26 September 2017

Inventory valuation caught in the web of ICDS, IndAS and settled jurisprudence!

Valuation of inventory is not supposed to give rise to any income and therefore the same should be at lower of cost or market value, as held Apex Court in a landmark decision [see End Note 1].  However, with changing accounting and tax regulations, the old age principles need to be revisited.

Section 5(1) of the Income-tax Act, 1961 (‘the IT Act’) provides that the total income of a person would include all sums that inter alia accrue or arise to him.  Section 14 of the IT Act provides that the income so accruing shall be classified under different heads of income, including ‘profits and gains of business or profession’ of a person and ‘income from other sources’.  Section 145(1) of the IT Act provides that the income chargeable under the above referred heads of income shall be computed in accordance with either cash or mercantile system of accounting which is regularly employed by the assessee. Section 145(2) of the IT Act further provides that the Central Government may notify Income Computation and Disclosure Standards (‘ICDS’) to be followed in computing the income taxable under the above referred heads of income. 

The Central Government vide a notification [see End Note 2] has notified 10 ICDS , effective financial year 2016-17, to be followed by all assessees other than individual and HUF who  is not required to get his accounts of the previous year audited in accordance with the provisions of section 44AB of the said Act) following the mercantile system of accounting, for the purposes of computation of income chargeable to income-tax under the head “Profits and gains of business or profession” or “Income from other sources”.  One such standard, ICDS-II, relates to method to be adopted for determining the value of stock in trade of any business (‘inventories’).  This write up discusses a few issues that arise in relation to ICDS II on valuation of inventory.

Even before specific Standards for Accounting were formally prescribed by any governing body, it was a well-established principle of commercial accounting that, the value of the stock in hand at the beginning and at the end of the accounting year should be recorded at ‘cost’ or ‘market value’, whichever is lower.  This is an exception to the general rule that a precautionary reserve for anticipated loss is not allowable and no unrealised loss can be set-off against the profits of the accounting period.  This accounting principle has historically been accepted in determining taxable profits as well [see End Note 3], although there is nothing about this in the taxing statutes [see End Note 4].


(i)   Validity of ICDS II vis-à-vis Ind-AS 2 read with Section 145A of the IT Act

1.      Section 145A of the IT Act was introduced by the Finance (No.2) Act, 1998 and came into force from A.Y. 1999-2000. This section inter alia provides that, not withstanding anything contained in Section 145 of the IT Act (under which ICDS has been prescribed),  purchase, sales and inventory shall be valued in in accordance with the method of accounting regularly employed by tax payer.  The Ministry of Corporate Affairs, in exercise of powers conferred under Section 133 and 459 of the Companies Act, 2013, notified the Companies (Indian Accounting Standard), Rules, 2015 which inter alia required companies to mandatorily maintain their books of accounts as per the ‘Ind-AS’ prescribed therein.  In other words, Ind-AS requires companies to maintain their books of accounts, inter alia, in relation to valuation of stock in trade, as per Ind-AS 2 notified by the Central Government. 
2.      A combined reading of Section 145A of the IT Act read with the Companies (Indian Accounting Standard), Rules, 2015 clearly shows that any rule made under Section 145 of the IT Act, including ICDS, cannot have a overriding effect on the method of accounting adopted by the tax payer, i.e. Ind-AS.  In other words, the scheme of ICDS, in so far as it is contrary not only to the IT Act, but also to Ind-AS on valuation of inventory, would be in contradiction to Section 145A of the IT Act, and hence invalid. 
3.      A few such deviations prescribed in ICDS II which are contrary to Ind-AS 2 include the following,


a.      Ind-AS 2 (in para 11) requires the cost of purchase of inventory to include only those taxes that are subsequently not recoverable by the entity from the taxing authorities (taxes for which credit is not available).  On the other hand, ICDS II (in para 5) requires cost of purchases to include all duties and taxes, irrespective of availability of credit for such taxes paid. However as this requirement of ICDS II is in conformity with section 145A, the same does not pose any challenge from income tax perspective.
b.      Ind AS 2 read with Ind AS 23 on borrowing cost provides that interest cost incurred on assets that take a ‘substantial period’ of time to bring them into existence shall alone be added to the cost of the inventory.  On the other hand, ICDS II (para 11) provides that any interest cost incurred towards an asset taking more than 12 months time to bring into existence shall be added to the cost of the asset and shall not be allowable as revenue expenditure. 
c.       While Ind AS 2 (para 25) provides an option to a company to follow either First-in-First-Out method or weighted average method for determining value of inventory, ICDS II (para 16) restricts the method to the one that would reflect the fairest possible approximation to the cost incurred on the inventory.  What is ‘fair’ approximation is a subjective and would lead to unwarranted litigation.  


(ii) Valuation of closing stock of service industry

The phrase ‘closing stock’ has traditionally been associated only with tangible goods in a manufacturing or trading business.  However, even with the significant contribution of service industry to the Indian economy [see End Note 5], adaptation of the concept of ‘inventory’ to service sector has not achieved much traction.  Though there exists a presumption (even amongst the judiciary) that a tax payer engaged in rendering services could not recognise ‘inventory’ in its books of accounts [see End Note 6], in practice, many IT and ITES businesses (as in other similar businesses) where contract terms provides for billing on a milestone basis, i.e. billing based on achieving a pre-designated milestone, costs incurred under such contracts are regarded as ‘closing stock’ and carried over to next year as such.
Neither Ind-AS 2 nor ICDS II specifically address the question of valuation of such service providers.  The definition of ‘inventories’ does not indicate as to whether the unbilled services of a service provides would be regarded as an ‘asset’ held for sale in the ordinary course of business.  However, the standards deal with certain isolated aspects of valuation of stock held by service providers.  While ICDS-II in para 6 explains as to what would constitute the ‘cost of services’, there is nothing to indicate as to how ‘Net Realisable Value’ of such stock has to be recognised.  To the contrary, while Ind-AS (in para 31) indicates how ‘Net Realisable Value’ for a service contract has to be recognised, it is silent about the determination of the cost of such services.  Interestingly, Ind-AS II which contemplates to adopt the international accounting practices, has intentionally omitted para 19 of International Accounting Standard 2 which deals with valuation of inventory by a service provider.  The position for tax purposes can be largely resolved by referring to ICDS III & IV which collectively prescribe Percentage of Completion Method (PoCM) for recognising revenue by Service Providers.  In essence, except at initial states of the contract (not beyond 25% of the stage of completion) where the outcome of the contract cannot be reliably estimated the service providers need to recognise revenue based on percentage of work completed as per methodology prescribed.  This in effect means that not only an inventory is (indirectly) recognised, the same will usually be above cost (assuming the contract to be profitable)


(iii)  Non-taxable, notional and hypothetical items being treated as income

As noted in the beginning, the Supreme Court in Chainrup Sampatram [see End Note 7] held that no taxable gains arises from the valuation of stock in trade at the end of the year and hence, stock in trade has to be valued in the books of accounts at cost or market value, whichever is lower.  The Supreme Court in ALA Firm [see End Note 8] held that the principle laid down in Chainrup Sampatram (supra) will hold good only for assessees who are carrying on their business as a going concern, but not to assessees who have dis-continued their business and are in the process of liquidation.  For the latter case, the Supreme Court held that the stock in trade has to be valued at the market value for determining the taxable profits of the liquidating firm.
This preposition was latter explained by the Supreme court in Sakthi Trading  [see End Note 9], wherein it was held that the principle laid down in ALA Firm (supra) would not apply to businesses that are succeeded by another person.  The Supreme Court held that “on no principle can one justify the valuation of the closing stock at a market value higher than cost as that will result in the taxation of notional profits the assessee has not realised”.  However ICDS II (para 24) mandates that in case of a dissolution of a firm or association of persons the inventory on the date of dissolution has to be valued at net realisable value, whether the business is discontinued or not.
When the Supreme Court has categorically held that no taxable income arises on succession of business due to revaluation of stock, it is no doubt true that the Legislature is free to amend the definition of ‘income’ to include such notional profits as taxable income.  The Legislature may also be competent to delegate the power to notify the items that would be regarded as ‘income’ for the purpose of the IT Act to the Central Government, and if, upon exercise of such power the Central Government notifies revaluation of stock to be regarded as ‘income’, no challenge could possibly arise on the exercise of power by the Central Government.  
However, under the power vested to notify Accounting Standards for the purpose of computing tax liability of an assessee engaged in carrying on business or profession, the Central Government has, by notifying ICDS II (para 24) requires the assessee to account as income, any increase in the market value of closing stock, if the business of the assessee is succeeded by another assessee. In some sense the rule in ICDS II goes beyond the avowed scope of ‘computing’ the income and extends to ‘treating’ something as income when there exists none.
It is true that the Legislature can expand the scope of meaning of income by including within its definition, which naturally cannot be treated as ‘income’.  However, such exercise can only be done by the Parliament [see End Note 10], or at best, by the delegated authority, if such power is delegated by the Parliament [see End Note 11].  However, where the delegation of power by the Parliament to the Central Government is restricted to framing of ICDS, in the opinion of the author, expansion of the scope of income in the garb of framing rules for the purpose of computation of ‘income’ would be read down by the Courts.  A challenge to ICDS as a whole as well as on specific standards is pending before the Hon’ble Delhi High Court [see End Note 12].
[The author is a Joint Partner, Direct Tax Practice, Lakshmikumaran & Sridharan, Mumbai]

End Notes: 

1. Chainrup Sampatram v. CIT, [1953] 24 ITR 481 (SC)
2. Notification No 87/2016 dated 29th September, 2016
3. Kikabhai Premchand v. CIT, [1953] 24 ITR 506 (SC)
4. Whimster & Co. v. IRC, [1925] 12 TC 813
5. World Bank estimates service sector to contribute 53.8% of Gross Value Addition to India’s GDP (https://data.worldbank.org/indicator/NV.SRV.TETC.ZS), accessed on 19th September, 2017
6. ACIT v. Curam Software International (P.) Ltd., [[2017] 82 taxmann.com 465 (Bangalore - Trib.)]
7. Chainrup Sampatram v. CIT, [1953] 24 ITR 481 (SC)
8. ALA Firm v. CIT, [1991] 189 ITR 285 (SC)
9. Sakthi Trading v. CIT, [2001] 250 ITR 871 (SC)
10. Navnitlal C. Javeri v. K.K.Sen, AAC, [1965] 56 ITR 198 (SC).
11. Tata Tea Ltd. v. State of W.B, [1988] 173 ITR 18
12. The Chamber of Tax Consultants v UOI, W.P.(C) 5595/2017



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