determination of tax in special cases, can provision of ICDS which are applicable on income under the head ‘Profit and Gains from Business and Profession’ and ‘Income from Other Sources’ be applied to these special taxation provisions. To conclude, one can say that initiative of the CBDT to provide clarifications is a welcome move. However, it would be imperative that industry inputs are constantly sought in this evolving domain of law, to ensure that it does not becomes another dampener in ease of doing business in India!

Click here to read "CBDT Clarifications on ICDS – An Incisive Analysis – Part II"