Delhi High Court Substantially Dilutes ICDS

Summary

This article summarises a Delhi High Court ruling, dated November 8, on a writ petition filed by The Chamber of Tax Consultants where the High Court was concerned with the constitutional validity of Section 145(2) of the Indian Tax laws authorising the central government to notify Income Computation and Disclosure Standards (ICDS), as also the validity of 10 ICDS notified by the centre, to the extent they are in conflict with the principles laid down in binding judicial precedents rendered prior to ICDS.

In a landmark ruling, the High Court read down Section145(2) of the tax laws to hold that the centre cannot notify ICDS that seek to override binding judicial precedents or statutory provisions. It held that the force of judicial precedents can be overridden only by a validation law passed by the Parliament, which removes the defect that the courts had found in the existing law. Such power cannot be exercised by the Executive. The High Court further held that if Section145(2) is not read in such restrictive manner, it would be ultra vires the tax laws, as also the Constitution of India.

The High Court also struck down several contentious provisions of each individual ICDS. It held that doing away with the concept of “prudence” (ICDS I), valuation of inventory at market value in case of dissolution of a partnership firm even when business is continued (ICDS II), taxation of unaccrued “retention money” (ICDS III), prohibition of reduction of incidental interest income from borrowing cost (ICDS III read with ICDS IX), recognition of export incentive as revenue before acceptance by the Government (ICDS IV), prohibition of completed contract method for revenue recognition from rendering of services (ICDS IV), prohibition of recognition of marked-to-market (MTM) losses on forward contracts held for trading or speculation (ICDS VI), recognition of government grants on the basis of receipt prior to accrual (ICDS VII) and valuation of inventory of securities at variance with GAAP [2] (Part A of ICDS VIII) are all ultra vires the tax laws and, hence, struck them down to that extent.

However, it held that the mandate of ICDS IV to recognise interest income on time basis, even in the absence of reasonable certainty of realisation, is a valid provision since it is backed up by a statutory provision under which the taxpayer can claim bad debt deduction for such unrealisable incomes.

Background

• Section 145 of the tax laws provides that the taxable income of a taxpayer falling under the “Profits and Gains from Business and Profession” (PGBP) or “Income from Other Sources” (IFOS) heads shall be computed in accordance with either the cash or mercantile system of accounting, whichever is regularly employed by the taxpayer. Section 145(2) grants power to the centre to prescribe the ICDS to be followed by any class of taxpayers or in respect of any class of income.
• Based on the recommendations of an Expert Committee (Committee) constituted by the Central Board of Direct Taxes (CBDT) and public consultation, the CBDT notified 10 ICDS under Section 145(2) of the tax laws, covering diverse items like Accounting Policies, Inventories, Revenue Recognition, Tangible Fixed Assets etc. The notified ICDS are applicable from tax year 2016-17 to taxpayers following the mercantile system of accounting and for the computation of income chargeable under the PGBP or IFOS heads. They do not apply to taxpayers who are individuals or Hindu Undivided Families, which are not liable for tax audit under the provisions of the tax laws.
• Having regard to concerns raised by stakeholders in the implementation of ICDS, the centre issued Circular Number 10/2017 dated March 23 providing clarifications on 25 issues, in the form of FAQs, for the smooth implementation of ICDS. However, some of the provisions of the ICDS, as well as clarifications provided in the FAQs, were directly in conflict with the settled judicial positions under the tax laws.
• In this regard, the Chamber, a voluntary non-profit organisation with tax and legal professionals as its members, filed a writ petition before the High Court challenging the constitutional validity of Section 145(2) to the extent it requires compliance of the ICDS and the Circular issued there under, in conflict with binding judicial precedents rendered prior to ICDS. The Chamber urged that while Section 145(2) of the tax laws permits the centre, as a delegate of the Legislature, to notify ICDS, it cannot be read as granting unfettered powers to the centre, in the guise of delegated legislation, to notify ICDS modifying the basis of taxation which can, if at all, be done only by the Parliament by amending the tax laws. The notified ICDS, to the extent they seek to unsettle binding judicial precedents and modify the basis of chargeability and computation of taxable income, are ultra vires the tax laws and the Constitution of India.
• On the other hand, the centre sought to defend the validity of ICDS by urging that they were aimed at codifying the law and give complete guidance to the tax authorities and, at the same time, act as a check on tax authorities not to deviate from the guiding principles. The centre argued that ICDS were aimed at bringing uniformity and clarity in computation of taxable income.

Issues For Consideration Before The High Court

• Are ICDS an instance of excessive delegation of legislative powers to the centre and, thus, constitutionally invalid.
• Whether the ICDS are in direct conflict with the settled judicial positions under the tax laws and, therefore, liable to be struck down.

High Court's Ruling

Constitutional validity of ICDS

• The High Court upheld the constitutional validity of ICDS but ruled that the centre, being a delegate of the Legislature, cannot override any statutory provisions or any binding judicial decision. The Legislature alone has the power to amend the provisions of the tax laws to overcome defects/loopholes in the existing law as pointed out by the judicial precedents.
• The provisions of ICDS, being a delegated legislation, have to be so read down such that they do not modify the basis for computation of taxable income as recognised by the provisions of the tax laws or the binding judicial precedents laid down by the Supreme Court or High Courts.
• It is, thus, clear that ICDS are not meant to overrule the provisions of the tax laws, the Rules there under and the settled judicial positions.
• Accordingly, the High Court dealt with each ICDS that was challenged by the Chamber and struck down some of the contentious provisions, which are discussed below.

ICDS I On Accounting Policies – Absence Of “Prudence” concept is in conflict with the tax law provisions and, hence, unsustainable .

ICDS I provides that expected or MTM losses are not to be allowed as deduction, unless specifically permitted by any other ICDS and, thus, does away with the concept of “prudence”.

The Chamber contended that this provision of ICDS I is contrary to the settled judicial position since the Delhi High Court and Gujarat High Court rulings have recognised the principle of ”prudence” by allowing deduction for provision for expected losses on contracts recognised in the books of account by the taxpayer in compliance with GAAP.

The tax laws also grant deduction for revenue expenses “laid out” or “expended” for the purpose of business in which the concept of “prudence” is inherent.

Accepting the above contentions, the High Court held that nonacceptance of the “prudence” concept is contrary to the tax laws provisions and, hence, ICDS I is unsustainable to that extent.

ICDS II On Valuation Of Inventory – ICDS II is contrary to the settled judicial position.

• As per the settled judicial position, if the business of a partnership firm continues after dissolution of the firm, then the inventory has to be valued at lower of the cost and the market price. On the other hand, if the business is discontinued on dissolution of the firm, then the inventory has to be valued at market price.
• ICDS II requires that inventory, as on the date of dissolution of the firm, is to be valued at market price, irrespective of continuance or discontinuance of the business. This leads to notional taxation of income contrary to the judicial position.
• Furthermore, there is a specific provision of the tax laws, which overrides Section 145 and provides that the inventory shall be valued as per the method of accounting regularly employed by the taxpayer.
• The High Court held that: (a) It is not permissible for ICDS II to override the settled judicial position. (b) Where the taxpayer follows a certain method of accounting for valuation of inventory, the same shall override ICDS II by virtue of the specific provision. Thus, the High Court held that ICDS II is ultra vires the tax laws and, as such, it is struck down.

ICDS III on construction contracts – Taxability of retention money depends on contractual terms, conditions attached to such amount and settled principles of accrual of income.

ICDS III provides that retention money should form part of the contract revenue and taxed on the basis of percentage of completion method (POCM). The Circular reiterates this position.

However, as per the settled judicial position, retention money accrues to the taxpayer only when the related performance conditions are fulfilled. Retention money cannot form part of the revenue unless the same has accrued as “income” as per the charging provisions of the tax laws.

The High Court held that taxation of retention money would need to be seen on a case-to-case basis depending upon the contractual terms, conditions attached to such amount and keeping in mind the settled tax principles of accrual of income. ICDS III, to the extent it seeks to bring retention money to tax at the earliest stage even when the receipt is uncertain or conditional, is contrary to the settled position and, therefore, ultra vires the tax laws.

ICDS III on construction contracts – Incidental income not allowed as reduction from borrowing cost is contrary to the settled judicial position and is unsustainable to that extent.

• The Supreme Court, in the case of CIT versus Bokaro Steel Ltd., held that receipts which are inextricably linked to the setting up of plant or machinery can be reduced from the cost of asset.
• However, ICDS III, read with the provisions of ICDS IX on Borrowing Cost, provides that incidental income earned cannot be reduced from the borrowing cost forming part of the cost of the asset.
• The HC held that, to the extent the provisions of ICDS III are contrary to the settled judicial position, they are not sustainable.

ICDS IV on Revenue Recognition – Export incentives are taxable only in the year of acceptance of claim by the government.

• As per the Supreme Court ruling in the case of CIT versus Excel Industries Ltd., export incentives are taxable only in the year in which the claim is accepted by the Government, as the right to receive the payment accrues in favor of the taxpayer when the corresponding obligation to pay arises for the Government.
• However, ICDS IV requires recognition of such income in the year of making claim if there is a reasonable certainty of ultimate collection.
• ICDS IV, being contrary to the Supreme Court ruling, is ultra vires the tax laws provisions and, hence, struck down to that extent.

ICDS IV on Revenue Recognition – Both POCM and completed contract methods are permissible for revenue recognition from service contract.

• Accounting principles permit the taxpayer to follow either completed service contract method or POCM for revenue recognition.
• Judicial precedents have recognized both methods as valid for tax purposes under the mercantile system of accounting.
• ICDS IV, which only permits POCM, is contrary to the above judicial position and, hence, liable to be struck down to that extent.

ICDS IV on Revenue Recognition – Recognition of interest income, in the absence of reasonable certainty of ultimate collection, is not ultra vires since corresponding bad debt deduction can be claimed.

• ICDS IV provides that interest income is to be taxed on time basis, irrespective of reasonable certainty of ultimate collection.
• The Chamber contended that under ICDS IV, interest income on non-performing assets (NPAs) of Non-banking Financial Companies (NBFCs) would become taxable on time basis even though such interest is not recoverable.
• The High Court noted that the Circular clarifies that while interest income is to be taxed on time basis alone, bad debt deduction, if any, can be claimed under the provisions of the tax laws. Furthermore, the Parliament has inserted a specific provision in the tax laws to grant bad debt deduction for incomes recognised under ICDS (without recognition in the books) in the year in which they become irrecoverable.
• The HC held that this provision of ICDS IV cannot be held to be ultra vires since a corresponding bad debt deduction can be claimed by the taxpayer if the amount of interest is irrecoverable. Also, the Chamber has not demonstrated that ICDS IV is contrary to any ruling of the SC or any other Court.
• The High Court further observed that one interest income is offered to tax on time basis by claiming corresponding bad debt deduction, if the amount is not recoverable, ICDS creates a mechanism to track unrecognized interest amounts for future taxability, if so accrued.

ICDS VI on foreign exchange fluctuations – ICDS VI not allowing MTM loss/gain in case of foreign currency derivatives held for trading or speculation purpose and taxation of opening balance of Foreign Currency Translation Reserve (FCTR) pertaining to monetary items is contrary to the settled judicial decision.

• The Supreme Court, in the case of Godhra Electric Supply Company Ltd versus CIT, held that hypothetical income cannot be taxed. Furthermore, it held, in the case of Sutlej Cotton Mills Ltd versus CIT, that exchange fluctuation gain/loss in relation to loan utilised for acquiring a capital item would be capital in nature.
• Case of foreign currency derivatives held for trading or speculation purposes shall be allowed on actual settlement, and not on MTM basis. The High Court held that this is not consonant with the ratio laid down by the SC in the Sutlej Cotton Mills ruling and, therefore, ultra vires the tax laws and, as such, struck it down.
• The Circular clarifies that the opening balance of FCTR Account as on April 1, 2016. (i.e., on the date ICDS first became applicable), which comprises of accumulated balance of exchange fluctuation gains/losses in relation to non-integral foreign operations, is taxable to the extent it relates to monetary items.
• However, the High Court held that valuation of monetary assets and liabilities of the foreign operations as at the end of the year cannot be treated as real income as it is only in the nature of notional or hypothetical income which cannot be subjected to tax.

ICDS VII on government grants – Taxation of unaccrued subsidy on the date of actual receipt is ultra vires the tax laws.

• ICDS VII provides that recognition of government grants cannot be postponed beyond the date of actual receipt. This is in conflict with the accrual system of accounting since, many times, conditions are attached to the receipt of government grant which need to be fulfilled in the future and, hence, the amount may not have accrued to the taxpayer.
• Therefore, the High Court held that ICDS VII is ultra vires the tax laws to that extent.

ICDS VIII on securities held as inventory – Part A of ICDS VIII which prescribes “bucket approach” applicable to taxpayers other than banks and public financial institutions is ultra vires the tax laws.

• ICDS VIII provides for valuation of securities held as inventory and is divided into two parts.
• Part A applies to taxpayers other than banks and public financial institutions. It requires valuation of inventory on “bucket approach” i.e., category-wise valuation of securities instead of individual valuation of each security. However, this is different from the normal accounting principles and, thus, taxpayers will need to maintain separate records for tax purposes every year.
• Part B of ICDS VIII, which applies to banks and public financial institutions, provides that recognition of securities should be in accordance with the RBI guidelines. The High Court held that Part A of ICDS VIII, which prescribes “bucket approach”, differs from ICDS II on valuation of inventory which, under similar circumstances, does not prescribe the ”bucket approach”. This shows that ICDS has adopted separate approaches at different places for valuation of inventory. This change is not possible without a corresponding amendment in the tax laws. Hence, to that extent, Part A of ICDS VIII is ultra vires the tax laws.

Comments

This High Court ruling is a landmark ruling which addresses several controversies which had arisen on interpretation of ICDS. It provides clarity on the interplay between ICDS and binding judicial precedents. It also provides a welcome relief to taxpayers by striking down several contentious provisions of ICDS, which had raised apprehensions of taxation of unrealized/notional incomes. Taxpayers which are yet to file returns for tax year 2016-17 can consider the impact of the present ruling in their tax computations. Taxpayers which have already filed returns for tax year 2016- 17 can explore revising their returns on the basis of the law laid down by the present ruling. While the ruling has addressed majority of the concerns of taxpayers, to the extent that the ruling has upheld the validity of taxation of unrealisable interest, it may have a significant impact on certain sectors like NBFCs, in relation to interest on NPAs. Those taxpayers will need to take care to offer such incomes in their tax computation (even if not recognized in the books) and claim bad debt deduction as per the specific provision in the tax laws. However, even on this issue, there is a silver lining for taxpayers in the form of the tax authority's admission before the High Court that ICDS does not, in any way, seek to alter the well-laid principles of “real income” by the Supreme Court, but merely ensures that there is a trace available of the income which is not taxed. Therefore, if there is an unrealisable interest income, it can be written off by the taxpayer for tax purposes and claimed as bad debt deduction in the same year under the specific provision inserted in the tax laws for this purpose. The tax authority's clarification that the process is intended to obtain information, rather than tax unrealisable income, should offer a sigh of relief to taxpayers.

This article was first published on the EY Tax Alert Bulletin.

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