Chapter 9: Accounting and Taxation

Learning Objectives

After studying this chapter, you should understand:

• Accounting treatment for exchange-traded currency derivatives under the ICAI Guidance Note on Accounting for Derivative Contracts (Revised 2021) and Ind AS 109.
• The distinction between trading positions and hedge accounting positions.
• Mechanism and accounting entries for Fair Value Hedges and Cash Flow Hedges.
• Classification of derivatives income under the Income-tax Act, 1961 (Profits and Gains of Business or Profession - PGBP).
• Statutory characterization of ETCD as Non-Speculative Business Income under Section 43(5) proviso (d).
• Tax treatment of Foreign Portfolio Investors (FPIs) under Capital Gains.
• Precise computation of turnover for tax audit purposes as prescribed by the ICAI Guidance Note on Tax Audit.
• Applicability of Section 44AB (Tax Audit) and Section 44AD (Presumptive Taxation Scheme).
• Set-off and carry forward rules for derivative business losses under Sections 71 and 72.
• Complete exemption of currency derivatives from Securities Transaction Tax (STT).

9.1 Accounting Guidelines and Disclosure Requirements

Accounting for Exchange-Traded Currency Derivatives (ETCD) in India is governed by the accounting standards issued by the Institute of Chartered Accountants of India (ICAI) and the Ministry of Corporate Affairs (MCA):

1. Ind AS 109 (Financial Instruments): Applicable to listed companies and non-banking financial companies (NBFCs) meeting net worth thresholds.
2. ICAI Guidance Note on Accounting for Derivative Contracts (Revised 2021): Applicable to non-Ind AS entities (SMEs, unlisted entities, partnerships, and proprietorships).

                      DERIVATIVE CONTRACT CLASSIFICATION
                                       │
                ┌──────────────────────┴──────────────────────┐
                ▼                                             ▼
       NON-HEDGE TRADING                             HEDGE ACCOUNTING
        (FVTPL Model)                           (Documented Hedging Strategy)
   Mark to market on balance                     │
   sheet date; all unrealized                    ├──────────────┬──────────────┐
   gains/losses go directly                      ▼                             ▼
   to Profit & Loss Statement.           FAIR VALUE HEDGE              CASH FLOW HEDGE
                                   Hedges fair value change       Hedges variability of
                                   of recognized asset/liability. future cash flows.
                                   Gain/loss in P&L offsets       Effective: OCI / Reserve.
                                   hedged item adjustment.        Ineffective: P&L.

1. Principle of On-Balance-Sheet Recognition at Fair Value

Both Ind AS 109 and the ICAI Guidance Note require that:

• All derivative contracts must be recognized on the Balance Sheet as either financial assets (favorable fair value) or financial liabilities (unfavorable fair value).
• Initial Measurement: Measured at Fair Value on the trade date (usually zero for futures at inception, except for transaction costs, and equal to the option premium paid or received for options).
• Fair Value Definition: The exit price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In liquid ETCD markets, fair value corresponds directly to the official Daily Settlement Price (DSP) published by the Clearing Corporation.

2. Accounting for Non-Hedge (Trading / Speculative) Positions

When derivative contracts are entered into for trading, speculative, or treasury purposes without formal hedge documentation:

• The contracts are classified as Fair Value Through Profit or Loss (FVTPL).
• Daily MTM Cash Settlements: Daily mark-to-market debits or credits settled through the clearing house are recorded directly in the Profit and Loss Statement as realized derivative gains or losses.
• Balance Sheet Date Valuation: Any open futures or options positions at the end of the accounting period are revalued at the closing settlement price. Any unrealized gain is credited to P&L (and shown as a current asset), while any unrealized loss is debited to P&L (and shown as a current liability).

3. Hedge Accounting Framework

Hedge accounting is a specialized accounting treatment that synchronizes the recognition of gains and losses on the hedging instrument (the currency derivative) with the offsetting losses and gains on the hedged commercial exposure.

Mandatory Prerequisites for Applying Hedge Accounting

An entity can only adopt hedge accounting if it satisfies strict compliance tests:

1. Formal Designation and Documentation: At inception of the hedge, formal documentation must be prepared detailing the risk management objective, the specific hedged item, the hedging instrument, the nature of the risk being hedged, and the methodology used to assess hedge effectiveness.
2. Economic Relationship: There must be an economic relationship between the hedged item and the hedging instrument (values move in opposite directions in response to the same currency risk).
3. Credit Risk Dominance: Credit risk must not dominate the fair value changes.
4. Hedge Ratio: The hedge ratio must align with the actual quantities used in commercial practice.

Types of Hedges in Currency Markets

Numerical Illustration: Cash Flow Hedge for an Exporter

• An exporter anticipates receiving USD 100,000 in 3 months. To lock in the rate, the exporter sells 100 USD/INR futures contracts at ₹84.00.
• At the end of Month 1 (balance sheet reporting date), USD/INR futures rise to ₹84.50.
  • The futures contract has an unrealized loss of $(84.50 - 84.00) imes 100,000 = -₹50,000$.
  • Assuming the hedge is 100% effective, this ₹50,000 loss is NOT charged to current P&L. Instead, it is debited to Other Comprehensive Income (OCI) and credited to Financial Liability on the balance sheet.
• At Month 3, export revenue is received and recorded at ₹84.50 (an extra gain of ₹50,000 on commercial revenue).
• Simultaneously, the ₹50,000 loss accumulated in the Cash Flow Hedge Reserve is reclassified from OCI to P&L, perfectly neutralizing the currency move.

4. Financial Statement Disclosures

Entities utilizing currency derivatives must provide extensive disclosures in the Notes to Accounts:

• Risk Management Objectives: Qualitative explanation of corporate currency risk exposure, sensitivity tolerances, and hedging policies.
• Accounting Policies: Detailed basis for measuring derivatives and determining hedge effectiveness.
• Quantitative Data: Contract notional values, strike prices, maturity profiles, and fair value assets/liabilities.
• Credit and Liquidity Risk: Maximum exposure to credit loss, collateral posted with clearing members, and credit limits.

9.2 Taxation of Exchange Traded Currency Derivatives

The taxation of exchange-traded currency derivatives in India is characterized by clear statutory provisions designed to separate legitimate exchange derivatives from speculative wagers.

1. Classification of Derivative Income: Non-Speculative Business Income

Under the Income-tax Act, 1961, income from trading in exchange-traded currency derivatives is assessed under the head: $$ extbf{"Profits and Gains of Business or Profession" (PGBP)}$$

The Section 43(5) Proviso (d) Exclusion

• Under general tax principles (Section 43(5)), any contract for the purchase or sale of any commodity, including stocks and shares, settled otherwise than by the actual delivery or transfer of the commodity or scrips is deemed to be a "speculative transaction".
• However, Clause (d) of the Proviso to Section 43(5) explicitly carves out an exception:

  "An eligible transaction in respect of trading in derivatives referred to in clause (ac) of section 2 of the Securities Contracts (Regulation) Act, 1956 carried out in a recognized stock exchange shall NOT be deemed to be a speculative transaction."

• Practical Implication: Because currency derivatives are defined under SC(R)A 2(ac) and traded on recognized exchanges with CCP clearing, profits and losses are treated as Normal (Non-Speculative) Business Income.

2. Taxation of Foreign Portfolio Investors (FPIs)

Under Section 2(14) of the Income-tax Act, any securities held by a Foreign Portfolio Investor (FPI) registered with SEBI are statutorily deemed to be "Capital Assets".

• Therefore, gains or losses arising to an FPI from dealing in currency derivatives are taxable under the head "Capital Gains" (and NOT as business income).
• Since currency derivative contracts have maturities of less than 12 months, the resulting income is categorized as Short-Term Capital Gain (STCG) taxable under Section 115AD at the applicable statutory rate.

3. Computation of Turnover for Tax Audit Purposes

The Income-tax Act does not contain a specific legislative definition for calculating "turnover" in derivative transactions. Therefore, the binding standard is set by the ICAI Guidance Note on Tax Audit under Section 44AB.

The ICAI Formula for Derivatives Turnover

Turnover is determined by summing the absolute value of all profit and loss movements, rather than using contract notional face values:

$$ ext{Turnover} = \sum | ext{Favourable Differences}| + \sum | ext{Unfavourable Differences}| + ext{Premium Received on Sale of Options} + ext{Differences on Reverse Trades}$$

• Rule 1: Positive differences (profits) and negative differences (losses) are both taken as positive absolute numbers.
• Rule 2: Premium received on the sale (writing) of options is included in turnover. (Premium paid on buying options is not added to turnover).
• Rule 3: Contract notional value (e.g., $100 ext{ contracts} imes $1,000 imes ₹84 = ₹84,00,000$) is NEVER used as turnover.

Worked Numerical Example: Turnover Computation

A market participant undertakes four derivative transactions during the financial year:

1. USD/INR Futures: Bought at ₹83.50, sold at ₹83.80. Realized Profit = +₹30,000.
2. EUR/INR Futures: Bought at ₹91.20, sold at ₹90.70. Realized Loss = -₹50,000.
3. USD/INR Call Option: Sold (written) 20 lots, receiving a total premium of ₹25,000.
4. GBP/INR Put Option: Bought 10 lots paying ₹12,000 premium; subsequently squared off for ₹18,000. Realized Profit = +₹6,000.

$$egin{aligned} ext{Turnover} &= |+30,000| + |-50,000| + 25,000 + |+6,000|
&= 30,000 + 50,000 + 25,000 + 6,000
&= \mathbf{₹1,11,000} \end{aligned}$$

4. Section 44AB Tax Audit Thresholds

Under Section 44AB of the Income-tax Act, every person carrying on business is required to get their accounts audited by a Chartered Accountant if total turnover exceeds statutory limits:

5. Section 44AD Presumptive Taxation Scheme

Eligible assessees (Resident Individuals, Hindu Undivided Families - HUFs, and Partnership Firms, excluding LLPs) carrying on derivative trading can opt for the simplified Presumptive Taxation Scheme under Section 44AD:

• Eligibility Ceiling: Total annual turnover (computed as per ICAI guidelines) must not exceed ₹2 Crores (extended to ₹3 Crores where cash receipts do not exceed 5% of total turnover).
• Presumptive Profit Rate: Because all receipts and payments in exchange-traded currency derivatives occur through banking channels, profit is deemed to be 6% of turnover (instead of 8% for cash transactions).
• Benefits:
  • No requirement to maintain detailed books of account under Section 44AA.
  • No requirement to undergo a tax audit under Section 44AB.
  • Assessee simply offers 6% of turnover as taxable PGBP income and pays tax at normal slab rates.

6. Set-Off and Carry Forward of Losses

Because currency derivatives are categorized as non-speculative business, loss treatment is significantly more favorable than for speculative equity day trading:

┌─────────────────────────────────────────────────────────────────┐
│               DERIVATIVE LOSS SET-OFF RULES                     │
├─────────────────────────────────────────────────────────────────┤
│ 1. INTRA-YEAR SET-OFF (Section 71):                             │
│    Loss can be set off against ANY head of income               │
│    (Business, Capital Gains, House Property, Other Sources)    │
│    EXCEPT "Salaries".                                           │
├─────────────────────────────────────────────────────────────────┤
│ 2. CARRY FORWARD OF LOSS (Section 72):                          │
│    Unabsorbed business loss can be carried forward for up to    │
│    8 CONSECUTIVE ASSESSMENT YEARS.                              │
│    In subsequent years, it can only be set off against          │
│    Business Profits (speculative or non-speculative).           │
├─────────────────────────────────────────────────────────────────┤
│ 3. MANDATORY CONDITION (Section 80 / 139(1)):                   │
│    To carry forward losses, the Income Tax Return (ITR)         │
│    MUST be filed ON OR BEFORE the statutory due date.           │
└─────────────────────────────────────────────────────────────────┘

7. Securities Transaction Tax (STT) Exemption

[!IMPORTANT] Securities Transaction Tax (STT) is NOT APPLICABLE to Exchange-Traded Currency Derivatives in India! While equity futures and equity options attract STT under Chapter VII of the Finance (No. 2) Act, 2004, the Central Government has explicitly exempted currency futures and currency options from STT. This is a crucial cost advantage for currency market hedgers and arbitrageurs.

8. Goods and Services Tax (GST)

• GST at the rate of 18% is levied on service fees charged by intermediaries, including:
  • Brokerage commissions.
  • Exchange transaction charges.
  • Clearing corporation settlement fees.
  • SEBI regulatory fees.
• GST paid on broking services can be claimed as an Input Tax Credit (ITC) by corporate and GST-registered business entities.

Chapter Summary & Exam Cheat Sheet