Over the past two years, forex derivatives have generated substantial legal controversy in India, perhaps because of the relatively recent rise in the use of these instruments in India. We have discussed the challenge to the legality of derivatives as wagering agreements, their regulation, taxability and other related issues.
The latest addition to this chapter of uncertainty is a report that the Central Board of Direct Taxes [“CBDT”] has issued an internal instruction directing Income Tax Officers to disallow forex derivatives losses incurred on account of currency fluctuations. The basis for this decision is reported to be that these losses are “unrealised” and present only in the books of accounts. The legal provision governing this question is s. 37 of the Income Tax Act, 1961. S. 37 is a “residuary” provision that allows assessees to deduct from their profits and gains from business certain expenses that do not fall within the other deduction provisions. The requirement, however, is that the expenditure must be “laid out or expended” wholly and exclusively for the business of the assessee.
An example illustrates the point. Suppose an Indian company deals in forex derivatives at a particular date in a particular currency and finds that the currency has become more expensive two months later, it will record the loss arising at the future date as a result of currency fluctuation in its Profit and Loss [“P&L”] account, and will show a correspondingly lower figure of net profit. The CBDT’s view would imply that the Indian company cannot deduct the currency fluctuation loss under s. 37, because it is “unrealised”. While this view has some force at first sight, it seems that it is misconceived, for several reasons.
First, it is possible to contend that s. 37 speaks of an “expenditure” and not a “loss” and consequently that a loss is by definition excluded from s. 37, whether incurred on account of currency fluctuation or otherwise. The legal position in this respect is not clear, and there are decisions that support both views. However, as Mr. Palkhivala points out in his commentary, the reason “loss” is not expressly mentioned in s. 37 is that it is in any case deductible under ordinary principles of accounting. Secondly, these ordinary principles of accounting are recognised in s. 145 of the ITA, which provides that an assessee may follow either the cash or mercantile system of accounting, and the Supreme Court has held that the books of accounts of an assessee cannot be ignored or disregarded unless there is clear evidence of mala fide.
Thirdly, it is surprising that the CBDT has rested its circular less on the scope of s. 37 and more on the proposition that an “unrealised” loss cannot be deducted. This seems, with respect, at odds with a basic assumption of the mercantile system of accounting – that a gain or a loss is accounted not when it is actually received or incurred, but when the legal right or liability arises. Indeed, there appears no reason in principle to confine the CBDT’s view to forex derivatives – if this view is correct, the corollary is that any unrealised loss or gain is excluded from the ambit of the ITA, which is not the case.
Fourthly, the ITA has in the past subjected gains from currency fluctuation to tax, on the basis that the mercantile system of accounting does not require actual receipt. While this is not a reason, as a matter of law, to question the CBDT’s view, it is interesting to note that the circular is at odds with the position the Department has consistently taken in the past.
These principles had been approved by the Supreme Court in 2009, in CIT v. Woodward Governor India P. Ltd., (2009) 13 SCC 1. In that case, an assessee debited approximately Rs. 29 lakh to the P&L account as a result of currency fluctuation. The Department disallowed the expenditure, on the basis that it represented a “contingent” liability. The Supreme Court rejected this contention, holding that s. 145 “recognizes the rights of a trader to adopt either the cash system or the mercantile system of accounting”, and further noted that “[a]ccounts regularly maintained in the course of business are to be taken as correct unless there are strong and sufficient reasons to indicate that they are unreliable.”
However, the CBDT will derive comfort from the Supreme Court’s express observation in Woodward Governor that these “ordinary principles of commercial accounting… may stand superseded or modified by legislative enactments”. Indeed, Justice Kapadia, who decided Woodward, observed in the more recent Southern Technologies decision, which we have discussed here, that the “real income” principle does not assist an assessee in contravention of statutory language. More ominously for assessees, the Court had held in Southern Technologies that a provision for bad debts is only a “notional expense” and must be added back to determine “real taxable” income. Thus, it is difficult to conclude that the CBDT instruction is ultra vires the Act, but this is an issue that requires adjudication.