LOSS ON VALUATION OF INTEREST RATE SWAP CONTRACTS – DEDUCTIBLE?

[Mr. M. GOVINDARAJAN]

Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have been  changed. Recently, swaps have grown to include currency swaps and interest rate swaps.  An interest rate swap (IRS) is a liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another. Interest rate swaps can be used for hedging and speculating.

The issue to be discussed in this article is whether the loss on valuation of interest rate swap contracts is deductible or not for the purposes of Income Tax Act, 1961 with reference to decided case law.

In ‘IDBI Capital Market Services Limited V. Deputy Commissioner of Income Tax’ – 2015 (8) TMI 1143 - ITAT MUMBAI  the assessee is engaged in the business of investment, share broking and Government securities.   It is a member of the Bombay Stock Exchange and National Stock Exchange.  The return of the assessee was selected for scrutiny assessment. The Assessing Officer noticed that an amount of ₹ 18,29,87,255/- has been debited to loss on swaps being marked to market loss as on 31.03.2008.  The assessee was asked to explain and justify the same. The assessee gave explanation to the Assessing Officer that the outstanding interest swap contracts were valued.   In case there was a loss in valuation the same is debited to Profit and Loss Account. The transaction of the assessee is akin to foreign exchange derivatives.  The Accounting Standard AS – 11 deals with giving of accounting treatment for the effect of changes in foreign exchange rate.

After considering the explanation of the assessee the Assessing officer observed that the assessee has recognized only the loss and not the profit. The assessee has not been consistent and definite in making entries in the account books in respect of losses and gains and accordingly denied the claim of the deduction.

Aggrieved against the order of the Assessing Officer, the assessee filed an appeal before the Commissioner (Appeals). The Commissioner (Appeals) confirmed the disallowance treating the same as contingent liability.

The appeal was filed before the Tribunal against the findings of the Commissioner (Appeals).  Before the Tribunal the assessee explained the nature of transactions.  The assessee contended that mark to market loss is allowed by the Tribunals in many cases. The liability is not a contingent liability as held by the Supreme Court in ‘Commissioner of Income tax V. Woodward Governor India Private Limited’ – 2009 (4) TMI 4 - SUPREME COURT.  The swap agreement is not a derivative contract and cannot be termed as commodity for the purpose of Section 43(5) of the Act.  The Revenue supported the findings of the Assessing Officer.

The Tribunal found that it is an undisputed fact that the assessee has made the valuation of interest rate swap contracts as at the end of the year.   It is also an undisputed fact that the assessee had incurred losses on such valuation.   The said losses have been claimed as deduction in the profit and loss account.  The assessee has made the entries following the Accounting Standard, AS – 11 of the Institute of Chartered Accountants of India.  Such losses being treated as mark to market losses have been allowed by the Tribunal in series of cases following the Special Bench decision.

The Tribunal held that the observations of the Assessing Officer that the assessee has never accounted for the gains on the transactions is totally misplaced and against the facts of the case.  The Tribunal found in the profit and loss account the assessee had gains of ₹ 25.57 lakhs and included the same in the income. The Tribunal set aside the order of Commissioner of Income Tax