ICDS as tax saving tool

Introduction

Ever since CBDT notified the new Income Computation and Disclosure Standards for computation of taxable income, many debates and analysis have been done with professionals giving their respective conclusions. We have conducted an independent and in-depth study of ICDS and found that it has significant tax savings avenues. As of now we present to you 3 key areas where ICDS can actually be beneficial for all the assessees in general & which we are delighted to present to you in the forth-coming paras

1. Advantage in Cost-Plus Transfer pricing:

One of the biggest challenges faced by assessees, especially in manufacturing industries, is transfer pricing additions on un-absorbed overheads. AS 2 mandates the company to absorb overheads based on normal capacity. This would result in Under-absorption of overheads where the company produces output below its normal capacity. When such companies justify transfer pricing using cost plus method, they arrive at arms’ length price by adding mark up on the direct costs and absorbed overheads. Consequently, under-absorbed overheads are not considered. Transfer Pricing Officers have always taken advantage of this situation and made significant addition by adding mark up to un-absorbed over heads thereby resulting in high pitched demands. However this scenario is all set to change with the introduction of ICDS. Para 8 of ICDS relating to Valuation of Inventories specifically states that “the amount of fixed production overheads allocated to each unit of production shall not be increased as a consequence of low production or idle plant”. Now TPOs don’t have any case for such additions – which have been plaguing manufacturers for quite some time.

2. Deferment of tax liability for Construction Sector in cases of disputes with contractee

The construction sector has never been without disputes with the contractee debiting significant chunks from the Running Account Bills of Contractors. If the assessee offers to tax its profits based on AS 7: Construction Contracts issued by ICAI, there will be no immediate tax relief where there is a dispute. However, this is all set to change with the implementation of ICDS. We will explain this with the following example. Let us consider a case where a contract of Rs 100 Crore was entered by assessee with total contract cost of Rs 40 Crore to be incurred equally in 2 consecutive years. Let us say, there arises a dispute with the contractee due to which contractee deducts Rs 30 Crores in first year from the RA Bills. The tax liability in the pre ICDS era and Post ICDS era is given below in the tabular form for your understanding:

[* (100-30)*50%]
[#(100x50%)]

The above computation is made based on the principles provided in Para 11 of ICDS C: Construction Contracts which states that amount written off shall be recognised as expenses and shall not be treated as adjustment of revenue.

While the assessee had to cough up Rs 4.5 Crore in the first year in Pre-ICDS era, there is no tax in the first year in Post ICDS era. ICDS effectively shifts the tax burden in the 2nd year where the financial position is better thereby giving breather in the year of distress.

3. Expected Losses on Onerous Contracts is ALLOWED under ICDS:

Simply put, onerous contracts are basically those contracts that has total costs which are likely to exceed the total revenue. This forces the assessee to provide for ENTIRE losses in the year in which such contracts are considered Onerous pursuant to Para 35 of AS 7.   We have come across interpretations where various professionals have opined that expected losses are dis-allowed as no specific provisions are available in ICDS to deal with the same. In our humble opinion, the same is certainly allowable on account of the following logic.

The preamble of the ICDS C: Construction Contracts specifically states in case of conflict between provisions of the Income Tax Act 1961 and the ICDS, the Act shall prevail to that extent. Honourable Mumbai Tribunal in ITD Cementation India Ltd Vs ACIT (ITA NO 2991 & 3669/MUM/11) has specifically held that such losses are allowable under section 37(1) of the Act.  While ICDS is silent on provision for expected losses on onerous contracts, section 37(1) of the Income Tax Act 1961 specifically allows the same. Consequently, there CANNOT be any disallowance on this ground!!!

Tax Saving Avenues peculiar for different assessees

As we have already stated above, we have also identified other avenues of tax savings which can be utilized only by specific assessee or a type of assessee while it does not favour the others. Following are the few cases where specific assessee (not all assessees) are likely to benefit from ICDS:

a. An assessee offering to tax its service income based on Actual billings ends up paying low taxes in initial years on account of the fact that the RA bills are not commensurate with the percentage of completion.

b. An assessee consistently being disallowed for provision for warranty expenditure can find solace in ICD X dealing with Provisions, Contingent Liabilities and Contingent Assets. Officers have consistently disallowed the same citing that provisions are disallowable expenditure.

c. In cases of gains in forward contracts for hedging firm commitments, the same is taxed only on completion of settlement.

Conclusion

We also do acknowledge the fact that ICDS are more taxing in certain cases. However, many of these have already been already highlighted in various articles. Some of prominent cases are preponing of tax liability owing to following factors:

a. Revenue recognition based on Percentage of completion in-spite of no billings made.

b. Inclusion of Cost of securing contracts in contract cost thereby preponing recognition of revenue and tax liability.

c. Retention portion of service contract shall be recognized as revenue on percentage of completion basis as against the retention portion of supply contract which can be recognized only when right to receive is established.

In light of the above, it is recommended that tax planning using ICDs need to be made which shall be specific for an assessee or industry. Surprisingly, we may subsequently find out that contrary to belief, ICDS could actually result in better tax implications of the assessee. While we would be updating the readers of other tax planning avenues that we may subsequently come across, we would also be glad if the readers could share any other tax planning techniques in the comments section below so that other professionals / assessees may benefit from the same.