Tuesday, May 25, 2010

Summary of CBDT instructions on the allowability of losses on account of forex derivatives Read more: http://www.taxguru.in/income-tax/summary-of-cbdt-instructions-on-the-allowability-of-losses-on-account-of-forex-derivatives.html#ixzz0osI2StzK

The Central Board of Direct Taxes ('CBDT') on 23 March 2010 issued instructions on the matter whether losses on account of foreign exchange derivative transactions can be allowed against the taxable income of an assessee under the Income-tax Act, 1961 ('the Act'). These instructions have been issued in wake of recent growth in the volume of foreign exchange derivative transactions entered into by the corporate sector in India combined with the volatility in the foreign exchange market in the last financial year.

It may be pertinent to note that this issue has been surrounded by litigation, given the Marked-to-Market ('MTM') valuation of these derivatives and the treatment of any consequential losses in the books is usually determined by compliance with Accounting Standards or the advisory circular issued by the Institute of Chartered Accountants of India or guidelines issued by the Reserve Bank of India (in the case of Banks, Primary Dealers and Financial Institutions). The aforesaid treatment has been challenged by the Revenue Authorities, in numerous cases, by disallowing such losses on the premise that the same are notional and contingent in nature.

As regards the actual / realised losses (i.e. the losses which incur on actual settlement/ conclusion of contract), the issue that is usually the cause of litigation is whether such a loss is on account of a speculative transaction as contemplated in section 43(5) of the Income-tax Act, 1961 ('the Act'). This is due to that fact that any loss in a speculative transaction can be set off only against profit from speculativetransactions.

The CBDT instructions which have been issued recently lay down directions that the Assessing Officers may follow while dealing with the above mentioned situations:

MTM Losses

MTM is a concept under which financial instruments are valued at market price so as to report their actual value on the reporting date (i.e. at the end of a financial year). The CBDT has drawn reference to two different accounting treatments which may be followed by the assessees while giving effect to the loss which may arise on account of such year­endvaluation of open positions:

  • Where the loss is reflected as a balance sheet item without making corresponding adjustment in the Profit and Loss Account, given that the same should not result in reduction oftaxable income, no instructions have been issued in this regard.
  • Where the loss is booked in the Profit and Loss Account, thereby resulting in reduction in book profit, the CBDT has instructed that such a notional loss would be contingent in nature and hence, cannot be allowed to be set off againsttaxable income. This is based on the premise that no sale or settlement has actually taken place.

Losses on actual settlement / conclusion of contracts

These are the losses which may arise on actual settlement / conclusion of foreign exchange contracts and hence, are not notional in nature. In such a situation, the CBDT has instructed the Assessing Officers to determine whether such losses are speculative in nature. For the same, reference is drawn to section 43(5) of the Act which defines 'speculative transaction' as under:

"…a transaction in which a contract for the purchase and sale of any commodity including stocks and shares is settled otherwise than by the actual delivery or transfer of the commodity or scrips".

It may be pertinent to note that in terms of the proviso (d) to section 43(5) of the Act, certain eligible transactions in respect of trading in derivatives (As referred in clause (ac) of section 2 of the Securities Contracts (Regulations) Act, 1956 ) are not to be considered as a speculative transaction, provided the transaction is carried out electronically on screen based systems through a stock broker or sub-broker or intermediary registered under SEBI on a recognised stock exchange (In order to be notified as a recognised stock exchange, a stock exchange needs to fulfill the conditions specified in rule 6DDA of the Income-tax Rules, 1962.)  and is supported by time stamped contract note.

In light of the above, the CBDT has instructed the Assessing Officers to determine whether the transaction under consideration is an eligible transaction [i.e. transaction covered by the proviso (d) to section 43(5) of the Act], else the loss arising from the same should be treated as a speculative loss and the same should be allowed to be set off against speculative profits only.

Guidance for undertaking tax assessment

The CBDT has also emphasized that the Assessing Officer should examine the statements of accounts and the notes to accounts with a view to find out any reference to any loss on account offoreign exchange derivatives.

The CBDT has also stated that in some cases these losses may be camouflaged under the 'financial charges' 'foreign exchange loss' or some similar head which may make it difficult to detect them. In such cases, the Assessing Officers have been instructed to make a specific query asking the assessee to give a break up of any 'Marked to Market' loss onforeign exchange derivatives included in the Profit and Loss Account and examine whether such transactions are 'eligible transaction' in terms of section 43(5) of the Act. Further, an adjustment to the taxable income may be made, if necessary, keeping in view the provisions of law referred to above.

Our Comments

In light of these instructions, the challenges by the Revenue Authorities as regards losses arising out of derivative transactions are likely to get stronger. The losses arising on account of year-end valuation of open contracts are likely to be disallowed on the ground that these are contingent and notional in nature. Further, the actual / settlement losses may be considered to be speculative in nature and hence, shall not be allowed to be set-off against normal profits, unless they are arising out of eligibletransactions . Interestingly, the instructions do not provide any guidance with respect to assessees, which are also offering MTM profits to tax on a consistent basis and therefore, it is unclear as to how the Assessing Officer would give effect to the above instructions in these cases.

Based on the facts of each case, the assessees could clearly continue to challenge the disallowance in the appellate proceedings. The views expressed by the CBDT are merely to provide guidance to the Assessing Officers. The Courts would review the transactions and formulate their own views and to that extent these instructions should not impact the litigation which is open on the matter before any Appellate Authorities. Assessees should ensure that appropriate disclosures are made in the tax filings to mitigate any penal exposure on account of disallowance of the losses.

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