Losses arising to Foreign Institutional Investors due to cancellation of foreign exchange forward contract are capital in nature
The Mumbai bench of the Income-tax Appellate Tribunal, (“Tribunal”) in a ruling’ in the case of Citicorp Banking Corporation, Baharain v. Addl. Director of Income Tax (I.T.)-Range 1-[2011-T11-40-1TAT-MUM-INTL] , held that losses arising on cancellation of foreign exchange forward contracts entered into by the assessee for protecting it against the risk of currency fluctuation would be characterised as capital loss and the said loss can be set-off against other capital gains under the provisions of the Income-tax Act, 1961 (the “Act”). Further, the Tribunal also held that section 115AD provides for tax rates on income from securities or capital gains and it has nothing to do with determination of the nature of gain or loss i.e. capital or revenue.
The assessee is a branch of Citicorp Banking Corporation and a tax resident of the USA. It is registered as an FII with the Securities and Exchange Board of India, carrying out investment activities in India. The assessee earned long-term capital gains from the sale of shares and declared a net long-term capital gain of INR 804 million after set-off of loss arising on cancellation of foreign exchange forward contract. The assessee offered the net long-term capital gains for taxation at the rate of 10 per cent under section 115AD of the Act.
Section 115AD of the Act provides that in the case of an FII, short-term or long-term capital gains would be taxed at the rate of ten percent.
The tax officer held that the loss that arose from cancellation of the foreign exchange forward contract could not be considered for taxation under section ii5AD and declined to allow the set-off against long-term capital gain claimed by the assessee. The Commissioner of Income-tax (Appeals) upheld the order of the tax officer; accordingly, the assessee approached the Tribunal.
• As per Exchange Control regulations, FIIs are allowed to hedge original capital investment into India. The foreign exchange forward contract is restricted to the extent of the investment made by the FII. The value of the foreign exchange forward contract does not constitute stock-in-trade, stores or raw materials in the context of business but is linked with investments, and hence, is a capital asset and not a trading asset.
• The foreign exchange forward contract was entered into by the assessee to protect it against the risk of depreciation in the value of currency in which capital asset was held and whenever there was a sale of shares, foreign exchange realised on sale proceeds would be utilised for making remittances. Accordingly, since the assessee, as a foreign investor, was holding shares on capital account, these shares were held to be capital assets, and accordingly, the gains/losses on the foreign exchange forward contract would be characterised as capital in nature.
• The assessee relied on decisions of the Supreme Court in the cases of Sutlej Cotton Mills Ltd. v. CIT  116 ITR 1 (SC), CIT v. Tata Electric & Locomotive Co. Ltd.  60 ITR 405 (SC), and CIT v. Canara Bank Ltd.  63 ITR 328 (SC) which dealt with characterisation of the nature of gain/loss into capital or revenue depending upon the gains or losses arising on devaluation of currency held on revenue or capital account.
- Foreign exchange forward contract is not in the nature of capital asset.
- The loss or gain arising from forward exchange forward contract cannot be considered for taxation under section 115AD of the Act.
- The Tribunal considered the decision of the Special Bench of Delhi Tribunal in the case of Apollo Tyres Ltd. v. ACIT  89 ITD 235 (Delhi)(SB) wherein the modalities of foreign exchange forward contract were discussed in detail and it was held that the dominant intention, motive and purpose of entering into forward foreign exchange contracts and cancellation thereof were clearly to provide a hedging mechanism against enhancement of liabilities for repayment of foreign loans raised for the purpose of acquisition of capital asset by the assessee.
- Revenue did not controvert the fact that the dominant purpose for entering into the foreign exchange forward contract was to hedge against the depreciation of foreign currency and it had direct nexus with the investment made by the assessee.
- The fact that the assessee was not doing any business in India and it was an FII engaged in investment activity in India was also admitted by both the assessee and the revenue.
- The loss accrued on account of cancellation of the foreign exchange forward contract is a capital loss having a direct nexus with the investment of the assessee, and hence, the assessee was entitled to set-off the same against capital gains.
- Section ii5AD decides the quantum of the tax payable by an FII on the income from securities and it has nothing to do with the determination of the nature of the gain or loss, whether capital or revenue.
Conclusion: – The Tribunal has pronounced an important decision, the first of its kind in respect of an FII, on characterisation of loss arising on cancellation of foreign exchange forward contract. The reasoning given by the Tribunal would equally apply in the case of capital gains. This decision would be useful for several FIIs in similar situations. The decision would also help in certain cases of FIIs wherein litigation is pending on the issue of considering the income/loss from such contracts under the head ‘other sources’. One would, of course, need to consider the treaty provisions in the case of FIIs where the tax treaty provide for exemption from capital gains.