Draft TAS: Impact On Business?
Tax Accounting Standards! There I've said it. That's what we are discussing this week. Yeah I know its Diwali and all and you are in no mood to listen to a tax discussion or an accounting discussion, worse still, a Tax and Accounting discussion. Yet I suggest you listen closely because these Tax Accounting Standards are going to have a material impact on your company's profitability. And while we can't cover all 14 standards in detail, due to lack of time we are going to focus on the genesis of Tax Accounting Standards or TAS, The deviations from Accounting Standards and the Implications on Business. To do that I am joined by Jamil Khatri of KPMG, Pritosh Basu of Essar and Vishal Shah of PwC.
Jamil lets start with you first. You were on the committee that drafted these draft Tax Accounting Standards. Very quickly in simple terms and 30 seconds explain to me the genesis of these TAS and what they intend to achieve?
Khatri: I think the background to this is that when India was trying to implement IFRS, one of the things that stopped us from moving forward was there was no certainty from a taxation perspective. The Ministry of Corporate Affairs then lobbed the ball at the Ministry of Finance to say how do we move into IFRS and still have some sensible approach on taxation. So, this committee was set up to look at that particular issue and advice on how the tax computation could be done in a post IFRS regime. But as we moved forward, the question really was that could we use this as an opportunity to come up with something which should provide a framework for computation of taxes and along the way deal with the uncertainty that is there on computation and areas which are being litigated between the department and between companies.
Doshi: So before we judge these TAS on those two counts which is reduce litigation and increase certainty, let’s look at what material impact they will have on companies and their balance sheets. I think three or four sectors have been spoken of already in the media and I want to start with you first Vishal- where do you see the maximum impact because these TAS deviate from accounting standards?
Shah: Historically the tax provisions are contained in the income tax law. There are specific provisions dealing with specific items in the income tax law. The accounting is relevant only to the extent those set of provisions are not dealt with in the income tax law. So, typically these areas are a) in terms of forex accounting, the ones which is sort of commonly debated is on the mark-to-market related adjustments that happens, the recognition of the revenue- the law does not specify as to how do you go about recognizing the revenue and therefore you go back to your accounting and some of the deviations proposed by the committee and the report is relating to recognition of revenues particularly for services companies that has an impact and also in respect of construction contracts of realty companies and the EPC contractors, etc which could have a potential impact in terms of how do they recognize their revenue.
Doshi: Lets go with forex first then. What impact do you think this TAS will have on the way you were accounting for forex transactions?
Shah: Once I look at the TAS, the forex deviations from the normal accounting standards as I look at it and Jamil can probably expand on that, is limited to the effect where the exchange difference arises on items which are not forming part of your balance sheet as on that date. So, only in respect of the monetary items like debtors, creditors, receivables, etc-that sort of exist on the balance sheet - the TAS continues to say that you will re-compute them as on the last date of the balance sheet based on the exchange rate as on the date of that balance sheet. Where the TAS deviates from the current practices is where they say that where people have entered into foreign exchange derivative contracts, which is what the hedging would typically be- policy of the companies would be to get into sort of hedging contracts for entering into foreign exchange derivatives. When foreign exchange derivatives is in relation to items which are probable in terms of your probable sales or your probable imports or exports, etc that are going to happen -that’s where the mark-to-market adjustments in respect of those items will not be considered in the profit and loss account for tax purposes effectively. So, those gains or losses would not be allowed as a deduction in computing the income where the items are not forming part of the balance sheet on large.
Exchange differences arising on reporting of monetary items at the exchange rate on the last day of the previous year should be recognized as income or expense
Mark-to-market gains or losses are unrealized in nature, all gains or losses on forward exchange or similar contracts entered into for trading or speculation contracts shall be recognized only on settlement
Doshi: Dr. Basu of what consequence will that be?
Basu: There will be consequence in terms of, suppose there is a certainty and if I see a trend that certain laws are going to occur, people who are booked somewhere in 45 it is never going to go to 45, its going to be between 52-53. So, if I can reduce the tax burden of this quarter I should be allowed to reduce that tax burden, isn’t it.
Doshi: But this TAS does not allow you to do so?
Basu: This TAS will not be allowing me to do so ultimately till such time I end up with the actual settlement of the issue. To add to what Vishal said in terms of not dealing with certain items which is not there in the standard today is related to share based payment. In the question of share based payment again the provision has allowed me to only book the liability, not book the asset not to the extent of the fair valuation of the asset. It will allow only to book the fair valuation of the asset which is lower. In that situation I will also be deprived a proper depreciation allowance and the asset will not be representing its true fair value. The question which will come in is that how the things will be seen by the ultimate critics of the balance sheet i.e. the analyst.
Doshi: Analyst community, right. Jamil you want to respond to this?
Khatri: Yes, I think if without being a defender of the committee because I am talking in my personal capacity but I think you touched upon a very important point on the exchange loss and derivatives. I think the way I look at this, one, as you rightly said there is nothing in the Income Tax Act which deals with it and therefore you have to fall back on what is there in the accounting standards. The accounting standards are meant for the purpose of giving a prudent view to the investors and readers of the financial statements and they need to know if there is a probable loss of the nature that you describe that look you are going to be impacted. Tax is, in my mind, not based on the same principle because there has to be parity between losses and gains and therefore in the same instance if a company is to claim a deduction for unrealized losses, then logically they should pay tax for the unrealized gain and the impact of that could be very significant because if you are in a good position – I know some of my clients who had hundreds of millions of dollars of mark-to-market gains, imagine paying taxes on that unrealized gains.
Basu: Leave alone this particular point but if you see the underlying theme right across your 14 standards which you have brought in, there the situation is that in most of the cases it is preponement of all the incomes and postponement of all the expenses particularly in areas of onerous contract and you are also saying that in case of a service contract in certain cases you will not be able to estimate suppose in a case of technology integration if the final product doesn’t come out the service provider has to go back to a zero, starting point and to start working. But you are asking him to provide right from day one to provide 25 percent. So I think there is an issue which we need to understand that certain established principle of accounting since World War II is being not considered in this TAS.
Shah: I must add to Jamil’s point on this. I think it’s a very rational view that the committee is wanting to take in the direction to say that if the gains are not taxed, you don’t get the deduction for the losses and I think it is a very rational approach because sometime back the CBDT had come up with an internal instruction on this issue to say that any mark-to-market adjustments even on items that are existing on your balance sheet like debtors, receivables as I mentioned earlier would be disallowed for tax computations. Now, those were only internal instructions, they don’t sort of have a binding effect on tax payers while computing their income but if this gets legislated the way it is proposed it sort of… (Interrupted)
Doshi: So you have come around to seeing it from Jamil’s point of view?
Basu: The point here is that another issue is brought in which Vishal you look at. You are allowed to do anticipated asset booking which was never done and reasonable certainty though reasonable certainty people who are in the gaining position to show their organizations profitability there will be controversy coming in, what is anticipated and reasonable certainty which was never a situation in accounting world so far.
Khatri: The position is this Dr. Basu- the choices, the way I see it is, today we make a provision for litigation. Let’s say there is a litigation against a company and you believe that in good faith that you will have to pay something and you make a provision. In the past, as Vishal said, there was uncertainty whether this provision which is recorded rightfully in the book should actually be allowed as a deduction and there were many tax officers who used to disallow that and there was a lot of confusion. What we feel is that the moment you have that in the tax accounting standard that if these conditions are met you need to make a provision. It will put an end to those kind of disputes because you know that is a legitimate item that is deductable. The question then comes up is that again if you give a deduction for a provision item on the debit side, on the loss side similarly if you filed a claim against somebody which you are going to receive it cant be – imagine two parties, one party cannot claim a deduction and the other party basically said that I am not going to offer that for taxation. So, I think we may disagree with how this will be implemented but the other option to this was to say okay similar to what we talked about on derivatives you will not get a deduction for any liability until you have to actually pay that liability. I thought that would be a very extreme measure and therefore it was better to kind of deal with it and not change that position.
Shah: It maybe so that from an accounting perspective because you follow prudence which is your basis of accounting, as an accounting policy you may not necessarily accrue because that test will not get satisfied and from a tax perspective you will tax it say in a particular year when you identify that the guidelines laid down by the report or the guidelines that sort of satisfies and therefore you accrue that as an income today and then sort of looking at to say that we don’t need to maintain separate sets of accounts which is what the core recommendation from the committee is. Also because that will increase lot of compliance and cost for corporates, it does lead to a situation where you have too many items sort of outside of your balance sheet or you P&L which then needs sort of adjustments from a tax perspective.
Khatri: I would like to again touch upon the point on reconciliation because that’s an important angle. I think like I said the approach, the way I see this is, for most companies 80-90 percent of what they do should be inline with what is there in the books of accounts and then there will be five or six items- even today as we know when we prepare our tax return and let’s say depreciation, we adjust our depreciation per books and we claim depreciation as per Section 32 of the Income Tax Act. The committee has recommended that we add other items to that and I agree with you that the risk is that this becomes a very cumbersome exercise in terms of doing it. As one very knowledgeable professional mentioned to me recently who I will not name- he basically said, as long as you deal with issues around disclosure, we don’t have a problem with TAS; as long as you deal with issues on measurement which are period end adjustments, we don’t have a problem; the moment you touch recognition which is how you deal with underlying transaction, that could create a very big void between what you do for books and what you do for tax and that is something that should be avoided.
Doshi: I think we briefly touched upon service revenues and Vishal if you’d like to explain to our viewers exactly where you see the deviation and hence what the impact will be?
Shah: So far as the services sector, I think currently most of the service providers where the contract or the engagements that the service entity gets into are for a limited period of one or two months; not the long two year or three year contracts but where there are two or three month contracts and typically that applies to both Jamil and to me in terms of our organizations which does that sort of engagements- you have a milestone based invoicing and therefore depending on the milestones achieved at the year end, you will accrue those invoices in your books and you will accordingly offer them to tax ….(Interrupted)
Revenue from service transactions shall be recognized by following only percentage completion method
Doshi: That seems to now change under the TAS to a percentage of completion.
Shah: And it says that you go to percentage of completion and therefore what that will entail is that for each of those engagements, I need to identify the cost that I have incurred until 31st of March which typically is the last date and therefore if I have sort of say personally I am working on 20 engagements- I will have to, in the last 15-20 days which I have not invoiced my clients for, I will have to allocate each of these cost towards each of these engagements and say that that will be forming part of my service revenue or the accrued revenue though I have not billed it to the customer. The second point related to that is that you might have a situation that you might not be making profit on that but the way I think the AS 2 on valuation of inventory is, in so far as services contract is concerned, that you only value them at cost and not at cost or the realizable value which is the basic phenomenon because if the realizable value or my billing that’s going to happen probably on 15th April or probably a 30th April is not what the cost that I have incurred, I shouldn’t be paying income on that logically because that’s not what I am going to get but the value in AS2 says the TAS read onto inventory says that you value it at cost which means that I might have income sitting out there which I may not be able to recover ultimately from my client.
Doshi: Material impact on profitability?
Basu: There will be certain issues in the context of lease accounting also. There will be certain issues in the context of certain contracts where there will be controversy that you have said 25 percent completion, you start to book it. But the person who is providing the service, he may anticipate that although as per the terms of contract I have done 25 percent of the service and if its contract is not properly framed on the milestone basis which is a vanilla simple contract, then the controversies will be less. But in the context of service industry which he is saying there will be lots of issues coming up in terms of litigations.
Khatri: If I can pick on the point that you made on why percentage completion for services- interestingly percentage completion for services is the only way to account for things under IFRS. So, when you move to IFRS anyways you will have to do it. There were some companies – I have a client personally which entered into services contracts in lasts two years, they are unlisted company and they decided to recognize revenues only when they complete and deliver that particular – they are a construction company- and on the other hand I equally have companies who are listed kind of companies who can never afford to do that because they need to show quarterly profits. The point is for the same transaction you cannot have taxability at two different points in time.
Doshi: I want to you go from defense to offence and I don’t mean offence in a way of criticism but can you raise for me or add to the list of accounting practices or sectors that will be impacted because these TAS deviate, knowingly, from accounting standards in certain cases.
Khatri: I think there are a couple of more which I would like people to focus on and comment either way. One is on translation of foreign branches and I will take a very practical example. If you are a bank which has foreign branches today, you classify your branches into two parts, certain which you call integral others which you call non integral. When you translate the numbers of the integral branch, you take all the exchange difference to your profits; when you translate the results of non integral branches, you take them to your reserves. I know one public sector bank which has Rs 1800 crore of this gain which came in last year. Under the current approach when this goes to reserves obviously you don’t pay taxes on that. The TAS recommends that because there is no distinction between an integral branch and a non integral branch they should come to income. I think that is going to have a material impact for many organizations. The second is for stock broking entities and banks who hold stock in trade. The simple issue there is let’s say an organization has a stock which it had bought at Rs 100 and today the market price is Rs 90. They claim a deduction for that Rs 10 as stock in trade. They have another stock which they bought at Rs 100 and the market price is Rs 200. They don’t offer that for taxation. What the TAS recommends is that you look at it on a portfolio basis i.e. you compare your Rs 200 with the Rs 290 of value and because in that case there is no diminution you don’t claim that deduction of Rs 10 i.e. you move away from an individual scrip by scrip comparison to a portfolio approach. That could have a material impact for most organizations.
Requires exchange differences on translation of non--integral foreign operations to be recognized as income or expense, instead of their recognition in the foreign currency translation reserve account as currently required by AS 11
Requires the comparison of cost & net realizable value for securities held as stock-in-trade to be assessed category wise and not for each individual security
Basu: Jamil, one clarification from you. Are you going to suggest on an underlying substance basis that you go out into block by block concept instead of asset to asset concept?
Khatri: No, what we are saying is only in the context of securities because of the fact that the deduction for unrealized kind of losses and if you see the TAS the TAS then lists down the six categories where – I don’t think that’s a generic principle we are going to go down- but specifically for the purpose of valuation of stock in trade of security is…. (Interrupted)
Basu: I understand that but when a downturn comes in a market and trading stocks are held, losses will not be allowed to be booked perhaps there will be an issue because you are not getting into asset by asset item but you are going into block by block by item.
Khatri: Yes Dr. Basu and again the thinking is simple that if you are sitting on a portfolio of assets some with a gain and some with a loss, at a personal level as well I feel, it is not correct to claim a deduction for the losses and not pay for the gain. One could have two views on this but that was the thinking behind the recommendation.
Doshi: Alright then that’s makes it clear. I think we are literally at the end of time. We have one minute left to go so I am going to give 25 seconds to each one of you, is this what you’d like to see rectified based on all the feedback that comes in as one mid-step towards converging to IFRS or do you believe another route would be more practical and viable for industry and what is that route?
Shah: I think the objectives of the report are very noble in terms of achieving consistency, reducing litigation, etc. The question is that is notifying accounting standards separately for tax purposing the only solution. Probably the other solution is to when you have these deviations which are rightly identified as the areas where you have concerns or you want consistency, why don’t you bring them as the part of the law itself.
Doshi: So, legislating part would be done as part of the DTC then eventually or in the existing Act?
Shah: In the Income Tax Act because in fact when you go to the DTC, the relevance of the accounting standards will be very different because the DTC goes on an income expense model for computing your income and that sort of completely deviates from the current scene where the accounting profits from the …. (Interrupted)
Doshi: So this will make not make any sense if we move to a DTC?
Basu: I personally feel that unless controversies are set at rest by giving implementation guideline and reducing some of the areas and scope where there can be difference of opinion and not aligning the tax accounting standards certainly with the law, there would be problems and from the industry perspective our people will have to sweat and stretch further to comply with both the accounting standards.
Doshi: So we have IND-AS, AS, TAS, DTC is this all going to eventually convert at some point?
Khatri: I think it’s unlikely and I think because the objective of fiscal and the objective of reporting is rightfully different and this is acknowledged across the world as well i.e. you don’t have to be aligned.