We are now in the final leg of our three article series on the issues emanating from the FAQs released by CBDT on Income Computation and Disclosure Standards (ICDS).  In this article, we are discussing four issues addressed by the FAQs, namely, allocation of general borrowings, treatment of derivative instruments, recognition of subsidies received and applicability for taxpayers preparing accounts under the new Ind AS regime.

ICDS IX relating to “Borrowing Cost” provides for capitalisation of borrowing costs in respect of qualifying assets. Qualifying assets are defined to mean tangible assets, intangible assets and inventories which take more than 12 months to become saleable. As per ICDS IX, if general borrowings i.e. not specifically borrowed for acquisition of a particular asset are utilised for acquisition, construction or production of a qualifying asset then general borrowing cost shall be capitalised in proportion of the cost of the qualifying asset to total assets of the taxpayer. In this regard, there was a doubt as to how to allocate general borrowing costs to different qualifying assets. The Question 22 of the FAQ in this regard clarified that capitalisation of general borrowings cost under ICDS IX shall be done on asset-by-asset basis, thus providing clarity on the issue. This can be illustrated by way of the following example:

A company has two qualifying assets, Plant 1 & 2. Capitalisation of Plant 1 at the beginning of the year was Rs 20 lakh and at the end of the year was Rs 1 crore. Similarly, capitalisation of Plant 2 at the beginning of the year was Rs 50 lakh and at the end of the year was Rs 60 lakh. Total assets of the assessee at beginning of the year were Rs 5 crore and at the end of year were Rs 8 crores. The company has a general borrowing of Rs 01 crore on which it paid interest of say Rs 10 Lakh. Applying formula as per ICDS IX, general borrowing cost of Rs 10 lakh will get attributed to Plant 1 at Rs 92 thousand {10*[(0.20+1)/2]/[(5+8)/2} and Plant 2 at Rs 84 thousand {10*[(0.50+0.60)/2]/[(5+8)/2}. Thus, applying asset by asset capitalisation, allocation of general borrowing cost to each of the qualifying assets can be achieved.

Another aspect dealt by the circular is the taxation of derivatives. The scope of ICDS VI on “Effects of changes in foreign exchange rates” inter-alia includes treatment of foreign currency transactions in the nature of forward exchange contracts. Further, ICDS defines forward exchange contract as 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. Hence, a doubt arose with respect to the treatment of derivative instruments other than forward contract such as futures, interest rate swaps, currency swaps, etc.?

The Question 10 of the circular clarifies that ICDS VI provides guidance only on  certain derivative contracts such as forward contract and other similar contracts and that derivatives not covered within the scope of ICDS VI, would be governed by the provisions of ICDS I. In this regard, it is pertinent to highlight that Para 4 of ICDS I provides that Mark to Market (MTM) loss or an expected loss shall not be recognised unless the recognition of such loss is in accordance with the provisions of any other ICDS. Further, vide Question 8 of the FAQs, it has been clarified that the same treatment shall apply to MTM / expected gains. Thus, MTM gains / losses on derivatives not covered by ICDS VI shall be disallowed and disregarded as per ICDS I. The following illustration will be helpful in understanding the above:

I Co imports raw material from US on 01 January 2016 for USD 10,000. The payment for the same is due on 30 June 2016. To hedge the currency fluctuation risk, the company enters into a forward contract with a bank at the rate of Rs 68 per dollar. The exchange rate as on 01 January 2016 was Rs 66 per dollar. While, on 31 March 2016 the exchange rate was Rs 67 per dollar. Thus, I Co records a forex loss of Rs 10,000 [(68–67)*10,000] on 31 March 2016. As per ICDS VI this loss would be allowed in the tax computation of I Co. However, if the company used any other derivative not in the nature of forward exchange contract, the MTM loss of Rs 10,000 in the books of I Co would have suffered disallowance for tax purposes in accordance with ICDS I.

Various Courts have held that expected loss from trading in derivative segment by entering into future and options contracts on MTM basis are allowed as deduction on the basis of commercial accounting principles. However, the Apex Court in the case of CIT v. Woodward Governor [TS-40-SC-2009-O] held that under section 145(2), Central Government is empowered to notify accounting standards and by such legislative enactment, the said system of commercial accounting can be superseded or modified. Hence it can be said that the issues which were addressed by the Courts relying on principles of commercial accounting in the absence of specific guidance under the Act shall now have to adhere to ICDS.

Hence, while MTM loss for hedging through forward contract may be allowed but MTM loss for hedging currency related risk through other instruments may not be recognised as a deductible item under ICDS. Thus, it may result in making other derivative instruments less tax efficient.

In the context of point of taxation of government grants, Para 4 of ICDS VII relating to “Government Grants” provides that grants shall be recognised when there is reasonable assurance that the taxpayer shall comply with conditions attached to it and that the grant shall be received but shall not be postponed beyond its actual receipt. Further, transitional provisions as per Para 13 of ICDS VII provide that grants which meet recognition criteria on or after 1^st April 2016 shall be recognised in accordance with ICDS VII.

In this regard, a query arose as to treatment of subsidy received prior to 31 March 2016 but not recognised pending satisfaction of related conditions. The CBDT in Question 17 of the FAQs has clarified that grants actually received prior to 1^st April 2016 but not recognised in the books pending satisfaction of related conditions and achieving reasonable certainty of receipt shall be outside the scope of ICDS VII and shall continue to be recognised as per the existing law i.e. law prevailing prior to ICDS.

The Institute of Chartered Accountants of India (ICAI) in 2011 issued IFRS converged accounting standards, referred to as Indian Accounting Standards or “Ind AS”. In 2015, the Ministry of Corporate Affairs issued the Companies (Indian Accounting Standards) Rules, 2015, where under Rule 4 all companies whether listed or otherwise with net worth of rupees five hundred crore are mandated to comply with the Ind AS in the preparation of their financial statements for financial year ending 31 March 2017 and onwards.

In this regard, a question was raised before the CBDT as regards applicability of ICDS to the companies preparing their financials as per Ind AS. The CBDT in reply to Question 5 has clarified that ICDS shall apply for computation of PGBP & IOS irrespective of the accounting standards followed by an assessee. Thus, ICDS shall apply to companies preparing their financials as per Ind AS as well.

Applicability of ICDS to companies following Ind AS accounting would have two significant implications a) in case of conflict, tax positions as per ICDS should be followed and b) in case where ICDS is silent, accounting treatment can be followed for tax purposes, given that it meets requirements of the Income-tax Act.

Generally speaking, Ind AS follows fair value accounting and substance over form principles in recording transactions. Thus, accounting under Ind AS may not follow legal form of the transaction in various circumstances. For instance, shares that are redeemable at the option of the holder can be treated as liability for accounting purposes. Accordingly, the dividend would be treated as interest pay-out in the books of accounts. This can lead to dispute with the tax authorities, which, in past have tried to apply the concept of substance over form in many cases.

Further, there would be several issues, especially in the context of revenue recognition, where Ind AS requires that revenue should be measured at the fair value of consideration received or receivable, while no such condition is present in ICDS. Thus, where ICDS is silent on a particular aspect, it would be interesting to analyse whether the fair value treatment under Ind AS would hold true or the contractual terms would need to be honoured while computing taxes.

To conclude, one can say that introduction of ICDS by Central government and its further clarification by CBDT is an attempt to usher a non-adversarial tax regime for the taxpayers. However, a detailed guidance is required for the issues emanating from accounting treatment under the Ind AS tax regime to minimize avoidable litigation and bring in ease of doing business in India in the truest sense of the phrase.

Click here to read CBDT Clarifications on ICDS – An Incisive Analysis – Part I.

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