Currently, books of accounts prepared for statutory reporting purposes are based on Accounting Standards (AS) issued by the Institute of Chartered Accountants of India (ICAI). However, tax treatment of certain items do tend to differ from the accounting treatment from time to time, resulting in adjustments to taxable income and thereby leading to disputes.
To alleviate disputes arising on account of different treatment in accounting vis--vis tax laws, the Government had taken an initiative way back in 2002 and under the aegis of the Central Board of Direct Taxes (CBDT) an Accounting Standard Committee (ASC) was constituted to harmonise the AS with the provisions of the Income Tax Act (IT Act). The ASC has recently submitted its final report containing recommendations on notification of 14 tax accounting standards (TAS).
The process for formulation of the TAS, as stated in the final report, are driven by three principles - reduction of litigation, minimization of alternatives and giving certainty to issues. These 14 TAS will stipulate tax positions to be adopted while computing taxable income, different from those followed for accounting purposes. A snapshot of the key recommendations is as under: Different sets of books for tax and accounting purposes not mandatorily required to be maintained;
The provisions of the IT Act to prevail over TAS in the event of conflict in tax positions; Change in accounting policies to be considered if it is supported with a reasonable cause; Tax auditor to certify compliance with TAS while computing taxable income, in tax audit report; Unrealized loss arising on reinstatement of year-end foreign exchange balances and mark to market losses on forward contracts not to be recognized and allowed until realization or settlement; Specific conditions for allowability of prior period expenses; Threshold of 25% of completion stage be set for recognition of revenues in case of construction contracts where AS 7 is followed;
Retention money to accrue on percentage of completion method in construction contracts; Reversal of unrealisable revenue to follow provisions governing bad debts; Losses on construction contracts to be recognised in proportion to completion stage, while anticipated losses to be allowed on actualisation;
Alternative to recognise income on completed service contract method from service transaction to be removed; Method of valuation of inventories to be prescribed for service providers; Depreciation to be allowed to lessee in case of finance leases; Criteria for capitalisation of improvement and repairs to the tangible fixed assets; and Treatment of fixed assets acquired via discharging non-monetary considerations i.e. in exchange for another asset, shares or other securities etc.
Undoubtedly, the Government deserves appreciation for its efforts to try and bring down protracted litigation by cutting down areas of uncertainty, however, the clarifications issued on tax positions tend to lean in favour of revenue, sometimes at the cost of overturning certain existing judicial precedents which favoured taxpayers. The final report will now be consulted at various forums and an assessment of the impact is worth a discussion. For the service industry, the ASC has recommended following percentage of completion method (POCM) for recognising revenue and prescribing a method for valuing inventory based on international best practices, for construction and EPC industry following AS - 7, significant proposals have been laid on the table for finalisation. These proposals include revenue recognition threshold beyond 25% of the completion stage for POCM, treatment of retention money, criteria for allowability of anticipated as well as actual losses, treatment of borrowing costs relating to the construction contracts etc. The impact of these recommendations and proposals on deferred tax, are to watch out for and the consequent impact on book profits for the purposes of MAT.
The proposals regarding expense items in TAS are understandable however, where revenue recognition criteria are undergoing a change, readers of financial statements are likely to scratch their heads over the Governments rationale for a different approach for tax purposes!
Coming to other specifics of the recommendations, ASC recommends providing for method of valuing inventory for service industry, though no proposals have been incorporated yet in the draft TAS for valuation of inventories. TAS does provide for provisions for allowability of prior period expenses but makes no mention for treatment of prior period income. Further, treatment of fixed assets exchanged with another asset has also been envisaged in the TAS. Such a fixed asset is to be recorded at its fair market value or the fair value of the asset given up, whichever is lower. Fair value, for this purpose, is the amount for which that asset could be exchanged between knowledgeable, willing parties in an arms length transaction. How to compute fair value and interpret arms length transaction continues to remain subjective and open to further interpretation!
The major change which industry will encounter is in relation to treatment of unrealised foreign exchange fluctuation losses provided for in accordance with AS 11, on year-end outstanding balances. Across the industry, taxpayers while computing taxable income have claimed deduction of such exchange fluctuation losses, a position duly validated by the Supreme Court; however, the draft TAS proposes to disallow such a loss until actual settlement. While tax payers will struggle to adhere to two sets of AS running in different directions. In times to come, perhaps, AS issued by the ICAI may lose their relevance for tax purposes in some cases where options provided by AS are done away with in TAS for instance - revenue from service transaction is to be recognised as per percentage completion method only.
It is noticeable that many issues are left untouched, such as treatment of lease rent equalization created under AS 19, provisions such as provision for warranty, sales return, special discounts etc. Harmonisation of AS and TAS will widen the gap between accounting profits and tax profits. From a taxpayers standpoint, there will be the rigours of following AS issued by the ICAI for accounting purposes and then separately following the 14 TAS for tax purpose. Indeed, tax payers are not required to maintain separate tax books as clarified in the ASCs final report, yet it is difficult to imagine reconciliation of two different positions without maintaining copious documentation, a job close to maintaining separate books of accounts!! Taxpayers will also be forced to maintain records to keep a track of differences every year, specially where income recognition criteria and other accounting aspects are significantly different such as cases of construction contracts, unarguably, leading to additional time spent on compliance.
It remains to be seen whether the implementation of the Tax Accounting Standards paves the path for curtailing tax dispute in an environment already vitiated with burgeoning tax disputes!