As part of the “Roadmap” laid down in 2010 for introduction of IFRS (Ind-AS), theCentral Board of Direct Taxes (‘CBDT’) started working on drafting ‘Income Computation and Disclosure Standards’ (‘ICDS’) to align the tax treatment with the Ind-AS. Finally, the CBDT vide Notification No. 32/2015, dated 31/03/2015 notified 10 ICDS under section 145(2) of the Income-tax Act, 1961 (‘the Act’). These ICDS prescribethe method of accounting to be followed for computing taxable income of the assessee. The Notification is basically a step forward towards announcements made by Finance Minister in his maiden Budget speech in July 2014, wherein the intention of laying down new framework was made public. Whilethe industry is preparing to adopt Ind-AS (voluntary adoption from the FY 2015-16), the ICDS have been notified and made effective from 1 April 2015. These ICDs will be applicable to all assessee following mercantile system of accounting for computing income under the heads “Income from Business and Profession” and “Income from Other Sources”. Accordingly, this ICDS should not be applicable to Proprietary Concerns, Partnership Firms, LLLPs, etc. who are not required to mandatorily follow mercantile system of accounting. Further, it is specifically clarified that in case of conflict between provisions of the Act and ICDS, provisions of the Act would prevail.. Though, it was intended that ICDS would simplify and reduce existing litigation as also bring more clarity, it does not seems to be the reality.

In particular, ICDS have given a “go bye” to the fundamental principles of accounting and taxation i.e. Prudence, materiality, and accounting of foreseeable losses, etc. As a result, in several situations this would result in earlier recognition of income or later recognition of expenses or losses resulting in potential tax impact. In some cases, such impact could be very significant that it could pose a question on “going concern” concept for the enterprise. The ICDS have become effective from 1 April 2015, whereas Ind-AS will become effective from 1 April 2016 and later. As a result, some of the accounting standards (in the form of ICDs) have been brought into force effective from 1 April 2015. This will impact the results of the companies and more so the tax implications for the contractor companies.

In this article, we have discussed key challenges the ICDS dealing with “Construction Contracts and Revenue Recognition”would throw open while implementation of ICDS and Ind-AS.

This ICDS will be applicable to construction contracts as well as contracts for the rendering of services which are directly related to the construction of the asset e.g. those for the services of project managers, architects, etc. As a result, such service providers will also have to necessarily follow POCM, which could pose significant challenges to them as their rendering of services do not necessarily co-inside with the contract duration and contract progression.

While Ind-AS permits adopting completed contract method for revenue recognition in certain situations, this ICDSdoes not permit accounting and revenue recognition under completed contract method (PCM) . It only mandates ‘Percentage of Completion Method’ (‘POCM’)method. .Again, the ICDS do not contain detailed guidance on recognition of revenue as a principal or agent (i.e. gross vs. net revenue) which could impact computation of turnover both for threshold purposes as well for complying with Section 44AB of the Act requiring Tax Audit to be carried out.

This ICDS prescribe provisions with respect to revenue recognition of single contract or group of contracts together. It lays down conditions for the contracts to be regarded as single contract or a group contract for revenue recognition. While executing contracts for construction of various assets for a single customer or several customers, it is important to undertake systematic study to determine which option (single contract or group contract) would be beneficial for revenue recognition purposes.

It provides non-recognition of margins at early stages of contract and thus revenue to the extent of actual costs incurred it to be recognized. It also provides that revenue recognitionshould not be deferred beyond 25% of the stage of completion of the contract. The upper limit of early stage is not defined in Ind-AS 11 / AS7 and would lead to double taxation of same income and have adverse impact at project level:

-     Taxation of margins in initial years while computing taxable income as per ICDS

-         Taxation of margins in later years under MAT provision where book profit would be more than taxable income due to recognition of higher revenue in the books.

The following deviating principles coined in the ICDS would pose challenges while computing “turnover”, threshold for recognising revenues, etc. and more so the applicability of tax audit under section 44AB getting triggered at an early stage.

-         Contract revenue already recognized and subsequently written off as uncollectible to be recognized as expense instead of reducing it from revenues;

-         Retention money to be included in the contract revenue;

Another key difference between the ICDS and Ind-AS 11/ AS7 is recognition of retention money.  It provides that retention money should be added to the contract revenue while determining revenue on the basis of POCM.However, Ind-AS11/AS7 provides that the retention money should be recognized on satisfaction of conditions prescribed in the contract, which would enable contractor to receive such money. This would prepone taxability of retention money.

Ind-AS 11/AS7 provides that foreseeable/expected losses should be recognized as expense in the year in which the same is estimated, whereas ICDS provides that in case of change in the estimates, additional income or expense should be recognized over the balance tenure. Further, ICDS I provides that the expected losses should be recognized in the year of actual realization. Given this contradiction, one need to assess whether the contractor assessee would able to claim provision for such foreseeable losses rather than postponing it till the date of its realization by relying on judicial precedents Mazagoan Dock Ltd (Mum) (29 SOT 356), Jacob Engineering India Pvt Ltd (Mum) (ITA No. 2009-TIOL-533) and ITD Cement Ltd (Mum ITAT) (ITA No.2991 & 3669/11)] wherein the Courts have held that the foreseeable losses are allowable as expenditure since the same have been recognized as per the consistent  accountingfollowing Ind AS  11 or  AS7.  

Further, it precludes reduction of certain incidental incomes like interest, dividend and capital gains from the contract costs which in turn would lead to taxation of such income in the year of its accrual or receipt thereby resulting in pre-ponment of income. Whereas such income would get accounted on POCM basis under the Ind-As resulting in higher income in the later years as well as higher book profit, which will increase MAT cost with potentially no corresponding set-off.

As per transitional provisions,this ICDS would apply to ll open contracts as at 31 March 2015. As a result, cumulative costs and revenues recognized in the past years has to be considered for revenue recognition purposes from the transition date. In cases where “completed contract” method is adopted, the contractor will have adopt POCM from FY 2015-16. This change could result in recognising income at an early stage and more impact would be felt in the year of transition depending on the progress of the project till the cut-off date of 31 March 2015. Therefore, the contractors will have a take a stock of their projects, the method for revenue recognition to be followed going forward and assess the impact of ICDS on their business from taxation stand point.

Further, the ICDS in relation to borrowing costs would also be relevant while applying the ICDS dealing with recognition of revenues for construction contracts as borrowing cost forms a significant and integral part of part of the project cost. Many of the principles laid down in the ICDS in relation to borrowing costs like – no minimum period required for classification as a “Qualifying assets”, exchange difference not to be included as part of borrowing costs, differential treatment for specific borrowings vs. general borrowings, capitalization of borrowing costs even if there are temporary Interruptions, etc. Further, the controversy would continue with regard to allowability of bowing cost as a period cost vs. project

The Most important positive aspect is that this ICDS does not apply to real estate developers carrying real estate development business unless it is carried out as a construction contractor. But the dichotomy would persist as Ind-AS 11 (corresponding to ICDS on revenue recognition for construction contacts) provides that it applies to real estate developers as well. As a result, the burning issue of whether one can follow POCM for accounting purposes and PCM for tax purposes would still remain alive and would get tested at the Court level time and again.

The intent of introducing ICDs was to fill up the gaps that exists between the accounting treatment and taxation treatment as also provide much needed clarity and consistency in computing the taxable income of the contractors. ICDS have to certain extent fulfilled this objective and have also sought to address some of the implementation challenges of In-AS, but at the same time it has deviated from the fundamental principles “Prudence”, “Materiality”, etc. and also chose to take completely opposite view in some of the matters. This will add more complexities while computing total income of the companies and more so for construction contractors. In order to bring out clarity in the matter and eliminate controversies leading to litigation, the CBDT should reconsider some of the aspects and appropriately modify the ICDS which will help to achieve the ultimate objective of making ICDS tax neutral.