The entities entering into foreign exchange transactions are exposed to foreign exchange risk i.e. risk that the exchange rate of the transactional currency may change which may lead to foreign exchange loss to such entities at the time of their realization or restatement. For the purpose of hedging such foreign currency risks, the entities generally enters into a forward contract with bank in order to hedge the receivable/ payable amount with respect to such currency. Paragraph 2(1) (h) of Income Computation and Disclosure Standards (“ICDS”) VI relating to the effects of changes in foreign currency rates defines such forward contracts as an agreement to exchange different currencies at a forward rate, and includes a foreign currency option contract or another financial instrument of a similar nature. In this article, we will understand the treatment to be given to the gain/ loss arises on forward contracts and the inter play between ICDS and recent Hon’ble Delhi High Court (DHC) judgment in case of the Chamber of Tax Consultants.
B. Classification of forward contracts for the purpose of tax treatment
ICDS VI relating to the effects of changes in foreign exchange rates provides that forward contracts can be divided into following types for the purpose of determining the tax treatment:
“Firm Commitment” shall mean a Commitment in foreign currency given by the entity without having the assets or liabilities existing in the books of account. In other words, forward contracts entered into for firm commitment are contracts which are related to future assets/ liabilities.
C. Tax Treatment of Forward Contracts NOT intended for trading or speculation purpose and entered into for the purpose of settlement of a particular asset/ liability on a future date:
The difference between spot exchange rate at the date of contract AND contracted forward rate is regarded as Premium/ Discount on such forward contract. The exchange difference in relation to such contracts is required to be amortized as an income or expense within the period of contract.
Any profit or loss arisen on the renewal/ cancellation of forward contract will be charged to profit or loss in the year of such cancellation/ renewal.
The restatement exchange gain/loss on forward contracts shall be allowed as deduction in the year of restatement (i.e. on the basis of its unrealized status also).
The realization exchange gain/loss on forward contracts shall be allowed as deduction in the year of its realization if the settlement has taken place within the same year.
D. Tax Treatment of Forward Contracts intended for trading or speculation purpose and entered into for the purpose gain from such forward contract:
Supreme Court in Sutlej Cotton Mills Limited has held that if foreign exchange loss is incurred on account of trading liability, the same would be a deductible expenditure. ICDS VI provides that exchange fluctuation loss/gain on foreign currency derivatives held for trading or speculation purposes are to be allowed only on actual settlement and not on mark to market (‘MTM’) basis which has been struck down by the Delhi High Court in the case of The Chamber of Tax Consultants and affirmed the applicability of Supreme Court ruling.
Hence, gain/loss arisen on forward contract entered into for trading and speculation purpose is allowed as deduction on the basis of Mark to Market (MTM).
E. Forward Contracts entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction:
Entire Profit and Loss impact w.r.t. Premium/ Discount and exchange difference on contracts that are entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction shall be recognized at the time of settlement.
F. Some Important Points:
Note: It is to note that once the assessee has taken any of the above option in a particular previous year, the same is not advisable to be changed in the subsequent years based on the beneficial status. Hence, the option should be chosen by due deliberation to be given to the future outcomes of foreign currency transactions.
I. Forward Contracts entered into on Revenue Account Transactions:
II. Forward Contracts entered into on Capital Account Transactions: