Derivative losses or Mark to Market losses are known to be unreal or notional and hence the taxman hates giving deduction for them.  The focus seems to be on distinguishing oneself from the accounting law makers and this cannot be denied when referring to umpteen cases where the books of accounts of the assessees have been rejected. It reminds us the CBDT circular which disallowed the Mark to Market loss provided on account of derivatives until the same crystallises at the time of settlement. Once the loss materialises, it has to be tested for its speculative nature by applying Sec. 43(5) of the Income tax Act. To recollect, this accounting was mandated by ICAI vide its announcement in 2008 which requires providing for derivative losses wherever AS-11 is not applicable, to observe prudence and conservatism.

Recent Delhi HC decision:

The impromptu for this write up is a very recent ruling of Delhi High Court (May 2013) in the case of SBI DHFL Ltd. The assessee had provided for loss occurring on account of a committed repurchase transaction on stock which was supposed to occur in the immediate next financial year. The department objected the same and went on appeal to the Tribunal. Finally the ITAT settled with the observation that the anticipated loss in outstanding repo transactions is virtually actual & real and not a notional loss and is not dependant on the happening or non-happening of a future event and, thus, cannot be said to be contingent in nature. Thus, the assessee has rightly debited the actual anticipated loss in its books of account as per RBI Guidelines. This reflects an episode of endless stubbornness on the part of CBDT to change its stand on the Mark to Market loss that it has to be disallowed due to its notional nature and nothing else. In the pertinent case the assessee has done exactly the same exercise of assigning value for the repurchase obligation and given effect for the price difference through P&L. Ultimately it has been accepted on merit. If not options, there is an actual and not any contingent obligation under forwards or futures to close them out just like these repurchase transactions.

Impact of Ind AS 39 or AS-30:

The issue unfortunately could arise for corporate who have voluntarily adopted AS-30 in entirety or Ind AS-39 (IFRS Converged Indian AS). The standards require Marking to Market for a derivative which is what ICAI had initiated, unless the herculean phenomenon of Hedge accounting is followed.  Even in hedge accounting the requirement is not the same as per AS-11 wherein forward premium or discount is accounted upfront and the forward obligation is accounted just like any other monetary item. The advantage with following AS-11 is the forward premium could become tax deductible (Delhi HC decision in the case of Industrial finance Corporation) whereas with AS-30 or Ind AS-39 even in genuine hedging cases, the entire MTM losses (comprising of forward premium) may have to suffer disallowance until the final settlement, thanks to the circular.

Counter arguments:

There can be many counter arguments to this move by department.

1. If after finding that the actual loss is pertaining to a derivative which is speculative within the meaning of Sec. 43(5), the CBDT intends to disallow them as well, why was the Act designed to allow carry forward of speculative losses under Sec.73 only to be set off against speculative income? In simple words, while Act allows loss deduction in subsequent years, why not the CBDT in current year?

2. If the intention of the circular was to punish speculative intention, why should the assessing officer wait until the settlement to do the screening and not in any preceding period? This could benefit the assessee.

3. How is a stock write off not notional so as to allow deduction for tax purpose? The taxpayer does not incur any loss unless he has sold off the inventory at a distressed price so as to claim it as real. But courts have relented by pitying the business expediency of assesses. In Hotline Teletube and Components Ltd vs. CIT case, the Tribunal allowed the loss claimed by the assessee on account of diminution in the value of obsolete stock. Toeing this line there could be same argument in many other occasion of write offs.

Taxpayer agony continues

Take the case of an exchange loss on settlement of a monetary item in foreign currency. AS-11 mandates restating the monetary items at the closing rate and taking the resultant gain or loss on such revaluation to P&L. How comparable is this with the Mark to market loss that is being discussed now? Probably the only difference is that element of uncertainty in the amount of settlement and not the settlement itself. Whereas in a derivative transaction, we are sure about the forward rate on the date of settlement of the contract, we do not know the exchange rate at which the foreign currency transaction will be settled. Still, the Honourable Supreme Court has allowed the assessee to claim deduction of exchange loss on accrual basis in the years not involving settlement (Woodward Governor case), while incidentally accusing the department for taking double standard in case of an exchange gain. It is noteworthy that the department has still not started to accept such accrual which is no excuse either.

Above all, the ITAT Mumbai has specifically allowed the derivative loss to be deductible for tax purpose in the case of Bank of Bahrain and Kuwait. Interestingly there has not been an emphasis or even a mention on such derivative contracts to be non speculative in nature for tax allowance. How good is the situation if the department overlooks decisions after decision issued by Honourable courts and keeps agonising the taxpayer?

The Circular disallowing the tax deduction of Mark to market losses needs to be seriously revisited by the department as it holds no authenticity while Courts hold no grudge towards the taxpayer.

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