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  Date: 30th Sep 2009

 Compiled by: M Sathya Kumar  

Convergence and Conflicts of Taxation and Accounting

1. Commercial Accounting Principles — basis of taxable profits :

Income-tax is a branch of law and its practice falls within the domain of lawyers. We Chartered Accountants have, however, entered and have successfully carried on practice in this field for the reason that income-tax is tax on income, profits and gains, and determination thereof needs expertise in accounting principles. The Apex Court has held time and again that in working out profits, the principles that have to be applied are those which are a part of commercial practice or which an ordinary man of business will resort to when making computation for his business purposes1. More recently, the Supreme Court has held in CIT v. U.P. State Industrial Development Corporation, (1997) 225 ITR 703 (SC) that it is well-accepted proposition that "for the purposes of ascertaining profits and gains the ordinary principles of commercial accounting should be applied, so long as they do not conflict with any express provision of the relevant statute". The Apex Court quoted with approval the principle laid down by the English Courts2 and also reiterated the principle laid down earlier by the Supreme Court in P.M. Mohammed Meerakhan v. CIT, (1969) 73 ITR 735 (SC) that it was the duty of the Income-tax Officer to find out what profit the business has made according to the true accountancy practice.

While the commercial accounting principles do form the basis of computing profits for tax purposes, the law-makers have a variety of agenda to be achieved through the Income-tax Act for which purpose, the commercial accounting principles are either given a complete go-bye or are somewhat modified or deviated from. Objectives of such deviations could be either simplification of the tax law or provision of incentives for economic development or just as a measure of ensuring effective revenue collection or check evasion. The objective of simplification is achieved by — for example — enacting provisions for presumptive taxation. This involves computing taxable income as a percentage of, say, gross revenues or some other quantitative measure like tonnage capacity in case of ships or number of trucks in case of small transport operators, etc. The objectives of incentives for economic development may involve creation of special-purpose statutory reserves (like SEZ Reserve or erstwhile Investment Allowance Reserve) that are otherwise not required under commercial accounting principles. Similarly, the objective of ensuring effective revenue collections is achieved by, say, allowing deduction for statutory liabilities only on actual payments, irrespective of whether the taxpayer follows mercantile or cash method of accounting. The exercise in computation of taxable income, thus, essentially involves sound knowledge of :

• Commercial accounting principles that form the basis for computation of profits; and

• The provisions of the law that require deviation from such commercial accounting principles or may just provide for artificial formulae in computing taxable profits.

S. 145 of the Act provides that income chargeable under the head ‘Profits and gains of business or profession’ or ‘Income from other sources’ be computed in accordance with either cash or mercantile system of accounting regularly employed by the taxpayer. It empowers the Central Government to notify accounting standards to be followed for computing such profits. Pursuant to the said powers, the Central Government has notified two accounting standards (AS), one of which needs to be mentioned here. The notified AS defines ‘Accounting Policies’ to mean the specific accounting principles and the methods of applying those principles adopted by the assessee in the preparation and presentation of financial statements. It further provides that the Accounting Policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business, profession or vocation in the financial statements prepared and presented on the basis of such accounting policies. For this purpose, the major considerations governing the selection and application of accounting policies are the following, namely :

The notified AS provides that ‘Accrual’, ‘Going Concern’ and ‘Consistency’ are the fundamental accounting assumptions in preparation and presentation of accounts. If these are not followed, a specific note is required. These terms are defined as follows :

‘Accrual’ refers to the assumption that revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate;

‘Consistency’ refers to the assumption that accounting policies are consistent from one period to another;

‘Going concern’ refers to the assumption that the assessee has neither the intention nor the necessity of liquidation or of curtailing materially the scale of the business, profession or vocation and intends to continue his business, profession or vocation for the foreseeable future.

There seems to be a significant convergence between the major considerations and fundamental assumptions as laid down in the CBDT-notified AS and the AS issued by the Institute of Chartered Accountants of India (ICAI), the apex accounting body in the country. Some differences, however, that are significant are discussed subsequently at appropriate places.

The accounting consideration of Prudence is adopted and recognised in several tax cases. A prominent illustration is where Courts have held that the closing stock ought to be valued at cost or market price whichever is lower3. Courts have also held in favour of providing for actuarially valued liabilities, though the amount cannot be determined with certainty and represents a best estimate in the light of available information.4 There are, however, conflicts on the aspect of point of accrual to which we shall refer a little later.

The consideration of Substance over form has been a major area of tax disputes for ages and the Courts have generally leaned in favour of substance rather than form5, though earlier there have been some exceptions6. In fact, the Courts have held that the accounting entries, though are indicative of the nature of the transaction, they are not decisive of the true legal character thereof 7. This is a classic tax law principle that demonstrates convergence within divergence.

The accounting assumption of Accrual essentially means that if accounts are not prepared on Accrual basis, appropriate disclosures should be made. The Companies Act was amended in 1988 so as to make Accrual as the method of accounting compulsory for all Companies. S. 145 of the IT Act permits cash and mercantile methods of accounting. There is an age-old fight between the accounting concept of accrual and the tax concept of accrual. While the accounting concept refers to matching of costs and revenues, the tax law concept refers to ‘vesting of right to receive’8 so far as income accrual is concerned and it refers to incurring or crystallising of the liability9 so far as the expense accrual is concerned. One of the recent exceptions is the decision of the Supreme Court in Madras Industrial Investment Corporation v. CIT, (1997) 225 ITR 802 (SC) wherein the Apex Court held that "ordinarily revenue expenditure which is incurred wholly and exclusively for the purposes of business must be allowed in its entirety in the year in which it is incurred.

It cannot be spread over a number of years even if the assessee has written it off in his books over a period of years. However, the facts may justify an assessee who has incurred expenditure in a particular year to spread and claim it over a period of ensuing years. In fact, allowing the entire expenditure in one year might give a very distorted picture of the profits of a particular year".

Saying so, the Supreme Court held that discount on issue of debentures is an instance where although the assessee has incurred the liability to pay the discount in the year of issue of debentures, the payment is to secure a benefit over a number of years and the liability should, therefore, be spread over the period of debentures. This is a classic case of convergence of accounting accrual with the tax accrual. Yet another illustration is the decision of the Supreme Court in the case of Bharat Earth Movers v. CIT, (2000) 245 ITR 428 (SC) wherein the Apex Court held that even if the liability to pay leave encashment to employees is not due but it has definitely accrued (which is asserted by actuarial evaluation of the liability), it should be held as allowable for tax purposes.

Although such instances seem to suggest the same direction of accounting and tax accrual, still lot of ground needs to be covered for achieving convergence. For instance, when a bank does not recognise revenues in respect of interest on sticky advances, the Tax Department still contends that income has accrued, though not recognised in the books. The Supreme Court held, in the case of State Bank of Tranvancore v. CIT, (1990) 186 ITR 187 (SC) that where interest on doubtful advances though not credited to the profit and loss account but credited to interest suspense account should be regarded as accrued and taxed accordingly.

This view was once again reiterated in Kerala Financial Corporation v. CIT, (1994) 210 ITR 129 (SC). There is thus a marked conflict between the accounting theory for revenue recognition and the tax law theory. This seems evident from an apparent difference between the understanding of the accounting consideration of Prudence under the ICAI Standard and the CBDT Standard. While the former specifically includes "In view of the uncertainty attached to future events, profits are not anticipated but recognised only when realised though not necessarily in cash", the latter is conspicuously silent on this aspect of Prudence.

In the context of NBFCs, the Tribunal held, in some cases10, that provisions made as per prudential norms ought to be allowed for tax purposes independent of the provisions of S. 36, while it held in some other cases11 that such provisions can be allowed only if they fall within the specific provisions of the IT Act and not otherwise. The Kolkata High Court has recently upheld the former view in the case of CIT v. Brabourne Investment Ltd., (ITA No. 333 of 2007). One doesn’t know the fate of this conflict if and when it reaches the Apex Court. But the point to be noted is that in the areas of revenue recognition and provisioning, the accounting and tax law concepts of Accrual have a long way to travel before a complete convergence is experienced.

Consistency principle finds a very satisfactory convergence in accounting and taxation. Courts have always held that the method of accounting regularly followed by the assessee and accepted in the past ought to be generally accepted12. However, in CIT v. British Paints India Ltd., (1991) 188 ITR 44 (SC) the Apex Court held that even though the Tax Department has accepted for past several years the assessee’s method of valuing closing stock of finished goods only at the cost of raw material and totally excluding overheads, the Tax Department was entitled to reject such method and require the valuation on the basis of raw material cost plus overheads. In this case the Court deviated from the principle of consistency, only because the method consistency followed was a wrong method of valuation not recognised even under the accounting theory. Barring such cases, the Courts have always held that though the concept of res judicata does not apply to tax cases, the rule of consistency does apply and hence if the facts and the law remain the same, the Tax Department should not take different views on the same subject matter in different years13. Courts have also held that when a change in method of accounting (e.g., stock valuation) is bona fide (i.e., more appropriate or required due to change in law) such change should be permitted for tax purposes, but the taxpayer should thereafter consistently follow the changed method14.

Going Concern assumption follows one set of rules for accounting and if the enterprise is under liquidation, the accounting rules change. This is recognised even for tax law purposes when the Supreme Court held, in the case of A.L.A. Firm v. CIT, (1991) 189 ITR 285 (SC) that "the principle of valuing closing stock of business at cost or market value whichever is lower is a principle that would hold good only so long as there is a continuing business and that where the business is discontinued, whether on account of dissolution or closure or otherwise by the assessee, then the profits cannot be ascertained except by taking the closing stock at market value. The assets have to be valued on the basis of the market value on the date of dissolution". There is thus a significant convergence as regards this concept from accounting and taxation perspectives.

While the above provides a bird’s-eye view of the fundamental or directional issues, the nitty-gritties and nuts and bolts issues are far too many and a lot needs to be done for resolving them if the desire is to achieve substantial convergence between accounting and taxation and thereby minimise tax litigation at least on this aspect. For achieving convergence between the Accounting Standards issued by the ICAI and the Accounting Standards required to be followed under the Companies Act, initially S. 211(3C) was enacted in the Companies Act in 1999 and today we have Companies (Accounting Standard) Rules, 2006. However, convergence for tax purposes has a long way to go. This article is not aimed at discussing right v. wrong, but the purpose is to have a glimpse of some of the major areas of conflicts and open up a discussion as regards the way forward to achieve convergence. Readers may take note of these and many other areas of conflict between accounting principles and taxation.

• Income earned during the period of construction of a project by an entrepreneur goes to reduce the cost of the project as per well-established accounting principles. However, the Apex Court held in the case of Tuticorin Alkali Chemicals & Fertilizers Ltd. v. CIT, (1997) 227 ITR 172 (SC) that certain income ought to be taxed as income from other sources. Though in certain subsequent decisions15, this decision has been explained and distinguished and the effect thereof is to a great extent diluted in respect of income that can be regarded as inextricably linked to the setting up of the project, the basic rationale — that commercially speaking, investment of temporary surplus funds go to reduce the cost of the project — which forms the basis of the accounting treatment remains disapproved and hence unrecognised for taxation purposes.

• AS-2 of ICAI requires valuation of costs of purchases at a price including duties and taxes ‘other than those subsequently recoverable by the enterprise from the taxing authorities’. As against this, S. 145A of the Income-tax Act requires valuation of purchases, sales and inventories inclusive of duties and taxes paid ‘notwithstanding any right arising as a consequence to such payment’. Thus, the ICAI Standard recommends exclusive method, while the tax law requires inclusive method. A predominant legal view16 is that both the methods result in the same profits. However, the issue has been a subject matter of immense tax litigation.

• AS-11 requires recognition of exchange differences in variety of situations. Year-end recognition of such exchange differences debited or credited to the profit and loss account have been a subject matter of litigation. Questions have arisen whether such debits are allowable for tax purposes or not. Fundamental principles were laid down by the Supreme Court in Sutlej Cotton Mills v. CIT, (1978) 116 ITR 1 (SC) to decide when the exchange loss can be treated as capital and when revenue. However, the controversy takes new dimensions with every different case. The Delhi High Court in a recent decision in CIT v. Woodward Governor India P. Ltd., (2007) 162 Taxman 60 (Del) held that "judicially accepted position appears to be that in determining whether there has in fact been accrual of liability or income, the accountancy standards prescribed by the ICAI would have to be followed and applied". In so deciding, the Delhi High Court took into consideration the various important aspects of AS-11. On the other hand, the Uttarakhand High Court, in CIT v. ONGC, (2008) 301 ITR 415 (Utt) has held that the foreign exchange loss claimed by the assessee on revenue account on accrual basis on account of foreign exchange fluctuation on the last day of the accounting year was only a contingent and notional liability, and did not crystallise or accrue in the year under consideration and hence was held as not allowable. On a plain reading of the judgment, one finds that there is no discussion at all on AS-11 and its requirements. Poor taxpayer is at a complete loss as to what the correct position in law is on the subject.

• AS-28 provides for impairment of assets and requires recognition for such impairment in certain circumstances. Indeed, the question whether such impairment is allowable for tax purposes or not is something that one may have to reckon with as and when the issue arises.

Article by Yogesh Thar , a renowed Chartered Accountant

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