Losses on un-matured forward contracts cannot be considered as notional or contingent in nature

Losses on un-matured forward contracts cannot be considered as notional or contingent in nature

Court : Mumbai Bench of the Income-tax Appellate Tribunal

Brief : In this case Special Bench of the Income-tax Appellate Tribunal dealt with the issue of allowability of losses on account of unmatured forward contracts in foreign exchange entered into by the taxpayer. The Special Bench while dismissing the contentions of the tax department held that the loss on unmatured forward contracts is in the nature of anticipated losses and not a contingent loss. The Special Bench observed that a binding obligation (although not fully ascertainable) arose against the taxpayer the moment it entered into forward foreign exchange contract. The Special Bench has relied on the recent decision of the Supreme Court in the case of CIT v. Woodward Governor of India [2009] 312 ITR 254 (SC) wherein the Supreme Court had held that exchange fluctuation loss arising on mark- to-market restatement of liability which is revenue in nature is an allowable loss. The Special Bench further observed that where profits were being taxed by the tax department in respect of such unmatured foreign exchange contracts then there was no reason to disallow the loss on such contracts.

Citation : DCIT v. Bank of Bahrain & Kuwait [2010-TIOL-447-ITAT-MUM-SB]

Judgment :

Facts of the case

• The taxpayer, a non-resident company carrying on banking business in India, entered into forward contracts with its clients to buy or sell foreign exchange at an agreed price on a future date. In cases where the date of maturity of the contract falls beyond the end of the accounting period, the taxpayer evaluates the unmatured forward contracts on the last day of the accounting period on the basis of rate of foreign exchange prevailing on that date and books the loss or profit accordingly. Accordingly the taxpayer booked losses of INR 1.2 million.

• However, the Assessing Officer (AO) observed that the principles of taxation require that actual profit or loss was to be brought to tax and not contingent losses. And since in a forward contracts, liability arises only on the date on which the contracts mature such losses should not be allowed as a deduction..

• The AO also referred to the Madras High Court’s decision in the case of Indian Overseas Bank v. CIT [1990] 246 ITR 206 (Mad) wherein it was held that before settlement of contracts in foreign currency, no actual profit could accrue and the amount in question represented notional profits only. Accordingly, the AO disallowed the loss of INR 1.2 million treating the same as notional loss.

Taxpayer’s contentions

• The taxpayer contended that as per the Reserve Bank of India guidelines, it was required to revalue its outstanding foreign exchange forward contract as per the rates notified by the Foreign Exchange Dealers Association of India (FEDAI) on 31 March every year. Therefore it had to re-assess the anticipated loss at the end of the year in accordance with the method of accounting consistently followed by it.

• The taxpayer relied on the Supreme Court’s decision in the case of Investment Ltd v. CIT [1970] 77 ITR 533 (SC) wherein, it has been held that the method of accounting consistently and regularly followed by the taxpayer cannot be discarded by the tax department merely on the ground that a better method of accounting could be the alternate one.

• In the case of Woodward Governor India (P) Ltd, the Supreme Court has held that the additional liability on account of fluctuation in foreign currency as on 31 March 1991 in respect of foreign currency working capital loans outstanding on that date was an allowable revenue loss and was not notional or contingent.

• A forward exchange creates a binding obligation arises which is required to be discharged. Therefore, the physical delivery of foreign currency on the date of maturity does not wipe out the present liability incurred by the taxpayer.

• The loss on the revaluation of the outstanding forward exchange contracts is to be allowed on the well recognised principle that taxpayer’s stock/circulating capital has to be valued at cost or market price, wherever is lower.

Tax department’s contentions

• The taxpayer was carrying on banking business in India and it is not the taxpayer’s business to deal in forward contracts. It entered into forward contracts with its clients to buy or sell foreign currency at an agreed price on a future date in order to in order to avoid wide fluctuation in foreign currency.

• The Tribunal’s decision in the case of Deutsche Bank A.G v. DCIT [2003] 86 ITD 431 (Mum) and the decision of the Bombay High Court in the case of CIT v. Bank of India [1996] 218 ITR 371 (Bom) proceeded on the footing that the securities were stock-in-trade. However, in the present case there is no material to prove that forward contract to buy or sell foreign currency itself constitutes the stock-in-trade and therefore these cases are not applicable to the case under consideration.

• The Supreme Court in the case of Woodward Governor of India observed that as per Accounting Standard (AS) -11 on “Effect of Changes in Foreign Exchange Rates”, effect of changes in exchange rate vis-à-vis monetary items denominated in a foreign currency has to be taken into account for giving accounting treatment on the balance sheet date. The tax department contended that in the present case, since no transaction has been entered into in the books of account, there was no monetary item requiring adjustment of exchange rate difference.

• The tax department relied on the Bombay High Court’s decision in the case of CIT v. Kamani Metals and Alloys Ltd [1994] 208 ITR 1017(Bom) wherein, the taxpayer had entered into a contract with MMTC for purchase of copper cathodes at a particular rate. The High Court observed that the material was received in the next accounting period and therefore there was no closing stock of the material in the hands of the taxpayer. Accordingly, the High Court held that the material contracted to be purchased could not be regarded as taxpayer’s stock-in-trade and hence, could not be valued in the accounts as such.

• The liability accrues or arises only on the date of maturity of the contract and estimated liability as per FEDAI guidelines cannot be allowed under the Act.

Special Bench’s ruling

• The Forward exchange contract creates a continuing binding obligation on the date of contract against the taxpayer to fulfill the same on the date of maturity.

• As observed by Supreme Court in the case of Woodward Governor, AS -11 which is mandatory requires that when the transaction is not settled in the same accounting period as that in which it occurred, the exchange differences arises in more than one period. The principle laid down by Supreme Court that in case of a working capital loan, loss on account of fluctuation in foreign currency as on the date of foreign exchange is an item of expenditure under Section 28 of the Income-tax Act, 1961 (the Act) would be applicable in this case too.

• Contingent liability is not allowed as a deduction. However, if an anticipated liability is coupled with present obligation and only quantification can vary depending upon the terms of contract, then a liability is said to have crystallised on the date of balance sheet date. Hence anticipated losses on account of existing obligation, determinable with reasonable accuracy have to be taken into account. Reliance was placed on the decision of the Supreme Court in the case of Bharat Earth Movers v. CIT [2000] 245 ITR 428 (SC).

• It is a settled law that a method of accounting regularly employed by the taxpayer cannot be disregarded by the AO unless he is of the opinion that profits are not correctly deductible from such method of accounting as per the provisions of section 145(3) of Act. However, the AO cannot reject the method of accounting followed by the taxpayer merely on the ground that a better method of accounting could be the alternate one. However, in the present case, though observations have been made by the AO to this effect but actual disallowance has been made by treating the impugned amount as contingent liability.

• The Special Bench observed that there was no dispute that the foreign exchange currency held by the taxpayer bank was its stock-in-trade and the taxpayer had entered into forward foreign exchange contracts in order to protect its interest against the wide fluctuation in the foreign currency itself. Therefore, this contract was incidental to taxpayer’s holding of the foreign currency as current asset. Towards this, the Special Bench relied on the Calcutta Special Bench decision in the case of Shree Capital Services Ltd. v. ACIT [2009] 121 ITD 498 (Kol) (SB)

• The Special Bench also observed that tax department had for the Assessment Year 2002-03 and 2003-04 assessed the taxpayer in respect of the profit shown by the Bank on restatement of outstanding forward foreign exchange. Accordingly, there was no reason to disallow the loss as claimed by taxpayer in respect of same contracts on the same footing.

Our Comments

This is welcome decision of the Mumbai Special Bench where it is held that losses arising on account of unmatured forward contracts are not notional in nature. This decision holds importance since prior to this decision there were no clear judicial precedents directly on the point. Before this decision reliance was generally placed on RBI guidelines, Accounting Standards and the Supreme Court decision in the case of Woodward Governor of India.

It is interesting to note that the Central Board of Direct Taxes had issued Instruction no. 03/20 10 dated 23 March 2010 to the effect that losses arising on account of year-end valuation of forex-derivatives are to be disallowed on the ground that these are contingent and notional in nature.