R. Raghunath, CA for the Assessee. Dr. Anjula Jain, Sr. DR for the Revenue.

The present appeal has been filed by the assessee against the order of ld . CIT(A)-33 , New Delhi dated 09 .05.2016.

2. Following grounds have been raised by the assessee:

“1. That on the facts and circumstances o f the case the impugned order o f the Ld . Commissioner o f Income Tax (Appeals) [hereafter referred to as “CIT(A)”] is bad in law and on facts.

2. That, on the facts and circumstances o f the case the learned CIT(A) has erroneou sly sustained the action o f the AO alleging sho rt recognition of contract revenue under “Accounting Standard (AS) 7 - Construction Con tracts” (hereafter re ferred to as “AS 7”) by incorrectly trea ting the ‘revised wo rk order value’ of Rs .27,70,60 ,188 for Pro ject Demo Zone as the ‘contract value’ (including the consideration for operation and maintenance services and all the applicable taxes of Rs 4,15,26000) instead of the con struction contract value of Rs .21,94,78 ,821.

2.1 That, the learned CIT(A) has erred in misapplication o f AS 7 to an item o f Income/ revenue amounting to Rs 4,15,26,000 not related to construction activity carried ou t during the po st construction period viz. Revenue from Operation and Maintenance (O&M) services during the regular O&M phase which is required to be con sidered only during the period when O&M activity actually takes place .

2.2 That, the learned CIT(A) has erred in con sidering amoun ts aggregating to Rs .26,839,975 towards Value Added Tax and Service Tax in cluded in the customer's work order as con stituting part o f construction contract value for the purposes o f recognizing revenue under AS7.

3. That the appellant may be allowed to add , supplement, revise or amend grounds raised hereinabove in the interests o f ju stice.”

3. The assessee company is engaged in activities relating to water distribution, supply, maintenance , treatment / management and / or sewage treatment/sanitation/related civil construction activities. It earns revenue from the execution of construction contracts for water infrastructural facilities as well as by way of income from operation and maintenance (O&M) of such facilities.

4. During the year under consideration, the assessee was offered and implementing construction contract o f the Pro ject Demo Zone (PDZ) pertaining to rehabilitation and implementation o f water supply in the pilot area of Dharampeth o f Nagpur Municipal Corporation. The contract received by the assessee consists o f three parts namely,

• Study Phase

• Rehabilitation Phase and

• O&M Phase

5. The issue to be adjudicated is whether the costs and expenses pertaining to O&M Phase are includable or not while calculating percentage completion method as per the provisions o f AS 7 (accounting standard relating to construction contract).

6. The AO has held that the entire contract value has to be considered while calculating percentage o f completion method on the grounds that it is a composite contract consisting of three dif ferent parts and hence, the third part cannot be considered separately. The ld. CIT (A) held that the O&M phase of the contract of Rs.4 ,15 ,00,000/- is to be considered for computation as per AS 7 instead of AS 9 . Before us during the argument, the ld . AR argued based on the submissions filed in the form of paper book page nos. 1 to 108 . The ld. DR relied on the orders o f the ld. CIT (A).

7. Heard the arguments o f both the parties and perused the material available on record.

8. The facts relevant to the adjudication are that, notwithstanding the revised work order, the sanctioned expenditure pertaining to O&M phase stood at Rs.4 ,15,26 ,000/- (page no . 48 & 50 PB). The key points of the contract issued by the Nagpur Municipal Corporation is as under:(page no . 52 & 53 PB)

“The Nagpur Municipal Corporation (NMC) as the owner of the water supply infrastructure assets o f the city o f Nagpur declares that the company Veolia Water (India) Private Limited (VW India) a subsidiary of Veolia Eau- Compagnie Generale Des Eaux, France and having its registered office at B-1, Marble Arch, 9 , Prithviraj Road, New Delhi-110011 was awarded the contract (“Contract”) for “Implementation o f uninterrupted water supply and reduction o f UFW with improvement in level of service to the consumer in pilot area of Dharampeeth Zone at Nagpur, Maharashtra, India.” Vide work order No .

W/EE/01/2007/JN115 dated June 7, 2007. The contract commenced on July 5, 2007 and is currently on going. Performance o f VW India has been satisfactory under this Contract.

A. Under this Contract following key issues have been implemented successfully:

1. Providing customers with un-interrupted water supply at stipulated pressure .

2. Reduction o f Un-account for Water (UFW) by reducing leakages and unmeasured supply.

3. 100% metering with good quality meters having long life spans.

4. Improved and ef ficient billing and collection mechanism including meter reading, bills generation, distribution & collection.

5. Be tter services to urban poor (customers in slums) by implementation o f slum policy; individual connections have been provided by replacing public stand posts.

6. Attending customer complaints within the stipulated time .

7. Implement good engineering practices to upgrade existing network .

8. Bring accountability on design, implementation, and O&M with single agency through performance based contract.

9. Improved water quality

10. All the Key Performance Indicators (KPIs) required

in the Contract are achieved

B. Contract Cost: Rs.302.6 million

i. Technical Services:

• Study Phase Rs.24 .36 million

• Rehabilitation Phase Rs.24 .90 million

• O&M Phase (5 years) Rs.41 .50 million

ii. Rehabilitation Cost: Rs.211.80 million

C. Contract structure and tasks performed:

1. Phase-I: Study – 9 Months (completed): Following works were carried out in this phase:

• Topographic survey

• Customer surveys for 17 ,500 households

• Pipeline condition survey

• Network modeling of water supply network including existing pipes and proposed rehabilitation and

replacements using water GEM with a network length of 205 KM

• Preparation o f Rehabilitation Plan for rehabilitation of water assets (pipes , valves , meters customer connections, billing and collection system etc.)

2. Phase Rehabilitation – 18 Months (completed): Following works were carried out in this phase

• Replacement o f House Service Connction: 16 ,125 connections Rehabilitation of water pipe line network of about 205 KM including laying of new pipelines of about 90 KM (HDPE pipe 71 Km and DI 19 Km)

• Establishment of monitoring points for flow & pressure – 15 nos .

• Establishment o f monitoring points for water quality – 10 nos .

• Progressive O&M of the refurbished water supply system where 24 points for water quality – 10 nos.

• Progressive O&M of the refurbished water supply system where 24×7 water was being delivered

• Developed an e fficient customer billing and collection

• Establishment o f customer care centre for water supply at Customer Facility Centre

• Meter reading, bill preparation, distribution and collection o f water bills on behalf of NMC .

3. Phase- III: Operation & Maintenance – 60 Months (on- going)

• O&M o f water supply network to deliver 24×7 water supply to all cuotomers; Jul 2011 onwards No. o f 24×7 Connections 16125

• Quarterly volumetric billing for domestic customers

• Monthly volume tric billing for bulk water customer and ma jor consumers

• Collection of payment related to water charges and deposit the same with NMC

• Attending customer complaints within stipulated time frame

• Submit a quarterly performance report on KPIs prescribed in the Contract

• New connections & disconnections.

• Detection of illegal connections.”

9. As per the terms mentioned in the letter dated 31.01.2012, the phase-I pertaining to the study phase of 9 months stands comple ted and phase-II pertaining to rehabilitation for a period o f 18 months also stands completed.

As per the letter of the NMC , Phase-III consisting o f O&M is for a period of 60 months and is ongoing. The letter also mentions that the O&M works involve volumetric building o f the consumers , collection o f payments , monitoring o f new connections, disconnections and illegal connections. This maintenance work is for a period of 5 years which is post the execution of work. The same can be deciphered from para 3 , phase-III o f the letter of the Executive Engineer, NMC. 10. In this background whether O&M phase falls under the part o f the composite contract liable to be apportioned in the percentage o f completion method is examined. The relevant excerpts o f AS 7 are as under:

“1. Types of Contracts

A Construction Contra ct is any contract which is entered into speci fically for construction of an asset or a combination of assets that are closely inter-linked or inter-dependent w.r.t . their technology/design/function or the nature of their ultimate purpose or use.

A. Fixed Price Contract

A contract in which the contractor agrees to a fixed contract price. In some cases, there may be an element of cost escalation clause in the contract which is mutually agreed to between the parties.

For example, the parties agree to include a clause in the contra ct for adjusting the Contract price on the basis o f an increase in the cost of raw materials.

B. Cost-plus Contract

A contract in which the contractor is reimbursed for costs incurred or agreed costs, plus a percentage of these costs o f a fixed fee.

2. Combining and Segmenting of Construction Contracts I. Combining o f Construction contracts – A group of contracts, either with one or more customers, shall be considered as a single construction contract when all the contracts are negotiated as a single package, are inter- linked and form part o f a single project and are performed in a continuous sequence. F For example, a contra ct for construction of three similar buildings (similar in all aspects) on a single plot negotiated all at once.

II . Segmenting of Construction contracts – Where a contract includes more than one asset, the construction of each asset should be treated as a separate construction contract when separate proposals have been given for each asset, each asset has been separately negotiated and the costs and revenues of each asset can be identified separately .

For example, a contract for construction of three different buildings on the same plot with di fferent speci fications and each building is separately negotiated with the contractor.

3. Revenue from a Contract The revenue from a contract includes the following to the extent it is probable o f genera ting revenue and is measurable:

i. The initial amount o f revenue agreed in the contract;

ii. Claims and incentives on account of variations in contra ct work;

4. Costs of a Contract The cost o f a contract includes the following:

i. Directly related costs that to the specific contract

ii. Costs which are generally attributable and allocated to the contract activities

iii. Other costs which are specifically chargeable to the customer under the terms of the contract

5. Recognition o f Revenue and Cost from a Contract Where the result or outcome of any contract for construction can be projected, the related contract revenue and contract costs shall be recognized by taking into account the stage of completion of such contract. Expected losses shall be recognized immediately a s expenses.

I. In case of a fixed price contract, the outcome can be estimated in a reliable manner when all the following conditions are satisfied:

i. The entire revenue from a contract can be reliably measured

ii. It is apparent that the economic benefits of such contract will flow to the organization

iii. Both contract costs and stage of completion can be measured

iv. Contract costs can be clearly identified for a comparison between actual costs and prior estimates

II . In case of a cost-plus contract, the outcome can be estimated in a reliable manner when all the following conditions are satisfied:

i. It is probable that economic benefits o f the contract will flow to the organization

ii. Contract costs attributable to the contract can be identified and measured clearly

III. Percentage of completion method – This method de fines the recognition of revenue and cost taking into account the stage of completion o f a contract. Under this method, revenue and cost are recognized in the statement of pro fit and loss in the accounting periods in which the work is performed.

IV. Contract work-in-progress – A contractor may incur costs that relate to future activity in a contract. Such costs are recognized as an asset i f it is probable that they will be recovered.

6. Determination of the stage o f completion The stage of completion of a contract may be determined in different ways. Depending on the nature o f the contract , the method s may include:

I. The proportion o f contract cost incurred w.r.t . the total estimated cost of contract; (for example: i f the total cost of the contract i s Rs. 30 lakhs and the cost incurred till date is Rs. 15 lakhs, the stage o f completion is regarded as 50% complete i.e. 15 lakhs / 30 lakhs)

II . Surveys o f work performed; (for example: in a contract for construction o f a bridge, the site inspector can do a survey and with regards to the technicalities o f the project , in form how much work has been completed)

III. Completion o f a physical proportion of contract work (for example: in a contract for construction o f a five storey building, if three stories are complete, the stage of completion for the same is regarded a s 60% i .e. 3 stories/5 stories)

When the outcome of a construction contra ct cannot be estimated , the revenue and cost should be recognized only to the extent of contract costs incurred whose recovery is probable.”

11. Similarly, the relevant part o f the AS- 9 with regarding rendering of services is as under:

“Applicability o f AS 9 Revenue Recognition

This standard was issued by ICAI in the year 1985 and in the initial years , it was re-commendatory for only Level I enterprises and but was made mandatory for all other enterprises from April 01 , 1993.

As per ICAI, “Enterprise means a company as de fined in section 3 of the Companies Act, 1956”. Level I enterprises are those enterprises whose turnover for the immediately preceding accounting year exceeds 50 crores. The turnover here does not include other income and is applicable for holding as well as subsidiary companies.

Explanation

Revenue recognition emphasizes on the timing of recognition of revenue in the statement of pro fit and loss o f an enterprise .

The amount o f revenue arising from a transaction is usually determined by an agreement between the parties involved in the transaction . When uncertainties arise regarding the determination of the amount or its associated costs , these uncertainties may influence the timing o f the revenue .

A. Sale o f Goods

One key element for determining the recognition of revenue of a transaction involving the sale o f goods is that the seller has transferred the property in the goods to the buyer for a consideration. In most cases , the transfer of property in the goods results in the transfer of the significant risks and rewards in ownership of the goods.

However, there are situations where the transfer o f significant risks doesn’t coincide with the transfer o f goods to the buyer, in such cases revenue has to be recognized at the time o f transfer o f significant risks and rewards to the buyer. Example: Goods sent to the consignee on approval basis.

There are certain cases in the specific industry where the performance may be substantially complete prior to the execution of the transaction generating revenue. In such cases, when the sale is assured under government guarantee or a forward contract or where the market exists and there is a negligible risk of failure to sell, the goods involved are often valued at the net realizable value (NRV) .

Such amounts are not defined in the definition o f the revenue but are still sometimes recognized in the statement of profit and loss. Example: Harvesting of Agricultural Crops or extraction o f mineral ores.

B. Rendering o f Services

Revenue recognition of services depends as the service is performed. This is further divided into two ways:

(a) Proportionate Completion Method: This method of accounting recognizes revenue in the statement of profit & loss proportionately with the degree of completion o f each service .

Here the service completion consists of the execution of more than one act. Revenue is recognized with the completion o f each such act.

(b) Completed Service Contract Method: This method of accounting recognizes revenue in the statement of profit & loss only when the rendering of services under a contract is completed or substantially completed.”

12. Further, we have gone through the payments made by the NMC to the assessee. The payment pattern reveals that the assessee has raised separate invoices for O&M phase on a regular basis as per Section 5 (of Income Tax Act, 1961) of TOR Clause 8.3 and the same have been duly accounted in the years in which it has been received. Thus, on going through the entire facts of the case , we find that the three different phases of the work which are totally separate in execution . Keeping in view the fact, that the O&M phase cannot be a part o f the construction activity as the O&M phase involves the supply o f water to the residence giving connections and monitoring the connections which is clearly a post construction activity, we hold that the amount allotted for O&M phase cannot be included in determining the percentage of completion method in recognition o f the revenue . We also find that the amounts o f O&M phase have been duly of fered to tax in the year of receipts . We also find that the Phase-I and the Phase-II are the preparatory construction phases over a period o f 18 months whereas the operations & maintenance (O&M phase) of such constructed pro ject is o f 60 months . Hence , the maintenance activities cannot be clubbed with the construction activity. Having gone through the accounting standards (AS-7 and AS-9), we find that application of the standard to separately identifiable components of single contract is allowable while determining the percentage completion o f the project. Since , the O&M phase commences after the construction of activity of rehabilitation phase , we hereby hold that the amount pertaining to O&M phase needs to be separately considered while determining the pro fits out of the construction activities. The appeal of the assessee on ground nos . 2 & 2.1 is hereby allowed. Consideration of VAT for recognizing the revenue under AS-7:

13. Brief facts o f the issue are that the contract given by the NMC include total taxes o f Rs.2,68,39 ,975, the breakup of which is as under:

(A) Service Tax (A1)

• Study Phase – Rs.30,10 ,893/-

• Rehabilitation Phase – Rs .30,83 ,944/-

• O&M phase – Rs.51,32 ,614/-

Total Rs.1 ,12 ,27,451/-

(A2) Rehabilitation Cost – Rs.65 ,66 ,588/-

(B) Value Added Tax

• Rehabilitation Phase – Rs .90,45 ,934/-

14. The AO has considered this amount for calculating the revenues o f the year.

15. The CBDT Circular No . 4/2008 dated 04 .04 .2008 clarified that service tax doesn’t partake the nature o f income. The Circular was issued while dealing with Section 194-I (of Income Tax Act, 1961). Since, the sum and substance of the circular is that the service tax doesn’t form a part o f the income of the assessee, the same need not be considered for calculating the pro fits o f the assessee for the year. Similarly, the Value Added Tax which do not form the part of the income of the assessee also needs to be excluded while determining the revenues of the year in the instant case . As a result, appeal of the assessee on ground no .

2.2 is hereby allowed.

16. In the result, the appeal of the assessee is allowed. Order Pronounced in the Open Court on 27/04/2020.