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CBDT: Notional losses on forex hedge not tax deductible
March, 30th 2010

A company that makes a notional loss on a forex derivative because of a fall in its value cannot deduct the loss from its taxable income since it still owns the derivative. This has been clarified by Central Board of Direct Taxes (CBDT), the apex body that administers direct taxes in the country.

The clarification comes in the wake of substantial losses to an assessee in the last financial year (FY2009) on account of trading in forex derivatives.

According to a CBDT circular, a large number of assessees are said to be reporting forex derivatives-related losses on their own or on the advice of chartered accountants. The tax body has made it clear that if no sale or settlement has actually taken place and the loss on mark-to-market basis has resulted in reduction of book profits, such a loss would not allowed to be offset against income.

Companies protect themselves against forex risk and volatility by entering into contracts with banks. In the simplest form, a company which, say, expects dollars on a periodic basis, enters into contracts with a bank to sell the dollars to it at a fixed rate for delivery at a future date. If during the life of a contract, the rupee falls below the rate fixed with the bank, the company books a mark-to-market loss (difference between value as on valuation date and purchase price of say an option or a futures contract) on either its balance sheet or its P&L account even thought the contract has not matured. Companies make this adjustment in the P&L account or balance sheet as part of transparent accounting practices.

However, according to CBDT, the companies cannot offset such notional losses against income. The CBDT has said that the losses should be added back to the income and be taxed.

Going one step further, the tax body has said that if a loss arises on actual settlement of such contracts and is not a notional or marked to market book entry, the assessing officer would have to determine whether such a loss is on account of a speculative or an eligible transaction. A speculative loss can only be offset against a speculative profit and can be carried forward for only four years.

However, an eligible transaction is one that is carried out electronically on a screen-based system through a stock broker or a sub-broker on a recognised stock exchange. This means that if companies buy or sell dollars or pounds on NSE and MCX-SX, the losses or profits arising out of such transactions can be offset against business gain or losses and can be carried forward for eight years. The CBDT has said that after due diligence by the assessing officer, such losses or gains may be offset against taxable income.

A note from Pricewaterhousecoopers said: The above instructions are not binding on taxpayers. Though the taxpayers may take a contrary position, the instruction would certainly be the basis of assessments completed hereafter. The positive fallout is that companies may take a view that MTM gains are not taxable unless realised.

Bombay-based counsel Bhupendar Shah said: The assessements made on the basis of this circular are likely to be contested before the court.

Sudhir Kapadia of Ernst & Young told ET: The circular is not in tune with the view taken by the Supreme Court in the case of Woodword Governor India. However, the circular issued to the assessing officers is not binding on the taxpayers.

Senior chartered accountant T P Ostwal said: This circular would lead to unintended consequences such as more litigation.

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