Tax disallowances on marked-to-market loss
The Hindu Business Line
Associate Director, Tax & Regulatory services
Ernst & Young
The Income-tax Act, 1961 provides that taxable income of businesses shall be computed according to the cash or mercantile system of accounting employed by the taxpayers. Furthermore, the Central Government has been empowered to notify the tax accounting standards (TAS) for specified classes of taxpayers.
The Central Board of Direct Taxes constituted a committee on December 20, 2010, consisting of revenue officers and professionals, to study the harmonisation of the accounting standards, or AS, issued by the Institute of Chartered Accountants of India with the Income-tax Act, and suggest standards for computing taxable income. On October 26, 2012, the committee released a paper containing the final recommendations and drafts of 14 tax accounting standards for computing taxable income. It recommends that while TAS should be applicable to compute taxable income, the taxpayer need not maintain two sets of accounts (for AS and TAS respectively).
The recommended TAS are different from AS in several ways. The draft TAS suggests that expected losses cannot be deducted from the income for tax, which is at variance from accounting standards.
AS-1 (Disclosure of Accounting Policies), based on the concept of prudence, requires recognition of expected losses but precludes recognition of anticipated profits. The concept of prudence as an accounting assumption has sought to be omitted in the corresponding draft of TAS.
While TAS provides that accounting policies should represent a true and fair view of the state of affairs and income of the business, the mark-to-market loss or expected loss shall not be recognised unless it is in accordance with the other provisions. This also applies to forward contracts for trading or speculation, or to hedge the foreign currency risk of a firm’s commitment, or a highly probable forecast transaction, as the premium or discount/ exchange difference on such contracts can be recognised only on settlement.
The courts and tribunals have held that the increase in liability due to forex fluctuation on the last day of the financial year is not a contingent or notional liability. Currently, mark-to-market losses recognised on the last day of the financial year are an allowable gain or loss in computing the taxable income and expense, though this has been a point of litigation between taxpayers and revenue authorities. In fact, in March 2010 the Central Board of Direct Taxes had directed the income-tax authorities to disallow such losses as they were notional.
Where TAS accounting policies is notified in its current form, the above issue should be put to rest, and the mark-to-market losses would be disallowed.
Similarly, in TAS construction costs, losses relating to future activity on contracts shall not be recognised. This is in contrast to AS-7, which requires that losses including the probable/ expected losses shall be recognised fully.
The new tax accounting standards provide clarity and certainty on mark-to-market gains and losses. By disallowing notional losses and excluding notional gain, the committee seeks to provide parity in computation of taxable income. It has also recommended transitional provisions, where required, to ensure the same income is not taxed in both pre-TAS and post-TAS periods, and that it does not escape taxation altogether either.