Forward Exchange Contract is one of the foreign exchange derivatives (like future contracts, options, swaps, forward exchange contracts etc.) commonly used in India by business firms to protect itself against the risk of fluctuations in foreign currency.
For Example, Infosys is going to receive $100000 in April 2015 on an account of sale made in January 2015. Seeing the trends of fluctuation in currency Infosys decided to enter into a forward market contract for 4 months with SBI at Rs 63/$ when spot rate prevailing in the market is 62/$. If on date of actual settlement rate declined to Rs 61/$, then infosys would make a profit of Rs 2/$(total profit Rs 200000) and correspondingly SBI would incur a loss by the same amount. Similarly, If rate increases to Rs 65/$ then Infosys would incur a loss of Rs 2/$(total Loss Rs 200000) and correspondingly SBI would make a profit by the same amount.
Marked to Market Loss
Marked to Market is a concept of valuing financial instruments (here forward exchange contract) on rate prevailing in the market as on reporting date i.e. date of Balance Sheet. Where the company makes an adjustment through profit & loss account and consequently loss is debited to profit & loss account which is computed by taking the difference between purchase price, which is Rs 63 as cited in above example, and the market value as on reporting date, say Rs 64. Hence company has incurred a total loss of Rs 100000= (Rs 64- Rs 63)*$100000 on valuation date which is considered as a notional loss. This treatment is required in order to comply with AS-11 and AS-30 issued by ICAI and also from the point of view of transparent accounting standards for the benefit of shareholders of the company and its stakeholders.
The issue arises whether such MTM losses in forward exchange contract will be allowed against taxable income of an assessee.
Judicial pronouncements on treatment of MTM losses.
The Apex Court in case of CIT vs. Woodward Governor India (p) Ltd and others has also given due importance to the accounting standards and the accounting method while dealing with issue whether unrealized revenue loss towards foreign exchange fluctuation is an allowable expense for tax purposes. The court held that under mercantile system of accounting what is due is brought into credit before it is actually received; it brings into debit an expenditure for which a legal liability has been incurred before it actually disbursed. The taxpayer following the mercantile/accrual system of accounting must necessarily undertake the balance sheet date valuation. The court, therefore, concluded that balance sheet date valuation is a part of mercantile/accrual accounting system.
In DCIT vs. Bank of Bahrain and Kuwait(2010) (SB)(Mumbai) held that the anticipated losses on account of existing obligation as on 31st March, determinable with reasonable accuracy, being in the nature of expenditure/accrued liability, have to be taken into account while preparing financial statements.
Reference may also be drawn to the Apex Court decision in the Oil & Natural Gas Corporation Ltd vs. C.I.T.(2010)(SC) wherein court reiterated the principles laid down in its earlier ruling in the case of Woodward Governor(supra) and held that loss on foreign exchange rate fluctuation is duly allowable under section 37(1) though liability actually not discharged.
In view of the above judicial pronouncements, a view may be taken that MTM losses arising on forward exchange contract obtained to hedge foreign currency risk on revenue transactions are not notional/contingent and are allowable in the year of accrual.
Instruction No. 03/2010, Dated 23.03.2010 –Clarification regarding allowing losses on account of forex derivatives.
CBDT issued instructions to its officers to disallow MTM losses occurring on account of foreign exchange derivatives. According to Circular, in cases where no sale or settlement has actually taken place and loss on MTM basis has resulted in reduction of book profits, such a notional loss would be contingent in nature and cannot be allowed to be set off against taxable income. The same should therefore be added back for the purpose of computing the taxable income of an assessee.
In light of above discussion, it can be inferred that Instruction No. 03/2010, Dated 23.03.2010 contrary to decision of Apex Court in Woodward Governor Case(supra) and thus can be challenged in court of law.
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Gagan Deep Singh
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