Concept of Mark to Market loss and issues connected with it. 93 taxmann.com 289
Mark to Market Loss is one of the contentious topics under Income Tax laws. This article is a brief on the verdict of the Hon’ble Delhi High on certain Income computation and Disclosure Standards and the Central Government’s subsequent action to nullify them by the Finance Act 2018.
1. As expected, the Finance Act 2018 brought about certain amendments to legitimate the Income Computation and Disclosure Standards (in short ‘ICDS’) which were struck down by the Hon’ble Delhi High Court during last November. Mark to Market (in short ‘MTM’) also known as ‘Fair Value Accounting’ refers to accounting of the ‘fair value’ of an asset or liability to its current market value.
Under the fair value approach, assets and liabilities are re-measured periodically, say on the last day of the financial year to reflect changes in their value. Fair value accounting is in practice for almost 30 years now and an indispensable part of Generally Accepted Accounting Principles (GAAP). MTM loss refers to losses generated through an accounting entry.
In other words, the value of the stock may change its value in the Balance sheet, depending upon the market fluctuations on account of favourable or unfavourable circumstances. Generally, mutual funds are marked to market on a daily basis. However, the said approach throws genuine issues when market-based measurements do not give the true picture. Financial statements are generally prepared on a conservative basis, i.e., showing a position better than what it is, is not permitted. ‘Prudence Concept’ under accounting means ‘anticipating no profits but recognizing all losses’.
Up to the Union Budget АавтТаТ│ 2018, ICDS-I did not recognize the concept of ‘Prudence’, even though it was one of the prominent accounting principles. The scenario, with the latest amendments, changed to a certain extent. The article is an attempt to understand the MTM concept under Income Tax perspective and issues connected therewith.
Income Tax Provisions
2. The Income Tax Act, 1961 (hereinafter referred to as “the Act”) provides detailed provisions to claim a deduction of an expense incurred for earning business income. Section 36(1)(xviii) deals with MTM concept, and prescribes certain conditions to avail of such deductions, Section 40A (13) provides for non-deduction of MTM loss with an exception and Section 145 (2) prescribes ten (10) ICDS to compute taxable income under the head ”Profits and gains from business or profession’.
Section 36(1) Other Deduction
3. 36(1) The deductions provided for in the following clauses shall be allowed in respect of the matters dealt with therein, in computing the income referred to in Section 28 –
(i) & (ii)** ** **
(xviii) marked to market loss or other expected loss as computed in accordance with the income computation and disclosure standards notified under sub-section (2) of Section 145.
The Finance Act, 2018 inserted a new sub-clause (xviii) in Section 36(1), which provides that any marked to market loss or other expected loss as computed in accordance with ICDS shall be allowed as a deduction with retrospective effect from 01.04.2017.
Section 40A-Expenses or payments not deductible in certain circumstances
4. 40A(1) The provisions of this section shall have effect notwithstanding anything to the contrary contained in any other provision of the Act relating to the Computation of Income under the head ‘Profits and Gains of business or profession’.
(2) & (3)** ** **
- (13) No deduction or allowance shall be allowed in respect of any marked to market loss or other expected loss, except as allowable under Section 36(1)(xviii).Due to insertion of sub-clause (xviii) in Section 36, the Finance Act, 2018 also amended the Section 40A suitably.
5. The Finance Act, 2018, inserted a new section 43AAwith the following provision. According to the new section, 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 shall be computed in accordance with the ICDSs notified under Section 145(2).
6. Section 145 (2) of the Act empowers the Central Government to notify from time to time ICDS to be followed by any class of taxpayers or in respect of any class of income. Compliance with the said section is mandatory. The Hon’ble Supreme Court in CIT v. Woodward Governor India (P.) Ltd.  312 ITR 254/179 Taxman 326 held that an assessee is obliged to follow the prescribed accounting standards to determine the taxable income under the head ‘business or profession’. Interestingly, the Central Government has delegated to CBDT, the computation part under Section 145(2) with retrospective effect from the assessment year 2017-18 onwards.
Era Prior to ICDS
7. As far as MTM losses on account of forex derivatives are concerned, the Central Board of Direct Taxes (‘CBDT’) has issued Instruction No. 3/2010 dated 23.03.2010. According to said Instruction, MTM losses on account of forex derivatives were a difference between the purchase price and the value as on the valuation date which is a notional loss and, therefore, not allowable. Hence, MTM losses shall be added back for computing the taxable income.
Income Computation and Disclosure Standards (ICDS)
8. ICDS is tax standard required to be applied while computing the taxable income of an assessee. One of the Key objects to introduce them was to bring consistency in computing and reporting of taxable income. Since inception, the ICDS have been a subject matter of litigation till Union Budget 2018. Sub-section (2) of Section 145 of the Act empowers the Central Government to notify from time-to-time ICDS to be followed by any class of taxpayers or in respect of any class of income. The CBDT vide Notification No. 87/2016 dated 29.09.2016 notified the revised ICDS and repealed its previous Notification No. 32/2015 dated 31.3.2015 on the same subject. The ICDS is applicable to all assessees except an individual and HUF who are not subject to tax audit under Section 44AB of the Act.
8.1 ICDSАавтТаТ│I The standard is applicable for computation of income chargeable under the head “Profits and gains from business or profession” and/or “Income from other sources”. However, ICDS is not for the purpose of maintenance of books of account. In case of conflict in provisions, the Act shall prevail.
The scope of the ICDS-I
To consider significant accounting policies such as ‘Going concern, consistency and Accrual.
To treat and present events and transactions by their substance instead of their legal form.
Not to recognize the MTM or an expected loss which is not in harmony with other ICDS.
To apply irrespective of the accounts adopted to corporate assessees, i.e., either Accounting standards or Ind-AS.
Recognition of MTM Gain or expected income
8.1.2 In so far as MTM gains are concerned, the same principle as contained in ICDS-I relating to MTM losses or an expected loss shall apply mutatis mutandis to MTM gains or an expected profit also. This position prevailed even after Finance Act, 2018 amendments. (CBDT Circular No. 10/2017 dated 23.03.2017)
Disclosure of accounting policies as per ICDS
8.1.3 There is no specific mention in ICDS-I about disclosures regarding adjustments to profit or loss in case of deviations from the Standard, which continues to be silent.
8.1.4 All existing transactions entered into on or after 01.04.2016 shall be dealt with in accordance with the provisions of ICDS-I after considering the income, expense or loss, if any, with respect to the said transaction for the previous year ending on or before 31.03.2016.
8.2 ICDS-VI deals with ‘Effects of Changes in Foreign Exchange Rates’. Prior to insertion of Section 43AA, MTM loss in case of foreign currency derivatives was not allowed. Since disallowance of MTM loss was not in consonance with the ratio laid down by the Hon’ble Apex court in Sutlej Cotton Mills Ltd. v. CIT  116 ITR 1, the Hon’ble Delhi High Court struck down it as such.
8.2.1 The scope of the ICDS-VI
To compute income under ‘Profits and gains of business or profession’ or ‘Other sources’
To treat foreign currency transactions appropriately ;
To translate the financial statements of foreign operations;
To treat forward exchange contracts occurred in foreign currency.
8.2.2 Initial recognition
A foreign currency transaction shall be recorded in the reporting currency, by applying the exchange rate as on the date of the transaction.
An average rate for a week or a month that approximates the actual rate at the date of the transaction may be used.
In case of significant fluctuation in the exchange rate, the actual rate at the date of the transaction shall be used.
8.2.3 Conversion of foreign currency
In case of monetary items АавтТаТ│ By applying the closing rate.
In case of absence of reasonable accuracy – The amount which is likely to be realized at the last date of the previous year.
In case of nonАавтТаТ░monetary items – By using the exchange rate at the date of the transaction.
8.2.4 Recognition of Exchange Differences
In case of monetary items – exchange differences arising on the last day of the previous year shall be recognized as income or as expense in that previous year.
In case of non-monetary items – exchange differences arising on the last day of the previous year shall not be recognized as income or as expense in that previous year.
However, initial recognition, conversion and recognition of exchange are subject to Section 43A of the Act and Rule 115 of the Income Tax Rules, 1962.
8.2.5 Translation of foreign operations
In case of Integral operations АавтТаТ│ any foreign exchange gain or loss shall be recognised in Profit & Loss account.
In case of non-integral operations – any foreign exchange gain or loss shall be recognised in Profit & Loss account but not in a Foreign Currency Translation Reserve account.
8.2.6 Forward Exchange contracts
Unrealized mark to market gains or loss on forward exchange contract shall be deducted.
Any Premium/discount at the inception of forward exchange contract shall be treated as expenses or income.
Exchange differences on such contract shall be recognized as income or expenses in the previous year.
Any Profit or loss arising on cancellation or renewal shall be treated as income or expense of the previous year.
Subject to certain conditions АавтТаТ│ the contract is not intended for trading or speculation purposes and is entered into to establish the amount of the reporting currency required or available at the settlement date of the transaction.
8.2.7 All foreign currency transactions undertaken on or after 01.04.2016, including exchange differences that arose in respect of monetary items or non-monetary items shall be recognised with the provisions of the ICDS – VI.
9. Specimen for computing Taxable Income under ICDS Framework
Particulars Amount (in Rs.)
Profit or loss as per Profit and Loss Account *****
Add or Less : Adjustments as per ICDS ***
Adjusted Income as per ICDS *****
Add or Less: Adjustments as per the provisions of the Act ***
Total Income *****
10. Effect of ICDS АавтТаТ│ ITR 3 for the Assessment Year 2018-19
Schedule ICDS ICDS Amount (+) or (-)
I. Accounting Policies
II. Valuation of Inventories (other than the effect of change in method of valuation u/s 145A, if the same is separately reported).
III. Construction Contracts
IV. Revenue Recognition
V. Tangible Fixed Assets
VI. Changes in Foreign Exchange Rates
VII. Government Grants
VIII. Securities (other than the effect of change in method of valuation u/s 145A, if the same is separately reported).
IX. Borrowing Costs
X. Provisions, Contingent Liabilities and Contingent Assets
11a Total effect of ICDS adjustments on profit(I+II+III+IV+V+VI+VII+VI
II+IX+X) (if positive)
11b Total effect of ICDS adjustments on profit (I+II+III+IV+V+VI+VII+VIII+IX+
X) (if negative)
11. Judicial Precedents
Chamber of Tax Consultants v. UoI  87 taxmann.com92/ 252 Taxman 77 (Delhi)
11.1 In last November, the Hon’ble Delhi High Court, in the above case, has struck down a number of ICDSs and several contentious issues pertaining to them, particularly whole ICDS-I and VI. The Hon’ble High court in the instant case held that (as far as concerned taxing statues) the essential legislative functions cannot be delegated. The Hon’ble High Court also opined that the ICDS is not meant to overrule the provisions of the Act, the Rules thereunder and the judicial precedents applicable thereto as they stand.
The said two ICDSs were challenged on the following grounds:
ICDS I was challenged on the ground of absolute absence of well-settled ‘Prudence Principle’, which was present in the earlier Accounting Standard – I. Prior to the latest amendment, the said ICDS stipulated that the prudence is not to be followed unless otherwise specified which is contrary to the face value of other landmark decisions on “Prudence Principle’ such as Triveni Engineering & Industries Ltd. v. CIT  49 DTR 253 (Delhi) and CIT v. Advance Construction Co. (P.) Ltd. v. CIT  143 Taxman 61/275 ITR 30.
ICDS VI was challenged on three grounds and they are, firstly, foreign exchange fluctuation as at the end of the year, on a loan is taken for the capital purpose would be treated as an item of income or expenses. Secondly, marked-to-market loss or gain in case of foreign currency derivatives held for trading or speculation purposes was not allowed. Thirdly, the clarification prescribed under Circular 10 for Foreign Currency Translation Reserve Account balance as on 01.04.2016 which was to be recognized as income or loss of the previous year relevant to the Assessment year 2017-18.
11.2 Bharat Earth Movers v. CIT  112 Taxman 61/245 ITR 428 (SC)-Expected losses on account of existing obligation as on 31stMarch, determinable with reasonable accuracy, being in the nature of expenditure or accrued liability have to be taken into account while preparing financial statements.
11.3 EDAC Engineering Ltd. v. Dy. CIT  30 taxmann.com355/141 ITD 231 (Chennai – Trib.) – For tax purposes, only expenses incurred or losses suffered could be allowed.
11.4 Dy. CIT v. Kotak Mahindra Investment Ltd.  35 taxmann.com 255/59 SOT 4 (Mum. – Trib.)-MTM losses on derivatives held as stock-in-trade shall be allowed as a business loss.
11.5 Reliance Industries Ltd. v. CIT  40 taxmann.com431/ 147 ITD 323 (Mum. – Trib.)-Foreign exchange loss computed at the end of the financial year on derivatives contract can be allowed as revenue expenditure
11.6 Dy. CIT (Int. Tax) v. Bank of Bahrain & Kuwait  41 SOT 290 (Mum.) (SB)-Loss incurred on account of evaluation of contract on last date of accounting period but before maturity of forward contract is an allowable deduction.
12. Overall impact of Finance Act 2018may be summed up as follows:
(i) Findings of the Hon’ble High Court with respect to ‘Prudence Concept’ are expressly overruled.
(ii) MTM loss or other expected loss would be allowed only to certain extent.
(iii) If there is no specific allowance of such loss under ICDS or where the ICDS is specifically denied allowance, same shall not be allowed.