It is codified in Section 145(1) of the Income-tax Act, 1961 (‘IT Act’), that income under the head ‘Profits or Gains from Business or Profession’ (‘PGBP’) and ‘Income from Other Sources’ (‘IOS’) is to be computed, in accordance with cash or mercantile system of accounting regularly employed by an Assessee. In most cases, Taxpayers follow the accrual basis of accounting to determine profit or loss in respect of every accounting year. The accrual basis of accounting recognises income and expenses as they are incurred, as opposed to actual cash inflow or outflow taking place.
Key considerations in income computation
While recognition is accorded to the method of accounting regularly followed by an Assessee in computing taxable income under the aforementioned heads, the following additional aspects must also be complied with by the taxpayer:
- The profits so determined should be in accordance with the provisions of Income Computation and Disclosure Standards (‘ICDS’) notified by the Central Government in exercise of powers conferred under Section 145(2).
- The taxable profits would additionally be subject to the specific provisions of the IT Act that restrict the claim of any deductions, notwithstanding the fact that it may otherwise constitute an expense under the IT Act. For instance, a provision made in the books of accounts towards gratuity liability of employees, even if based on actuarial valuation, would not be allowed as a tax deduction unless the amount of gratuity is actually paid, by virtue of Section 40A(9) of the IT Act.
As far as ICDS is concerned, these are specific standards formulated for the purpose of computing income under the head PGBP and IOS. Where conflicts arise between ICDS and the IT Act, it is clarified in the preamble of ICDS that the provisions of the IT Act shall prevail. A fundamental question that merits consideration is where (i) no express treatment is provided in ICDS and (ii) no express bar is contained in IT Act, would treatment permitted otherwise under the Accounting Standards issued by the Institute of Chartered Accountants of India (’ICAI’), and regularly followed by an Assessee in preparing its books of accounts, be accepted as a basis for claim of deduction under the IT Act.
Harmonizing accounting practices with tax law: A judicial perspective
It would, at this juncture, be relevant to note that judicial precedents in the past have upheld the validity of following the principles enunciated under the Accounting Standards to compute income for the purposes of the IT Act. In the judgment of Woodward Governor India Pvt. Ltd.[1], the Hon’ble Supreme Court recognized that genuine losses arising from the ordinary course of business, even if arising from accounting adjustments, should be allowed as deductions, if there is no specific provision in the tax law barring such claim. The Court emphasized that, in the absence of a contrary tax provision, accounting principles can be relied upon to determine the true income. The ratio of this judgment was followed by various High Courts and Tribunals.
Although these precedents were rendered prior to ICDS being made an embedded part of Legislature, the principle laid down in these decisions will still be valid for the reason that, introduction of ICDS has not in any way altered the parent provision of sub-section (1) of Section 145, which mandates the taxpayer to continue to compute income under the head PGBP by following the regularly employed method of accounting.
Fair Value Accounting: Implications on income tax computation
Having stated thus, we now proceed to examine the implications of fair value accounting advocated by the Accounting Standards and whether the computation of income for the purposes of IT Act can be made with reference to the fair value accounting carried out in books of accounts.
Fair value accounting is a concept recognised in the Accounting Standards issued by the ICAI. This essentially involves recognising an asset or a liability at their respective realisable values as on the date of drawing up the financial statements, as opposed to recognising the same at their historical costs or future values.
Illustrative example in the context of Fixed Assets:
An example for historical cost would be a scenario where a fixed asset is purchased at a historical cost of INR 10 crores and has a depreciated cost of INR 8 crores as on the balance sheet date, is compared with its realisable value. Assuming such realisable value is INR 7 crores, the asset would be recognised in the books of account at INR 7 crores and the difference is accounted for as a loss in value, debited to profit and loss account. From an income tax perspective, this loss in value would not be allowable as a deduction for the reason that manner of computing depreciation and written down value are clearly enshrined in the IT Act itself, and no departure therein would be permissible.
Illustrative example in the context of Revenue Recognition:
Another example is a scenario where for a revenue transaction of sale, the settlement is agreed to be received in 4 equal annual instalments. Assume that the value of the revenue transaction is INR 10 crores, with INR 2.5 crores being eligible to be received annually. In this case, absent a separate interest component to compensate for the loss in time value of money, it is considered that the agreed upon consideration of INR 10 crores embeds the interest component and hence, the transaction is to be recorded not at INR 10 crores but at the value that excludes the interest component, if such interest component is significant in the transaction. Such recognition is permitted in Ind AS 115 read with Ind AS 109 which deals with recognition of revenue and accounting for financial instruments respectively. Assuming in the present case, the cash selling price is INR 7 crores, the revenue is recognised at INR 7 crores. The balance is recognised as interest income over the tenor of the payment duration.
The question that arises is whether for the purposes of computation of income under IT Act, should one recognise the revenue at INR 10 crores or INR 7 crores as is permitted under the Ind AS.
The ICDS notified under the IT Act contains a separate standard to deal with revenue recognition in ICDS IV. The said standard does not specifically contain a guideline similar to that contained in Ind AS 115/109. However, the standard does recognise that interest income is to be recognised on accrual and on time basis. Further, it is also relevant to note that the IT Act does not expressly bar dissecting a transaction to reflect their actual nature and accordingly offer income for tax purposes. In a transaction where there is a significant time period involved in cash settlement and therefore, a natural inference of significant finance costs being embedded therein, bifurcation of the transaction into two parts and recognising the interest element separately is certainly reasonable.
Considering that there is no express bar and considering that the bifurcation is only a mechanism to reflect the true nature of the transaction, the recognition of revenue adopted for Ind AS must equally apply for the purposes of computing income under the IT Act as well.
Impact of deferred payment terms on existing contracts:
A modification to the example discussed above would be a scenario where the transaction of sale is agreed at INR 10 crores, however subsequently, the parties have agreed for deferred payment terms to settle the transaction at the same value of INR 10 crores over equal instalments across 4 years. In such a scenario, recognition of receivable is once again to be carried out on a fair value basis in terms of Ind AS 115 read with 109. This is a scenario akin to:
- A discount granted on the sale value earlier recorded.
- Subsequent recovery of the agreed upon value along with interest.
In such a scenario, while recording the transaction at fair value, the difference is recognised as a loss in the financial statements. The question that arises here is whether such a loss can be claimed as a deduction for computing income under the IT Act.
The loss in the present transaction arises on account of the modification of the contractual terms between parties as regards payment of consideration. The Authors believe that it may be possible to contend, placing reliance on the principles enunciated in judicial precedents discussed above and in the absence of a specific provision either in IT Act or under ICDS barring claim of deduction, that adjustments arising on application of Ind AS should be allowable as a deduction. The loss recognised in books, it can be contended, is not an estimated future loss but a recognized reduction in the value of an existing asset due to a change in payment terms.
Potential challenges and supporting arguments
It is certainly possible that the Revenue may deny claim of the loss for the reason that the said loss is notional and therefore, cannot be eligible for deduction. However, as already stated, the modification in terms of payment has in effect resulted in (i) waiver of a portion of the principal receivable, which is under law allowable as claim for bad debts and (ii) compensation in the form of interest for the finally agreed upon principal which will be offered to tax on par with payment terms. Further, the fact that such treatment is mandated under the Accounting Standards, under strength of which deduction can be claimed, such a principle being recognised and upheld by the judiciary. At this point it is pertinent to note that like in the case of fixed assets, Ind AS for the first time has introduced the concept of depreciation in the context of receivables so as to reflect their fair value. Though in cases like these, there is indeed a loss suffered by the companies, until the introduction of Ind AS, companies did not recognize the same in the books; with the implementation of Ind AS, recognition for such loss is being made by the companies. Further, the Supreme Court in the decision of Badridas Daga v. CIT[2] held that while computing profits and gains from a business or profession, an assessee shall always be allowed a deduction in respect of incidental losses that are directly emanating from the carrying on of the business. This school of thought will be even more relevant in the present case; the reason being, trade receivables are directly linked to the core activities of any business and any loss arising on such receivables shall also be treated as a loss under the charging section of PGBP i.e., Section 28.
Conclusion: Bridging the gap between accounting and tax laws
To conclude, with evolving Accounting Standards and incongruence persisting between the tax laws and such standards, doubts and disputes surrounding taxability and claim of deductions are bound to arise. Deliberations on this front would dilute if tax laws explicitly recognise or deviate from the treatment adopted in books of accounts. Till such clarity expressly emerges, it would not be incorrect for Assessees to mirror an accounting treatment for tax computation as well, provided such an act is not expressly prohibited under the IT Act.
[The first two authors are Associate Directors while the third author is an Associate in Direct Tax practice at Lakshmikumaran & Sridharan Attorneys, Chennai]
[1] Commissioner of Income-tax, Delhi v. Woodward Governor India (P.) Ltd. – (2009) 179 Taxman 326 (SC)
[2] Badridas Daga v. Commissioner of Income-tax – (1958) 34 ITR 10 (SC)
