Mumbai Tribunal Allows Loss due to Fair Valuation under Mark-To-Market Principle on Market-Linked Debentures as Business Deduction

The Mumbai Bench of the Income Tax Appellate Tribunal (‘Tribunal’) held that loss arising on fair valuation of Benchmark Linked Debentures (BLDs), market linked securities, cannot be disallowed merely because it represents a mark-to-market adjustment. The Tribunal observed that where financial instruments are valued in accordance with recognised accounting standards and the method is consistently applied, the resulting loss represents a legitimate business loss and cannot be treated as merely notional.

Background

·       The taxpayer recognised a loss on account of fair valuation of Benchmark Linked Debentures (BLDs), as on the balance sheet date.

·       The BLDs were principal-protected, but the coupon/interest payable was linked to the NIFTY index, creating a potential liability if certain market thresholds were crossed.

·       During assessment, the Assessing Officer (AO) disallowed the loss, holding that it arose due to year-end revaluation and had not actually crystallised, as the securities had not been sold or redeemed.

·       The AO treated the loss as notional/ contingent and therefore not allowable as a deduction.

·       The appellate authority, i.e., the National Faceless Appeal Centre, upheld the disallowance.

·       The taxpayer then filed an appeal before the Tribunal.

AO’s Findings

·       The AO viewed the loss as arising solely from year-end valuation and not from an actual transaction, treating it as a contingent liability.

·       Since the securities continued to be held, the AO concluded that the loss had not crystallised and therefore could not be allowed.

Taxpayer’s Contentions

·       Valuation was carried out in accordance with recognised accounting standards applicable to financial instruments.

·       It argued that entities engaged in financial market activities commonly follow mark-to-market / fair valuation, and the resulting loss reflected the true financial position.

·       The taxpayer also emphasised that the accounting methodology was consistently applied and represented a known liability, not a contingent one.

Tribunal’s Findings

·       The Tribunal held that the fair valuation loss constituted a known liability as on the balance sheet date, arising from the market-linked obligations of the debentures, and therefore represented a business loss rather than a contingent liability.

·       It observed that valuation of financial instruments at fair value in accordance with recognised accounting principles is a valid accounting practice.

·       Where such a method is followed consistently, the resulting gain or loss cannot be regarded as merely notional.

·       Relying on Supreme Court rulings (including Woodward Governor) and the Mumbai ITAT decision in J.P. Morgan and Bank of Bahrain & Kuwait (Special Bench), the Tribunal observed that “expenditure” under section 37(1) covers business losses, even if there is no immediate cash outflow and noted that accounting for known liabilities and losses is prudent and mandated under accounting standards.

·       Accordingly, the Tribunal concluded that the loss was allowable as a business expenditure, and the AO’s disallowance was not justified.

Key Takeaway
Loss arising from fair valuation or mark-to-market adjustments of market-linked financial instruments, arising from existing binding obligations, determined with reasonable certainty, using a consistent method in accordance with accounting standards, represents a legitimate business loss and cannot be treated as notional or contingent. Such losses may be allowable as a business deduction