ICDS on Real Estate Transactions
The 10 Income Computation and Disclosure Standards (‘ICDS’) notified by the Central Board of Direct Taxes (‘CDBT’)in September 2016 created a debate on applicability thereof, especially ICDS III and ICDS IV to real estate transactions. Finally, the CBDT issued draft ICDS on Real Estate Transactions on 11 May 2017 (‘RETICDS).
RETICDS is based on Guidance Note on Real Estate Transactions (‘GN on RET’) issued by the ICAI except for certain deviations namely adopting fair value for recording Transferable Development Rights (‘TDR’)which are acquired by giving up interest in land, omission of criteria of receipt of critical approvals for application of percentage of completion method (‘POCM’), definition of project and project cost, etc. Many of these deviations could have an impact of higher revenue recognition for tax purposes as compared to books of account and consequential higher tax outflow.
RETICDS applies to all forms of transactions in real estate like sale of plot of land including long term leases, development and sale of residential and commercial apartments, acquisition and transfer of development rights, redevelopment projects, Joint development arrangements (‘JDAs’), sale of TDR, etc.
Recognition of revenue and cost
RETICDS requires application of the POCM for recognition of project revenue and project cost where the economic substance is similar to construction contracts, whichis to be determined based on various parameters viz. the duration of project is beyond 12 months and project commencement and completion date fall into different previous years, project involves substantial construction activities, etc.
If transactions and activities in substance are not similar to construction contracts but akin to delivery of goods, provisions of ICDS IV on revenue recognition shall apply wherein revenue is to be recognized at the time of transfer of significant risks and rewards of ownership to the buyer. Thus, it is vital to determine whether economic substance of a real estate project is similar to construction contract or delivery of goods and accordingly, whether such transactions shall be covered by the RETICDS or ICDS IV.
Since no specific method was prescribed under the Income-tax Act (‘Act’), many developers have been following project completion method (PCM) for computation of taxable profits although POCM has been followed in their books of account and such treatment has been upheld in number of judicial precedents.
With RETICDS requiring following POCM where economic substance of real estate transaction is akin to construction contract, the option to follow PCM for computing taxable profits shall no more be available to developers. Thus the computation of taxable profit under POCM could trigger early payment of taxes under normal provisions of Act and could have an adverse impact on cash flows of the developer.
Further, the computation of POCM under RETICDS does not include land cost unlike the RERA provisions, which include land cost to work out POCM and withdrawals from the specific bank account.
Concern Areas and suggestions
Projects under ‘build to lease’ model: Constructive reading of RETICDS does not apply projects under‘built to lease’ model which typically include developing and leasing of malls, IT Parks, SEZs, commercial premises etc., and accordingly, income from such projects would need to be computed as per ICDS IV on revenue recognition.
As a result the controversy will continue whether the lease charges on leasing of such premises is taxable as Business Income or Income from House Property (‘IFHP’). Developers will have to take calls based on conflicting rulings of CIT vs. Shambhu Investment Pvt. Ltd (263 ITR 143)(SC)wherein the Court held that such lease rentals are as IFHP and Chennai Properties & Investments Ltd. vs. CIT (373 ITR 673) holding that such lease charges are taxable as Business Income.In order to remove this controversy and avoid potential litigation the CBDT should provide timely clarity on applicability of ICDS to such lease transactions.
JDA arrangements: RETICDS certainly applies to Developer under JDA transaction, but it’s applicability to land owners would depend upon nature of asset held by land owner, construct and terms of JDA, roles and responsibilities of the parties, etc.
If the land parcel transacted under JDA is held as a capital asset, then provisions of the RETICDS should not apply and instead provisions of section 45 of the Act shall apply. Contrarily, if land is held as a stock-in-trade and land owner takes active participation in the development activities like obtaining approvals, supervision and project monitoring, etc., in that case RETICDS on RET could be applied for such land owner requiring him to follow POCM for computing Business Income. The stage of completion of work for POCM as applicable to developers should equally apply to land owners. I highly recommend that CBDT should issue appropriate clarifications on these issues on priority basis.
Deductibility of Interest expense: Para 2(1)(c)(A) of RETICDS defines ‘Project Cost’ to include borrowing cost incurred directly in relation to a project or apportioned in accordance with ICDS IX. Such borrowing cost needs to be inventorised based on the nature of borrowings. In case of specified -, from the date of borrowing and in case of general – from utilization date.
Whereas, section 36(1)(iii) of the Act clearly provides that such borrowing cost is deductible business expense in the year of incurrence except where funds are utilized for acquiring/constructing capital asset. In that case only, interest is to be capitalised till the asset is first put to use. This section does not take into account the nature & purpose of borrowings, period of development of inventory, etc. This principle has been approved by various Courts in
- CIT vs. Lokhandwala Construction Industries Ltd. (260 ITR 579) (Bombay HC)
- Cellice Developers Pvt Ltd in (231 Taxman 255) (Calcutta High Court)
- India Cements vs. CIT (60 ITR 52) (Supreme Court)
As per ICDS and as clarified by the CBDT, in case of conflict between provisions of the Act and ICDS, provisions of the Act shall prevail. Accordingly, following provisions of section 36(1)(iii) of the Act, borrowing cost should be deductible in the year of incurrence. However, the Revenue Authorities, bound by the CBDT instructions, could follow RETICDS religiously and create dispute resulting in huge tax demand. The CBDT should provide appropriate clarifications in this regard on priority basis to avoid any potential litigation.
Transition Provisions: RETICDS provides grandfathering to projects commenced before 01 April 201X, wherein project revenue and cost could be recognized as per the method regularly followed prior to 01 April 201X i.e. as per POCM or as per PCM. However, it is pertinent to note that the word ‘commence’ has not been defined in the draft ICDS on RET.
In order to avoid litigation, it would be relevant to clarify when a project could be said to be commenced, whether upon filing of application before authorities for the approvals or purchase of land or signing of JDA, or receipt of Intimation of disapproval (‘IOD’) in case of greenfield projects or redevelopment projects or receipt of Letter of Intent (‘LOI’) in case of Slum Rehabilitation projects, etc.
RETICDS provides much needed clarity, certainty and uniformity in the tax treatment of various real estate transactions.The issues like its applicability to transactions of long term leasing of plot of lands, taxability of TDR received in exchange of land or existing structure, etc. needs to be addressed.