Taxable income under the Income-tax Act is a result of the net profits according to statutory financial statements, specific requirements of the Act, rules, circulars and notifications, and judicial pronouncements. The statutory financial statements are prepared in accordance with accounting standards issued by the Institute of Chartered Accountants of India, which are notified in the Companies Act (Indian GAAP).

One reason for postponing the implementation of International Financial Reporting Standards in India (Indian-adapted IFRS are known as Ind-AS) was that they were geared to meet investors’ requirements and were not suitable to determine taxable profits. For example, investors in an investment property company would like to judge the company based on the fair value of the investment property. Considering this, IFRS allows companies an option to account for the investment property at fair value, with changes recognised in the profit-and-loss statement. Income-tax authorities, on the other hand, seek to tax companies based on the rent earned or capital gains on sale of property.

Thus, there was a need to separate accounting standards used for statutory reporting and to determine taxable income. In fact, this need was felt way back in 1995, with the introduction of section 145(2). However, not much has been achieved since, other than the issuance of two inconsequential tax standards. It may be noted that the Direct Taxes Code Bill 2010, which is proposed to substitute the current Income-tax Act, also has provisions comparable with section 145(2).

With growing pressure to implement Ind-AS, the Central Board of Direct Taxes in 2010 constituted a committee comprising experts from the government and professionals to draft tax accounting standards (TAS) for notification under section 145(2). In the interim, the committee exposed two draft TAS — on construction contracts and government grant — for public comment. There are reports that the committee has completed its work and a slew of TAS will soon be exposed for public comment. Final standards would be issued after due process.

Significant differences

The TAS on construction contracts is based on current Indian GAAP (AS-7) but with significant differences. First, unlike AS-7, TAS does not allow recognition of expected losses on onerous contracts. Second, even though TAS permits non-recognition of margins during early stages of a contract, when the contract outcome is not certain, it prohibits deferral of margins if the completion stage exceeds 25 per cent. Currently, tax assessees have the option to follow either the ‘completed contract method’ or ‘percentage of completion method’, provided it is consistent. TAS requires the ‘percentage of completion method’ only, but there is no clarity on how the first-time transitional income arising from the switchover would be taxed.

The second draft TAS on government grants is based on current Indian GAAP (AS-12), with significant changes. Under TAS, the initial recognition of grant income cannot be postponed beyond the date of actual receipt. Under AS-12, mere receipt of a grant is not necessarily evidence that conditions attached will be fulfilled. While government grants in the nature of promoter’s contribution is credited to capital reserves and treated as part of the shareholders’ funds under AS-12, it is disallowed under TAS.

These two TAS represent a huge change that will significantly impact how taxable income is determined. If we consider all the TAS in the offing, the impact will be manifold, probably even greater than that of DTC.

Need to remain tax-neutral

If the purpose of TAS is to ensure smooth implementation of Ind-AS rather than alter the manner of computing tax, TAS should have remained tax-neutral. It should have focused on codifying existing Indian GAAP standards and other tax practices, rather than change the basis of tax computation. For example, if under the current tax regime both ‘completed contract method’ and ‘percentage completion method’ are allowed, TAS should retain that position. Unfortunately the two draft TAS are not tax-neutral and hence may face stiff opposition from taxpayers.

Indian GAAP is the culmination of four decades of development and implementation of accounting standards and interpretations. One of TAS’s objectives is to reduce the discretion under currently available standards issued under the Companies Act, thereby reducing chances of litigation. But, on the contrary, by creating a parallel maze of TAS, prepared in a hurry and with no precedence of application or interpretation, chances of litigations may actually increase exponentially.

Dolphy D'Souza is Partner and National Leader, IFRS Services, in a member firm of Ernst & Young Global.

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