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INTRODUCTION
In any given industry, there are ample amounts of import and export, leading to exchange of foreign currency between the countries. Whilst the transaction in the domestic trade takes place in the local currency, the trade between two countries may take place in the denomination of other country or more commonly in US dollars. Due to fluctuating currency and difficulty to estimate the future cash flows, companies tend to hedge their foreign currency inflow and outflow by way of certain instruments, which inter-alia includes hedging through forward exchange contracts. A forward exchange contract(FEC) is a customized contract between two parties, wherein they agree to sell or buy designated currencies on a specific rate at specific time in future.
In India, the accounting treatment of the forward exchange contract is governed by Accounting Standard (AS) 11 or Indian Accounting Standards (Ind AS) 21 “Effects of Changes in Foreign Exchange Rates”. Further, as far as the Indian taxation is concerned, the same are governed by a newly inserted (Finance Act 2018) section 43AA, with retrospective effect from assessment year 2017-18 which provides that the foreign exchange fluctuations shall be treated in accordance with Income Computation and Disclosure Standard notified under section 145(2).
While the financial statements are prepared in accordance with accounting standards, the computation of income is subject to the provisions contained in ICDS notified in this regard. ICDS VI deals with the provisions/adjustments to be made with regard to the treatment vis-à-vis a Forward Exchange Contract and the same are also applicable w.e.f. Assessment year 2017-18 onwards.
As per para 2(h) of ICDS VI, a “Forward exchange contract” means 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.
ISSUES
As far as the forward exchange contracts are concerned, when it comes to the taxability of certain transactions, the following issues are to be foreseen:
- Taxability of Premium or Discount arising at the inception of Forward Exchange Contracts
- Taxability of Marked to Market Loss on account of exchange fluctuation on reporting date
- Taxability of actual gain/loss at the time of contract settlement date
Issue 1
Taxability of Premium or Discount arising at the inception of Forward Exchange Contracts
In accordance with para 8(1) of ICDS VI, any premium or discount arising at the inception of a forward exchange contract shall be amortized as expense or income over the life of the contract, which is line with the provision contained in the para 36 of AS 11.
Para 8(1) also provides that, exchange differences on such a contract shall be recognized as income or as expense in the previous year in which the exchange rates changes. Any profit or loss arising on cancellation or renewal shall be recognized as income or as expense for the previous year.
Further, as per Para 8(4), Premium or discount that arises on the contract is measured by the difference between the exchange rate at the date of the inception of the contract and the forward rate specified in the contract.
Issue 2
Taxability of Marked to Market Loss on account of exchange fluctuation on reporting date
Also, as per Para 8(1) of the said ICDS Exchange differences on such a contract shall be recognized as income or as expense in the previous year in which the exchange rates change, which implies that the forward exchange contracts shall be reinstated at the end of reporting period and the gain/loss therein shall be recognized as income or expense and offered to tax.
The exchange difference shall be computed by taking into account difference between the foreign currency amount of the contract translated at the exchange rate at the last day of the previous year and the same foreign currency amount translated at the date of inception of the contract or the last day of the immediately preceding previous year, whichever is later.
Issue 3
Taxability of actual gain/loss at the time of contract execution date
As regards the treatment of actual gain/ loss at the time of contract execution date, the treatment shall be same as that of loss/gain on account of reinstatement as on last date of reporting period. Further, the exchange difference shall be computing by taking into account difference between the foreign currency amount of the contract translated at the exchange rate prevailing on the settlement date and he same foreign currency amount translated at the date of inception of the contract or the last day of the immediately preceding previous year, whichever is later.
In order to better understand the calculations and analyze the treatment thereof, let’s take an example:
Say ABC Pvt. Ltd. (India) purchased raw material from SBZ Inc. (USA) for USD 50,000 on 01st February 2020 payable in 3 months i.e., 01st May, 2020
Spot INR/USD was INR 74.00 per USD;
Forward Exchange Contract prevailing on 01.02.20 for 3 months was at INR 75.50 per USD;
Spot INR/USD as on 31st March 2020 was INR 73.50 per USD.
Spot INR/USD as on 30th April 2020 was INR 76.00 per USD.
Reporting currency: INR; Current Reporting period: F.Y. 2019-20
- In this case, premium on account of forward exchange contract is the difference between the exchange rate at the date of the inception of the contract and the forward rate specified in the contract.
In our example, the same can be calculated as under:
Deferred Gain is equal to 50,000 X ( 75.50 – 74.00 ), which comes out to INR 75,000.
The same shall be amortized over the life of the contract which is 3 months. Thus, for F.Y. 2019-20 the amount of premium to be amortized can be worked out as under:
Amount to be credited is equal to 75,000 X 2/3 = 50,000
Thus, an amount of INR 50,000 shall be added while computing the total income for FY 2019-20.
- Foreign Exchange Gain/Loss as on end of reporting period, to the extent of Forward Exchange Contract is equal to difference between the foreign currency amount of the contract translated at the exchange rate at the last day of the previous year and the same foreign currency amount translated at the date of inception.
Which can be calculated as under:
Exchange Loss as on 31st March, 2020 is equal to 50,000 X ( 75.50 – 73.50 ), which comes out to INR 1,00,000 and the same shall be reduced from the income while computing the income from business and profession.
- Further, the amount of exchange gain/loss on the date of settlement shall be calculated by taking difference between the foreign currency amount of the contract translated at the exchange rate prevailing on the settlement date and same foreign currency amount translated at the last day of the immediately preceding previous year.
Therefore, Exchange Gain on 30th April 2020 is equal to 50000 X ( 76.00 – 73.50 ), which comes out to INR 1,25,000 which shall be added while computing the income from business and profession for F.Y. 2020-21.
However, it is interesting to note here that while only the treatment of forward exchange contracts has been discussed, considering the treatment of foreign currency fluctuations on account of actual payable w.r.t. purchases, the overall gain/loss over the period of contract shall be nil.
Having said that, it is also important to understand the exclusions provided in the ICDS with regard to the provisions iterated above. In this connection, para 8(2) of ICDS VI excludes contract that is entered into to hedge the foreign currency risk of a firm commitment (does not include assets and liabilities existing at the end of the previous year) or a highly probable forecast transaction, and premium/discount or exchange difference from the said contracts shall be recognized at the time of settlement as per para 8(5).
SPECIAL CONSIDERATION
The provisions of section 43AA (which governs treatment of foreign currency fluctuations) are subject to section 43A. Also, Para 6 of ICDS VI states that the rules relating to initial recognition, conversion and recognition of exchange difference shall be subject to provisions of section 43A of the Income tax Act, 1961 read with rule 115 of Income tax Rules, 1962.
Section 43A deals with the assets acquired from a country outside India for the purposes of business or profession under twin circumstances, namely:
- Foreign Supplier’s credit;
- Loan in Foreign Currency;
and such loan is outstanding as on the date of fluctuation in foreign exchange rates. Then the difference on account of amount required to be paid to discharge the aforesaid liability, along with interest if any shall be added to or reduced from, cost of asset irrespective of the accounting treatment followed by the assessee.
Further, Explanation 3 to section 43A provides that, if the assessee has entered into an forward contract with respect to discharging such liability, then the adjustments specified in the said section shall be made in consonance with rate of foreign exchange entered into the forward exchange contract, subject to the sum specified in the contract to the extent available to discharge the aforesaid liability.
Also, apex court in the case of Maruti Udyog Ltd., 320 ITR 729 allowed claim of depreciation on account of enhanced cost due foreign exchange fluctuation.
JUDICIAL PRECEDENCE
One may note that ICDS VI does not demarcate between capital and revenue items. However, it only allows to account for foreign currency fluctuations on account of monetary items. Further, in order to mitigate the tax litigations, one may look into a following judicial pronouncements:
SUTLEJ COTTON MILLS LTD (SC) 116 ITR 1
“The law may, therefore, now be taken to be well settled that where profit or loss arises to an assessee on account of appreciation or depreciation in the value of foreign currency held by it, on conversion into another currency, such profit or loss would ordinarily be trading profit or loss if the foreign currency is held by the assessee on revenue account or as a trading asset or as part of circulating capital embarked in the business. But, if on the other hand, the foreign currency is held as a capital asset or as fixed capital, such profit or loss would be of capital nature.”
BABY MEMORIAL HOSPITAL LTD. (COCHIN ITAT) 77 ITR(T) 484
Yet another interesting pronouncement by Cochin bench of Honorable Income Tax Appellate Tribunal, in the case of Baby Memorial Hospital Ltd. 77 ITR(T) 484 allowed the loss on foreign exchange fluctuations on capital assets not acquired from outside India by relying on the judgements of apex courts in the cases of Tata Iron & Steel Ltd. (231 ITR 285) and Woodward Governor India Pvt. Ltd. (312 ITR 254) and allowing the loss on account of foreign currency fluctuations calculated in accordance with revised AS 11.
TREATMENT UNDER MAT PROVISION
As far as MAT Provisions are concerned, MAT is payable on the book profits which requires certain prefixed adjustments to be made in accordance with Explanation 1 to section 115JB of the Income Tax Act, 1961. Second proviso to Section 115JB also provides that while preparing profit and loss, the accounting policies; accounting standards; method and rate of depreciation shall be same as have been adopted for the purpose of preparing such accounts in accordance with the companies act.
On a careful reading and analysis of Section 115JB and explanation 1 thereto, the inference which can be drawn is that there is no specific clause which requires the tax payers to add or reduce the foreign exchange loss including the premium or discount; gain either on account of reinstated liability on the last date of previous or loss/gain on account of final settlement. Therefore, this implies that the adjustments made to the statement of profit and loss account prepared in accordance with Accounting Standards, shall hold good for the purpose of calculation of Book Profits under section 115JB.
Therefore, to sum up, it can be said that the treatment of premium/reinstatements losses/loss on settlement shall be same as given above since there is no difference of accounting for between Accounting Standards and ICDS VI.
CONCLUSION
In conclusion, it can be said that from A.Y. 2017-18 onwards, there is no difference between tax treatment of transactions relating to foreign exchange contracts as the same are governed by the ICDS. As far as the judicial precedence is concerned, it has been clarified by CBDT that the provisions of ICDS shall over rule judicial pronouncements as the case laws have been duly reviewed before issuing the standards and necessary adjustments therein have already been incorporated. However, the taxpayers will need to evaluate whether the said transactions falls within the overall scope of ICDS VI and is not covered by the exclusions specified therein.