2011 (8) TMI 246 - AT - Income Tax

Dissallowance - loss on account of valuation of interest rate swap - accounting principle of prudence u/s 145(2) - 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 - Held that - 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 - loss on valuation of interest rate swap is to be allowed as a deduction in computation of business income, a reference was made to Hon ble Supreme Court s judgment in the cases of Sanjeev Woolen Mills vs CIT (2005 -TMI - 6166 - SUPREME Court) - relief is 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 - Decided in favour of assessee.

Issues Involved:
1. Disallowance of loss on account of valuation of interest rate swap.
2. Nature and treatment of interest rate swap contracts.
3. Applicability of accounting standards and principles.
4. Timing of deduction for anticipated losses.

Detailed Analysis:

1. Disallowance of Loss on Account of Valuation of Interest Rate Swap:
The primary issue in this appeal is whether the loss of Rs. 10,10,92,000 on account of the valuation of interest rate swaps, claimed by the assessee, should be allowed as a deduction. The Assessing Officer (AO) disallowed this loss, considering it a notional or imaginary loss, as it was based on the valuation of unsettled interest rate swap contracts as of the balance sheet date.

2. Nature and Treatment of Interest Rate Swap Contracts:
Interest rate swaps are financial contracts where two parties exchange streams of interest payments for a notional principal amount. These contracts typically involve exchanging fixed interest rates for floating rates or vice versa. The assessee had three ongoing interest rate swap contracts with a notional principal amount of Rs. 185 crores, under which it was to pay a fixed rate and receive a floating rate of interest. The loss claimed was based on the valuation of these contracts as of the balance sheet date, considering the future extrapolation of the yield curve, past rates, and current market rates.

3. Applicability of Accounting Standards and Principles:
The assessee argued that the valuation was in accordance with the Reserve Bank of India's guidelines and consistently followed accounting methods. The AO, however, argued that the loss was an unascertained liability and not allowable as a deduction. The AO cited judicial precedents to support the view that only ascertained and enforceable liabilities could be deducted. The Tribunal noted that Section 145 of the Income Tax Act requires business income to be computed per the cash or mercantile system of accounting regularly employed by the assessee, and mandatory accounting standards must be followed. One such standard mandates provisions for all known liabilities and losses, even if the amount cannot be determined with certainty.

4. Timing of Deduction for Anticipated Losses:
The Tribunal emphasized that the real issue was not the deductibility of the loss but its timing. The valuation of interest rate swaps as of the balance sheet date indicates the computation of profit or loss on these contracts as of that date. The loss claimed at this stage is eventually adjusted against the actual loss or profit on settlement in subsequent years. The Tribunal held that anticipated losses, even if not crystallized in the relevant year, should be allowed as a deduction in the computation of business profits, in line with the principle of conservatism in accounting.

Conclusion:
The Tribunal concluded that the loss on valuation of interest rate swap contracts should be allowed as a deduction in the relevant previous year. The Tribunal noted that the assessee's estimated liability on account of fixed interest rates, after considering the discounting factor for the time value of money, was higher than the amount receivable. The Tribunal also observed that the principle of prudence in accounting, now binding under Section 145(2) of the Income Tax Act, mandates the provision for anticipated losses. The Tribunal upheld the assessee's grievance and deleted the impugned disallowance, subject to verification of corresponding adjustment in the year when the next settlement date falls.

Result:
The appeal was allowed in favor of the assessee, with the relief subject to verification of corresponding adjustments in subsequent years.

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