Forex Loss allowability

Background :

So long as the exchange rate of Indian Rupee against US Dollar was relatively stable or depreciating, the exporters did not resort to complex hedge instruments to cover their currency risks. But when the Indian Rupee started steeply appreciating against US Dollar during April to June 2007, many were caught unaware suffering severe losses.

During this period, few banks came up with a novel idea of ‘foreign exchange derivatives’ with possible attractive returns for the exporters and entered into several forex derivative contracts. Initially, some exporters made some gains in the transactions and more exporters opted for the arrangement. However, in the end, almost everyone who went for the arrangement suffered significant losses.

Some of the exporters challenged the validity of the contracts itself as illegal under the provisions of the Contract Act, while some others have settled the issue with the banks and the banks have waived a portion of their claims under the derivatives contracts, still leaving the exporters with substantial loss in the bargain.

There is a view that these contracts may be treated as speculative in nature hit by the provisions of S.43(5) of the Income-tax Act, thereby the loss on such contracts may be disallowed. There are few other issues as to the accounting methodology adopted by the organisation, compliance with AS 31-33 and the recent Circular issued by the CBDT in this connection that require careful consideration.

In this article it is proposed to analyse various issues that confront a taxpayer in claiming deduction for these forex derivative losses while computing his total income in this article.

Forex derivatives :

The term derivative is defined u/s.45V of the Reserve Bank of India Act, 1949 as meaning “an instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called ‘underlying’), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the Bank from time to time”.

To put it in simple language, a derivative is a financial instrument whose value depends on the values of the underlying exposure. The underlying exposure in the case of forex derivatives is the foreign exchange rates.

Commonly used forex derivatives are Forward Contracts, Option Contracts and Swap Contracts. These instruments are used to hedge the currency risk on account of adverse currency movements.

Hedging and need for hedging :

Hedging is defined as ‘to enter in to transactions that will protect against loss through a compensatory price movement’. A hedging transaction is one which protects an asset or liability against a fluctuation in the foreign exchange rate. Any person having an exposure to foreign currency may resort to hedging so as to fix his cost and profits at a particular level.

For example, an exporter of T-shirts has the following cost structure :

                                                       Rs.

Sale price in India     ...     ...     ...     45

Total cost                 ...     ...     ...     40

Profit                        ...     ...     ...       5

• The buyer agrees to buy the T-shirt at the rate USD 1 per T-shirt.
• The current price of USD is Rs.46.
• The seller prefers to sell the T-shirt for USD 1 each, since he is going to make Re 1 extra because for each dollar he will get Rs.46.
• Sale proceeds will be received three months from today.
• The exporter is wishes to enter into hedging transaction so that future adverse movements of USD against INR will not affect his earning.
• For which he has two choices, one is Forward Contracts and the other is Options.

Forward contracts :

A forward contract is nothing but an agreement between an enterprise and a banker to purchase or sell a particular quantity of a currency for a mutually agreed price at a particular future date. Exporters are extensively using forward contracts to get their export receivables hedged against adverse currency movements.

In the above example, if the exporter books a forward contract for Rs.46 to be delivered on a specified future date synchronising with the date of realisation of his export proceeds, his risk is neutralised inasmuch as he is certain to receive Rs.46 per USD, irrespective of the spot price on the date of delivery of the transaction. But in case the spot price is Rs.48 per USD, there will be an opportunity loss of Rs.2 about which the exporter is consciously taking the risk.

Option contracts :

Option contracts are slightly different from forward contracts. They give the exporter a right to exercise the option of buying/selling a foreign currency at a particular price, but the exporter is not obliged to buy/sell if the spot market prices are favourable to him. This involves a price which is called option premium upon payment of which the exporter is hedged against adverse currency movement and also not liable to lose in case of favourable currency movement.

In the above example, if the exporters takes an option at 1USD = Rs.46, his minimum realisation is assured at Rs.46 on the date of delivery. If the spot rate on delivery is above Rs.46, he can leave the option unexercised and go for the spot rate. This right he acquires by payment of an option premium.

Exotic options :

Exotic options are structured contracts which are extremely difficult for an ordinary exporter to understand. Among the most successful exotic option products are barrier options. The pay-off of a barrier option depends on whether the price of the underlying asset crosses a given threshold (the barrier) before maturity. The simplest barrier options are ‘knock-in’ options which become exercisable when the price of the underlying asset touches the barrier.

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 :

(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 ?

(c) Whether crystallised losses on account of forex derivatives including exotic option contracts settled otherwise than by delivery of foreign currency are speculative in nature and liable to be dealt with separately as per S. 43(5) of the Income-tax Act ?

(d) In cases where few assessees have challenged the validity of these contracts on the ground that they are wager in nature and void u/s.30 of the Contract Act, whether the said loss may be termed as speculative u/s.43(5) of the Income-tax Act ?

(e) In cases where the exporters have gone to the Courts challenging the validity of the contracts under the Contract Act on the ground that they are illegal contracts, whether disallowance could be made under explanation to S. 37(1) ?

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 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”.

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 :

Recently, the CBDT has issued Instruction No. 03/2010, dated 23-3-2010 to assessing officers regarding the loss on account of currency derivatives. The crux of the said instruction can be captured as under :

(1) 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.

(2) 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.

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 the following observations :

(i) A binding obligation accrued against the assessee the minute it entered into forward foreign exchange contracts.

(ii) A consistent method of accounting followed by the assessee cannot be disregarded only on the ground that a better method could be adopted.

(iii) 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 the rate prevailing on March 31.

(iv) 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.

(v) 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.

(vi) The forward foreign exchange contracts have all the trappings of stock-in-trade.

(vii) In view of the decision of the Supreme Court in the case of Woodward Governor India (I) P. Ltd., the assessee’s claim is allowable.

(viii) 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 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.

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 satisfied :

(a) It should arise or spring directly from or be incidental to the carrying on of a business operation;

(b) There should be direct or proximate nexus between the business operation and the loss;

(c) It should be a real loss and not notional or fictitious;

(d) It should be a loss on revenue account and not on capital account;

(e) It must have actually arisen and been incurred, not merely anticipated as certain to occur in future; and

(f) There should be no prohibition in the Act, express or implied, against the deductibility thereof.

Whether forex derivative loss satisfies the above conditions ?

Losses on account of forex derivatives satisfy the above conditions and are squarely covered by the judgments referred above because of the following reasons :

(a) Forward and option contracts are used to hedge currency exposure.

(b) Most of these forward contracts are settled by delivery of currency.

(c) Forex derivative contracts are entered into with a view to make good the loss incurred on account of rupee appreciation by earning some profits.

(d) Loss on account of forex derivative contracts springs directly from and is incidental to the carrying on of business.

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

(f) There exists a direct and proximate nexus between export business and the loss on account of forex derivatives.

Applicability of S. 43(5) :

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 :

(a) The term ‘commodity’ is defined neither in the Income-tax Act nor in the General Clauses Act.

(b) Dictionary meaning of the term ‘commodity’ is ‘raw material or agricultural product that can be bought and sold — something useful or valuable’.

(c) 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.

(d) 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’.

(e) 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.”

(f) 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. 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).

(g) 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.

(h) 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.

Wager v. Speculation :

Some assessees, after incurring and paying the osses, have proceeded to challenge the validity of the contract under the Contract Act. There is a view that that since the assessees themselves are claiming the contracts as wager, the loss on account of the same is nothing but a speculation loss and accordingly subject to S. 43(5). This ground will not hold water because of the Supreme Court judgment in the case of Davenport & Co. P. Ltd. v. CIT, reported in (100 ITR 715) wherein the Apex Court has held as under :

“For income-tax purposes speculative transaction means what the definition of that expression in Expln. 2 says. Whether a transaction is speculative in the general sense or under the Contract Act is not relevant for the purpose of this Explanation. The definition of ‘delivery’ in S. 2(2) of the Sale of Goods Act which has been held to include both actual and constructive or symbolical delivery has no bearing on the definition of ‘speculative transaction’ in the Explanation. A transaction which is otherwise speculative would not be a speculative transaction within the meaning of Expln. 2 if actual delivery of the commodity or the scrips has taken place; on the other hand, a transaction which is not otherwise speculative in nature may yet be speculative according to Expln. 2 if there is no actual delivery of the commodity or the scrips. The Explanation does not invalidate speculative transactions which are otherwise legal but gives a special meaning to that expression for purposes of income-tax only.”

Applicability of explanation to S. 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 of our case as loss from forex derivatives is not business expenditure but a business loss.

To sum up :

(a) Loss from forex derivatives is a business loss and not a business expenditure and accordingly allowable u/s.28;

(b) 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.

(c) 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;

(d) They cannot be termed as speculative simply because few assessees have challenged the validity of these contracts on the ground that they are wager in nature.

(e) 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.

Clarification regarding allowing losses on account of forex derivatives

Instruction No. 03/2010

Dated 23-3-2010

Foreign Exchange derivative transactions entered into by the corporate sector in India have witnessed a substantial growth in recent years. This combined with extreme volatility in the foreign exchange market in the last financial year is reported to have resulted in substantial losses to an assessee on account of trading in forex-derivatives. A large number of assesses are said to be reporting such losses on 'marked to market' basis either suo motu or in compliance of the Accounting Standard or advisory circular issued by the Institute of Chartered Accountants. The issue whether such losses on account of forex-derivatives can be allowed against the taxable income of an assessee has been considered by the Board. In this connection, I am directed to say that the Assessing Officers may follow the guidelines given below:

'Marked to Market Losses':

2. "Marked to Market" is in substance a methodology of assigning value to a position held in a financial instrument based on its market price on the closing day of the accounting or reporting record. Essentially, 'Marked to Market' is a concept under which financial instruments are valued at market rate so as to report their actual value on the reporting date. This is required from the point of view of transparent accounting practices for the benefit of the shareholders of the company and its other stakeholders. Where companies make such an adjustment through their Trading or Profit/Loss Account, they book a corresponding loss (i.e the difference between the purchase price and the value as on the valuation date) in their accounts. This loss is a notional loss as no sale/conclusion/settlement of contract has taken place and the asset continues to be owned by the company.

A 'Marked to Market' loss may be given different accounting treatment by different assesses. Some may reflect such loss as a balance sheet item without making any corresponding adjustment in the Profit and Loss Account. Other may book the loss in the Profit and Loss Account which may result in the reduction of book profit. In cases where no sale or settlement has actually taken place and the loss on Marked to Market 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 the taxable income. The same should therefore be added back for the purpose of computing the taxable income of an assessee.

3. Treatment of loss from actual transactions in forex-derivatives

In a case where a loss on a forex-derivative transaction arises on actual settlement / conclusion of contract and is not a notional or marked to market book entry, a further question will arise as to whether such a loss is on account of a speculative transaction as contemplated in Section 43(5) of the Income tax Act. For determining whether loss from a transaction in respect of a forex-derivative is a speculation loss or not, the Assessing Officers may refer to Proviso (d) below sub-section (5) of Section 43 inserted by the Finance Act, 2005, with effect from 1.4.2006. It lays down that any 'eligible transaction' in respect of trading in derivatives referred to in clause (ac) of section 2 of the Securities Contracts (Regulation) Act, 1956, that has been carried out in a recognized stock exchange shall not be treated as a speculative transaction. Further, an 'eligible transaction' for this purpose would be one that fulfils the conditions laid down in Explanation to Section 43(5)(d). Any loss in a speculative transaction can be set off only against profit from speculative transactions.

As the revenue implications of such transaction are large, the Assessing Officers need to examine the statements of accounts and the notes to accounts with a view to find out any reference to any loss on account of forex-derivatives. In some cases, these losses may be camouflaged under the 'financial charges' 'foreign exchange loss' or some similar head which may make it difficult to detect them. In such cases, the Assessing Officers should make a specific query asking the assessee to give a break up of any 'Marked to Market' loss on a forex-derivatives included in the Profit and Loss Account and examine whether such transactions are 'eligible transaction' in terms of Sec.43(5)(d). An adjustment to the taxable income may therefore be made, if necessary, keeping in view the provisions of law referred to above.