In Shankara Infrastructure Materials Ltd. vs. Assistant Commissioner of Income-tax, it was held that the assessee engaged in trading business having notional loss on foreign currency swap option transaction was not hedging transaction, but the same was speculative in nature, thus, not deductible.   

Facts of the case:

The assessee was in business of trading of steel, tubes, pipes, PVC etc. For the said business, the assessee raised a bank loan. To reduce the interest cost on the loan, the assessee entered into a ‘foreign currency swap option’.

While preparing the balance sheet, the assessee had shown certain amount as provision for FCNR fluctuation loss. The said amount was treated as the notional loss from the speculative business in the Original Return of Income. The assessee revised the return and treated the said amount as Revenue Loss and claimed a deduction.

In the assessment proceedings, the Assessing Officer examined the details of the transaction and disallowed the assessee’s claim of the said loss as the revenue loss. The AO held the loss to be the notional loss as the transaction involved was speculative in nature.

On this, the assessee appealed to the Commissioner (Appeals). The AO’s order was upheld. Aggrieved by the said order, the assessee appealed to the Tribunal.

It was held that:

A derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate. Derivatives can be used for insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard to trade assets or markets. The foreign exchange derivatives are Forward, Future, Option, Swap etc.

The swap agreement defines the dates when the cash flows are to be paid and the way they are accrued and calculated. Usually at the time when the contract is initiated, at least one of these series of cash flows is determined by an uncertain variable such as a floating interest rate, foreign exchange rate, equity price, or commodity price. The cash flows are calculated over a notional principal amount.

In the case in the light, the assessee has submitted copies of quotations of the option contracts as additional evidences in terms of Rule 29 of the ITAT Rules. The said documents submitted give the indicative terms and conditions for the FCNR hedge taken by the assessee. The trade date is not specified, indicating that the date can be decided by the assessee at a later date. Also, the payoff is not firmed up or certain but would depend on the currency trading position.

As the payoff date and payoff amount is not certain therefore, provision created on the balance sheet date was unascertained liability. The assessee had entered into a derivative contract of option and on close examination it was concluded that the transaction entered into by the assessee was not hedging transaction, but the same was speculative in nature.

The Tribunal held that the losses shown were notional in nature and therefore, the provision for loss claimed as a deduction shall be disallowed. The assessee argued that if thetransaction is held to be speculative in nature, then the provision for loss should be allowed as a deduction from the profit generated from such transactions. On this, the Tribunal cleared that the assessee is not engaged in the speculative business and the loss shown is a notional loss. It is to be noted that the notional loss shall not be adjusted against the actual profit earned by the assessee. Such adjustment is only possible when the loss actually turns out.

Thus, the assessee’s appeal was dismissed.