Before going into the concept of notional loss arising out of Mark-to-Market on forward contract, let's brush up some important basic definitions relating to the above treatment.
What is Notional Loss?
We have come across many situations where notional income, such as expected rents are getting taxed under its appropriate heads of income. The same types of incomes are also possible in case of Capital Gains and Income from other sources. But going deep into the concept of notional gain or loss, it is nothing but a gain or loss as on the reporting date in relation to a derivative contract. Derivative contracts may still have time until expiration, but for the purpose of reporting income or loss on the reporting date, such notional gain or loss has been arrived at the prevailing rate on the closing of the books of accounts. If it results in a loss, it is termed as notional loss and accordingly charged to profit and loss account.
Notional Gain or Loss in case of a forward contract
Without going deep into the nature of a forward contract, let's analyze the concept of the notional loss with an example.
Let's say, Company A Ltd is engaged in the business of trading in gold. A ltd engages in the hedging of a forward contract in relation to a purchase of gold by getting credit from Nova Scotia Bank. Golds are purchased and then within a credit period, the same are paid along with interest. Remember, gold vendors are in Dubai and accepts payments only in US dollars. So, the forward contract entered via Nova Scotia is for hedging the risk of a rise in currency rates within a credit period. A Ltd enters in a 3-month forward contract for the USD for Rs. 65. The current payable comes to $100,000 @63. Now the following two scenarios are possible,
If the rate moves to $70:
In this case, A Ltd will book a profit of $5 on account of a forward contract entered at $65. On the reporting date, it will be booked as notional gain and accordingly be credited to profit and loss account.
If the rate moves to $60:
In this case, A Ltd will book a loss of $5 on account of a forward contract entered @$65 (cash outflow, compared to $60). This will be reported as a notional loss on the reporting date and appropriately be charged to the profit and loss account. This treatment of marking loss on the reporting date on a notional basis is known as Mark-to-Market (MTM).
Having known the basic concept of notional loss, forward contract, and MTM. Let's move on to the treatment of the notional loss as per Income Tax act, 1961:
Various case laws and clarifications by CBDT have been referred relating to the treatment of notional loss on account of the forward contract.
The following case laws are important in reaching the conclusions on the current issue.
1) CIT Vs Woodward Governor (P) Ltd (Delhi HC, 2007)
2) ONGC Vs CIT (SC, 2010)
3) DCIT Vs. Bank of Bahrain and Kuwait(2010) (SB)(Mumbai)
4) DCIT Vs Maruti Udyog Ltd (Delhi ITAT, 2006)
5) Emmons International Ltd Vs ACIT (Delhi ITAT, 2019)
All the above case laws support a view that unfavourable forward exchange differences arising on the reporting date will be considered as a notional loss and subsequently be allowed as business expenditure u/s 37(1) of the act.
All the above case laws were decided based on CIT Vs Woodward Governor (P) Ltd given by the Delhi High Court during the year 2007. Without going deep into the case law lets look at the important points which warrants the High Court to come up with the decision of allowing notional loss on account of foreign exchange rate fluctuations as business expenditure u/s 37(1) of the act.
As per sec 37(1) expenditure shall mean;
"Any expenditure (not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the purpose of the business or profession shall be allowed in computing the income chargeable under the head Profits and gains of business or profession".
From the above reading, it is evident that expenditure even if the same is laid out wholly for the purpose of the business or profession the same will be considered as allowable expenditure under sec 37(1) of the act.
Further, the assessee has been regularly following an accounting policy of treating the gain or loss on a notional basis to the profit and loss account and has accordingly paid tax if the same results in notional gains.
Hence, notional loss on account of foreign exchange differences by entering into the forward contract will be allowed as deductions u/s 37(1), in the above case.
On taking Woodward Governor (P) Ltd as a primitive case law based upon which ONGC Vs CIT (SC) and other following cases were decided, it can be concluded that notional loss on the foreign exchange difference on reporting date on account of a forward contract will be allowed as an expenditure as per sec 37(1) of the act.
CBDT Clarification dated 23.03.2010
"If any loss as a result of MTM, then such loss should be added back to profit while determining the tax liability of the assessee"
The clarification goes exactly opposite to the High Court's decisions in the case of Woodward Governor (P) Ltd. However, the question of CBDT clarification superseding the court's decision is subject to debate but still, the case of notional loss is a matter of grey area in which a lot of explanation yet to be sought.
This brings us to the latest ITAT decision in the case of Emmsons International Ltd Vs ACIT (Delhi ITAT, 2019) in which both the CBDT clarification and Woodward Governor's case law was incorporated and given the decision.
Important points with regards to Emmsons International Ltd Vs ACIT (2019):
I) The assessee company had a notional loss of Rs. 8.95 crores on account of the forward contract at the reporting date.
II) The assessee during the previous two years relating to the year under consideration had a notional gain of Rs. 71.58 crores and Rs. 3.74 crores which were genuinely offered to tax by consistently following the accounting policy and as well as AS-11 (effects of changes in foreign exchange rates)
III) In this case, tribunal considered the above points and allowed the notional loss as business expenditure u/s 37(1).
How CBDT clarification Vs Apex Court decision was dealt in the above case
It was decided that CBDT is only an authoritative body which manages and clarifies from time and again with relation to the Income-Tax provisions. We have seen case laws that were decided against the CBDT orders and clarifications on the subject matter of interpretations. Hence, CBDT is in no way can supersede the orders of the Apex Court and give a contrary clarification to that of an order passed by the Apex Court. The fact that clarification came after the Apex Court judgment will not make any difference in the stand taken by the Apex Court in the case of ONGC Vs CIT. (citing the case law Woodward)
Hence the above order of Apex Court has put to rest the debate of whether CBDT clarification which came after Woodward and ONGC case laws have a superseding effect on the treatment of notional loss on account of foreign exchange differences on a forward contract.
My view on the case
Even though the company reports the notional loss on the reporting date, subsequently there may be a chance of gain on the closing of the forward exchange contract.
Consequently, allowing notional loss or gain to be treated while computing the income tax has no bearing on taxing the actual gain or loss on the final outcome at the time of closing the forward contract.
Therefore, notional loss or gain arising on the reporting date on account of foreign exchange difference by entering into the forward contract should have no impact on the taxable income of the assessee. However, on the closing date of the contract, it will either be at loss or gain to the assessee which can be treated appropriately in the subsequent year's income.
It can be concluded that notional loss on account of foreign exchange differences on the reporting date due to entering into the forward contract will be allowed as a deduction u/s 37(1) of the act.