IFRS Diary: Tax Accounting Standards
Published on Tue, Nov 27,2012 | 15:43, Updated at Tue, Nov 27 at 16:11Source : Moneycontrol.com
By Jamil Khatri, Partner & Global Head – Accounting Advisory Services, KPMG
Even though I am tempted to apologize for the long gap since my previous column, the truth is that over the last several months there have been no credible updates around IFRS convergence in India. As a quick recap, the implementation date of the IFRS converged standards (Ind AS) issued in February 2011 is yet to be notified by the Ministry of Corporate Affairs (MCA), and there is no clarity on the form & timing of any future implementation. In the interim, the previously proposed date of April 1, 2011 has passed by a long time ago. Though new dates of April 1, 2013 & April 1, 2014 are being discussed in professional & regulatory circles, in the absence of any firm announcement by the government, these are merely conjectures.
One of the reasons previously sighted by the MCA for delay in implementation was the lack of clarity on taxation. At least this has now been addressed through the issuance of the report of a Committee formed by the Ministry of Finance (MoF) to address this issue. I was a member of this Committee and thought it may be useful to share my personal perspectives on this development.
At a fundamental level, the Committee has determined that the accounting standards issued by the Institute of Chartered Accountants (ICAI) and notified under the Companies Act, cannot be the sole basis for computing taxable profits. This is based on the analysis that the accounting standards incorporate principles such as prudence; provide alternatives; and are not necessarily aligned to other provisions of the Income Tax Act (the Act). The Committee concluded that while prudence may be relevant for readers of financial statements, it is not necessarily the most relevant attribute for taxation.
Consider, unrealized losses on derivative contracts. While recognition of such losses would be appropriate for accounting, this may not be appropriate for taxation since unrealized gains are not required to be offered for taxation and there should not be inconsistency between the treatment of gains and losses for taxation. Similarly, the accounting standards provide alternatives in revenue recognition on service contracts whereby the completed contract method can be followed in certain cases. The Committee determined that the tax implication of similar transactions cannot be different just because different reporting policies are followed. Accordingly, many such alternatives are proposed to be eliminated. Lastly, to seek alignment with the provisions of the Act, changes were considered necessary to the accounting standards.
Accordingly, the Committee has recommended that the accounting standards should be modified and issued separately as ‘Tax Accounting Standards’. Once notified under the Act, these TAS are intended to provide a comprehensive framework (along with the Act itself) for computation of taxable income.
The following points merit attention:
- The TAS will be applicable only to those tax payers who follow the mercantile system of accounting. Tax payers who follow the cash basis will not be impacted;
- Companies will not be required to maintain books of account based on TAS. The books of account may be maintained based on the primary basis of accounting (Indian GAAP) followed by the company, as long as the company maintains supplemental records to reconcile the profits per the financial statements with profits per TAS. In a way, this is similar to the current situation where profits per the books are adjusted for computation of income in areas such as depreciation;
- It is likely that profits as per the financial statements may need to be reconciled with profits per the TAS through additional disclosures in the Form 3 CD and/or the return of income;
- Since taxable profits will be derived from profits computed per the TAS, the framework of accounting followed for the financial statements becomes less relevant. Thus, even if Ind AS is implemented only for a class of companies, these companies will not be better or worse off as compared to companies that continue to follow Indian GAAP (except for Minimum Alternate Tax implications discussed separately);
- The Committee has not currently address the MAT implications for companies that may transition to Ind AS in the future. It is likely that guidance in this area will be provided as we move closer to Ind AS sometimes in the future;
- Since the Committee focused on modification of accounting standards issued by the ICAI, areas that are currently covered by Guidance Notes (for example, stock options, revenue recognition by real estate developers) or by non-mandatory accounting standards (for example, financial instruments) have not been covered by the TAS. However, the Committee has recommended issuance of TAS in the future to cover such areas;
- Since the TAS will be notified under the Act, they seek to override judicial pronouncements in areas directly covered by the TAS. However, in the event of any conflict between the TAS and the provisions of the Act itself, the Act will prevail. Though the TAS have been drafted using the ICAI standards as a base, there are several areas where the accounting standards have been modified. Some of the key areas where the provisions of the TAS are different from the accounting standards (and may hence change practice) are as follows:
- The TAS eliminates the concept of prudence. Hence provisions for anticipated losses on onerous (loss) contracts are not permitted. Similarly, provisions for mark-to-market losses on derivatives are not permitted, except in the case of certain foreign exchange derivatives that relate to assets and liabilities existing at the balance sheet date;
- The TAS requires revenues on all construction and service contracts to be recognized based on the percentage of completion method (completed contract is no longer permitted). While applying the percentage of completion method, profits cannot be postponed beyond 25% of project completion (several companies used to defer recognition beyond the 25% threshold). Lastly, revenue recognition cannot be postponed merely on the grounds of uncertainty if a legal right to recover the revenues exists. Any such uncertainty should be recorded through a separate bad debt expense;
- Though a separate TAS on revenue recognition by real estate developers may be issued in the future, several provisions in the TAS on construction contracts & revenue recognition may become applicable to real estate developers;
- Exchange differences on all loans & borrowings are required to be recorded through profits, unless they relate to import of fixed assets and are covered by Section 43 A of the Act. This could potentially resolve many disputes around whether such exchange differences are of a capital or revenue nature;
- Exchange differences arising on translation of results of all foreign branches are required to be recorded through profits. This is a significant change for companies that otherwise record translation differences relating to ‘non-integral’ branches through reserves;
- Gains and losses on foreign exchange derivatives are required to be recorded only on settlement, unless they relate to assets & liabilities that exist on the balance sheet (in which case the exchange differences on the derivatives would off-set the exchange difference on the underlying asset or liability);
- Government grants would either be recorded as a reduction from the actual cost of the asset (if they related to a depreciable asset) or recorded in profits immediately/over a period of time (based on conditions attached). The option of recording such grants as capital contributions has been eliminated;
- Unrealized losses on securities held as stock-in-trade would be recorded on a portfolio basis and not for each individual security. This could change practice since many securities dealers record such losses separately for each security. Similarly, the TAS provides that such losses cannot be recorded for unquoted/illiquid securities;
- Borrowing costs relating to specific borrowings are required to be capitalized in full without off-setting any interest income on unutilized funds. Similarly, borrowing costs on general borrowings would be capitalized based on a prescribed formula that is different from current practice. Borrowing costs would exclude any exchange differences and are required to be capitalized irrespective of the period of construction (even if the period is less than 12 months). Lastly, borrowing costs would be capitalized even during periods where construction activity is suspended due to regulatory or other considerations. Several of these provisions may represent a significant change in practice followed by individual companies;
- Depreciation on finance leases will be provided to the lessee and not the lessor. This aligns the treatment to the financial statements, but changes tax practice in this area;
- While the TAS clarifies that provisions for contingencies and claims can be made if certain conditions are met (largely aligned to the financial statement treatment), it requires that gains from contingent assets for claims made should also be recognized using similar principles (this is a significant change from current practice where such gains are generally recorded on realization/settlement).
In summary, the TAS seeks to establish a comprehensive framework for determining profits and thereby resolve uncertainty and litigation in many areas. In the process, the TAS change practice in several areas. However, the real benefit of this framework will accrue only if the principles of the TAS are correctly interpreted and applied by the tax & judicial authorities at the field level. Though the issuance of TAS provides another opportunity to implement Ind AS in India, whether the MCA will capitalize this opportunity is currently uncertain.