- The Income Computation and Disclosure Standards (hereinafter ICDS) came into effect on 01 Apr 2015 for the computation of taxable income.
- The ICDS is to be complied with by all ‘persons’ who follow the mercantile system of accounting, from the assessment year 2016-17
- It is a set of ten standards that incorporates various Accounting Standards laid down in Ind-AS. The object is to harmonise the accounting requirements with taxability of an item.
- It is applicable solely for the purpose of computation of income chargeable under the heads of “Profits and gains of business or profession” or “Income from other sources” referred to in Sec 145 of the Income Tax Act, 1961
- In cases of conflict between ICDS and the Income Tax Act, 1961, the latter shall prevail
- It incorporates the concept of ‘Accrual’ as a key element where an income is recognised as it is accrued or earned irrespective of the actual time of receipt of the same.
- ICDS IV that deals with Revenue Recognition is the subject matter of the following discussion
ICDS, Income Tax Act, 1961 and the Constitution
1. Legislative competence
By virtue of Art. 246 of the Constitution, the Parliament (Central Legislature) has exclusive power to enact laws with regard to Income Tax (other than agricultural income). The Income Tax Act, 1961 is the relevant legislation governing tax levy on Income.
The Central Government (Ministry of Finance) has notified the ICDS based on the powers conferred upon it under Sec 145 (2) of the Act. To address the issue of legislative competence to enact ICDS, it is important to review Sec 145 of the Act. It reads as follows:
Method of accounting
(1) Income chargeable under the head “Profits and gains of business or profession” or “Income from other sources” shall, subject to the provisions of sub-section (2), be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee.
(2) The Central Government may notify in the Official Gazette from time to time [accounting standards]to be followed by any class of assessees or in respect of any class of income.
(3) Where the Assessing Officer is not satisfied about the correctness or completeness of the accounts of the assessee, or where the method of accounting provided in sub-section (1) [or accounting standards as notified under sub-section (2), have not been regularly followed by the assessee], the Assessing Officer may make an assessment in the manner provided in Sec 144.
Sec 145 of the Act deals with the method of accounting to be used. It recognises only two forms of accounting system. As per 145 (2) the Central Government is empowered to notify accounting standards to be followed by assessees. ICDS notified under Sec 145(2) is a form of delegated legislation.
With regard to delegated legislations in tax matters, the Supreme Court has granted a broader scope for the Central Government to exercise functions delegated to it by the legislature, in its role as a tax collector.
In Municipal Corporation of Delhi v. Birla Spinning and Weaving Mills Ltd, a 7 Judge bench of the Supreme Court upheld the validity of section 150(1) of the Delhi Municipal Corporation Act, 1957 that allowed the Central Government to decide the maximum rate of tax that could be levied. It was held that when the constitutionality of a delegation is considered, it has to be seen in light of the ‘guideline theory’, which posits that a delegation is permissible, if it is made with sufficient guidelines and policy for the exercise of the power conferred.
In Gwalior Rayon Mills v. Asst. Commissioner of Sales Tax, a 5 Judge SC Bench upheld the validity of the Sec 8(2)(b) of the Central Sales Tax Act, 1956 and reaffirmed the guideline theory that was accepted by the Birla Mills Case. Justice Mathew held that it was not for the Court to ‘hunt for legislative policy or guidance in the crevices of the Statute.’
Hence the notification of ICDS by CBDT is within the scope of legislative competence of the Parliament.
2. Sec 145 of the IT Act and ICDS – machinery or charging provision?
Now the next issue is to do determine the nature of Sec 145 of the IT Act and accounting standards under it. Sec 145 deals primarily with the “method of accounting”. A plain reading of the provision indicates that the object and the purpose of the provision is to ensure that a standard, consistent and appropriate accounting system is to be used by an assessee so as to minimise the possibility of unfair deductions or escaping chargeability under the IT Act. Therefore Sec 145 (and accounting standards) is merely a machinery provision that is to be construed in a way to give effect to the charging provisions of the IT Act.
Sec 4 and Sec 5 of the IT Act are charging provisions. Sec 4 enables levy of tax on the total income of an assessee while Sec 5 deals with the scope of the total income. Sec 5 includes in its scope, accrual of incomes that are chargeable in a particular year of assessment. The word ‘income’ is defined in an inclusive manner under Sec 2(24) of the Act. Sec 5 read with Sec 2(24) requires that an income should accrue for it to be taxable. Sec 145 being a machinery provision is sub-ordinate to the charging provisions under Sec 4 and 5 of the Act. An income that does not accrue as per Sec 5 cannot be made taxable under Sec 145.
The view that Sec 145 is not an assessment section but a machinery section is affirmed by the Supreme Court in CIT vs. Mariappa Gounder; CIT vs. Standard Triumph Motor and State Bank of Travancore vs. CIT. Moreover in Canara Bank vs. JCIT, it was held that the provisions of Sec 145 cannot override Sec 5 of the Act (i.e. charging provision).
3. ‘Real Income’ theory and ICDS IV
Having established that Sec 145 and ICDS are machinery provisions, the next issue is to test whether ICDS IV, the accounting standard that deals with principle of Revenue Recognition for tax purposes is in compliance with the ‘Real Income’ theory laid down by the Supreme Court in several cases.
The ‘Real Income’ theory is the principle that for an Income to be taxable it needs to have actually accrued and not be a hypothetical one. Moreover an income is said to accrue only when there arises a corresponding liability of the other party from whom the income becomes due to pay that amount.
Now moving on to the relevant part of ICDS IV which reads as follows:
D. Income Computation and Disclosure Standard IV relating to revenue recognition
2(1)(a) “Revenue” is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of a person from the sale of goods, from the rendering of services, or from the use by others of the person’s resources yielding interest, royalties or dividends. In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration.
The use of resources by others Yielding Interest, Royalties or Dividends
7. Interest shall accrue on the time basis determined by the amount outstanding and the rate applicable. Discount or premium on debt securities held is treated as though it were accruing over the period to maturity.
ICDS IV requires that an income from debt securities or other interest-bearing instruments need to be recognised on a time basis for the purposes of computation of taxes. So for example, an investor investing in a zero coupon bond that pays a fixed return upon redemption in 2020, the interest income from the bond needs to be computed on an annual basis as if the investor has received a proportional part of the income at the end of every year even though such an income accrues only in 2020.
In purely accounting terms under the mercantile system, income is said to accrue as soon as there is a right to receive a payment/income. However for tax purposes, the legal right to such an income accrues only on the date of redemption [See DIT vs. Credit Suisse First Boston]. The principle behind this is that there is no right to claim that income in law any earlier than the date of redemption.
Therefore ICDS IV is contrary to the ‘real income’ theory and the principle of accrual laid down by the Supreme Court.
4. Test of Constitutionality
For a legislation to be constitutionally valid, it needs to satisfy the following three-tier test:
- It needs to be within the legislative competence of the Central or State Legislature as the case may be
- It should not violate any fundamental rights under Part III of the Constitution
- It should not be in conflict with any other constitutional limitations
We have already established that CBDT’s notification of the ICDS is certainly within the Legislative Competence of the Parliament. There is no constitutional bar for such a notification as the Supreme Court has granted a broad scope for delegated legislation related to tax matters.
With regard to violation of fundamental rights, it is a well-settled principle in Indian Constitutional jurisprudence that under Art. 14 of the Constitution, any State action whether legislative or administrative, shall be free of any arbitrariness. In the absence of any substantive reasoning, ICDS IV mandating the recognition of a fictional income that is contrary to the provisions of the IT Act as well as the accrual principle, is arbitrary and therefore in violation of Part III of the Indian Constitution.
Lastly, as per Article 265 of the Indian Constitution, a tax can be levied only as per authority of law. Therefore there is a constitutional limitation in matters of taxation, that the State cannot levy any charge except by a clear authority of law. The CBDT’s power to issue a notification is to be exercised within the four corners of the legislation governing it. The sub-ordinate legislation under Sec 145(2) (i.e. ICDS) cannot be contrary to any provision in the Act. Moreover ICDS itself recognises that in the event of a conflict between its provisions and the Act, the latter shall prevail. As highlighted earlier, Sec 145 and ICDS are machinery provisions that cannot over-ride the charging provisions under Sec 4 and 5 nor can it add new heads of charging.
There is no constitutional bar on the issue of the ICDS notification as it falls within the legislative competence of the Parliament. However the revenue recognition principle under ICDS IV is contrary to the charging provisions of the IT Act, 1961 and thereby violates Art. 265 of the Constitution, that deals with the authority to levy taxes. Moreover the said provision being contrary to the charging provisions and also the ‘real income’ theory recognised by the Supreme Court, is also arguably arbitrary and thereby falls foul of Article 14 of the Indian Constitution. For the above reasons, ICDS IV regulation would not stand legal scrutiny on the ground that it is contrary to the Constitution and the parent statute.
 Municipal Corporation of Delhi vs. Birla Spinning and Weaving Mills,  3 SCR 251
 Gwalior Rayon Mills vs. Asst. Commissioner of Sales Tax,  94 ITR 204 (SC)
 CIT vs. Mariappa Gounder,  232 ITR 2 (SC)
 CIT vs. Standard Triumph Motor,  201 ITR 391 (SC)
 State Bank of Travancore vs. JCIT,  158 ITR 102 (SC)
 Canara Bank vs. JCIT,  84 ITD 310 (Bang)
 E.D. Sassoon & Co. vs. CIT,  26 ITR 27 (SC); CIT vs. Shoorji Vallabhdas & Co.,  46 ITR 144 (SC); Kedarnath Jute Manufacturing Co. vs. CIT,  82 ITR 363 (SC)
 CIT vs. Excel Industries,  358 ITR 295 (SC)
 DIT vs. Credit Suisse First Boston,  351 ITR 323