The Mumbai Bench of the Income Tax Appellate Tribunal (ITAT) has held that gains earned by a Foreign Portfolio Investor (FPI) from the early cancellation or settlement of forward foreign exchange contracts entered into for hedging currency exposure are taxable as capital gains and cannot be assessed as income from other sources.
The bench of Beena Pillai (Judicial Member) and Arun Khodpia (Accountant Member) ruled that forward contracts are inseparably linked to the underlying investment in debt securities and therefore assume the same tax character as the investments they protect.
The assessee invests in Government of India securities and debt securities of listed Indian companies. To protect itself against fluctuations in foreign exchange rates affecting these investments, it entered into forward foreign exchange contracts in accordance with the Reserve Bank of India’s regulatory framework for FPIs.
During AY 2023-24, the assessee earned ₹11.94 crore from the cancellation or early settlement of such forward contracts. It claimed the amount as capital gains exempt under Article 13(5) of the India-Singapore Double Taxation Avoidance Agreement (DTAA) and filed its return declaring taxable income of only ₹1.10 lakh.
However, during scrutiny assessment, the Assessing Officer (AO) rejected the claim. According to the Revenue, the assessee failed to establish that the forward contracts were inextricably linked to its debt investments. Consequently, the AO treated the ₹11.94 crore gain as “Income from Other Sources”, substantially increasing the taxable income. The Dispute Resolution Panel (DRP) upheld the AO’s view, despite acknowledging that earlier Tribunal decisions had favoured the assessee.
Before the Tribunal, the assessee contended that the forward contracts were entered into solely for hedging foreign exchange risk associated with its investment portfolio and were not speculative or independent trading transactions.
It pointed out that under RBI regulations, FPIs are permitted to hedge only to the extent of their actual underlying foreign exchange exposure. The notional amount and tenor of the forward contracts cannot exceed those of the underlying investments. Once the debt securities are sold, the corresponding forward contracts must necessarily be cancelled or unwound.
The assessee also furnished detailed evidence, including lists of debt securities purchased and sold. Details of forward contracts entered into for hedging. Deal confirmations for underlying investments. Deal slips relating to booking and cancellation of forward contracts.
It further argued that forward contracts constitute capital assets, and their cancellation amounts to a transfer under the Income Tax Act, making any resulting gain taxable under the head “Capital Gains.” The assessee also relied on several earlier ITAT decisions in its own case, where similar gains had consistently been treated as capital gains.
The Tribunal accepted the assessee’s submissions and held that the regulatory framework itself establishes that the forward contracts were entered into purely as hedging instruments and not as independent speculative transactions.
The Bench observed that RBI regulations restrict FPIs from entering into foreign exchange derivatives beyond the exposure arising from the underlying securities. Once the underlying investment is disposed of, the hedge cannot continue independently.
According to the Tribunal, this regulatory structure clearly demonstrates that the forward contracts are intrinsically linked to the capital investments and exist only to protect those investments from currency fluctuations. The Revenue had produced no evidence to show that the assessee was separately trading in foreign exchange.
The Tribunal held that once the forward contracts are accepted as hedging instruments, the tax character of any gain or loss arising from them must follow the character of the underlying asset.
Since the underlying debt securities are capital assets, gains arising from the cancellation of hedging contracts cannot be treated differently merely because the contracts were settled before maturity.
The Bench further observed that the expression “capital asset” under Section 2(14) of the Income Tax Act has a broad scope. Forward foreign exchange contracts entered into by an FPI qualify as derivative securities, and their cancellation extinguishes the contractual rights and obligations, thereby constituting a “transfer” under Section 2(47) of the Act.
An important aspect of the ruling was the Tribunal’s emphasis on judicial discipline.
The Bench noted that the issue had repeatedly been decided in favour of the assessee in earlier assessment years, beginning from AY 1998-99. In several subsequent years, the Tribunal had consistently held that gains or losses arising from early settlement of hedging contracts are capital in nature. In some years where losses arose, the Revenue itself had accepted them as capital losses during scrutiny assessments.
The DRP had nevertheless upheld the addition only to “keep the issue alive” because appeals against earlier Tribunal orders were pending before the High Court.
Rejecting this approach, the Tribunal observed that mere pendency of appeals does not dilute the binding nature of earlier coordinate bench decisions in the absence of any stay or reversal by a higher court. Judicial discipline required the authorities to follow those precedents.
The ITAT directed the Assessing Officer to assess the ₹11.94 crore gain under the head “Capital Gains” instead of “Income from Other Sources”, in accordance with law.
The Tribunal held that the gain arising from cancellation or early settlement of forward foreign exchange contracts entered into for hedging foreign exchange exposure of the underlying debt investments is capital in nature.
Consequential grounds relating to interest and tax demand were disposed of accordingly, while the challenge to initiation of penalty proceedings was held to be premature. The connected stay application was dismissed as infructuous after the assessee succeeded on merits.
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