Treatment of Gain or loss on Forward Contracts under Income Tax Act
Treatment of gain or loss on forward contracts may significantly differ in the Ind-AS as compared to the provisions of the Income Tax Act, 1961. Thus, the assessee might be required to make adjustment to their book profits to compute the taxable income under the head “Profits and Gains of Business or Profession”. Let’s have an understanding of the treatment of gain or loss on forward contracts under Income Tax Act.
It is important to refer ICDS-VI dealing with “Effect of changes in Foreign Exchange Rates” for this purpose.
Para-5 of ICDS-VI
Para-5 of ICDS-VI deals with the recognition of exchange gain or loss in respect of monetary items and non-monetary items. According to it, the exchange differences will be recognized in respect of monetary and non-monetary items in the following manner:
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Monetary Items |
Non-Monetary Items |
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Exchange difference arising on the settlement thereof or on conversion thereof at last day of the tax year shall be recognized as income or expense in that tax year. In other words, any gain or loss which has been realized on settlement of monetary items will be considered in the ITR. Further, the loss or gain on conversion at year end shall also be considered in the ITR. |
Exchange differences arising on conversion thereof at the year end shall not be recognized as income or expense in that tax year. |
Further, we should refer Section 43AA of the Income Tax Act which states as below:
Section 43AA (1)
Subject to provisions of section 43A, any gain or loss arising on account of any change in foreign exchange rates shall be treated as income or loss, as the case may be, and such gain or loss computed in accordance with the ICDS notified under Income Tax Act. Thus, making a combined reading of Para-5 of ICDS-VI and section 43AA, it is clear that exchange gain or loss arising on settlement as well as conversion of monetary items will be considered in computation of taxable income. Exchange gain or loss in respect of non-monetary items will not be considered in computation of taxable income.
Sub-section (2) of section 43AA makes the above conclusion more clear stating that:
“ For the purposes of sub-section (1), gain or loss arising on account of the effects of change in foreign exchange rates shall be in respect of all foreign currency transactions, including those relating to-
(i) Monetary items and non-monetary items;
(ii) Transaction of financial statements of foreign operations;
(iii) Forward exchange contracts;
(iv) Foreign currency translation reserves;”
Now, we will refer Para-8 of ICDS VI which states as below:
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Forward Exchange Contracts not intended for trading & speculation purposes |
Forward Exchange Contracts intended for trading & speculation purposes |
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Premium, discount or exchange difference on contracts that are intended for trading or speculation purposes, or 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. In other words, unrealized loss or gain shall not be considered in this case. |
We will also go through provisions of section 36(1)(xviii) of the Income Tax Act and ICDS I Para-4 guiding us about recognition of MTM loss in respect of forward contracts.
Section 36(1)(xviii) of Income Tax Act, 1961
Market to market loss or other expected loss as computed as per ICDS notified under section 145(2) of the Income Tax Act, 1961 will be allowed as deduction.
ICDS I Para-4
Marked to Market loss or an expected loss shall not be recognized unless the recognition of such loss is in accordance with the provisions of any other ICDS.
Both these provisions reiterate the law that recognition of MTM loss or expected loss in the ITR shall be guided by the provisions of the applicable ICDS. Therefore, where an entity enters into a forward exchange contract without any intention of trading or speculation, MTM loss or unrealized loss shall be considered for computing taxable income of that year.
However, where the forward exchange contract is entered into for trading or speculation, gain or loss arising thereon shall be considered in the year of settlement.
Disclaimer: The above information is meant for educational purposes only. Readers are requested to act diligently and under consultation with any professional before applying the information contained in this article. For any support mail at: support@taxwink.com
