AXATION OF DERIVATIVES - wirc-icai.org taxation - 16 July... · -Settlement By Actual Delivery Of The ... (SCRA), 1956 to include the ... Does trading in commodity derivatives amount

ISSUES & CONTROVERSIES IN

TAXATION OF DERIVATIVES

NIHAR JAMBUSARIA

BDO CONSULTING PRIVATE LTD

16 JULY 2011

INDEX

•WHAT IS A “DERIVATIVE”?

•TYPES OF DERIVATIVES INSTRUMENTS

•DERIVATIVES MARKET – “THE GROWTH STORY”

•ACCOUNTING & LEGAL FRAMEWORK

•TAXATION OF FOREX DERIVATIVES•TAXATION OF FOREX DERIVATIVES

•TAXATION OF COMMODITY DERIVATIVES

•TAXATION OF CURRENCY DERIVATIVES

•ALLOWABILITY OF LOSSES

•YOUR QUESTIONS

WHAT IS A “DERIVATIVE”?

� In common parlance, a “Derivative” is

understood as an instrument, the value of

which is derived from the value of its

underlying cash or physical asset.

� Underlying asset could be a real asset like

foreign exchange, currency, securities &

commodities or an hypothetical asset likecommodities or an hypothetical asset like

LIBOR, bourses’ indices or benchmark interest

rates, etc

� There are three categories of players

operating in the Derivatives market viz:

� Hedger – Mitigates risk from genuine business

transactions

� Speculator – Invests with the intention to make

profit without any corresponding risk exposure

� Arbitrageur – Takes benefit of the discrepancies

between prices prevailing in different markets

TYPES OF DERIVATIVE INSTRUMENTS� Derivative instruments have typical attributes and hence it becomes essential

to have a basic understanding of their nature for the purpose of

comprehending their accounting and taxation nitty-grittys.

ONTRACTS - Agreement to

Buy/Sell

- On A Future Date

ONTRACTS - Agreement to

Buy/Sell

- On A Future Date/Or Before

ONTRACTS - Agreement

Granting Right To Buy/Sell – Not An Obligation

SWAPS - Agreement To

Swap Benefits/Obligations From Financial

FORWARDSCONTRACTS

Date

- At An Agreed Price

- Settlement By Actual Delivery Of The Underlying Asset On Maturity F

UTURESCONTRACTS

Date/Or Before


- Settlement By Payment For Difference In Contract Price And The Prevailing Market Price Of The Underlying Asset

OPTIONSCONTRACTS

- On A Future Date/Or Before


- Settlement By Payment For Difference In Contract Price And The Prevailing Market Price Of The Underlying Asset

Financial Instruments

- Settlement By Payment For Difference In Contract Prices The Underlying Assets

DERIVATIVES MARKET – “THE GROWTH

STORY”� 1995 - Passing of the Securities Laws(Amendment)

Ordinance, 1995, withdrawing the prohibition onoptions in securities

� 1998 - Report of 24-member committee constitutedby SEBI promulgating conditions for structuring theregulatory framework to govern the derivativesmarket

� 1999 – Amendment in Securities Contract RegulationAct (SCRA), 1956 to include the term derivativeswithin the ambit of “Securities”, to assimilate thelegal framework applicable for securities, toderivative transactions

� 2000 – Rescission of notification dated 27th June,1969 prohibiting forward contracts in securities

� 2001 – SEBI granted final approval for trading inDerivatives segment to Bombay Stock Exchange(BSE) and National Stock Exchange (NSE)

ACCOUNTING FRAMEWORK

ACCOUNTING FOR DERIVATIVES� Derivatives are financial instruments with varied and often customized

transactional flows. As a result, the way accounting for traditional financial

instruments is done, cannot be imitated in the case of derivative instruments

� Accounting for Derivatives mandates an understanding of the following accounting

standards dealing broadly with accounting for financial instruments:

� AS 11: The Effects of Changes in Foreign Exchange Rates (Revised 2003)

� AS 13: Investments� AS 13: Investments

� AS 30,31&32: Financial Instruments (with effect from 1st April, 2011)

� In addition to above, the guidance note issued by the ICAI on “Accounting forEquity Index and Equity Stock Futures and Options” would also have to be

reckoned

� Accounting aspects are significant as they are also taken recourse in determining

the taxability of incomes/losses under certain cases

ACCOUNTING FOR DERIVATIVES� Accounting for Derivatives mandates an understanding of the following accounting standards

dealing broadly with accounting for financial instruments:

� AS 11: The Effects of Changes in Foreign Exchange Rates (Revised 2003)

� Accounting Standard – 11 which that exchange differences arising on settlement of monetary terms

should be recognized as expenses in the period in which they arise.

� This indicates that such loss can be written off to the profit and loss account.

� Schedule VI treatment - Schedule VI of the Companies Act, 1956, allows foreign exchange fluctuations

to be adjusted in the cost of fixed assets, for which foreign currency loans were raised.

� National Committee on Accounting Standards (NACAS) – issued a notification to minimize the impact of� National Committee on Accounting Standards (NACAS) – issued a notification to minimize the impact of

accounting standards. This followed by acceptance of recommendation by the ministry of corporate

affairs (‘MCA’)

� MCA Notification - has issued notification on 1 April 2009.

� Companies will be allowed to capitalise forex losses on capital assets instead of charging to revenue.

(Amendment 1)

� Companies can create a special reserve or transitory account to park MTM forex losses and amortize

upto March 31, 2011. (Amendment 2)

� Section 43(1) of the Act – Where any amount is paid or is payable as interest in connection

with the acquisition of an asset, so much of such amount as is relatable to any period aftersuch asset is first put to use shall not be included in the actual cost of asset.

� Therefore any interest expenditure incurred prior to the asset is first put to use shall be capitalized.

INCOME TAX - PROVISIONS

& PRECEDENTS& PRECEDENTS

PURVIEW OF SECTION 43(5)� In the context of Income tax law, the subject of derivatives has not been paid

sufficient reverence, which is promulgated by the fact that there are no specific

provisions for taxability of income from derivatives transactions

� The sole provision, granting recognition to derivatives under the Income Tax Act,

1961 is Section 43(5)(d), which excludes “an eligible transaction in respect oftrading in derivatives” from the definition of the term “speculativetransaction”transaction”

� Inclusion in the ambit of Chapter IV D – Profits and Gains of Business or Profession

and also by reason of the use of the term “trading” in the above exclusionary

provision, explicates the restrictive application of the provision to only those

assessees carrying out a “business” activity

� How to categorize income between “business income” “capital gain” &

“investment income” for the purpose of taxability of income?

“BUSINESS ACTIVITY”� The categorization shall be conferred, depending upon the facts of each case.

� A few determinants for categorizing the income between business income or capitalgains, as derived from the judicial precedents, include the following:

� Magnitude of purchases and sales and the ratio between purchases and sales

� Period of holding

� Manner of maintaining books of accounts

� Motive to Resale

� Sources of Funds� Sources of Funds

[Fidelity Northstar Fund v. DIT (2007) 288 ITR 641(AAR)] [Gopal Purohit v. ACIT[2009] 29 SOT 117]

� Also, the term “eligible transaction” shall be construed to include only thosetransactions which are carried out on a recognised stock exchange in India

� Bombay Stock Exchange (BSE), National Stock Exchange (NSE) and MCX Stock Exchange(MCX-SX) have been notified for this purpose [Notification No. 2/2006, dated 25-1-2006 &Notification No. 46/2009, dated 22-5-2009] [Rule 6DDA, 6DDB]

� What are the tax implications in case when the derivative transactions are carried outthrough any other stock exchange????...

SPECULATIVE TRANSACTION� In case the transaction is carried out from any stock exchange, other than those

notified for the purpose of section 43(5)(d), the exclusionary proviso shall not be

applicable and the income/loss will be treated as speculative income

� However, in the case of ACIT v. Shreegopal Purohit [ITA NO. 5666/M/2007], it

has been held that for a transaction to be treated as speculative transaction, the

following ingredients shall be satisfied:

� The transaction is in purchase/ sale of commodity. Commodity would include � The transaction is in purchase/ sale of commodity. Commodity would include

stock and share

� The transaction envisages delivery/ transfer

� The transaction is settled otherwise than by delivery or transfer

� The Mumbai Tribunal, relying upon the case of PS Kapur (29 SOT 587), held that

derivative products are intangibles and are not capable of delivery or transfer.

Hence, the second condition i.e. “transaction envisages delivery/transfer” is

not satisfied to regard transaction in derivatives as a speculative transaction

SPECULATIVE TRANSACTION� The above judgments have been overruled by the Special Bench judgment in the

case of Shree Capital Services Ltd. 121 ITD 498 (Kol) which asserted as follows:

� The term commodity is wider and, therefore, derivatives would fall within the

term ‘commodity’

� The insertion of proviso (d) to section 43(5) is prospective and not retrospective

in nature

� Also, whether FOREX derivatives can be said to be a transaction in “commodity” to� Also, whether FOREX derivatives can be said to be a transaction in “commodity” to

render section 43(5) applicable????...

FOREX DERIVATIVES� As discussed, section 43(5) covers within only transaction in commodity, stock and

shares

� As per the New Oxford Dictionary of English, the term “commodity” is definedas:

� a raw material or primary agricultural product that can be bought or sold, suchas copper or coffee;

� a useful or valuable thing such as water or time.

� It can thus be construed to encompass all types of commercial goods and articles

� Forward Contracts (Regulation) Act (FCRA), 1952 defines “goods” as “every kindof movable property other than actionable claims, money and securities”

� The Delhi Bench of ITAT in the case of Munjal Showa Ltd Vs. DCIT [ 94 TTJ 227]has held as under:

� Foreign currency or any currency is neither commodity nor shares. The Sale ofGoods Act specifically excludes cash from the definition of goods.

“INVESTMENT” ACTIVITY� IFOS is a residuary head of income, such that any income not governed within the

purview of any of the specific heads of Income, would automatically fall within the

ambit of IFOS

� Taxability under Capital Gains preempts “Transfer” of “Capital Asset” to invoke

taxability under those provisions

� The term “transfer” defined u/s 2(47) includes, inter alia, the sale, exchange or� The term “transfer” defined u/s 2(47) includes, inter alia, the sale, exchange or

relinquishment of an asset and extinguishment of any rights therein

� Derivatives transactions (except Forward Contracts) do not involve actual sale,

exchange or relinquishment of the underlying asset. Thus, due to the non-

satisfaction of the basic condition, taxability under the head CG cannot be

deliberated further

� However, whether income from exercise of Options, which grants a right to the

holder of the option to buy/sell the underlying asset, can be treated as an

“extinguishment of rights” ????...

OPTIONS

� Options transaction involves two parties – “option writer” and “option buyer”

� Writer receives income in the nature of “Premium” against the granting of the

right to the buyer of the option to buy/sell the underlying asset at a future date

� Whether such income can be treated as an income from extinguishment of rightand charged to tax as Capital Gains??

� In case it is treated as Capital Gains, following the rationale established in the case

of B. C. Srinivasa Shetty [128 ITR 294] that in the absence of cost of acquisition,

the computation mechanism fails and there can be no charge of capital gains

� Income arising to the option buyer on the exercise of the option on maturity –whether extinguishment of right

� Whether premium paid to option writer, can be treated as “Cost Of Acquisition”of the right??

TAXATION OF DERIVATIVES

TAXATION OF FOREX DERIVATIVESDefinition

� “Speculative transaction” is defined under the Act – as a transaction in which a contract

for the purchase or sale of any commodity, including stocks and shares, is periodically or

ultimately settled otherwise than by actual delivery or transfer of commodity or scrips.

� The Act provides for a simple and objective test. Reference is invited to a Delhi HC

decision in the case of M.R. Dhawan v CIT [1979] 119 ITR 412 (Del)

- ‘Speculation’ in common parlance connotes an intention to speculate, gamble, take a chance or

risk.

- The Act however provides a very simple and an objective test for determining whether a- The Act however provides a very simple and an objective test for determining whether a

transaction is a speculative transaction or not. Under this definition, all that has to be found is

whether the contract was periodically or ultimately settled by actual delivery, transfer or other

wise.

- Even thought the scrip or commodity are highly speculative in nature – if such scrip or

commodities have actually been taken delivery of pursuant to a contract, then it would not be a

speculative transaction irrespective of whether the person taking the delivery had any idea of

taking the delivery at all.

- On the other hand, if the contract is settled otherwise than by actual delivery, then it will be a

speculative transaction notwithstanding that the nature of the commodity was not one lending

itself to possibilities of speculation or that the intention of the parties at the time of entering into

the contract might have been to take actual delivery but this intention could not be effectuated

for one reason or the other.

TAXATION OF FOREX DERIVATIVES

� Contract must be enforceable – CIT v S.C. Kothari [1971] 82 ITR 794 (SC)

� Part settlement of contract is also covered - CIT v Aditya Mills Ltd [1994]209 ITR 933

� Delivery must be real and not optional –

• Davenport & Co (P) Ltd v CIT [1975] 100 ITR 715 (SC)

• Nirmal Trading Co v CIT [1980] 121 ITR 54 (SC)

• Jute Investment Co Ltd v CIT [1980] 121 ITR 56 (SC)• Jute Investment Co Ltd v CIT [1980] 121 ITR 56 (SC)

� In the above case laws it has been explained that the words ‘actual delivery’

mean real as opposed to notional delivery.

� ‘Speculative’ under the general sense or under the Contract Act is not

relevant.

� A transaction which is otherwise speculative would not be a speculative

transaction u/s 43(5) of the Act if actual delivery of scrips or commodities is

taken place. Vice versa also holds true.

� It provides a special meaning to the expression ‘Speculative’ for income tax

purpose only.

� Thus, merely transfer of delivery notes and not actual delivery of goods will

be treated as speculative u/s 43(5) of the Act.


� Taking physical delivery of goods by the assessee – Is it the real test?

• Sripal Satyapal v ITO [2008] 217 CTR 337 (Raj)

� On perusal of section 43(5) of the Act there is no reference for requirement of actual

delivery or transfer of scrips or commodities by the assessee or his nagent.

� The emphasis is on settlement of transaction otherwise than by the actual delivery or

transfer of scrips or commodities.

� Taking the physical delivery of goods by the assessee is not the test for determining the� Taking the physical delivery of goods by the assessee is not the test for determining the

speculative transaction in terms of section 43(5) but the test is settlement of transaction

entered into by the assessee or on his behalf otherwise than by actual delivery of scrips

or commodities; where ultimately transaction entered into by the assessee has been

settled by the actual delivery of goods to the ultimate buyer, in terms of section 43(5),

the transaction cannot be regarded as speculative transaction.

� Further so long as the nexus between the actual delivery of goods and the transaction of

sale conducted by the assessee himself or through his agent exists, the actual settlement

of account between the assessee and his agent cannot affect the nature of transaction

from real to speculative.

� In such an event, actual payment or receipt is merely a convenient mode of settling the

account, distinct from settling the transaction.


� Solitary transactions

• It may be noticed that the language of explanation 2 to section 28 speaks of

‘speculative transactions’ in plural, and, further of such a nature as to constitute

business. The quality of business is its continuity, a course of transactions.

• The ‘continuity character’ is emphasized also in section 43(5) which speaks of such

transactions as are ‘periodically or ultimately settled’. Hence, any speculation

loss arising out of a solitary transaction cannot be carried forward under this

section, or under any other provision.

• It is only when the transactions amount to a speculation business that carry

forward of loss is permitted.

– Thus where an assessee has entered into a solitary transaction for purchase of 1001 bags

of cashews, it was held that though the transaction was otherwise speculative, the loss

was not speculative, the assessee having entered into a solitary transaction.

» CIT v Indian Commercial Co Pvt Ltd [1977] 106 ITR 465 (Bom)

» CIT v Soorajmull Nagarmull [1981] 129 ITR 169 (Cal)

» CIT v Maggaji Shermal [1978] 114 ITR 862 (AP)

Contra decision is given in the case of CIT v Shree textiles [1994] 206 ITR 345 (Raj)


� Exceptions

• Section 43(5) of the Act further provides few exceptions where transactions will

not be considered to be as speculative in nature.

• Such exception is largely provided to hedging type of transactions where neither

delivery nor transfer is contemplated or effected and yet they are exempted from

the category of ‘speculative transactions’

• This inter-alia includes:

- A contract entered in respect of scrips or commodities guard against loss

through future price fluctuations in their normal course of business.

- A transaction of trading in derivatives carried out on a recognized stock

exchange. Derivatives as referred to section 2(ac) of the SCRA 1956

TAXATION OF COMMODITY DERIVATIVES

BACKGROUND

� Commodity derivatives are traded on commodity exchanges and not on stock

exchanges. Transactions are routed through commodity brokers.

� It is regulated by Forward Markets Commission.

� It can be settled by way of delivery

� Dictionary meaning of the term ‘commodity’ is ‘raw material or agricultural

product that can be bought and sold — something useful or valuable’.

ISSUE

� Does trading in commodity derivatives amount to business income?

� Does trading in commodity derivatives amount to investments and income taxable

as capital gains?


Transaction considered as business

� Whether the commodity derivatives are linked to other business of the

individual

� Frequency of transactions

� Volume of transactions

� Ideally treated as short-term products

Transaction considered as investments

� Buy – Gold. if the intention is to take delivery of gold then it can be

considered as investment. However considering the spiraling prices, if the

same is squared off within a month – it could be treated as short term

gains.

� This may be taxed at MMR. As it is not traded on the stock exchange –

lower tax rate as applicable in equity shares or equity oriented fund may

not be applicable.


Transaction considered as speculative?

� Largely this transaction is likely to be treated as speculative. In such a

scenario – will it be treated as speculative business, if no delivery is

taken?

� The definition of speculative transaction provides that “… anytransaction in which a contract for the purchase or sale of any commoditytransaction in which a contract for the purchase or sale of any commodity(including stocks and shares) is periodically settled otherwise than byactual delivery or transfer of commodity or scrips”

View

� Commodity derivative contracts are certainly contracts for the purchase

or sale of commodities and, therefore, would clearly be covered by this

definition if the transaction is squared off without delivery


Set-off of losses

� Security derivatives have been provided with specific exemption under this clause –

if they are traded on the notified stock exchange.

� Such exemption does not apply to commodity derivatives – as they are traded onthe commodity exchanges. In view of this – it is likely that commoditytransactions squared off without delivery would amount to speculativetransactions squared off without delivery would amount to speculativetransactions.

� Bifurcation / Division is required for delivery based and non-delivery based

transactions.

� Profit / Loss for each set of transactions needs to be computed separately.

� Losses from non-delivery based transactions cannot be set-off against delivery-

based transactions. (even if both are traded at the same time, through the sameexchange / broker etc)


Set-off of losses

� Can speculative transactions (otherwise than by delivery) under commodity

derivatives be set off against gains from speculative transactions under currency

derivatives?

� Security derivates transactions are not regarded as speculative transactions by

virtue of explicit exemption.virtue of explicit exemption.

� Such speculative loss (otherwise than by delivery) cannot be set off against

speculative transactions under currency derivatives.

� This is irrespective – of the fact that both the speculative transactions are

undertaken with the same speculative intent.

� Further such loss cannot be set-off against any capital gains, whether from

shares or any other asset.


Set-off of losses

� Can speculative transactions (otherwise than by delivery) under commodity

derivatives be set off against gains from speculative transactions – in a case where

day trading transactions in shares takes place

� Day trading transactions in shares, where no delivery is taken but the transactions

are squared up the same day, would be regarded as speculation business and it

would be possible to set off the loss from such commodity derivatives transactionswould be possible to set off the loss from such commodity derivatives transactions

against such profits from day trading in shares


Issue in - 1st Provisio:

� The first provisio states – “…a contract in respect of raw material or merchandise

entered into by a person in the course of his manufacturing or merchanting business to

guard against loss through future price fluctuations in respect of his contracts for actual

delivery of goods manufactured by him or sold by him.”

� Assuming a contract is entered into for sale of finished stock of raw material at a

future date which is ultimately settled by sale of gold (out of stock in hand) (anotherfuture date which is ultimately settled by sale of gold (out of stock in hand) (another

assumption – both are trade-able commodities).

� Assuming the prices of both the above commodities follow 1 specific direction (either

upwards or downwards)

� Will it still qualify for exemption under the first provisio?

� International accounting standards allows for such settlement

� Section 43(5) (It is silent)

TAXATION OF CURRENCY DERIVATIVES

Background

� Currency derivatives cannot be settled by physical delivery

� They are settled by cash or involves differential payment

� General life of currency derivatives does not exceed 12 months

Issue

� In view of the above, for taxation purpose - will they be treated as

security derivatives or as commodity derivatives?

� Would transactions of trading in currency derivatives be

considered as speculative transactions?


� Can shares / securities be considered as commodities? Yes – Derivatives

with underlying asset as shares / securities should be considered as

derivatives

� [Shree Capital Services Ltd. v. ACIT, (121 ITD 498) (SB) (Cal)]

� There is an old decision of the court of appeals in England – which has

held currency as commodities.

� Can currency be considered as a commodity? No - currency is not a

commodity.

� [Munjal Showa Ltd. v. DCIT, (94 TTJ 227) (Del)]

� [Shree Capital Services Ltd. v. ACIT, (121 ITD 498) (SB) (Cal)]

� The issue is partly debatable. There is a view that since currency has

physical existence and is a subject matter of trade – it could be treated as

a commodity.


� If the above holds good, then it would be covered by the main part of the

definition u/s 43(5). Would it fall under any of the exceptions?

� One of the exception is – hedging transaction. This is applicable to contracts in

respect of raw material to guard against loss through future price fluctuations.

� Currency derivatives are not contracts of raw materials and hence the

exception may not apply

� The definition u/s 43(5) further has a clause for trading in derivatives as

referred to in section 2(ac) of the SCRA. This is a larger issue

� Currency derivatives are traded on the stock exchange and not on commodity

exchanges. Hence, if they qualify as derivatives under SCRA then they wouldexchanges. Hence, if they qualify as derivatives under SCRA then they would

not be regarded as speculative transaction.

� From the reading of section 2(ac) it can be understood that definition under

SCRA is fairly broad and would include currency derivatives.

View

� Thus it can be said that – profit or loss derived from trading in currency

derivatives would not be considered as speculative income or loss, but

treated as any other business profit or loss.

� Most derivative transactions are for hedging purpose. They are entered

into normal course of business.

ALLOWABILITY OF LOSSES

CRYSTALLISED LOSSES V MARK TO MARKET LOSSES

� The term ‘crystallised losses’ refers to the losses crystallised and debited to the

exporter’s account whereas the term ‘Mark to Market’ losses’ (MTM) refers to losses

computed as on a particular date with reference to prevailing exchange rate in

respect of contracts that have not matured (open contracts).

� As per the recommendatory Accounting Standard 30, companies are required to

account for the mark to market losses in their books despite the fact that the

contract has not yet matured as at the balance sheet date.

– The following issues arise in connection with the allowability of forex

derivative losses :derivative losses :

• (a) Whether losses on account of forex derivatives are to be considered in the

threshold itself u/s.28 as a business loss or they are in the nature of business

expenditure subject to the restrictions u/s.29-44?

• (b) Whether the MTM loss provided for in the books of an entity pursuant to AS-30

is allowable under the Income-tax Act?


• Expenditure v. Loss :

– The terms ‘Loss’ and ‘Expenditure’ have distinct meanings and are defined as follows in

the Webster New Word Dictionary :

• (a) Loss — the damage, disadvantage, etc. caused by losing something

• (b) Expenditure — an expending/a spending or using of money.

– This was highlighted in Allen (H.M Inspector of Taxes) v. Farquharson Bros and Co (1932)

17 Tax Cases 59 (KB) wherein the King’s Bench observed as follows :

• “An expenditure relates to disbursement; that means something or other which the

trader pays out; I think some sort of volition is indicated. He chooses to payout trader pays out; I think some sort of volition is indicated. He chooses to payout

some disbursement; it is an expense; it is something which comes out of his pocket.

A loss is something different. That is not a thing which he expends or disburses.

That is a thing which, so to speak, comes upon him ab extra”. (from without / outside)

• Based on the above discussion, it is clear that the case of forex derivative losses

squarely falls within the purview of the term ‘loss’ and cannot be termed as an

‘expenditure’.


Allowability of MTM losses

• CBDT Instruction no 03/2010 dated 23-03-2010

– Recently, the CBDT has issued to assessing officers regarding the loss on account of

currency derivatives. The crux of the said instruction can be captured as under :

• (a) In respect of MTM losses debited to Profit and Loss account, the Assessing

Officers are instructed to disallow the same while computing the taxable income.

• (b) In respect of actual or crystallised losses, the Assessing Officers are instructed to

verify whether the losses are on account of speculative transaction as specified

u/s.43(5) and decide in accordance with law.

– The above instructions make it extremely difficult for claiming deduction for MTM losses

provided for in the books in respect of open contracts in compliance with AS-30.

• Contra view

– However, in a very recent order in the case DCIT v. Bank of Bahrain and Kuwait, (ITA Nos.

4404 & 1883/Mum./2004 reported in www.itatonline.org) the Special Bench of Mumbai

ITAT, while holding that MTM losses in respect of forward foreign exchange contracts

debited to profit and loss account is allowable, has made certain observations :


Observations

• A binding obligation accrued against the assessee the minute it entered into forward

foreign exchange contracts.

• A consistent method of accounting followed by the assessee cannot be disregarded

only on the ground that a better method could be adopted.

• The assessee has consistently followed the same method of accounting in regard to

recognition of profit or loss both, in respect of forward foreign exchange contract as per recognition of profit or loss both, in respect of forward foreign exchange contract as per

the rate prevailing on March 31.

• A liability is said to have crystallised when a pending obligation on the balance sheet

date is determinable with reasonable certainty. The considerations for accounting the

income are entirely on different footing.

• As per AS-11, when the transaction is not settled in the same accounting period as that

in which it occurred, the exchange difference arises over more than one accounting

period.


• The forward foreign exchange contracts have all the trappings of stock-in-trade.

• In view of the decision of the Supreme Court in the case of Woodward Governor India

(I) P. Ltd., the assessse's claim is allowable.

• In the ultimate analysis, there is no revenue effect and it is only the timing of taxation

of loss/profit.

• This creates an interesting situation whereby there is a Special Bench decision which • This creates an interesting situation whereby there is a Special Bench decision which

allows MTM losses, whereas CBDT Instruction mandates disallowance. It appears that

the instruction from CBDT was not pointed out to the ITAT. Also, the question in the said

case was whether MTM loss was a real loss or notional loss and the issue of speculation

under 43(5) was not an issue before the ITAT.

On this background, whether we can take the benefit of this Special Bench

order for claiming allowability of MTM losses despite the instruction to the

contrary by the CBDT remains to be seen.


• Allowability of crystallised losses u/s.28 :

– There is no clear-cut instruction in the above CBDT Instruction dated 23-3-2010 to

disallow the crystallised loss on account of currency derivatives.

– If it is accepted that currency is not a commodity and the loss in question is only a

business loss and not a business expenditure, there is ample scope for getting

deduction for the actual crystallised loss on account of currency derivatives.

• Judicial precedents

• In the case of Ramachandar Shivnarayan v. CIT, (111 ITR 263), the Supreme Court observed that :

– “there is no specific provision to be found in either of the two acts for allowing deduction of a

trading loss . . . but it has been uniformly laid down that a trading loss not being a capital loss

has got to be taken into account while arriving at the true figures of the assessee’s income in

the commercial sense.

– The lists of permissible deductions in either acts is not exhaustive. If there is a direct and

proximate nexus between the business operation and the loss or it is incidental to it, then the

loss is deductible, as without the business operation and doing all that is incidental to it, no

profit can be earned. It is in that sense that from a commercial standard, such a loss is

considered to be a trading one and becomes deductible from the total income, although, in

terms of neither the 1922 Act nor in the 1961 Act, there is a provision.”


• Also, in the case of Sutlej Cotton Mills Ltd. v. CIT, (116 ITR 1) the Supreme Court has

held that loss on account of revaluation of foreign currency is a trading loss to the

extent it does not relate to any capital asset and accordingly allowable.

• Similar view was expressed by the Supreme Court in the case of Badridas Daga v. CIT,

(34 ITR 10), wherein it was held the embezzlement by an agent is incidental to the

carrying on of business and accordingly allowable.

• To sum up, a loss will be allowable u/s.28 if the following conditions are • To sum up, a loss will be allowable u/s.28 if the following conditions are

satisfied :

– It should arise or spring directly from or be incidental to the carrying on of a business

operation;

– There should be direct or proximate nexus between the business operation and the loss;

– It should be a real loss and not notional or fictitious;

– It should be a loss on revenue account and not on capital account;

– It must have actually arisen and been incurred, not merely anticipated as certain to occur in

future; and

– There should be no prohibition in the Act, express or implied, against the deductibility

thereof.


• Whether forex derivatives loss satisfies the above conditions?

Losses on account of forex derivatives satisfy the above conditions and can be covered by the

judgments referred above for reasons given under:

– Forward and option contracts are used to hedge currency exposure.

– Most of these forward contracts are settled by delivery of currency.

– Forex derivative contracts are entered into with a view to make good the loss incurred on – Forex derivative contracts are entered into with a view to make good the loss incurred on

account of rupee appreciation by earning some profits.

– Loss on account of forex derivative contracts springs directly from and is incidental to the

carrying on of business.

– The loss is not incurred on a capital account or fixed assets so as to make it a capital loss.

– There exists a direct and proximate nexus between export business and the loss on account of

forex derivatives.


Are crystallised losses speculative in nature?

• S. 43(5) defines ‘speculative transaction’. One view could be that that the term ‘commodity’ as

used in S. 43(5) includes foreign currency also and hence the forex derivative contracts settled

otherwise than by delivery of currency are nothing but speculation on currency movement.

– The above argument is not tenable in law because of the following reasons :

• The term ‘commodity’ is defined neither in the Income-tax Act nor in the General Clauses

Act.

• Dictionary meaning of the term ‘commodity’ is ‘raw material or agricultural product that

can be bought and sold — something useful or valuable’.

• Another definition for the term ‘commodity’ is ‘any product that can be used for

commerce or an article of commerce which is traded on an authorised commodity

exchange is known as commodity’. The article should be movable of value, something

which is bought or sold and which is produced or used as the subject of barter or sale.

– In short, commodity includes all kinds of goods. The Forward Contracts (Regulation) Act, 1952

(FCRA) defines ‘goods’ as ‘every kind of movable property other than actionable claims,

money and securities’.


Are crystallised losses speculative in nature?– The Delhi Bench of ITAT in the case of Munjal Showa Ltd. v. DCIT, (94 TTJ 227) has held as under :

• “Foreign currency or any currency is neither commodity nor shares. The Sale of Goods Act specifically

excludes cash from the definition of goods. Besides, no person other than authorised dealers and

money changers are allowed in India to trade in foreign currency, much less speculate. S. 8 of the

Foreign Exchange Regulations Act, 1973, provides that except with prior general or special permission

of the RBI, no person other than an authorised dealer shall purchase, acquire, borrow or sell foreign

currency. In fact, prior to the LERMS, residents in India were not even permitted to cancel forward

contracts. The presumption of any speculative transaction is, therefore, directly rebutted in view of

the legal impossibility and in view of the fact that foreign currency was neither commodity nor

shares.”

– The Special Bench of ITAT Kolkata in the case of Shree Capital Services Ltd. v. ACIT, (121 ITD 498) has held

that derivatives with underlying as shares and securities should be also considered as commodities as the

underlying shares and securities as specifically included within the term commodities. Accordinglyunderlying shares and securities as specifically included within the term commodities. Accordingly

transactions in security derivatives are subject to the provisions of S. 43(5). However, a currency cannot be

termed as a commodity so as to attract the provisions of S. 43(5).

– The Mumbai Bench of ITAT in the case of DCIT v. Intergold (I) Ltd., (124 TTJ 337) has held that profits from

cancellation of forward exchange contracts are business profits and not speculative profits.

– The Calcutta High Court in the case of CIT v. Soorajmull Nagarmull, (129 ITR 169) has held that where in

the normal course of business of import and export of jute, the assessee entered into foreign exchange

contract to cover up the losses and differences in exchange valuation, the transaction is not a speculative

transaction.

Thus it can be said that crystallised losses are not speculative transaction.


Applicability of explanation to section 37(1)

• Explanation to S. 37(1) inserted by the Finance Act 1998 with retrospective effect from 1-4-1962

reads as under :

– “Explanation — For the removal of doubts, it is hereby declared that any expenditure incurred

by an assessee for any purpose which is an offence or which is prohibited by law shall not be

deemed to have been incurred for the purpose of business or profession and no deduction or

allowance shall be made in respect of such expenditure.”

• There is a view that the forex derivative contracts entered into in excess of the underlying foreign

exchange exposure of the assessee are in violation of the guidelines of RBI and FEMA and

therefore are hit by Explanation to S. 37(1).

• The Supreme Court in Dr. T. A. Quereshi v. CIT, (287 ITR 547) has categorically held as under :

– “Explanation to S. 37 has really nothing to do with the present case as it is not a case of a

business expenditure, but of business loss.

– Business losses are allowable on ordinary commercial principles in computing profits. Once it

is found that the heroin seized formed part of the stock-in-trade of the assessee, it follows

that the seizure and confiscation of such stock-in-trade has to be allowed as a business loss.

Loss of stock-in-trade has to be considered as a trading loss vide CIT v. S.N.A.S.A. Annamalai

Chettiar, 1973 CTR (SC) 233: AIR 1973 SC 1032.”

Hence, the provisions of explanation to S. 37(1) are not applicable to the facts in this case as loss

from forex derivatives is not business expenditure but a business loss.


SUMMARIZE

• Loss from forex derivatives is a business loss and not a business expenditure and

accordingly allowable u/s.28

• MTM losses provided for in the books in compliance with AS-30 may be disallowed

pursuant to specific instruction from the CBDT. However, the Special Bench of ITAT in

the case of DCIT v. Bank of Bahrain and Kuwait, has held that these losses are

allowable.allowable.

• Crystallised losses on account of forex derivative contracts are not speculative in nature

within the meaning of S. 43(5) as the definition for speculative transaction is an

exhaustive one and the term ‘commodity’ does not include currency;

• Explanation to S. 37(1) is not applicable in view of the categorical finding of the

Supreme Court in the case of Dr. T. A. Quereshi (supra) that the said Explanation is

applicable only to business expenditure and not for business loss.

“NOTIONAL” GAINS/LOSSES� The accounting norms for forwards contracts require that the contracts pending to

be executed on the end of the accounting period are required to be marked-to-

market to reflect their current market value

� Whether any notional loss/ gain arising on such accounting treatment is liable to

income tax

� Exchange Fluctuation loss on pending forward contracts is an “accrued” loss and� Exchange Fluctuation loss on pending forward contracts is an “accrued” loss and

not a “contingent” and thus allowable as a deduction - DCIT vs. Bank of Bahrain& Kuwait (ITAT Mumbai Special Bench)

� Anticipated losses on incomplete projects are allowable as a deduction subject to

their being calculated as per AS-7 - Jacobs Engineering vs. ACIT (ITAT Mumbai)

� Loss arising on Marked-to-Market basis is a notional loss and contingent in nature

and thus cannot be allowed to be set off against the taxable income - InstructionNo. 3/2010

“NOTIONAL” GAINS/LOSSES� In the ordinary business also, the closing stock of inventory is valued at fair market

value, if the same is less than the cost of purchase of the inventory

� Drawing analogy from the above, it can be asserted that the notional loss on

pending derivative contracts shall be allowed as a deductible expense

� However, whether the same is required to be added back for the computation of

Book Profits under the Minimum Alternate Tax (MAT) provisions????...Book Profits under the Minimum Alternate Tax (MAT) provisions????...

OTHER ISSUES� “Roll over premium charges” paid in respect of the forward foreign currency

contracts in respect of liabilities relating to the acquisition of fixed assets have to

be capitalized with the Cost of Acquisition of the Asset u/s 43A [Royal Bank ofCanada (AAR) [2010-TIOL-21-ARA-IT]

� Computation of “Turnover” for the purpose of Tax Audit u/s 44AB – Guidance Noteon Tax Audit

� Withholding tax on payment of interest made under SWAP transactions

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