Unrealised loss on outstanding interest rate swaps would be allowable as business deduction

In brief :-In a recent ruling, the Mumbai Income-tax Appellate Tribunal (the “Tribunal”) in the case of J P Morgan Chase Bank Vs. ADIT [2010-T11-185-ITAT-DEL-INTL, held that unrealized loss on outstanding interest rate swap transactions at year end would be allowed as a deduction, when the assessee had been following the same method of accounting consistently in accordance with the mandatory requirement under the Reserve Bank of India (the “RBI”) guidelines.

Facts

•  The assessee had debited to the profit and loss account a certain amount as loss incurred on revaluation of interest rate swap transactions. It marked-to-market (“MTM”) the entire outstanding trading swap by comparing present value of floating interest cash flow with present value of cash flows on the fixed rate. The difference between the two amounts i.e. MTM gain or loss was recorded in the profit and loss account.

• The assessing officer (“AO”) disallowed the claim for deduction of the loss on these transactions.

• The assessee contended that its claim should be allowed since the profit on revaluation of interest rate swaps arrived at in the same manner was taxed in earlier years, and the method of accounting system followed was in terms of the guidelines on Interest Rates Swap issued by the RBI.

• The CIT(A) relied on the decision in the case of  United Commercial Bank v. CIT [1999] 240 ITR 355 (SC) and held that the premium is a cost of the swap transaction to the assessee. Therefore, the proportionate premium on the outstanding swap contract at the end of the financial year worked out on the basis of the number of days for which the contract was held in the relevant financial year was charged to the assessee’s profit and loss account. Hence, the loss for the period upto the year end was allowed by the CIT(A).

•  The revenue filed an appeal against the CIT(A)’s order.

Issue

Whether unrealized loss on outstanding interest rate swaps at the year end would be allowed as business deduction.

Tribunal Ruling

The Tribunal observed and held that:

•  The assessee was following consistent method of accounting for interest rate swaps in terms of the guidelines issued by the RBI.

• As per the rule of consistency, the method adopted by the assessee had to be accepted and expenses would be allowed on accrual basis.

• Hence, the unrealized loss on interest rate swaps for the period upto the year end would be allowed as a deduction

In this case, in relation to the  issue of interest for broken period, the Tribunal also held that broken period interest on securities purchased would be allowed as revenue expenditure on accrual basis, by relying on the decisions in the case of American Express International Banking Corpn. v. CIT [2002] 258 ITR 601 (Bom.)

Conclusion- This decision is relevant to assessees following RBI guidelines for accounting for interest rates swaps. Companies which are claiming unrealized loss on outstanding interest rate swaps at the year end would find this ruling useful. While this ruling is allowing the unrealized loss on interest rate swaps, it may be noted that the method of accounting for the purpose should have been consistently followed.

NF