Convergence – Divergence? The Evolving Relationship Between Direct and Indirect Taxes in India – Part 2 – Inventories
In Part 1, the author of the article has dealt with aspects of revenue recognition. In this article, the author has dealt with Convergence-Divergence? The Evolving Relationship Between Direct and Indirect Taxes in India” vis-à-vis Inventories.
Financial statements are considered a reflection and barometer of business enterprises’ performance. They ensure compliance with complex legal frameworks, including Generally Accepted Accounting Principles (GAAP), Accounting Standards (AS), Indian Accounting Standards (Ind AS), Auditing Standards (Statements of Auditing), and Direct and Indirect Tax Laws, while leveraging modern technological advancements. All financial statements are prepared following various allied laws, such as Corporate Laws, Customs Acts, Contract Acts, Sale of Goods Acts, Factories and Establishment Acts, Stamp Duty Laws, Evidence Laws, Digital Laws, the Prevention of Money Laundering Act, the Benami Property Act, the Legal Metrology Act, FEMA, Local Laws, and others.
Various stakeholders utilise financial statements to derive valuable insights regarding enterprise value and intrinsic value and key financial metrics such as EBITDA, ROC, ROCE, CAGR, PEG, NCF, margin trends, ratio analysis, PE ratio, dividend yield, and other indicators. These metrics are often compared with industry peers to assess the company’s financial health and performance. Tax authorities also conduct similar analyses to evaluate the disclosures in audited financial statements. While listed companies publish their financial statements publicly, unlisted and closely held companies do not. With technological advancements, financial data and records reported under statutory and regulatory frameworks are now seamlessly shared among tax authorities. This enables them to review and examine potential revenue leakages in real-time—at speed comparable to light.
In this article, the author explores key aspects of Direct and Indirect Taxes under the Income Tax Act 1961, and the Goods and Services Tax (GST) Act 2017, respectively. These tax laws are fundamentally applicable to every enterprise, depending on its size, volume, and the nature of its business activities. When analysing the application of direct and indirect tax laws, they can be metaphorically compared to the **two poles—North and South—**, raising the question of whether they share any similarities or are entirely distinct. The core issue to examine is whether a meaningful comparison exists between Direct Tax Laws, which have evolved and stabilised over nearly a century, and Indirect Tax Laws, which remain in a nascent stage of development, having been in effect for just about seven years. The implementation of each tax law has significant ramifications on working capital management and the overall regulatory taxation framework. This becomes particularly crucial in an era where regulatory authorities are leveraging data-sharing mechanisms and digital reporting systems, ensuring that all stakeholders remain duty-bound to comply with evolving tax regulations.
In this article, the author has attempted to explore complementary or completely opposing perspectives by examining aspects such as revenue recognition of revenues and expenditures, inventories, capital expenditures (Capex), and related party transactions.
All readers would agree that conducting business within India or internationally has become akin to solving a jigsaw puzzle of multiple regulatory compliances. This means that before executing any transaction, one must carefully evaluate all applicable regulations to arrive at a validated conclusion for the execution of economic business transactions. With the continuous growth of trade, commerce, and industry, regulatory compliance requirements are expected to increase multifold, further emphasising the need for meticulous adherence to legal and financial frameworks.
The article has been crafted to discuss broadly Direct and Indirect Tax Regime provisions with a broad framework:
- Revenue Recognitions – Revenues – Toplines
- Inventories
- Revenue Recognitions – Expenditure
- Capex
- Related Party Transactions
Part 2- Inventories
The Dictionary meaning of inventory as per Merriam Webster Dictionary is as follows:
1.
A: an itemised list of current assets, such as
(1) a list of goods on hand
(2) a catalogue of the property of an individual or estate
B: a list of traits, preferences, attitudes, interests, or abilities used to evaluate personal characteristics or skills
C: a survey of natural resources
2. the quantity of goods or materials on hand: Stock
3. the act or process of taking an inventory
Inventory is the term used to refer to the goods available for sale and the raw materials used to manufacture products for sale. Inventory is one of a company’s most valuable assets since inventory turnover is one of the critical sources of revenue generation and corresponding earnings for shareholders in the company.
Inventory is the collection of finished products or items used in a company’s production. It is listed on a company’s balance sheet as a current asset and acts as a buffer between manufacturing and order fulfilment.
On the income statement, when an inventory item is sold, its carrying cost is transferred to the cost of sold goods (COGS) category.
Various methods are followed for inventory valuation: FIFO, LIFO, the Weighted Average Method, and Net Realisable value.
Typically, Inventory is classified as follows:
- Finished Goods
- Work in Progress
- Raw Materials
- Stores and Spares etc;
- Inventories with stockists
- Inventories at Work and/or Project Sites;
- Inventories in transit
- Inventories in Custom Bonded Warehouses;
- Inventories sent on Approval Basis
- Inventories with job workers
- Dead inventories or Obsolete Inventories
According to my limited understanding, the above inventory classification is rarely disclosed in financial statements in detail.
Direct Taxes– Broad Framework
Section 2(12A) defines “books” or “books of account” to include ledgers, day-books, cash books, account-books, and other books, whether maintained in written form, electronic form, digital form, or as printouts of electronically or digitally stored data. This also extends to floppy disks, tapes, or any other form of electromagnetic data storage device.
Under Section 145A, it is provided that for the purpose of determining the income chargeable under the head “Profits and Gains of Business or Profession”,
a. the valuation of inventory shall be made at lower of actual cost or net realisable value computed in accordance with the income computation and disclosure standards notified under sub-section (2) of Section 145.
b. the valuation of purchase and sale of goods or services and of inventory shall be adjusted to include the amount of any tax, duty, cess or fee (by whatever name called) actually paid or incurred by the assessee to bring the goods or services to the place of its location and condition as on the date of valuation;
c. the inventory being securities not listed on a recognised stock exchange, or listed but not quoted on a recognised stock exchange with regularity from time to time, shall be valued at actual cost initially recognised in accordance with the income computation and disclosure standards notified under sub-section (2) of section 145
d. the inventory being securities other than those referred to in clause (iii), shall be valued at lower of actual cost or net realisable value in accordance with the income computation and disclosure standards notified under sub-section (2) of Section 145
Provided that the inventory being securities held by a scheduled bank or public financial institution shall be valued in accordance with the income computation and disclosure standards notified under sub-section (2) of Section 145 after taking into account the extant guidelines issued by the Reserve Bank of India in this regard:
Provided further that the comparison of actual cost and net realisable value of securities shall be made category-wise.
Explanation 1. —For the purposes of this section, any tax, duty, cess or fee (by whatever name called) under any law for the time being in force shall include all such payment notwithstanding any right arising as a consequence to such payment.
Explanation 2. —For the purposes of this section,—
a. “Public financial institution” shall have the meaning assigned to it in clause (72) of section 2 of the Companies Act, 2013 (18 of 2013)
b. “recognised stock exchange” shall have the meaning assigned to it in clause (ii) of Explanation 1 to clause (5) of section 43;
c. “scheduled bank” shall have the meaning assigned to it in clause (ii) of the Explanationto clause (viia) of sub-section (1) of Section 36
Similarly, ICDS II provides a similar treatment of inventories aligned to Section 145A of the ITA.
To my limited understanding, inventories and/or stock-in-hand are not explicitly defined under the Income Tax Act (ITA) provisions. Thus, these terms must be interpreted in common parlance when analysing the impact of inventory valuation while determining the total income of a business enterprise in any previous year relevant to the assessment year
Indirect Taxes– Broad Framework
Section 2(83) defines “outward supply” in relation to a taxable person, means supply of goods or services or both, whether by sale, transfer, barter, exchange, licence, rental, lease or disposal or any other mode, made or agreed to be made by such person in the course or furtherance of business;
Section 2(67) defines “inward supply” in relation to a person, shall mean receipt of goods or services or both whether by purchase, acquisition or any other means with or without consideration;
Section 2(82) defines “output tax” in relation to a taxable person, means the tax chargeable under this Act on taxable supply of goods or services or both made by him or by his agent but excludes tax payable by him on reverse charge basis;
Section 2(62) defines “input tax” in relation to a registered person, means the central tax, State tax, integrated tax or Union territory tax charged on any supply of goods or services or both made to him and includes—
(a) the integrated goods and services tax charged on import of goods;
(b) the tax payable under the provisions of sub-sections (3) and (4) of section 9
(c) the tax payable under the provisions of sub-sections (3) and (4) of section 5of the Integrated Goods and Services Tax Act;
(d) the tax payable under the provisions of sub-sections (3) and (4) of Section 9 of the respective State Goods and Services Tax Act; or.
(e) the tax payable under the provisions of sub-sections (3) and (4) of section 7 of the Union Territory Goods and Services Tax Act
but does not include the tax paid under the composition levy;
Section 2(63) defines “input tax credit” means the credit of input tax;
Section 31- Tax Invoice provides as under:
31. (1) A registered person supplying taxable goods shall, before or at the time of,—
(a) removal of goods for supply to the recipient, where the supply involves movement of goods; or
(b) delivery of goods or making available thereof to the recipient, in any other case,
issue a tax invoice showing the description, quantity and value of goods, the tax charged thereon and such other particulars as may be prescribed:
Provided that the Government may, on the recommendations of the Council, by notification, specify the categories of goods or supplies in respect of which a tax invoice shall be issued, within such time and in such manner as may be prescribed.
31(7) Notwithstanding anything contained in sub-section (1), where the goods being sent or taken on approval for sale or return are removed before the supply takes place, the invoice shall be issued before or at the time of supply or six months from the date of removal, whichever is earlier.
Section 35 – Accounts and Other Records provides as follows:
35. (1) Every registered person shall keep and maintain, at his principal place of business, as mentioned in the certificate of registration, a true and correct account of—
(a) production or manufacture of goods;
(b) inward and outward supply of goods or services or both;
(c) stock of goods;
(d) input tax credit availed;
(e) output tax payable and paid; and
(f) such other particulars as may be prescribed:
Provided that where more than one place of business is specified in the certificate of registration, the accounts relating to each place of business shall be kept at such places of business:
Provided further that the registered person may keep and maintain such accounts and other particulars in electronic form in such manner as may be prescribed.
(2) Every owner or operator of warehouse or godown or any other place used for storage of goods and every transporter, irrespective of whether he is a registered person or not, shall maintain records of the consigner, consignee and other relevant details of the goods in such manner as may be prescribed.
(3) The Commissioner may notify a class of taxable persons to maintain additional accounts or documents for such purpose as may be specified therein.
(4) Where the Commissioner considers that any class of taxable persons is not in a position to keep and maintain accounts in accordance with the provisions of this section, he may, for reasons to be recorded in writing, permit such class of taxable persons to maintain accounts in such manner as may be prescribed.
(5)…………………
(6) Subject to the provisions of clause (h) of sub-section (5) of section 17, where the registered person fails to account for the goods or services or both in accordance with the provisions of sub-section (1), the proper officer shall determine the amount of tax payable on the goods or services or both that are not accounted for, as if such goods or services or both had been supplied by such person and the provisions of section 73 or section 74 or section 74A, as the case may be, shall, mutatis mutandis, apply for determination of such tax.
To my limited understanding, inventories and/or stock-in-hand are not defined under the GST Act’s provisions. Thus, such terms must be understood in the common parlance when we analyse the impact of inventory valuation while determining the output tax payable or input tax credit on the supply of goods or services of the business enterprise.
Given the above background concerning Inventories under the Direct and Indirect tax broad framework, let us try to examine some aspects of inventories in a tabular format:
| Description | Direct Tax Regime | Indirect Tax Regime |
| Ownership | Business enterprises should legally own inventories to recognise the purchase, procurement, and sale of them in the financial statements.
If not legally owned but procured and sold, such a transfer is not valid as per the law. |
Ownership of Capex is pari materia to the provisions applicable under the provisions of the Indirect Tax Regime.
If a supply is made without legally owning it, it would be termed a defective transfer, considering the principles of the Indian Contract Act and the Sale of Goods Act.
The moot question is to be examined here: Can a person claim ITC without valid ownership of goods as per the provisions of the GST Act 2017?
To my understanding, such a transaction won’t be considered legally valid; thus, no ITC can be claimed under GST provisions. |
| Valuation | The valuation of inventories must be conducted at arm’s-length prices, ensuring consistency with the taxpayer’s method of accounting on a year-on-year basis.
If the taxpayer follows an exclusive method of reporting taxes, adjustments as per Section 145A or ICDS II must be incorporated while determining total income under Section 28 of the ITA and the relevant rules thereunder.
If an audit is applicable under the Companies Act 2013 or a Tax Audit under the Income Tax Act, the auditor is duty-bound to report any such lapses in the audit reports prescribed under the statute.
If the above adjustment is made to the computation of total income, the return filed by the taxpayer may be considered defective. Consequently, the ramifications of defective returns shall apply as per the provisions of the ITA.
|
The valuation of inventories must be determined at arm’s-length prices, in accordance with Section 15 and Rules 27 to 35, as applicable to supplies made under Section 7 of the CGST Act, 2017.
For transactions specified under Schedule I, the taxpayer is required to determine deemed consideration and discharge GST levies as applicable based on the nature and facts of the transaction.
Furthermore, such deemed consideration under Schedule I must be reported in the appropriate GST returns, with the corresponding GST levies deposited as required.
Specified Transactions under schedule I (discussed in detail in the other sections of this article) are as follows:
1. Permanent transfer or disposal of business assets where input tax credit has been availed on such assets.
2. Supply of goods or services or both between related persons or between distinct persons as specified in Section 25, when made in the course or furtherance of business:
Provided that gifts not exceeding fifty thousand rupees in value in a financial year by an employer to an employee shall not be treated as supply of goods or services or both.
3. Supply of goods—
(a) by a principal to his agent where the agent undertakes to supply such goods on behalf of the principal; or
(b) by an agent to his principal where the agent undertakes to receive such goods on behalf of the principal.
4. Import of services by a person from a related person or from any of his other establishments outside India, in the course or furtherance of business |
| Quantitative Disclosures | Under the Companies Act, 2013, quantitative disclosures regarding the purchase and sale of goods, along with the bifurcation of domestic and imported transactions, are mandatory.
Additionally, specific remarks on inventory verification, valuation, and disclosures made to bankers for availing banking finance must be examined and reported by auditors. Any lapses or discrepancies identified must be reported in the auditor’s report under CARO and Internal Financial Controls (IFC) reporting for the audit period under consideration.
Furthermore, foreign exchange outgoings must be disclosed in the Director’s Report and Notes to Accounts.
Clause 35(a) and (b) of Form 3CD under the Income Tax Act mandates the disclosure of quantitative details of traded and manufactured goods, including shortages/excess, yield, and percentage of yield, for reporting purposes.
Such quantitative information is correlated with information disclosed and reported in the Indirect Tax Laws using technology developments and compared with prevailing trends in similar trade, commerce, and industry to examine revenue leakages.
Considering modern trade practices, most organizations maintain computerized electronic records for bank funding, MIS, and regulatory compliance.
If a cost audit is applicable to an enterprise, various stakeholders also examine the records maintained for Cost Audit as part of their assessment.
|
Under the indirect tax regime, quantitative details must be reported in:
Data reported under other allied laws such as Corporate Laws, Direct Tax Laws, Cost Audits, Banking, Customs, or other regulatory authorities is often shared among stakeholders to mitigate revenue leakages through the optimum use of technology.
Incorrect reporting under tax laws is often perceived as an attempt to evade taxes, even when such errors are genuine mistakes committed by clerical team members.
These mistakes frequently result in litigation, consuming time, effort, and energy to resolve disputes under various legal frameworks.
To my limited understanding, such situations are unproductive for maintaining an effective and efficient business ecosystem.
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| Classification | There are no specific requirements under the Direct Tax regime to classify the nature of goods or services. However, when filing Tax Audit Reports and Income Tax Returns (ITRs) of enterprises, it is compulsory to report the nature of the business, profession, or services the taxpayer provides with specific digital codes. | As discussed in the preceding para relating to quantitative disclosures (supra), it is mandatory to report HSN and SAC code as per Notification No 78/2020 – Central Tax dated 15/10/2020 with phase-wise implementation and phase III to be implemented from Feb 2025 or if deferred further whereby it is provided as follows:
1. Manual entry of HSN Codes will not be allowed; 2. HSN codes to be selected from the drop-down menu; 3. A customised description in the HSN master will auto-populate in a new file called “Description as per HSN Code.”
In addition, bifurcation of B2B and B2C Supplies.
Thus, it implies that in the future, we may witness the implementation of the nexus theory of input and output to monitor and prevent potential revenue leakages by harnessing technology across various business segments. |
Readers, please note that I have attempted to explain certain inventory transactions to illustrate the distinction between the direct and indirect tax regimes. Many more transactions may need to be considered and validated to fully decipher the implications under either law. Thus, the above tabulations should not be regarded as exhaustive in understanding the convergence between the two tax frameworks.
Conclusion:
Readers of this article should keep in mind probable future developments which are envisaged as under:
- Expansion of data reporting under the Direct Tax and Indirect Tax regimes especially if we examine the definition of computer systems as provided under the new Income Tax Bill 2025 which is reproduced below;
- Clause 261 (e) states “computer system” means computers, computer systems, computer networks, computer resources, communication devices, digital or electronic data storage devices, used on stand-alone mode or part of a computer system, linked through a network, or utilised through intermediaries for information creation or processing or storage or exchange, and includes the remote server or cloud server or virtual digital space;
- Whether such a change would mean the integration of evidence law, digital data protection laws, digital data sharing, and extended by the invasion of the privacy of the taxpayers (Food for thought)
- KYC (Know your customer) requirements;
- Digital Trail Monitoring and the significance of electronic evidence;
- Increase in data points applicable to E-Invoicing requirements & mandatory e-invoicing for B2C transactions;
- Geo Tagging and Mapping of Place of Business & movement of supply to plug leakage of revenues;
- Implementation of Unique Identification Markings for implementing the Track and Trace Mechanism.
- Mandatory Bio-metric authentication for registrations, additional or changes in place of Business;
- Data locking of values reported in the returns filed under GST Returns;
- Synchronization of data across allied laws vis-à-vis direct tax and indirect tax regime;
- Deep dive to verify the inputs and output analysis using the nexus theory mapped to HSN and SAC Classifications;
- Advanced AI, ML and RMS tools to plug out revenue leakages, etc.
In this article, the author has sought to restrict discussions to the broad areas specified while being fully aware that several related discussions are covered in the RRC booklet. To avoid repetition, this article does not consider those aspects. Given the fast-evolving nature of laws and their underlying regulations, the statements made herein may undergo significant changes due to amendments, notifications, or circulars issued after the article’s publication. The author urges all readers to validate the assertions and statements by corroborating them with the latest legal precedents before drawing any conclusions or relying on this document. Any suggestions for improving the content of the article are welcome with folded hands. Further, my views are personal and based on my limited understanding of the subject. My views shall not be considered explicit/implicit opinions. They are not binding on me as an organisation established for the benefit of all indirect professionals based in and outside India.
In the upcoming article, Part 3, the author will discuss the aspects of Revenue Recognition – Expenditure from the perspective of Convergence – Divergence. The Evolving Relationship Between Direct and Indirect Taxes in India.
Happy reading to all.
