A derivative is a financial instrument, whose value is derived from some underlying source. In other words, its value fluctuates with the value or performance of the underlying on which it is based.
Black’s Law Dictionary defines the term “derivative” as:
“A financial instrument whose value depends on or is derived from the performance of a secondary source such as an underlying bond, currency or commodity.”
International Accounting Standard 39 defines a derivative in paragraph 9 as under:
“A derivative is a financial instrument or other contract with all three of the following characteristics:
(a) its value changes in response to change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices of rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the “underlying”);
(b) It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and
(c) it is settled at a future date.”
The Exposure Draft issued by the Institute of Chartered Accountants of India (ICAI) on the proposed Accounting Standard on “Financial Instruments – Presentation” also uses the same definition as used in IAS 39.
The Economist Pocket Investor describes derivatives as under:
“The generic name for financial products which are derived from other financial products and, according to some, are the ogre which threatens to bring chronic instability to the world’s financial system. All derivatives contracts – whether they are options, futures, swaps or products with more exotic names - give one party the right (or at least the option) to make a claim on an underlying asset at some point in the future and bind another party to meet a counter-balancing obligation. The underlying product might be an ordinary share, a stock-market index, a commodity, a string of interest payments; the list goes on.
From this, two things follow. First, derivatives can offer insurance for whomever buys contracts because they take the uncertainty out of the future value of an asset. Second, derivatives offer lots of risk – that is, the potential to make large losses as well as large gains – for someone who does not have a cash position to hedge because, in return for a comparatively small payment upfront, that party accepts the consequences of what transpires in the future.
Derivatives are traded either on a recognised exchange, such as the Chicago Mercantile Exchange or LIFFE, or Over The Counter (OTC), mainly by banks. In the case of the former, exchange places itself between all market participants and therefore accepts the risks of a counterparty defaulting. In the latter case, the obligations lie with the specific parties to a contract, making OTC derivatives – implicitly at least -a greater threat to financial stability because of the panic that might ensue if, say, a major bank did default on its commitments.”
From the above, it is clear that though derivatives are financial instruments, they could be based on different underlying sources. Therefore, one comes across commodity derivatives, equity, bond and equity index derivatives, money market interest rate derivatives, foreign exchange derivatives, credit derivatives, economic derivatives, energy derivatives, freight derivatives, insurance derivatives and even weather derivatives. This article focuses primarily on derivatives based on equities and equity indices in India, which are regarded as securities under the Securities Contracts (Regulation) Act, 1956.
Section 2(aa) of the Securities Contracts (Regulation) Act, 1956 defines derivatives in an inclusive manner as under:
‘"derivative" includes –
A. a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security;
B. a contract which derives its value from the prices, or index or prices, of underlying securities.’
Today, futures and options based on individual stocks or based on stock indices are the major derivatives traded on the exchanges. The focus of this article is therefore restricted to these futures and options.
Options:
An option is a right, but not an obligation, to acquire or sell a security at a particular price. Black’s Law Dictionary defines an option as - “The right (but not the obligation) to buy or sell a given quantity of securities, commodities or other assets at a fixed price within a specified time.”
IAS 33 defines options, warrants and their equivalents as “financial instruments that give the holder the right to purchase ordinary shares”.
The Economist Pocket Investor describes options as under:
“The best known of all types of derivatives, an option gives the holder the right, but not the obligation, to buy or sell a specific amount of an asset, probably ordinary shares, at a specified price within a specific period. Correspondingly, a person who underwrites an options contract accepts the obligation to deliver or buy shares according to the terms of the contract. In return, the buyer of the contract pays that person a fee upfront."
The ICAI Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options describes options as under:
“An Option is a type of derivative instrument whereby a person gets the right to buy or sell at an agreed amount an underlying asset on or before the specified future date. He is not under any obligation to do so.”
The specified price at which the option can be exercised is called the “strike price”.
One also needs to keep in mind that while the buyer of an option has the right but not the obligation to buy or sell, the seller of the option has a corresponding obligation (but not the right) to buy or sell the share, if the buyer so chooses to exercise the option.
The price paid by the buyer of the option to the seller for acquiring an option, which is paid upfront, is called the premium for the option. Since it is the buyer who gains a right, and the seller undertakes an obligation, the premium is always paid by the buyer of the option to the seller.
A call option is an option to buy, whereas a put option is an option to sell. Therefore, the buyer of the call option has the right to buy the share at the specified price, while the buyer of the put option has the right to sell the share at the specified price during the life of the option.
In India, we have options based on stock indices, such as the Sens*x and the Nifty, as well as based on individual stocks permitted by SEBI.
In the Indian context, options cannot be exercised to take or give delivery. They are cash settled on maturity, by payment of the difference between the cash price of the underlying on maturity and the strike price in case of a call option (and vice versa in the case of a put option) to the holder of the option, if the option is in the money ( i.e. the cash price of the underlying is higher than the strike price in case of a call option or vice versa in the case of a put option). If the option is out of the money (i.e. the cash price of the underlying on maturity is lower than the strike price in case of a call option or vice versa in case of a put option), the holder of the option does not receive any payment on maturity. Therefore, the holder of a call option of a particular share at a particular price cannot choose to take delivery of the underlying shares. He can either receive/pay the difference between the market value of the underlying share/index and the strike price on expiry of the option, or if he desires to square up his position before expiry of the option, he can sell an identical call option of the same share at the same price and of same maturity.
A buyer of a put option does not square up his position by buying a call option of the same strike price and maturity. Both positions of put and call option remain open separately.
An option of one share/index is obviously different from an option of another share/index. But options of the same share/index at different prices or of differing maturities are also regarded as different types of options, since, for the purchase of an option to be squared off against sale of another option, the underlying share/index, the strike price as well as the expiry date of both have to be identical. One option can therefore be distinguished from another by underlying share/index, strike price or expiry date.
In India, options are for a maximum maturity of 3 months. The options for a particular month expire on the last Thursday of that month.
Futures:
Futures are contracts to buy or sell shares on a specified future date. Black’s Law Dictionary defines “futures contract” as “an agreement to buy or sell a standardised asset (such as a commodity, stock, or foreign currency) at a fixed price at a future time, usually during a particular time of a month.”
The ICAI Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options describes “futures” as:
“A futures contract, like a forward contract, is an agreement between two parties to buy or sell an asset at a certain time in future for an agreed price. Futures contracts are normally traded on an exchange. To make trading possible, the exchange specifies certain standardised features of the contract. The exchange may also provide for guarantee mechanism to ensure that each party to the contract meets its obligations and, consequently, risk from default by parties is minimised.”
The difference between futures and options is also highlighted by the Guidance Note. “Futures and options are both standardised derivative instruments traded on a stock exchange. The difference between these two types of derivative instruments is in respect of the rights and obligations of the parties involved in such contracts. In case of a futures contract, both the parties are under obligation to complete the contract on the specified date. However, in case of options contract, the buyer/holder has a right, but no obligation to exercise the Option, whereas the seller/writer has an obligation but no right to complete the contract.”
Like options, futures are also for a maximum maturity of 3 months, expire on the last Thursday of the month and have to be cash settled on maturity. Unlike options, where the premium fluctuates for a particular strike price, the price of the futures itself fluctuates for a particular maturity. On maturity, the purchaser of a futures contracts receives (or pays) the difference between the market price of the underlying share/index on the maturity date and the purchase price of the futures, while the seller of a futures contract receives (or pays) the difference between the sale price of the futures and the market price of the underlying share/index on the maturity date.
Taxation of Futures & Options
Till Assessment Year 2005-06, the Income Tax Act, 1961 did not have any special provisions dealing with taxation of derivatives transactions in general, and dealing with futures and options in particular, though derivatives contracts have been traded on Indian stock exchanges since 2000. The Finance Act 2005 has amended the proviso to section 43(5), with effect from Assessment Year 2006-07, to provide that derivatives trading transactions would not be regarded as speculative transactions, subject to the fulfilment of certain conditions.
For the most part, therefore one needs to look at the normal provisions of the Income Tax Act and understand their applicability to derivatives transactions. Various issues do arise for consideration, more so, since there is also no case law on the subject, as futures and options transactions are of recent origin.
To understand the taxation, one also needs to understand the accounting treatment. The ICAI Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options provides guidance as to how such transactions are to be accounted for.
In substance, the Guidance Note provides that the profit or loss on the transactions are to be recognised only on expiry of the future or option or on squaring up of the position (unless there is an intervening balance sheet). Till such time of expiry or squaring up, the initial margin, premium paid and mark-to-market margin is to be accumulated and shown as a current asset. If a balance sheet is prepared during the intervening period before expiry of the future or option, a provision is to be made for the notional loss, if any, as on that date on a mark-to-market basis, but no profit is to be recognised on such basis.
Whether Always Taxable as Business Income:
The most common issue that arises in taxation of derivatives transactions is that of whether derivatives transactions are always to be regarded as business transactions.
It is true that in most cases, derivatives transactions would be regarded as business transactions on account of the following factors:
1. The purpose behind entering into most derivatives transactions is to profit from short-term fluctuations in market prices.
2. The period of any derivatives transaction cannot exceed 3 months, and such transactions are invariably short-term transactions.
3. Often, the sheer volume of trades in derivatives transactions entered into by a person on an ongoing basis indicates that it amounts to a business.
4. Many people who trade in derivatives may be associated with the stock market in some way or the other – they may be stock brokers or their employees, or regular day traders. For such people, derivatives trading is an extension of their normal business activities.
However, the issue of whether an activity amounts to a business or not depends upon various factors, and is not decided just because of the existence or absence of any one circumstance. There can be situations where derivatives transactions may not amount to a business. For instance, derivatives transactions may be carried on by an investor to hedge his investment portfolio. In such a case, the mere fact that the investor had to square up his derivatives position every 3 months and take up a fresh position, or pay mark-to-market on a daily basis, would not detract from the fact that the prime purpose of such transactions was to preserve the value of the investment portfolio.
Another common practice in the stock markets is arbitrage between the cash market and the futures market. It is a well known fact that the difference in prices between the futures market and the cash market is primarily dictated by the short-term interest rates, and such difference is normally equivalent to the interest that one would earn on short term lending. Therefore, a person having surplus funds may buy shares in the cash market, while simultaneously selling an equal amount of futures of the same share in the futures market. He would take delivery of the shares bought in the cash market. On maturity of the futures, the shares bought in the cash market would be sold in the cash market. Since the futures would be squared off at the cash market price, the profit on the transaction would normally consist mainly of the difference between the initial purchase price in the cash market and the initial sale price in the futures market, with small adjustments for expenses such as brokerage, securities transaction tax, service tax and the market spread between the buying and selling quotes in the cash market.
Are such arbitrage transactions business transactions, or are they really in the nature of interest seeking transactions? If one looks at the substance of these transactions, they are not motivated by a desire to earn profits, but just to avail of the benefit of the short term interest rates. There just two legs of the transaction – the purchase and futures sale, and the expiry of futures and cash sale. The income element in the transactions is determined right at the outset, and does not fluctuate to any material extent, even if there is substantial volatility in the market. Going by the principle of the substance of the transaction, a view is possible, as was being taken in the past in the case of vyaj badla transactions, that such transactions are in the nature of earning of interest, though they take the form of arbitrage transactions.
It may be however noted that other factors, such as frequency of transactions, nature of other business carried on, etc., would also determine whether such transactions are business transactions or not.
If not Business Income, under which Head Taxable:
The question arises that in a situation where derivatives transactions are not business transactions, under which head of income should such transactions be considered?
The answer to this question would partly depend upon the substance of the transactions. If the transactions are in the nature of interest-seeking transactions, then going by the substance of the transactions, the income from such transactions may be considered as interest.
But if the transactions are in the nature of hedging of investments, how would they be taxed? A derivative, being a security and a right under a contract, is certainly a valuable right, which is capable of being assigned. The right under the derivatives contract can therefore certainly be regarded as property, and therefore as a capital asset.
The issue which arises is – is there a transfer of the capital asset? When the transaction is squared up by an opposite corresponding transaction, there is certainly a transfer. But in cases where the squaring up is on expiry of the contract, can a transfer be said to have taken place? Considering the definition of “transfer” in section 2(47), the expiry of such a contract can possibly be regarded as an extinguishment of the rights in the asset. As held by the Supreme Court in the case of CIT vs. Grace Collis 248 ITR 323, the definition of “transfer” in section 2(47) clearly contemplates the extinguishment of the rights in a capital asset distinct and independent of such extinguishment consequent upon the transfer itself. A view is therefore possible that on expiry of the derivatives, there is a transfer of the capital asset. The gains or losses arising from such derivatives would accordingly be taxable under the head “Capital Gains”.
Though such income would be taxable under the head “Capital Gains”, and the derivatives transactions would be subject to Securities Transaction tax, such gains would not be entitled to the concessional tax treatment for short-term capital gains under section 111A, since the benefit of that section is available only to equity shares in a company or a unit of an equity oriented mutual fund.
Determination of Turnover:
If derivatives transactions are business transactions, the question then arises as to what constitutes the turnover in derivatives transactions for the purposes of section 44AB or for other purposes?
In the case of futures, the purchases of futures is not recorded as a purchase in the books of account, nor is the sale of futures recognized as a sale. Only the initial margin and mark-to-market margins are recorded as and when paid, and the profit or loss on the futures transaction is recorded as an income/expense on squaring up of the transaction or on expiry of the futures contract.
The margin paid is certainly not the turnover, and neither can the futures sale be regarded as a sale in the light of such accounting treatment. At best, only the difference (profit or loss on the futures transaction) can be regarded as turnover.
The question then is – should one net off the profits and losses and is only the net profit or loss to be regarded as the turnover? This does not appear to be proper, as the net profit or loss would not reflect a measure of the actual volume of transactions. It should be the gross differences which would constitute turnover, and not the net differences. The scrip wise gross differences for each maturity should be determined, the negative signs of the losses within a scrip of each maturity ignored and such losses grossed up with the gains to compute the turnover.
In the case of options, only the premium and margins paid is reflected in the books of account at the inception of and during the currency of the option. The strike prices of the margins do not get reflected in the books of account, except for the limited purpose of identifying different sets of options. On the squaring up or expiry of the options, the value of the option on sale or maturity is received or paid, and the profit/loss on the options accounted for. There is a view that such value of the options on squaring up/maturity would constitute the turnover in case of options, though the better view seems to be that it would be the gross differences (taking the losses also as a positive figure) as in the case of futures, that would constitute the turnover.
Exclusion of Derivatives from definition of Speculative Transaction:
A new clause (d) has been added to the proviso to section 43(5), excluding certain derivatives trading transactions from the definition of “speculative transaction”. Such exclusion of derivatives transactions is however subject to certain conditions.
These conditions are:
a. the transaction should have been carried out electronically on a screen-based system. This condition does not pose any difficulty, as all derivatives transactions on the National Stock Exchange or the Bombay Stock Exchange (which today are the only stock exchanges in India offering derivatives transactions) are electronic screen-based transactions.
b. The transaction should have been carried out through a stock broker or sub-broker or other intermediary registered under section 12 of the SEBI Act, 1992 in accordance with the Securities Contracts (Regulation) Act, 1956, the SEBI Act, 1992 or the Depositories Act, 1996 and the rules, regulations or bye-laws made or directions issued under those Acts, or by banks or mutual funds. Since all derivatives transactions on NSE or BSE have to be routed through stock brokers, this condition also does not pose any difficulty.
c. The transaction has to be carried out on a recognised stock exchange. Unfortunately, the definition of “recognised stock exchange” for the purposes of this provision is not the same as under the Securities Contracts (Regulation) Act, 1956, and requires certain further conditions to be fulfilled. A recognised stock exchange is defined as a stock exchange recognised u/s.2(f) of SCRA, and which fulfils the prescribed conditions and which is notified by the Central Government for this purpose. The prescribed conditions have been laid down vide rule 6DDA notified on 1st July 2005 [276 ITR (St.) 69]. These are:
(i) the stock exchange shall have the approval of the Securities and Exchange Board of India established under the Securities and Exchange Board of India Act, 1992 (15 of 1992) in respect of trading in derivatives and shall function in accordance with the guidelines or conditions laid down by the Securities and Exchange Board of India ;
(ii) the stock exchange shall ensure that the particulars of the client (including unique client identity number and PAN) are duly recorded and stored in its databases ;
(iii) the stock exchange shall maintain a complete audit trail of all transactions (in respect of cash and derivative market) for a period of seven years on its system ;
(iv) the stock exchange shall ensure that transactions once registered in the system cannot be erased or modified.
The procedure for notification of a recognised stock exchange has been laid down in rule 6DDB. Since no stock exchange has been notified so far as a recognised stock exchange, the question arises as to the position of derivatives transactions entered into till date. Rule 6DDB does not clarify whether a notification can be issued with retrospective effect, but merely clarifies that the notification will be valid until cancelled. One will therefore have to await the notification of stock exchanges as recognised stock exchanges, which, in all probability, will be with effect from 1st April 2005.
d. The transaction has to be supported by a time-stamped contract note issued by such stock broker, sub-broker or other intermediary. This also poses no difficulty, as all contract notes now issued by NSE or BSE bear the time-stamp.
e. The contract note has to indicate the unique client identity number allotted under SCRA, SEBI Act or Depositories Act and the permanent account number of the client. The system of unique identification number (UIN) under the MAPIN system introduced by SEBI was to be made mandatory for all non-corporate investors for all transactions exceeding Rs.1 lakh after 31st March 2005. Because of objections raised by investors, this date was postponed, and a committee was set up by SEBI to take a relook at the system. After considering the committee report, SEBI has now made such unique identity number mandatory for all investors for transactions exceeding Rs.5 lakhs. It is therefore quite possible that many investors entering into derivatives transactions during financial year 2005-06 may not have obtained such UIN.
If such UIN is not mentioned in the contract note, as it has not been obtained, can the benefit of derivatives transactions not being regarded as speculative transactions be denied? If the UIN has ultimately been obtained before the end of the year, it may be possible to contend that the main requirement of obtaining the UIN has been complied with, and the mere fact of non-mention of such number in the contract note cannot result in denial of the benefit. Such an argument may not be tenable in a case where the UIN has not been obtained at all, though one can certainly contend that since the date for obtaining UIN has been extended by SEBI, non-mention of UIN in contract notes for the financial year 2005-06 in cases of non-corporates should not result in denial of the benefit.
There may be cases where the value of the transactions is below Rs.5 lakhs, where UIN is not made mandatory by SEBI. In such a case, can the benefit of treatment of derivatives transactions as non-speculative be denied to such a person, on the ground that he has not obtained UIN? The purpose of mention of UIN and PAN is to ensure that such transactions of one person are not recorded as the transactions of another. If, through PAN identification on the contract notes, such purpose is served, an assessee should not be denied the benefit for not complying with a requirement that is not otherwise mandatory for him.
It needs to be understood that the classification of derivatives transactions as non-speculative is not always beneficial. Take for instance, a day trader who trades in shares and also trades in derivatives. If he has incurred a loss in his share day trading activities, and earned a profit on his derivatives transactions of an equal amount, only the day trading loss will be regarded as a speculation loss, and the derivatives profit will be taxable as normal business income. If the derivatives transactions had also been regarded as speculative transactions, the speculation profit or loss would have been the net result of both his day trading as well as derivatives trading activities, whereby in effect the day trading loss would have been set off against his derivatives trading profit.
Can the exclusion granted by clause(d) be regarded as clarificatory, and therefore applicable even to past transactions? Since the exclusion is subject to various conditions, it may be difficult, in most cases, to claim the benefit for earlier years. Besides, the Explanatory Memorandum clarifies that the amendment is being carried out due to the fact that recent systemic and technological changes introduced by stock exchanges have resulted in sufficient transparency to prevent generating fictitious losses through artificial transactions or shifting of incidence of loss from one person to another. In such a situation, the argument that the amendment is clarificatory may be difficult to sustain, if one looks only at the amendment.
The question that is then often asked and will continue to be relevant in the future will be – are derivatives transactions speculative transactions, even in the absence of applicability of clause (d) of the proviso to section 43(5)? Can it be argued that index futures or index options are certainly not stocks and shares, and that the definition of speculation transaction, which requires the contract to be for the purchase or sale of any commodity, including stocks and shares, therefore does not apply? Even otherwise, can a transaction for purchase or sale of an equity stock future or an equity stock option be regarded as a transaction for purchase or sale of shares?
It is fairly clear that derivatives are securities which are distinct from the underlying securities. The definition of securities under SCRA very clearly shows that shares and derivatives are two distinct types of securities. Therefore, purchase and sale of derivatives cannot be equated with purchase and sale of stocks and shares.
Can derivatives be regarded as commodities? Can the decisions in the cases of Imperial Tobacco Co. (of Great Britain & Ireland) Ltd. vs. Kelly (H.M. Inspector of Taxes) 25 Tax Cases 292 (C.A.), ANZ Grindlays Bank vs. Dy. CIT 88 ITD 53 (Del.) and Comfund Financial Services (I) Ltd. vs. Dy. CIT 67 ITD 304 (Bang.) be relied upon to treat derivatives as commodities? In these decisions, foreign currency, government securities and units of UTI and mutual funds were held to be commodities, on the footing that they satisfied the dictionary meaning of “any article of trade or commerce”.
If one examines the definition in Black’s Law Dictionary, after defining “commodity” as an article of trade or commerce”, it goes on to clarify that the term embraces only tangible goods, such as products or merchandise, as distinguished from services. An alternative definition is “an economic good, especially a raw material or an agricultural product. The very term “article” also indicates physical goods.
From this, it is clear that a commodity has to be in the nature of tangible goods, and not something which has no existence of its own, but is a mere contractual right, such as a derivative. The better view therefore seems to be that transactions in derivatives would even otherwise not have been covered by the definition of “speculative transaction” in section 43(5).
Another aspect is that transactions in derivatives, particular derivatives based on indices such as index options and index futures, are by their very nature incapable of being delivered. From inception in 2000 till today, equity stock options and equity stock futures cannot be settled by delivery, but can only be cash settled. Can a person be penalised by law for not doing the impossible? This supports the view that even de hors clause (d) of the proviso to section 43(5), a derivatives transaction could not have been regarded as a speculative transaction, and that clause (d) therefore merely clarifies the position as it always has been.
Whether explanation to s.73 attracted?
The explanation to section 73 deems the business of a company consisting of purchases and sale of shares as speculation business. This explanation applies to a company, notwithstanding the fact that the transactions may otherwise not have been regarded as speculative transactions by applying the provisions of section 43(5).
Can purchase and sale of equity stock future/option be regarded as purchase/ sale of shares of other companies? As discussed above, derivatives are distinct securities, separate from shares. Transactions of purchase and sale of derivatives therefore cannot be regarded as transactions in shares, and the provisions of explanation to section 73 would therefore not apply to a derivatives trading business.
Deductibility of Provision for loss on outstanding net position on Balance Sheet Date
In accounting for derivatives, the ICAI Guidance Note requires provision to be made for any diminution in value of derivatives outstanding on the Balance Sheet date. Is such provision for possible loss arising on the derivatives outstanding transactions allowable as a deduction in computing the taxable income?
If the derivatives transactions constitute a business, is such a provision a provision for a contingent loss, or can one contend that it is a method of stock valuation? Considering the fact that derivatives are not accounted for as purchases and therefore not accounted for as stock in trade, it may be difficult to claim that the loss provided for on the Balance Sheet date is really a method of stock valuation. It is more in the nature of a provision for a loss, which is estimated on the Balance Sheet date.
Can one draw upon the real income theory to claim that such loss is an allowable deduction? The Supreme Court, in the case of Godhra Electricity Co. Ltd. vs. CIT 225 ITR 746, has reiterated the concept of taxability of “real income”, which was enunciated by it earlier in the cases of CIT v. Shoorji Vallabhdas and Co. 46 ITR 144, CIT v. Birla Gwalior (P.) Ltd. 89 ITR 266, Poona Electric Supply Co. Ltd. v. CIT [1965] 57 ITR 521, and R. B. Jodha Mal Kuthiala v. CIT 82 ITR 570 and by the Bombay High Court in the case of H. M. Kashiparekh and Co. Ltd. v. CIT 39 ITR 706. In all these cases, the Courts have held that tax can be imposed only if there is real income and income-tax cannot be imposed on hypothetical income. The real income theory would dictate that business income can be computed only after taking into account losses up to the end of the year.
This view is also supported by the decision of the Special bench of the Income Tax Appellate Tribunal in the case of Oil & Natural Gas Corpn. Ltd. vs. Deputy Commissioner of Income-tax 83 ITD 151 (Del) (SB), where it has been held that foreign exchange loss in respect of outstanding transactions on the balance sheet date is not a contingent loss, but a fait accompli, and is an allowable deduction.
Further, section 145 requires that accounting standards prescribed by the CBDT are to be followed in computing the business income. Accounting Standard 1 prescribed by the CBDT vide notification no. SO 69(E) dated 25th January 1996 provides that accounting policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business in the financial statements prepared and presented on the basis of such accounting policies. It further provides that for this purpose, the major considerations governing the selection and application of accounting policies are prudence, substance over form and materiality. As per this standard, under consideration of prudence, provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information. On this criteria, provision for such loss is in accordance with such standard.
Therefore, the better view seems to be that such loss is an allowable deduction.
Would such loss be an allowable deduction in computing book profits for the purposes of section 115JB? The explanation to Section 115JB provides that amounts set aside to provisions made for meeting liabilities, other than ascertained liabilities, is to be added to the amount of net profit to compute the book profits. Going by the logic of the decision in ONGC’s case (supra), such a provision is for an ascertained liability, and is therefore not required to be added to the net profit to compute book profits.
If the derivatives transactions are regarded as taxable under the head “Capital Gains”, there is no provision for deduction of such provision, particularly as the gains would be computed and taxable only on the date of transfer, i.e. the date of squaring up or expiry of the derivatives, and not on any interim date. Further, in computing capital gains, only the cost of acquisition, cost of improvement and expenses in connection with the transfer are deductible. Such provision would therefore not be deductible if the derivatives transaction income is taxable as capital gains.
If the derivatives transactions are taxable as “Income from Other Sources”, the real income theory would again require the deduction of such provision for loss in determining the taxable income.
CAclubindia
