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T. C. A. Ramanujam

T. C. A. Ramanujam on the problems in determining taxable profits for turnkey projects

A REAL-ESTATE developer took up both big and small contracts. While the smaller contracts were usually completed within a year, the bigger ones took many more years. No day-to-day accounts were maintained and so the assessing officer (AO) resorted to estimating profits.

The Tribunal directed the assessing authority to determine the profit only on the year of completion of the project. The Income-Tax (I-T) Department went in reference before the Madras High Court.

The matter involved the principles of accounting. Accounting Standard (AS) 7, issued by the Institute of Chartered Accountants of India (ICAI), permits an assessee to assess profits after completion of a contract.

The method of accounting for profits in turnkey projects, on completion of the contract, is well known in accountancy. Nevertheless, such a system apparently flies in the face of the principle of annual accounts and assessment for every assessment year.

The Revenue relied on the Delhi High Court ruling in Tirath Ram Ahuja (P) Ltd vs CIT (103 ITR 15), wherein it was held that in the case of incomplete contracts it was not necessary to wait till the contract was completed in order to ascertain the income and that it was open to the Revenue to estimate the profit on the basis of the receipts in each year of construction, although the contract was not complete.

In that case also, the contract spilled over from one year to another.

The Delhi High Court referred to the old case of Sri Sukhdeodas Jalan vs CIT (26 ITR 617 Patna) and pointed out that merely because the contract was completed after the accounting period, it could not be presumed that no profits arose or accrued to the assessee in the accounting year and that, in the case of an incomplete contract, there is a well-established method of calculating profits accruing in the accounting year, as indicated in Batliboi's Advance Accounting.

The Delhi High Court's view was approved by the Supreme Court in Tirath Ram Ahuja (P) Ltd vs CIT (186 ITR 428).

The Madras High Court noted that the contractor did not have proper accounts and, in the absence of these, the authorities were bound to follow the accepted method of calculating the profits on an yearly basis.

It ruled that, going by the facts of the case, it would not be correct to introduce the method of calculating the profits only after the completion of the contract (123 Taxman 781).

The principles of accountancy recognise assessment of profits on the basis of the system of completed contracts. There is a difference between the English and the Indian laws with regard to taxation based on accounting principles.English courts have always taken the view that book-keeping entries cannot alter the rights of the Crown.

The liabilities of the company can never be made dependent solely on its system of accounts.

According to English courts, where the running contract is spread over several years, profits should be apportioned over each year on the best data available. However, where the transaction is treated as a single venture, the ITO will be justified in holding that the income accrued in the last year (Chinnathambi Rowther vs CIT Madras (99 ITR 490 at 494).

The problem in ascertaining profits in works contract running over several years relates mainly to the valuation of work in progress.

In the `direct cost method' of valuation, the cost of contract materials used and the wages of labour directly employed alone are taken into account.

In the `on cost method', a proportion of indirect expenditure, such as factory and office expenditure, will be added to the direct cost. The House of Lords approved both these methods as correct in Duple Motor Bodies Ltd vs Inland Revenue Commissioner (39 Tax Cases 537 HL).

Section 145 of the I-T Act, 1961 was recast by the Finance Act, 1995 with effect from April 1, 1997. The Central Government, from time to time, was enabled to notify in the Official Gazette the accounting standards to be followed by any class of assesses or in respect of any class of income.

The Government issued a notification (SO 69(E) dated January 25, 1996) making it mandatory for all assessees following the mercantile system of accounting to obey AS 1 relating to the disclosure of significant accounting policies adopted in the preparation and presentation of financial statements.

Assessees are now required to specify accounting principles and the methods of applying these in the preparation of financial statements. Six years have gone by and no other standards have been prescribed. The work done by the ICAI in this regard is also incomplete.

In the mean time, the Supreme Court has pronounced judgments recognising the value of accounting principles in evaluating the provisions of law.

The world over, the focus has now shifted to the way accounts are made up and there is a crying need for transparency in the preparation and finalisation of accounts.

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