27 June 2018

Retention money - Is recognition as contract revenue sufficient to tax it early

by Bharathi Krishnaprasad


The Central Government, in exercise of its powers conferred under the Income tax law[See endnote. 1] notified[See endnote. 2], in September 2016, Income Computation and Disclosure Standards (shortly, ‘ICDS’) that would govern computation of income of an assessee (interchangeably used in this article with ‘taxpayer’) under the head ‘profits or gains from business or profession’ and ‘income from other sources’. The introduction of these standards necessitated a taxpayer to take a fresh look at certain issues that were accepted as setteled long ago. The subsequent move by the taxpayer to knock the doors of a Writ Court was surely anyone’s foretelling and equally prophetic was the taxman’s response in amending the Income Tax Act, 1961 (shortly, IT Act) to bestow a fresh lease of life to the notified ICDS[See endnote. 3] after the ruling of the Hon’ble Delhi High Court[See endnote. 4]. This article takes a look at one such issue, viz., taxability of retention monies aka retentions, that was considered settled and so would it have remained but for the amendment in the IT Act read together with the ICDS.

Retentions, in common parlance, are contractual amounts withheld by a contractee from a contractor, to be paid in future to such contractor only on completion/‘satisfactory’ completion of work undertaken. The general rule of taxability is to tax incomes as and when they ‘accrue’ or ‘arise’ or as and when they are received unless there existed an artificial fiction created under the law deeming such accrual or receipt to have taken place[See endnote. 5]. As per Sampath Iyengar’s ‘Law of Income Tax’[See endnote. 6], the two words i.e, accrue and arise, together mean ‘to become a present and enforceable right’ and ‘to become a present right of demand’ and that ‘both words are used in contra distinction to the word receive and indicate a right to receive’. The Courts also have uniformly opined that for an income, to be considered to have ‘accrued’ in the hands of the assessee, such assessee must have the right to receive the income[See endnote. 7]. In other words, there must be a debt owed by somebody to the assessee and until such a debt is created, it cannot be said that the assessee acquired right to receive the income.[See endnote. 8] Further, merely because entry is made in the book accounts would not in itself, lead to a conclusion that any income had accrued to assessee[See endnote. 9]. Applying these principles to the case of taxing retention monies, the Courts held that the same was not taxable until an assessee had the right to receive the same from the contractee[See endnote. 10].

This settled position of taxing retention monies had to be revisited in the wake of introduction of ICDS. Standard III of ICDS deals with construction contracts. The said ICDS provides that contract revenue shall be recognized when there is reasonable certainty of its ultimate collection[See endnote. 11] and that the contract revenue shall comprise retentions as well[See endnote. 12].  Retentions are defined in the Standard to mean ‘amounts of progress billings which are not paid until the satisfaction of conditions specified in the contract for the payment of such amounts or until defects have been rectified’. The Standard advocates use of percentage completion method for recognizing contract costs and revenues[See endnote. 13] and contract revenue as such is to be recognized when there is a reasonable certainty of its ultimate collection. This inclusion of retention money under contract revenue under ICDS – III was challenged before the Hon’ble Delhi High Court on the ground that such an inclusion was contrary to position taken by Courts in this regard. In its ruling, the Hon’ble High Court held that Paragraph 10 of ICDS – III could not be interpreted in a manner seeking to tax retention monies at an earliest possible stage when the receipt of such sum is uncertain or unconditional. Paragraph 10 of ICDS - III, the Hon’ble High Court opined, did not state the stage at which the retentions need to be aggregated with contract revenue and thus, the settled principles of accrual would still prevail and only upon such retentions accruing to a taxpayer, should they be considered as part of contract revenue.

In an attempt to make the notified ICDS effective even after the Delhi High Court’s ruling, the Finance Act, 2018 made certain amendments in the IT Act which included insertion of a new section that dealt with computation of income from construction and service contracts[See endnote. 14]. The Memorandum explaining the amendments proposed by the Finance Bill, 2018 suggested that these amendments were being made ‘in order to bring certainty in the wake of recent judicial pronouncements on the issue of applicability of ICDS’. Apart from reiterating that percentage completion method was to be followed, the new section also specified that contract revenue shall include retention money. Whether such an amendment is sufficient to tax retention monies even prior to their accrual to the taxpayer is the moot question here.

Neither the Standard nor the IT Act has deemed the time of accrual of retention monies to be in the year in which the related work is completed, notwithstanding the fact that such retentions may be payable at a future date. It is nobody’s dispute that contract revenue would include retention monies. However, the subtle aspect, as the Hon’ble High Court had rightly pointed out is whether such retention money has acquired the character of income and if it so did, only then it would be included as part of contract revenue and not otherwise. In other words, if retentions can be said to be accruing to taxpayer, the extent of such retentions would be added to contract revenue and if there is no such accrual, the retention money component would be zero. The amendment made in the IT Act has merely stated what was already provided in the ICDS-III but interpreting that to tax retentions at a stage anterior to such accrual appears to be contrary to the scope of taxation under the IT Act.  Be that as it may, even under ICDS – III, contract revenue shall be recognized as and when there is reasonable certainty of its ultimate collection. While the term reasonable certainty is not defined in the ICDS, in the context of retention monies, one may argue that there exists a complete uncertainty as to whether a taxpayer would at all be eligible to receive either whole or part of the sum and hence taxing such retentions would therefore tantamount to taxing hypothetical income which is not permissible[See endnote. 15], absent a legal fiction to tax the same.  Thus, depending on the terms of the contract and surrounding facts and circumstances of the case, it may be possible to argue that even after the amendment vide Finance Act, 2018 the retention money does not accrue until the time of its receipt.

[The author is a Principal Associate in Direct Tax Practice in Lakshmikumaran & Sridharan, Chennai]


See endnotes

1. Section 145(2) of the Income Tax Act, 1961
2. S.O.3079 (E) dated 29th September, 2016
3. Certain amendments were made vide Finance Act, 2018 to address the findings of the Hon’ble Delhi High Court.
4. Chamber of Tax Consultants v. UoI [2017] 299 CTR 137 (Del)
5. CIT v. A. Ganapathi Raju [1964] 53 ITR 114 (SC)
6. Sampath Iyengar’s Law of Income Tax, 11th Edition
7. CIT v. Govind Prasad Babu Nath [1987] 35 Taxman 513 (Cal)
8. Anup Engineering v CIT [2013] 33 taxmann.com 139 (Guj)
9. CIT v. Shoorji Vallabhdas & Co [1962] 46 ITR 144 (SC), Godhra Electric Company Limited v. CIT [1997] 139 CTR 564 (SC)
10. CIT v. Simplex Concrete Piles India P Ltd [1989] 45 Taxman 370 (Cal) Anup Engineering v CIT [2013] 33 taxmann.com 139 (Guj)
11. Paragraph 9 of ICDS III on Construction Contracts.
12. Paragraph 10 of ICDS III on Construction Contracts.
13. Paragraph 16 and 17 of ICDS III on Construction Contracts.
14. Section 43CB of the Income Tax Act, 1961
15. CIT v. Excel Industries Limited [2013] 358 ITR 295 (SC); CIT v. Bokaro Steel Limited [1999] 151 CTR 276 (SC)


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