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In Brief
In a recent ruling, the Special Bench of the Mumbai Income-tax Appellate Tribunal (“Special Bench”), in the case of M/s Bank of Bahrain & Kuwait1 (the “assessee”) allowed losses on account of valuation of an unmatured forward contract, ie a forward contract falling beyond the last date of the accounting period.
The Special Bench also affirmed that the interest income from securities accrues only on fixed coupon dates and not on a day-to-day basis, and would accordingly be taxable only when the income is due.
The Special Bench also allowed broken period interest paid on the securities purchased and lying in the closing stock as a deduction while computing the taxable income of the assessee.
1 DCIT v. Bank of Bahrain & Kuwait [2010-TIOL-447-ITAT-MUM- SB]
Facts
• The assessee, a non-resident company carrying on banking business in India, entered into forward contracts with its clients to buy and sell foreign exchange at an agreed price on a future date.
The assessee valued the unmatured forward contracts on the last day of the accounting period on the basis of the exchange rate prevailing on that date and booked the loss or profit.
This was undertaken on the premise of the guidelines laid down by the Reserve Bank of India (“RBI”) as per rates notified by the Foreign Exchange Dealers Association of India (“FEDAI”).
The loss was disallowed by the Assessing Officer (“AO”) on the ground that the loss will be incurred on the date of maturity of the contract and there cannot be any loss prior to that date. However, the Commissioner of Income-tax (Appeal) (“CIT(A)”) allowed the claim of the assessee.
Losses on account of valuation of unmatured foreign exchange forward contract are allowable
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25 August, 2010
• The facts with regard to the other grounds of appeal were as follows:
− The assessee had recognised income from interest on Government securities on a day-to-day basis in the books of account. However, in the return of income filed, the assessee had claimed that interest, which had not become due during the previous year, should not be included as income.
The AO did not agree with this treatment, however, the CIT(A) did agree with the contention of the assessee.
− The assessee had claimed that the broken period interest paid by it on purchase of securities and lying in closing stock should be allowed as a deduction while computing the taxable income of the assessee. The CIT(A) agreed with the assessee’s contention.
− The assessee also claimed that the guarantee commission was required to be spread throughout the life of the guarantee and hence should not be taxable in the year of receipt of the guarantee commission. The CIT(A) agreed with the assessee’s contention.
Aggrieved by the above views of the CIT(A), the Revenue filed an appeal before the Income-tax Appellate Tribunal (“Tribunal”) and the matter was referred and heard by the Special Bench constituted under the provisions of section 255(3) of the Income- tax Act, 1961(“the Act”).
Issues
• The most important matter of debate was whether the loss on account of valuation of unmatured forward contract at the end of the year was a “notional” or
“contingent” loss or whether it was an “accrued” loss and hence to be allowed as a deduction.
• In addition to the above issue, the other grounds of appeal were as follows:
− Whether the interest income arising from securities to the assessee should be taxed on due basis or on day-to-day basis.
− Whether broken period interest paid by the assessee should be allowed as a deduction.
− Whether guarantee commission received should be liable to tax in the year of receipt or is required to be spread throughout the tenure of the guarantee and hence liable to tax on a deferred basis.
Revenue’s contentions
• For the allowability of losses on the evaluation of the unmatured forward contracts, the key contentions of the Revenue were as follows:
− The assessee was not in the business of dealing in forward contracts. Hence, the unsettled forward contracts did not constitute stock-in- trade and, therefore, there was no question of valuation as on the balance sheet date.
− The anticipated loss was primarily in the nature of notional liability and hence should not be allowed as expenditure.
− Furthermore, the Accounting Standard (“AS”) - 11 issued by the Institute of Chartered Accountants of India (“ICAI”) stipulates that the effect of changes in foreign exchange rates is required for monetary items denominated in foreign currency. However, in the present case, no transaction had been recorded in the books of account for the unmatured forward contracts and hence no adjustment was required.
− The accounting method adopted by the assessee was not correct as the liability accrued or arose only on the date of maturity of the contract and prior to that, it was purely on the basis of estimated liability in accordance with FEDAI guidelines. Hence, the notional loss could not be allowed as a deduction.
• With regard to the other issues, the Revenue’s contentions were as follows:
(a) The interest income arising from Government securities should be taxed on a day-to-day basis since income accrued as and when the assessee acquired the right to receive such income or the right became vested in the assessee.
In the case of Government securities, although the interest became due for payment (interest to be received on Government securities) only at six monthly intervals, such interest certainly accrued from day-to-day. The amount of interest accruing was also known to the assessee. Since the assessee was following mercantile system of accounting, the profit or loss at the end of the accounting year would not be based on the difference between what was actually received or paid but on the right to receive and liability to pay.
(b) For the broken period interest paid by the assessee, the Revenue contended that the facts of the present case were different from American Express International Banking Corporation2 as in that case the securities were held as a trading asset.
The CIT(A) and the assessee had relied on the above mentioned decision.
However, the Revenue submitted that, in the present case, the Government securities and other securities had been classified as investment in Schedule 8 of the balance sheet and, hence, they were not stock-in-trade. Therefore, the broken period interest was to be capitalised with the cost of securities relying on the decision in case of Vijaya Bank Ltd.3
(c) The Revenue was of the view that the guarantee commission was not in the nature of advance commission and that the spread over of the guarantee commission could be allowed only if the commission was refundable on premature revocation of the guarantee.
The Revenue also contended that the decision (relied on by the assessee and the CIT(A)) in the case of Bank of Tokyo Ltd.4 was not applicable because in the said case, the guarantee commission was refundable if there was premature revocation of the guarantee.
2 American Express International Banking Corporation v. CIT [2002] 258 ITR 601 (Bombay)
3 Vijaya Bank Ltd. v. ADIT [1990] 187 ITR 541 (SC)
4 CIT v. Bank of Tokyo Ltd. [1993] 71 Taxman 85 (Calcutta)
Assessee’s contentions
• The assessee, among other things, contended the following with regard to the deduction on account of evaluation of the forward contract as at the date of the balance sheet:
− The RBI guidelines provide that the outstanding foreign exchange forward contract is required to be revalued as per the rates notified by the FEDAI on 31 March every year.
− The assessee also had to re-assess the anticipated loss at the end of the year in accordance with the method of accounting. The assessee contended that the AO was obliged to allow the loss, as the provisions of section 145(3)5 of the Act were not invoked.
− The loss claimed by the assessee was not a notional or a contingent loss, but an actual loss which was entitled to be deducted. The moment a forward exchange contract is entered into, the bank becomes liable to honour it. A binding obligation arises against the bank which it is required to discharge.
Therefore, the physical delivery of foreign currency on the date of maturity did not wipe out the present liability incurred by the bank.
− Foreign currency was the bank’s stock-in-trade and since, in forward foreign exchange contracts, the underlying security was foreign currency, it should be taken as stock-in-trade to be valued at cost or market value, whichever was lower. Therefore, any resultant loss on fluctuation of the Indian rupee had to be allowed as a deduction on the normal principles of commercial accounting.
• With regard to the other issues, among other things, the assessee contended as follows:
− Interest on Government securities did not accrue on a day-to-day basis but on fixed dates and hence the entry made in the books was not relevant for income tax purposes. Accordingly, interest on Government securities would be taxable
5 Section 145(3) of the Act provides that if the AO is not satisfied about the correctness of the books of the assessee, he may complete the assessment on best judgement basis.
on a due basis. Furthermore, this issue was held in favour of the assessee in the earlier Assessment Years.
− The assessee relied on the case of American Express International Banking Corporation (above) and submitted that any broken period interest should be allowed as a deduction. Furthermore, the profit made by the bank on sale of securities had been taxed as business profit and not as capital gains in the return of income, notwithstanding that securities were classified in Schedule 8 as investments in the books of account.
− The assessee relied on the Supreme Court decision in the case of United Commercial Bank6, wherein it was observed that preparation of the balance sheet in accordance with the statutory provisions would not disentitle the assessee from submitting the income-tax return on real taxable income.
− Furthermore, the entire interest received on the due date had been offered to tax and, therefore, the broken period interest paid at the time of purchase had to be allowed as a deduction.
− The assessee relied on the order of the CIT(A) and the decision of the Calcutta High Court in the case of Bank of Tokyo Ltd. (above) where it was held that guarantee commission was required to be spread over the period of guarantee.
Special Bench Observations and Ruling
• The loss incurred on account of evaluation of the forward contract due for maturity subsequent to the end of the accounting period should be allowable:
− There was an obligation binding on the assessee at the time when the forward contract was entered into.
6 United Commercial Bank v. CIT [1999] 240 ITR 355 (SC)
− The liability in respect of the forward contract due for maturity after the end of the accounting period crystalises when a pending obligation on the balance sheet date can be determined with reasonable certainty.
Furthermore, an anticipated liability coupled with the present obligation and where only quantification varied depending on the terms of the contract, that liability was said to have been crystalised on the balance sheet date.
− Accounting Standard-11 issued by ICAI states that 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. The Accounting Standard mandates that in a situation like the present case, since the transaction was not settled within the same accounting period, the effect of exchange difference has to be recorded on 31 March.
− The assessee did not have any closing stock of unmatured forward foreign exchange contracts as at the balance sheet date and had only booked the profit and loss in that regard. However, the foreign currency held by the assessee bank was its stock-in-trade and the assessee had entered into forward foreign exchange contracts in order to protect its interest against the wide fluctuation in the foreign currency itself.
− Therefore, the contract was incidental to the assessee’s holding of the foreign currency as stock-in-trade.
− Hence, in substance, it could not be said that the forward contract had no trappings of stock-in-trade.
− Also, when the profits in respect of unmatured forward foreign exchange contracts were being taxed by the Income-tax Department, then the loss on the same contracts should also be allowed as a deduction.
• The key observations of the Special Bench with respect to other issues were as follows:
− The Special Bench relied on the decision of the Jaipur Income-tax Appellate Tribunal in the case of State Bank of Bikaner and Jaipur7, where it was held that the provisions of section 5 of the Act could not be ignored and the method of accounting followed by the Bank could not override the provisions of section 5 of the Act.
Accordingly, the issue of whether the assessee’s income arising from securities and on debenture would be liable to be taxed on a due basis or on day-to-day basis was decided in the favour of the assessee: that the interest accrues only on the specified coupon dates and not on a day to day basis.
7 State Bank of Bikaner and Jaipur v. DCIT [2000] 74 ITD 203 (Jaipur)
− The Special Bench upheld the view of the CIT(A), in which the CIT(A) deleted the disallowance on account of the broken period interest paid by the assessee.
Since the entire interest received on the due date, ie coupon date, was offered to tax, the broken period interest paid at the time of purchase had to be allowed as a deduction, irrespective of its classification in the books of account.
− With regard to charging the whole of deferred guarantee commission in the year of receipt, the Special Bench observed that the matter should be restored back to the AO to determine whether the commission was repayable on the revocation of guarantee; if so, the commission could be spread over the period for which the guarantee was given.
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