Loss arising on year-end valuation of an interest rate swap allowable as a deduction – ITAT Mumbai

ITAT Mumbai

ITA No. 7073/Mum/06

Assessment year: 2003- 04

O R D E R

Per Pramod Kumar:

1. By way of this appeal, the assessee appellant has challenged correctness of CIT(A)’s order dated 18^th August 2006, in the matter of assessment under section 143(3) of the Income Tax Act, 1961 for the assessment year 2003 -04, on the following ground:

Based on the facts of the case and in law, the CIT(A) erred in confirming the action of the Assessing Officer in disallowing the loss of Rs 10,10,92,000 being loss on account of valuation of interest rate swap on the basis that the same is a notional or imaginary loss.

2. The assessee is engaged in the business of dealing in government securities, bonds, debentures and providing services of arranging and underwriting the issue of debentures and bonds etc. During the course of the assessment proceedings, the Assessing Officer noticed that the assessee has claimed a deduction of Rs 10,10,92,000 being loss on interest rate swap valuations. In the course of ensuing examination of this claim by the Assessing Officer, it was submitted by the assessee that interest rate swap is a financial contract between two parties exchanging a stream of interest payments for a notional principal amount, on multiple occasions, during the contract period. It was also submitted that these contracts generally involve exchange of fixed rate of interest, with floating rate of interest, and vice versa. On each payment date, the interest is notionally paid on the agreed fixed or floating rate by one party to the other, by settling for the difference payments. Having so explained the nature of interest rate swap, the assessee submitted that the assessee had three ongoing interest rate swap contracts, for a notional principal amount of Rs 185 crores, under which the assessee was to pay a fixed rate of interest and receive the floating rate of interest. It was then submitted that the deduction of Rs 10,10,92,000 has been claimed on account of unrealised loss on the basis of valuation of interest rate swap. This valuation, according to the assessee was arrived at by working out future extrapolation of the yield curve, considering past history of available rates and current market rate. It was also submitted that this provision has been made in accordance with the guidelines issued by the Reserve Bank of India, and the method of valuation consistently followed all along. It was also submitted that the assessee being engaged in the business of dealing in the interest bearing securities, and the interest rate, i.e. yield, being contingent upon various economic, political and international factors, over which assessee has no control, the interest rate swaps entered into by the assessee act as an insurance against losses due to heavy fluctuations in the yield. It was further submitted that Reserve Bank of India guidelines are mandatory on the assessee, and the interest rate swap valuations have been done in accordance with such guidelines. In support of the proposition that loss on valuation of interest rate swap is to be allowed as a deduction in computation of business income, a reference was also made to Hon’ble Supreme Court’s judgement in the cases of Chainrup Sampatram Vs CIT (24 ITR 481), ALA Firm Vs CIT (189 ITR 285) and Sanjeev Woollen Mills Vs CIT (279 ITR 434).

3. The Assessing Officer, however, was not impressed by any of these submissions. He was of the view that this loss on valuation of interest rate swap is nothing but an un ascertained liability which cannot be allowed as a deduction in computation of business income. He noted that whatever losses had actually incurred in connection with these interest rate swap contracts, and debited to the profit and loss account upon their becoming payable, have already been allowed as a deduction. However, what has been claimed as deduction in the impugned claim is the loss which would have occurred if the swaps are to be squared up as on the balance sheet date. It was thus an unrealized loss which may, or may not, actually occur. The Assessing Officer, on the basis of this reasoning, concluded that what has been claimed as deduction is only a contingent liability and a provision made for a liability which may arise in future. It was also observed that as the assessee was following mercantile method of accounting, “no deduction can be made in respect of a liability which has not definitely arisen” and that deduction can only be allowed in respect of ascertained and enforceable liability which could be enforced on or before the end of the relevant previous year. In support of this stand, a reference was made to Honourable Bombay High Court’s judgement in the case of CIT Vs. Phalton Sugar Works (162 ITR 622) and to Honourable Madras High Court’s judgement in the case of CIT Vs. Indian Overseas Bank (151 ITR 446). As for the Reserve Bank of India’s guidelines and the accounting treatment, the Assessing Officer referred to Honourable Supreme Court’s judgement in the case of Tuticorin Alkali Chemicals & Fertilisers Ltd Vs CIT (227 ITR 172) in support of the proposition that merely because stand of the assessee is supported by RBI guidelines and accounting practices, it entitles assessee to get the deduction as ‘income tax law does not match step by step with the divergent footprints of the accountancy profession’. As regards the judicial precedents cited by the assessee, the Assessing Officer was of the view that these decisions are fully distinguishable as the issue for consideration in these cases was valuation of stock. It was thus concluded that the claim of deduction in respect of loss on valuation of interest rate swap was not admissible, and it was, accordingly, declined. Aggrieved, assessee carried the matter in appeal before the CIT(A) but without any success. The assessee is not satisfied and is in second appeal before us.

4. We have heard the rival contentions, perused the material on record and duly considered factual matrix of the case as also the applicable legal position.

5. It is, to begin with, necessary to understand the nature of interest rate swap valuations. An interest rate swap contract is typically a contract between two parties which decide to pay interest on fixed rate, as agreed to between the parties, on a notional principal amount in consideration of receiving a floating rate of interest, or vice versa. In practice, these obligations are settled by making a net payment, i.e. difference between fixed and floating rate of interest. If fixed rate of interest is more than the floating rate of interest, the person under obligation to pay fixed rate of interest only pays the difference between fixed rate and floating rate, and when it is the other way round, the net payment is made by the person under obligation to pay the floating rate of interest. These contracts are entered into to hedge against variations in floating rate of interest from time to time. The floating rate of interest is indicated by MIBOR (Mumbai Inter Bank Offer Rate), which is benchmark interest rate for the call money market, and the rate at which banks can borrow funds, in a marketable size, from other banks. Let us say assessee has an obligation to pay floating rate of interest on bonds of a value of Rs 100 crores but, since the assessee perceives the markets as volatile and not fit for open risk being taken, the assessee hedges against this obligation by entering into an interest rate swap at 4% which he finds reasonable at that point of time. The fixed rate of interest in such cases is a negotiated rate, while floating rate of interest is at the mercy of the market forces, When market expectations of the floating interest rate is low, the agreed fixed rate of interest under the swap contract rate is also low. However, many factors affect the variable rate and the rates could move either way; it is this risk of significant variations in the floating rate which is sought to be mitigated by the assessee by entering into interest rate swaps. For example, on 30^th June, assessee enters into an agreement with party A to pay fixed rate of interest @ 4% on a notional principal amount of Rs 100 crores, in consideration of receiving floating rate of interest on the same, for a period of one year. The settlements are to be done on half yearly basis beginning with 31^st December of that year. There will be no cash flows as on the date of contracts, but, assuming that floating rate of interest is 4.50% on 31^st December, the assessee will receive .50% interest on Rs 100 crores for six months, as on that date. Similarly, if the floating rate of interest as on 30^th June of the following year is 3.75% the assessee will pay .25% interest on Rs 100 crores for six months on that date. Depending on whether the amount is receivable or payable under the interest rate swap contract, the amounts are booked as income or expenditure in the profit and loss account. There are no issues with regard to the income so disclosed or the expenditure so claimed for deduction.

6. The dispute, however, arises with respect to unsettled interest rate swap contracts as at the end of the year.

7. While computing the position of unsettled interest rate swap, it is also important to bear in mind the fact that the settlements are to take place in future, and, therefore, the future cash inflows and outflows are to be discounted by time value of money and ‘net present value’ of the cash inflows or outflows are to be taken into account. It is like this. If you have to receive Rs 100 six months now, and the benchmark discounting rate is 6% for this six month period, Rs 100 received six months from now is as good as Rs 94.34 today, because this 94.34% invested for an yield of 6% will work out to Rs 100 six months from today. What has been referred to as ‘discounting curve’ is this discounting factor, which is again a figure driven by money markets and is in market domain. Let us say, in the example we have taken above, we want to evaluate the results of these interest rate swap contracts as on intervening 31^st March. The computation will then be on the following basis:

Present value of the fixed interest rate payable under the contract:

Interest payable for Rs 100 crores @ 4%                                                                        4,00,00,000

Discounted value as on today *

(*taking the discounting factor say @ 6% –

determined by using a discount curve which

is publicly known number)

i.e. 4,00,00,000 X 4% X 6/12 X 0 .9434                                                              1,88,68,000

Present value of floating interest rate receivable under the contract:

Interest receivable under the contract @ 3.75%                                      3,75,00,000

Discounted value as on today *

(*taking the discounting factor say @ 6% –

determined by using a discount curve which

is publicly known number)

i.e. 4,00,00,000 X 4% X 6/12 X 0 .9434                                              1,76,88,750

8. The net negative value of this contract, as on 31^st March, is Rs 11,79,250 because that is the amount the assessee will have to pay under the contract if the contracts are to be settled at the floating rates prevailing as on 31^st March. In plain words, this figure represents the loss on interest rate swap contracts if these contracts were to be settled as on 31^st March, or, to put in differently, market value of these contracts as on that day. The issue requiring our adjudication is whether this loss on valuation of interest rate swap contracts can be allowed as a deduction or not.

9. In plain words, the valuation of interest rate swap as on the balance sheet date only indicates computation of profit or loss on account of these profits as on that date. It is also important to bear in mind the fact that whatever is claimed as a loss at this stage, is eventually reduced from the overall loss or added to overall profit taken into account, for tax purposes, in the subsequent assessment year in which the settlement date falls. There is no dispute that whatever is the loss on interest rate swap valuation as on the balance sheet date is to be squared up by transfer to the actual loss or profit on settlement. Its not really, therefore, the question as to whether the deduction is to be allowed or not, but only the assessment year in which deduction is to be allowed. Viewed in the long term perspective, thus, it is wholly tax neutral but for the timing of deduction.

9. Section 145 of the Income Tax Act, as it stands now, inter alia lays down that business income has to be computed “in accordance with the cash or mercantile system of accounting as regularly employed by the assessee”. The only rider to this statutory requirement regarding method of accounting is that “the Central Government may notify, in the official gazette from time to time, accounting standards” and the applicable accounting standards will have to be followed by the assessee in the method of accounting followed. One of these mandatory accounting standard, notified vide notification no. 9949 dated 25^th January 1996, inter alia provides that “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”. This approach requires all anticipated losses to be taken into account in computation of income taxable under the head ‘profits and gains from business and profession’. Unlike in the pre amended section, as it stood before 1.4.1997, which provided that “in any case where the accounts are correct and complete to the satisfaction of the Assessing Officer but the method employed is such that, in the opinion of the Assessing Officer, the income cannot properly be deduced therefrom, then the computation shall be made upon such basis and in such manner as the Assessing Officer may determine”, there is no enabling provision now which permits the Assessing Officer to tinker with the profits computed in accordance with the method of accounting so employed under section 145 and as long as the mandatory accounting standards are duly followed. It is not even Assessing Officer’s case that the mandatory accounting standards have not been followed. This analysis of Section 145, read with applicable accounting standards, apart, even on first principles, deduction in respect of anticipated losses, as a measure of prudent accounting principles, cannot be declined. It is only elementary that the accountancy principle of conservatism, which has been duly recognized by the Courts, mandates that anticipated losses are to be provided for in the computation of income but it does not permit anticipated profits to be taken into account till the profits actually arise. That is the underlying reason that in the case of unsold stock, when market rate is higher than the purchase price, the market price is ignored in computation of value of stock, and, as a result, anticipated profit on sale of such stock is ignored. However, when the market price of stock is lower than the purchase price, the market price is taken into account, and, accordingly, anticipated loss is taken into account. These dual standards in recognizing anticipated losses and anticipated profits are accepted accounting norms. In the case of Chainrup Sampatram vs. CIT (1953) 24 ITR 481 (SC), Hon’ble Supreme Court took note of this position and observed that “while anticipated loss is taken into account, anticipated profit…is not brought into account as no prudent trader would care to show increased profit before its actual realisation. This is the theory underlying the rule that the closing stock is to be valued at cost or market price whichever is lower, and it is now generally accepted as an established rule of commercial practice and accountancy”. No doubt these observations were made in the context of valuation of stock but what is material is the theory underlying the principle of valuing closing stock and the fact that such a theory has the acceptance of the Hon’ble Supreme Court. Whichever way one looks at it, whether from the point of view of the impact of Section 145 and the mandatory accounting standards or from the point of view of pure accounting principles duly approved by Hon’ble Supreme Court, even an anticipated loss, even if it may not have crystallized in the relevant previous year, is to be allowed as a deduction in the computation of business profits.

10. It is important to bear in mind the fact that the interest rate swap was entered into as the assessee wanted to hedge against the increase in floating rate of interest which would meant higher cash outflows for the assessee, and it was for this reason that the assessee entered into three contracts for a notional value of Rs 185 crores, which were to remain valid till 4^th July 2006, 15^th May 2007 and 13^th July 2006 respectively, and settled for paying an agreed fixed rate of interest on the notional value of Rs 185 crores. As the assessee has incurred loss on valuation of these contracts, it is obvious that fixed rate payable by the assessee is higher than the floating rate receivable by the assessee. On these facts, it cannot be disputed that the assessee did incur a loss on these contracts even on the balance sheet date. The assessee’s estimated liability on account of fixed rate of interest, after duly taking into account discounting factor for time value of money, is clearly more that the amount receivable by the assessee for the same amount at the agreed fixed rate. This aspect has not been disputed by the authorities below at all. There is no dispute on the discounting factor either and that discounting factor, being a market driven rate in the call money market, is not in dispute either. However, since the settlement date is still a little away and in case the floating rate indeed goes up, the assessee may be able to recoup some of these losses, but that is a double edged sword in the sense in case floating rate comes down even further, the assessee’s losses may even go up, and it is not the loss but recovery which is contingent upon factors beyond assessee’s control. Loss having been incurred is a reality, its recoupment or aggravation is contingent. It is contingent upon future happenings is whether or not loss the assessee will be able to recoup the losses till settlement date, and such recoupment or aggravation of loss will fall in period beyond the end of the relevant previous year. Viewed thus, and bearing in mind the fact that the real issue in this appeal before us is not the deductibility but only timing of the deduction, we are of the considered view that the loss computed vis-à-vis the variation as on the end of the relevant previous year, the loss is deductible in the relevant previous year.   As regards Assessing Officer’s objection that accounting principles need not govern the deductibility, and reliance on judicial precedents in support thereof, this objection is not sustainable in law for the reason that the accounting principle of prudence, which has been relied upon by the assessee, is now binding in view of Section 145(2) read with notification no. 9949. As regards reliance upon Honourable Madras High Court’s judgement in the case of Indian Overseas Bank (supra), in support of the proposition that when anticipated profits on unmatured contracts are held, to be non-taxable, there is no good reason as to why anticipated losses on unmatured contracts can be taken into account while computing business income, we find that there is an inherent fallacy in this approach inasmuch as anticipated losses and anticipated profits are not treated in the same manner in the computation of business profits. These dual standards in recognizing anticipated losses and anticipated profits are accepted accounting norms and in the case of Chainrup Sampatram (supra), Hon’ble Supreme Court has approved this duality in approach. Just because anticipated profits are not assessed to tax, it would not follow, as a corollary thereto, that anticipated losses cannot be allowed as deduction in computation of business income. In view of these discussions, as also in view of Special Bench decision in the case of DCIT Vs Bank of Bahrain & Kuwait (132 TTJ 505) and a coordinate bench decision in the case of ADIT Vs J P Morgan Chase Bank ( 2010 TII 185 ITAT MUM), we uphold the grievance of the assessee. The impugned dis-allowance is accordingly deleted. This relief is, however, subject to the rider that the allowability in deduction in the current year is subject to verification of corresponding adjustment in the year in which next settlement date falls. The assessee gets the relief accordingly.