14 Draft TAS: Deviation & Impact

By: PR Ramesh, Chairman, Deloitte India

Section 145(2) of the Income-tax Act,1961 (the ‘Act’) empowers the  Central Government to notify from time to time accounting standards to be followed by any class of assessees or in respect of any class of income. In 1996, two Accounting Standards relating to disclosure of accounting policies and disclosure of prior period and extraordinary items and changes in accounting policies were notified. Since then, two Committees were constituted by the Central Board of Direct Taxes for formulation of Accounting Standards for the purposes of notification under the Act. In August 2011, the present Committee submitted its first interim report along with three [draft] Tax Accounting Standards (TAS), whereas in October 2011, a discussion paper on TAS was released along with only two Draft TASs-one on Construction Contracts and another on Government Grants. In May 2012, the Committee submitted its second interim report along with six [draft] TASs. In August 2012, the Committee submitted its final report.  Now, in October 2012, the CBDT has published the final report of the Committee along with 14 [draft] TASs, including the nine [draft] TASs included in earlier interim reports. Limited revisions to two [draft] TASs (Intangible Assets and Valuation of Inventories) included in earlier interim reports have also been proposed.

Applicability

TASs are intended for application by all classes of taxpayers for computation of income chargeable under the head ‘Profits and gains of business or profession’ or ‘Income from other sources’. These are applicable only for computation of income and no separate sets of books are required to be kept based on TASs. Nonetheless, in practice, parallel books may have to be kept or at least System should be developed to capture and process data for making necessary adjustments to accounting income to arrive at taxable income based on TASs. The Committee feels that the proposed TAS along with the provisions of the Act will provide a comprehensive framework for computation of income (other than MAT) even if Ind-AS (Standards converged with IFRSs) are made mandatory.  Since the [draft] TASs are basically derived from non-converged Standards, the need for System development is more relevant in the context of Ind ASs.

It is specifically provided that in case of conflict between the express provisions of the Act and the TAS, provisions of the Act will prevail over the provisions of TAS.

 Some observations

 The [draft] TASs use the expressions ‘previous year’ and ‘person’ instead of  ‘reporting period’ and ‘enterprise’ respectively to suit the terminology used in the Act’. Generally, TASs eliminate options in accounting treatment. However, the option between FIFO and weighted average cost formula for determining cost of inventories, permitted in AS 2 issued by Institute of Chartered Accountants of India (ICAI), is retained in the [draft] TAS on Inventory Valuation. Significant deviations from Accounting Standards issued by the ICAI found in [draft] TASs and their impact are outlined in this write-up.

 Accounting Policies (Source: AS 1 and AS 5]

•  Expected losses or mark-to-market losses should not be recognised unless permitted by any other TAS.

 Impact: Prudence concept has been diluted.

•  Concept of materiality is not relevant for selection of accounting policies, since, it is not relevant for computation of taxable income.

 Impact: Only for selection of accounting policies, materiality is irrelevant.  Concept of materiality is found in going concern concept and disclosure of impact of change in accounting policies. This is also found in some other [draft] TASs. Example: [Draft] TAS on Events Occurring After the End of Previous Year (discussed later on).

•  Change in accounting policies is not permitted  without a reasonable cause.

 Impact: What is reasonable cause is to be decided based on legal precedents.

 Valuation of Inventories[Source: AS 2]

•  Inventories of service providers are also covered within the scope of the [draft] TAS. However, service providers should value inventories at cost only, whereas others can value inventories at the lower of cost and net realisable value.

 Impact: Service providers will be affected, if net realisable value is lower than cost.

•  Standard cost method is not permitted.

 Impact: Entities following standard cost should develop System to determine cost of inventory on FIFO/weighted average cost basis (unless specific identification method or retail method is applicable).

•  Change in method of valuation is not permitted without a reasonable cause.

 Impact: What is reasonable cause is to be decided based on legal precedents.

• Some clarifications relevant for tax purposes, such as valuation at the time of dissolution of a firm or  association of persons or body of individuals have been given in the [draft] TAS.

 Events Occurring After the  End of  Previous Year [Source: AS 4]

•  Adjustments should be made for events occurring after the end of the previous year, only if they provide additional information materially affecting the determination of the amounts relating to conditions existing at the end of the relevant previous year.

  Impact:  In addition to the above events, AS 4 requires adjustment for some other post-balance sheet events. Examples: Events requiring adjustment because of statutory requirements. These events are to be disregarded for tax purposes.

 Prior Period Expense [Source: AS 5]

•  Prior period expense should not be considered as allowable deduction in the previous year in which it is recorded unless it is proved that such expense accrued during the said previous year.

 Impact:   If an expense accrues in the year of recording, it cannot qualify as prior period  expense at all. The intention of the above provision is not clear. Further, tax treatment of prior period income is not prescribed in the [draft] TAS.

 Construction Contracts [Source: AS 7]

•  Criteria for reliable estimation of the outcome of a construction contract are not included.

 Impact: Tax incidence is earlier

• Recognition of revenue to the extent of costs incurred cannot be done beyond reaching 25% of stage of completion. Probable recovery of cost incurred is not required for revenue recognition.

 Impact:  Prescription of 25% threshold is a reasonable approach to avoid litigation, since, AS 7 does not provide any quantitative threshold for early stages of a contract. However, taxable income will be increased even if the probable recovery test is not met. This will get reversed if it is subsequently established that the cost is not recoverable.

•  Future or anticipated losses are not allowed unless such losses are actually incurred.

 Impact:  Taxable income will be increased in the year of creating provision for anticipated losses, which will get reversed as the loss is actually being incurred (and provision is withdrawn).

•  Reliable measurement is not necessary for attributing costs incurred in securing a contract to a construction contract. Only separate identifiablity and probability of securing the contract are sufficient for such attribution.

 Impact:  Taxable income will be increased even if a cost in securing a contract is not reliably measurable. This will get reversed at the time of expensing of such costs over the duration of the contract.

•  Contract costs which relate to future activity should be recognised as an asset whether or nor it is probable that such costs will be recovered.  (Subsequently, if such costs are not realisable, then the same may be allowed under provisions of the Act).

 Impact:  Taxable income will be increased even if the probable recovery test is not met. This will get reversed if it is subsequently established that the cost is not recoverable.

•  Some tax specific provisions are also included. Examples: Tax treatment of pre-construction period interest, dividend and capital gains (which cannot be reduced from contract costs for tax purposes), taxability of retention money, write-off of unrealisable contract revenue.

 Revenue Recognition [Source: AS 9]

•  Postponement of revenue recognition when the ability to assess ultimate collection with reasonable certainty is lacking is restricted to claims for escalation and export incentives only.

 Impact: For other claims, tax incidence is earlier.

•  Only proportionate completion method is permitted for recognition of revenue from rendering of services. For this purpose, provisions of [draft] TAS on Construction Contracts shall apply.

 Impact: Entities following completed service contract method as permitted in AS 9 will suffer early incidence of taxation.

• Some tax specific provisions are also included. Examples: Tax treatment of interest income, premium/discount on debt securities held.

 Tangible Fixed Assets [Source: AS 10]

•  In the case of acquisition of an asset in exchange for another asset, shares or other securities lower of the fair market value of the asset acquired and the fair value of the asset given up/securities issued should be recorded as actual cost.

 Impact:  In the case of asset-for-asset exchange, while the acquisition of the new asset will have the above cost for tax purposes, there is lack of clarity on the amount of the ‘disposal proceeds’ of the existing asset. As per the provisions of the ‘Act’, the disposal proceeds should be the price at which the existing asset is sold and sale includes transfer by way of exchange. [Under AS 10, fair market value or net book value of the asset/fair market value of securities issued or fair market value of the asset acquired whichever is more clearly evident will be the cost of acquisition of the asset].

•  Some provisions of AS 10 have been either modified or deleted in the [draft] TAS due to specific provisions of the Act. Examples: Definition of tangible fixed assets, capitalisation of exchange fluctuations, omission of  provisions relating to revaluation, retirement and disposals.

 The Effects of Changes in Foreign Exchange Rates [Source: AS 11]

• Though the points below cover, inter alia, foreign operations, it seems that the impact mentioned in the points may not be relevant for the foreign operations (whether integral or non-integral) due to the overriding effect of  Rule 115 of the Income Tax Rules, 1962, dealing with income expressed in foreign currency.
• Foreign operation is defined to mean a foreign branch only. 
• Non-monetary items of a reporting entity and its integral foreign operation should be translated at the exchange rate on the date of the transaction.

 Impact: Even if the non-monetary such as inventory is measured at net realisable value, exchange rate on the date of the transaction should be used.

•  Exchange differences arising on conversion of non-monetary items of reporting entity and its integral foreign operation should not be recognised as income or expense.

 Impact: There is some lack of clarity here. When non-monetary items should be translated at the exchange rate on the date of the transaction in the above case, exchange difference cannot arise at all.

•  Exchange differences arising on reporting of monetary items or settlement of monetary items of reporting entity and its integral foreign operation at the exchange rate on the last day of the previous year should be recognised as income or expense.

 Impact: Even for monetary items forming part of net investment in a foreign operation, the above rule is applicable.  This may result in volatility in tax liability due to impact of currency fluctuations on such a long-term monetary item.

• Exchange differences arising on translation of financial statements of a non-integral foreign operation  should be recognised as profit or loss (and not as a reserve movement).

 Impact: Volatility in tax liability due to currency fluctuations.

•  Forward exchange contract is defined to mean an agreement to exchange different currencies at a forward rate, and includes a foreign currency option contract or another financial instrument of a similar nature.

 Impact: Accounting treatment of foreign currency options could lead to complications.

•  Premium, discount or exchange difference on forward exchange contracts that are intended for trading or speculation purposes, or that are entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction shall be recognised at the time of settlement.

 Impact: The intention of the above provision is not clear.

•  Tax specific provision is also included to the effect that provisions of section 43A of the Act and Rule 115 of the Income-tax Rules, 1962 will override the provisions of the [draft] TAS.  For example, as per section 43A of the Act, asset-related exchange differences should be capitalised for tax purposes, and, that too on settlement basis and not on accrual basis. 

 Government Grants [Source: AS 12]

•  Government grants should be recognised as revenue receipt or reduced from the cost of depreciable fixed assets based on the purpose for which such grant or subsidy is given. For grants related to non-depreciable assets as well as revenue-related grants, the same should be recognised over a period of time in the manner stated in the [draft] TAS.

 Impact:  Treatment as deferred income is not permitted for grants related to depreciable assets. This is not likely to have much impact.

•  Recognition of government grant cannot be postponed beyond the date of actual receipt.

 Impact:  There is some lack of clarity here. The [draft] TAS also requires treatment of the grant as deferred income in some situations. It is not clear as to whether the above provision is applicable only for situations where deferred income treatment is not permitted (e.g. reduction of the grant from the cost of a depreciable asset)

•  Some tax specific provisions are also included. Example: Pro-rata allocation of government grant to various assets for which the grant is received where the grant cannot be directly related to any specific asset.

 Securities [Source: AS 13]

•  Applicable only for securities held as stock-in-trade. For this purpose, securities mean securities as defined in clause (h) of section 2 of the Securities Contract (Regulation) Act, 1956, other than Derivatives referred to in sub-clause (1a) of that clause
•  In the case of acquisition of a security in exchange for other securities or another asset, lower of the fair value of the security acquired and the fair value of the securities issued/ asset given up should be recorded as actual cost of the security acquired.

 Impact: In the case of disposal of another asset, while the acquisition of the security will have the above cost for tax purposes, there is lack of clarity on the amount of the ‘disposal proceeds’ of the existing asset. The ‘disposal proceeds’ will affect the written-down value of the block of assets in case of depreciable assets. As per the provisions of the ‘Act’, the disposal proceeds should be the price at which the existing asset is sold and sale includes transfer by way of exchange. [Under AS 13, (i) in case of issue of securities, fair value of the securities issued and (ii) in case of another asset given up, fair value of the asset given up or the fair value of the security acquired whichever is more clearly evident , will be the cost of acquisition of the security].

•  Comparison of cost with net realisable value should be done specified category-wise and not for each individual security.

 Impact: This will increase tax incidence since loss in respect of an individual security will be offset by gain in respect of another security, if they both fall within the same specified category. Such increased tax incidence will be neutralised in subsequent year(s). However, it may take many years for neutralisation.

•  Securities not listed on a recognised stock exchange; or listed but not quoted on a recognised stock exchange with regularity from time to time, should be valued at actual cost initially recognised.

 Impact: For infrequently quoted securities and non-quoted securities, impairment is not allowed for tax purposes. This increases tax incidence on ‘real income’ which will be nullified on subsequent disposal of the securities.  Further, the expression ‘regularity from time to time’ can lead to interpretational problems.

•  Tax specific provision is also included to the effect that where the actual cost initially recognised cannot be ascertained by reference to specific identification, the cost of a security shall be determined on the basis of ‘FIFO’ method.

 Borrowing Costs [Source: AS 16]

 AS 16 has been modified on the following lines mainly for alignment with the provisions of the Act and certain judicial rulings:

•  Borrowing costs do not include any exchange differences.
•  Income on temporary investment of funds borrowed specifically for obtaining a qualifying asset should not be reduced from borrowing costs eligible for capitalisation. 
•  Definition of qualifying asset and determination of commencement, cessation and suspension of capitalisation of borrowing costs  have been modified.

 Leases [Source: AS 17]

•  A joint confirmation is required regarding consistency of classification of lease (finance lease or operating lease) between the lessor and the lessee.

 Impact: Joint confirmation by the lessor and lessee may be difficult, if the lessor and lesse want to treat the lease differently for tax purposes.

•  Some provisions have been inserted like adjustment in the sale price where there is artificially high rate of interest in case of manufacturer/dealer-lessor, adjustments in the residual value only at the end of the lease term.
•  There is no clarity in the [draft] TAS on treatment of contingent rent.
•  Provisions relating to sale and lease back transactions are not included since the Act contains specific provisions in this regard.

 Incidentally, the Committee recommends suitable amendments in the Act relating to depreciation, ownership, block of assets, transfer etc. in respect of leased assets.

 Intangible Assets [Source: AS 26]

•  In the case of acquisition of an intangible asset in exchange for another asset, shares or other securities lower of the fair value of the asset given up/securities issued, or fair value of the asset acquired shall be recorded as actual cost.

 Impact: In the case of asset-for-asset exchange, while the acquisition of the new asset will have the above cost for tax purposes, there is lack of clarity on the amount of the ‘disposal proceeds’ of the existing asset. As per the provisions of the ‘Act’, the disposal proceeds should be the price at which the existing asset is sold and sale includes transfer by way of exchange.    [Under AS 26 read with AS 10, fair market value or net book value of the asset/fair market value of securities issued or fair market value of the asset acquired whichever is more clearly evident will be the cost of acquisition of the asset].

•  Provisions relating to amortisation, retirement and disposal of intangible assets, and intangible assets acquired on amalgamation are not included in the [draft] TAS in view of the specific provisions of the Act.
•  Cost of intangible asset also includes exchange fluctuations in accordance with [draft] TAS on the Effects of Changes in Foreign Exchange Rates. It may be noted that such capitalisation is in respect of forex liabilities related to acquisition of assets as required by the overriding provisions of section 43A of the Act because other provisions of the [draft] TAS on the Effects of Changes in Foreign Exchange Rates do not permit capitalisation of exchange differences.

 Provisions, Contingent Liabilities and Contingent Assets [Source: AS 29]

•  A provision should be recognised when (a) there is a present obligation as a result of a past event; (b) it is reasonably certain that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation.

 Impact: The above provision is likely to postpone allowability of provisions for tax purposes. It may be noted that AS 29 uses the term ‘probable’ and not  ‘reasonably certain’.

•  Onerous contracts are not brought within the scope of the [draft] TAS.

 Impact: It seems that provisions for onerous contracts will not be allowed for tax purposes. Only  when the loss actually materialises, the loss will be allowed.

•  Contingent assets are assessed continually and when it becomes reasonably certain that inflow of economic benefit will arise, the asset and related income are recognised in the previous year in which the change occurs.

 Impact: The above provision is likely to accelerate tax incidence of an income represented by a contingent asst. It may be noted that AS 29 provides for recognition of a contingent asset when the realisation of related income is virtually certain.

•  In view of the specific provisions in the Act for restructuring expenses, provisions of AS  29 relating to restructuring costs are not included in the [draft] TAS.

 Future developments

 The Committee has recommended formulation of TAS on the following areas:

 (i) Share based payment

 (ii) Revenue recognition by real estate developers

 (iii) Service concession arrangements (example, Built Operate Transfer agreements)

 (iv) Exploration for and evaluation of mineral resources.