Deductibility of premium on forward contracts in the year of entering into such contracts

The Delhi High Court (HC) [2010-TIOL­42-HC-DEL-IT] in the case of CIT v. Industrial Finance Corporation of India (Taxpayer) which held that the difference between forward rate and exchange rate prevailing on the date of entering into forward contracts is fully allowable as deduction even if the difference is amortized in the books of account over the life of the forward contracts.

Background and facts of the case

• The Taxpayer, a financial corporation, is engaged in the business of making loans and advances to various industrial concerns. The Taxpayer raises foreign currency borrowings for the purpose of meeting lending requirements. In order to safeguard loss on account of foreign exchange fluctuation, the Taxpayer enters into forward contracts with banks for the purchase of foreign currency.

• During the tax year 1994-95, the loss of INR 817 million was reckoned based on the difference between the forward rate and the exchange rate prevailing on the date of entering into the forward contracts. In terms of the relevant Accounting Standard issued by The Institute of Chartered Accountants of India, the Taxpayer amortized the loss over the life of the forward contracts and recognized INR 146 million as exchange loss in its books of account in tax year 1994-95 and carried forward the balance INR 671 million to be recognized over the balance life of the forward contracts. However, for tax purposes, the Taxpayer claimed deduction for the full amount of INR 817 million.

• The Tax Authority restricted the deduction to INR 146 million and disallowed the balance INR 671 million on the ground that the same pertained to future years.

• Aggrieved by the action of the Tax Authority, the Taxpayer appealed to the first appellate authority who upheld the Tax Authority’s order. The Taxpayer appealed further to the Tribunal which ruled in favor of the Taxpayer and allowed deduction for the full amount of INR 671 million. The Tax Authority appealed to the Delhi HC against the Tribunal’s ruling.

Contentions of the Tax Authority

• The Taxpayer follows the mercantile system of accounting in terms of which, only those expenditure accrued during the year are deductible. The exchange difference of INR 817 million on the forward contracts is an upfront payment, the benefit of which accrues over the period of the foreign currency borrowing in respect of which such forward contracts were entered.

• Applying the matching concept under the mercantile system, the loss should be spread over the period of use of funds.

• Reliance was placed on the Supreme Court (SC) decision in the case of Madras Industrial Investment Corpn. Ltd. v. CIT[ 225 ITR 802] and the Bombay HC decision in the case of Taparia Tools Ltd. v. JCIT[260 ITR 102] where the courts held that the discount on issue of debentures should be spread over the term of the debentures. In these cases, the taxpayer had incurred liability to pay discount in the year of issue of debentures but secured continuing benefit over the term of the debentures.

• The exchange difference of INR 817 million should be spread over on a pro-rata basis and the deduction should be allowed in respect of the amount of INR 146 million pertaining to the year under reference only.

Contentions of the Taxpayer

• The exchange difference between forward contract rate and prevailing exchange rate represented the cost of entering into forward contracts which crystallized in its entirety during the year under reference. Once crystallized, the entire liability is allowable as deduction notwithstanding that the forward contracts may be settled at a future date.

• Reliance was placed on the SC decisions in the cases of Calcutta Co. Ltd. v. CIT [37 ITR 1) and Bharat Earth Movers v. CIT[245 ITR 428] where the SC held that deduction for a business liability which has definitely arisen in the accounting year should be allowed in its entirety although the liability may have to be quantified and may be discharged at a future date.

Ruling of the HC

The HC ruled in favor of the Taxpayer and held that the Taxpayer was entitled to deduction in the tax year 1994-95 for the full amount of INR 817 million on account of the following reasons:

• The Taxpayer entered into forward contracts to safeguard itself against the exchange fluctuation loss on the foreign currency borrowings made for meeting its lending requirements. The forward contracts represent legally binding, enforceable contracts for purchase of foreign currency on a future date at pre-determined rates. The date of purchase and the rate is fixed at the time of entering into the forward contracts itself. Hence, the difference between the forward rate and the exchange rate prevailing on the date of entering into the forward contracts has to be recognized as an expense, as a definite and ascertained liability exists in the year of entering into the forward contracts.

• The determination of the liability is possible at the time of execution of the forward contracts itself and, hence, the loss cannot be regarded as notional or contingent. In terms of the tests laid down in the SC rulings in Calcutta Co. Ltd. (supra) and Bharat Earth Movers (supra), the liability was a debt owed by the appellant which accrued on the date of entering into the forward contract itself and, hence, the entire loss was allowable in the year under reference.

• 4  The rulings in Madras Industrial Investment Corpn. Ltd. (supra) and Taparia Tools Ltd. (supra) are distinguishable since the benefit of the discount allowed on the debentures is obtained over the period of the debentures. The money secured by the issue of debentures is used over a number of years and, hence, there is a continuing benefit to the taxpayers’ business over the entire period.

• Ordinarily, revenue expenditure incurred in a particular year should be allowed in the same year and the Tax Authority cannot deny the deduction if the taxpayer claims it in that year. However, in those cases where the taxpayer himself wants to spread the expenditure over a period of ensuing years, it can be allowed only if the principle of matching concept is satisfied, which, in the case of debentures, is fulfilled.

Comments

The current ruling holds that premium on forward contracts, being a definite and ascertained loss, is allowable as deduction in the year of entering into the forward contracts although it may be amortized in the books over the period of the forward contracts. Further, the current ruling also provides guidance that the ratio of Madras Investment Industrial Corpn. Ltd.’s ruling on spread over of deduction has limited application to cases where there is continuing benefit to the taxpayer.