CBDT Instruction No. 3/2010, dated 23-3-2010 — Allowing losses on account of forex derivatives under the Income-tax Act, 1961 — reg — F. No. 225/143/2009-ITA.II.

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 assessees 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 :

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 assessees. 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 S. 43(5) of the Income-tax Act. For determining whether loss
from a transaction in respect of a forex derivative is a speculatidn loss or
not, the Assessing Officers may refer to proviso (d) below Ss.(5) of S. 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 S. 2 of the Securities Contracts (Regulation) Act, 1956, that has
been carried out in a recognised 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 S.
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 forex derivatives included in the
Profit and Loss Account and examine whether such transactions are ‘eligible
transaction’ in terms of S. 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.