Comprehensive Study Notes on Chapter 8: Accounting and Taxation of Exchange-Traded Currency Derivatives (ETCD)

1. Introduction to Accounting Guidelines and Disclosure Requirements

The accounting, valuation, and capital requirements for Exchange-Traded Currency Derivatives (ETCD) are governed by the applicable accounting standards and valuation methods prescribed by the Institute of Chartered Accountants of India (ICAI) or other standard-setting organisations, alongside specific regulations issued by the respective financial sector regulators of the participants.

ICAI Guidance Note on Accounting for Derivative Contracts (Revised 2021)

The ICAI has issued an authoritative Guidance Note on Accounting for Derivative Contracts (Revised 2021) to standardise derivative accounting across entities in India.

• Regulatory Scope: Entities like banks, Non-Banking Financial Companies (NBFCs), Housing Finance Companies (HFCs), and insurance companies are required to follow the accounting treatment prescribed by their concerned regulators. This includes the Reserve Bank of India (RBI) for banking entities and NBFCs/HFCs, and the Insurance Regulatory and Development Authority of India (IRDAI) for insurance entities.
• Default Application: In case the concerned regulator has not prescribed any specific accounting treatment for derivative contracts, the recommendations contained in this ICAI Guidance Note must be followed.

Core Accounting Principles

The accounting for derivatives covered by this Guidance Note is based on five key principles:

1. Balance Sheet Recognition: All derivative contracts must be recognised on the balance sheet. A derivative contract represents a legally enforceable contractual right or obligation, and therefore must be recorded as an asset or liability.
2. Fair Value Measurement: All derivative contracts recognized on the balance sheet must be measured at fair value.
3. Treatment of Non-Hedge Derivatives (FVTPL): If an entity chooses not to apply hedge accounting, its derivative contracts must be accounted for at fair value, with all changes in fair value recognised immediately in the statement of profit and loss.
4. Hedge Accounting Qualification: If an entity decides to apply hedge accounting, it must clearly identify its risk management objectives, the specific risk being hedged, and how it will measure whether the objective is being met. This must be documented adequately at the inception of the hedging relationship and evaluated on an ongoing basis.
5. Adequate Disclosures: Financial statements must include robust disclosures regarding accounting policies, risk management objectives, and hedging activities.

The Concept of Fair Value

Under the Guidance Note, Fair Value represents the "exit price".

• Definition: The exit price is the price that would be paid to transfer a liability or received when transferring an asset to a knowledgeable, willing counterparty in an orderly transaction.
• Credit and Collateral Adjustments: The calculation of fair value must incorporate the effect of credit risk associated with the future fulfilment of obligations. Furthermore, the availability and extent of collateral must be factored into the valuation.

2. Hedge Accounting Framework and Models

An entity is permitted, but not mandatorily required, to designate a derivative contract as a hedging instrument. To qualify for hedge accounting, the entity must meet specific criteria at the inception of the hedge and during its lifetime.

Prerequisite Criteria for Hedge Accounting

At a minimum, the entity must:

1. Identify and state its risk management objective.
2. Demonstrate how the chosen derivative contract helps meet that risk management objective.
3. Specify how it plans to measure the fair value and effectiveness of the derivative contract (including the relevant hedge ratio).
4. Formally document this assessment at the inception of the hedging relationship and subsequently at the end of each reporting period.
5. For hedges of future cash flows, demonstrate that the anticipated cash flows are highly probable of occurring.
6. Conclude that the hedged risk could impact the statement of profit and loss.
7. Provide adequate disclosures of its accounting policies, objectives, and hedging activities in its financial statements.

Note on Exchange-Traded Derivatives: Standardised contracts traded on stock exchanges (such as currency futures or options) do not inherently meet these documentation requirements by default. Thus, entities must actively demonstrate compliance with all of the above criteria before hedge accounting can be applied to ETCD. If these criteria are not met, the derivatives are classified as non-hedges, measured at fair value, and changes are recognized directly in the statement of P&L.

Types of Hedge Accounting Models

The Guidance Note recognises three distinct hedging models:

Accounting Treatment for Hedges of a Net Investment in a Foreign Operation

The following principles apply specifically to net investment hedges:

• Foreign exchange gains and losses on a net investment in a non-integral foreign operation are recognized directly in equity through the translation of net assets during consolidation.
• Gains and losses of foreign currency derivatives used as hedging instruments are recognized directly in equity to the extent that the hedge is considered to be effective.
• The ineffective portion of the gains and losses on the hedging instruments is recognized in the statement of profit and loss immediately.
• Any net deferred foreign currency gains and losses (arising from both the net investment and the hedging instrument) are recognized in the statement of profit and loss at the time of disposal of the foreign operation.

Presentation of Derivatives in Financial Statements

Derivative assets and liabilities recognized at fair value must be presented as current or non-current based on the following rules:

1. Trading/Speculative Derivatives: Must always be reflected as current assets and current liabilities.
2. Hedges of Recognized Items: Classified as current or non-current based on the classification of the underlying hedged item.
3. Hedges of Forecasted Transactions/Firm Commitments: Classified as current or non-current based on the contractual settlement or maturity dates of the derivative contracts.
4. Multi-settlement Derivatives (e.g., Interest Rate Swaps): Must not be split into current and non-current elements. Their classification is determined by when the predominant portion of their cash flows is due for settlement as per their contractual terms.
5. Netting Rule: The Guidance Note does not permit any netting of assets and liabilities on the balance sheet, except where a basis adjustment is applied under cash flow hedges. Thus, balance sheet presentation must reflect gross amounts. However, gains and losses for derivatives not designated as hedges may be presented on a net basis within the statement of profit and loss.

Financial Statement Disclosures

Entities must disclose:

• Overall financial risk management objectives and policies, including what the financial risks are and why derivatives are entered into to hedge those risks.
• The exact methodology used to arrive at the fair value of derivative contracts (whether used for hedging or not).
• The total amount of fair value gains or losses recognized in the statement of P&L and in equity.
• Specific disclosures regarding outstanding hedge accounting relationships.
• All foreign exchange assets and liabilities (including contingent liabilities), clearly separating those that are hedged from those that are unhedged, in the format specified under the Guidance Note.

Measuring Hedge Effectiveness

• Hedge Effectiveness: The degree to which changes in the fair value or cash flows of the hedged item (attributable to a hedged risk) are offset by changes in the fair value or cash flows of the hedging instrument.
• Hedge Ineffectiveness: The extent to which the changes in the fair value or cash flows of the hedging instrument are greater or less than those of the hedged item.
• Testing Methods: No single method is prescribed. The choice depends on the entity's risk management objectives and program. Commonly accepted methods include:
  1. Critical terms match
  2. Dollar offset method
  3. Regression analysis

3. Accounting Standard (AS) 30 and Transition to Indian Accounting Standard (Ind AS) 109

The accounting standard landscape in India has transitioned over time to align with global reporting standards.

Definition of Derivative under Accounting Standard (AS) 30

Accounting Standard (AS) 30, "Financial Instruments: Recognition and Measurement", originally defined a derivative as a financial instrument or contract within its scope that possesses three key characteristics:

1. Value Linkage (Underlying): Its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or index, or other variable (the "underlying"). In the case of a non-financial variable, the variable must not be specific to a party to the contract.
2. Minimal Initial Investment: It requires no initial net investment, or an initial net investment that is smaller than would be required for other types of contracts expected to have a similar response to changes in market factors.
3. Future Settlement: It is settled at a future date.

Transition to Ind AS 109

• Withdrawal of AS 30: Accounting Standard 30 was eventually withdrawn and replaced by Ind AS 109 when India adopted the Indian Accounting Standards (Ind AS) framework.
• Mandatory Application: For Indian companies that fall under the Ind AS implementation roadmap, Ind AS 109 (Financial Instruments) is now the mandatory standard governing derivatives. Ind AS 109 is based on the international reporting standard IFRS 9.
• Scope of Ind AS 109: It covers classification, measurement, impairment of financial assets, hedge accounting, and derecognition of financial assets and liabilities for contracts like forwards, futures, options, swaps, and embedded derivatives.
• Non-Ind AS Companies: For companies not following the Ind AS framework, the Guidance Note on Accounting for Derivative Contracts (Revised 2021) is the applicable framework for derivatives not covered by other specific accounting standards like AS 11.

Key Principles of Derivatives under Ind AS 109

• Initial Recognition: Derivatives are recognized on the balance sheet at fair value when the entity enters into the contract. Fair value is defined as the price in an orderly transaction between market participants.
• FVTPL Default: Unless a derivative is designated in a qualifying hedging relationship, it is measured at Fair Value Through Profit or Loss (FVTPL), with all gains or losses recognized immediately in the statement of profit and loss.
• Hedge Accounting Criteria: Ind AS 109 aligns gain and loss recognition to reduce income statement volatility, requiring formal documentation, an economic relationship, confirmation that credit risk is not dominant, and a consistent hedge ratio.
• Types of Hedges: Outlines Fair Value Hedges (gains/losses in P&L), Cash Flow Hedges (effective portion in OCI, ineffective portion in P&L), and Net Investment Hedges (effective portion in OCI, ineffective in P&L).
• Embedded Derivatives: Ind AS 109 requires derivative components embedded in non-derivative (host) contracts to be separated and accounted for as standalone derivatives if they are not "closely related" to the host contract. If the embedded derivative cannot be measured reliably, the entire hybrid contract must be designated as FVTPL.

4. Taxation of Exchange-Traded Currency Derivatives (ETCD)

The tax implications of trading in ETCD are governed by the Income-tax Act, 1961, and distinguish between normal business transactions and speculative transactions.

Tax Head and Deductibility

• Tax Head: Gains or losses arising from trading in Exchange-Traded Currency Derivatives are taxable under the head 'Profits and Gains from Business or Profession' (PGBP).
• Deductibility of Expenses: Any administrative and operational expenditure relating to derivative trading is considered a deductible expense.

Non-Speculative Nature of ETCD Transactions

• General Speculative Rule: Under the Income-tax Act, a transaction is deemed "speculative" if it is periodically or ultimately settled otherwise than through the actual delivery or transfer of the underlying asset. Speculative business income is treated rigorously: speculative losses can only be set off against speculative business income.
• Exclusion under Section 43(5): Section 43(5) of the Income-tax Act specifically excludes eligible derivative transactions from the definition of speculative transactions.
• The Derivative Exception: Any eligible transaction in respect of trading in derivatives referred to in clause (ac) of Section 2 of the Securities Contracts (Regulation) Act, 1956 (SCRA), carried out on a recognized stock exchange, is deemed a non-speculative transaction.
• Tax Consequence: Because ETCD transactions on recognized exchanges are deemed non-speculative (normal business), any loss arising from exchange-traded currency derivatives can be set off against any normal business income. The resulting net business income is taxed at the normal rates applicable to the assessee.

Taxation of Foreign Portfolio Investors (FPIs)

The taxation rules differ significantly for Foreign Portfolio Investors (FPIs):

• Capital Asset Treatment: Securities held by FPIs are always treated as capital assets under the Income-tax Act.
• Tax Head: Any profits and gains arising to an FPI from derivative transactions are always taxable under the head 'Capital Gains' (not PGBP).
• Holding Period Rule: If the derivative positions are held for less than 12 months, any gain or loss arising to the FPI is classified and charged as a short-term capital gain or loss.

5. Computation of Turnover and Presumptive Taxation (Section 44AD)

Since the Income-tax Act does not contain a specific legislative provision defining "turnover" for exchange-traded derivatives, taxpayers must refer to the Guidance Note on Tax Audit issued by the ICAI.

Formula for Turnover Computation

According to the ICAI Guidance Note on Tax Audit, the turnover of a derivative trading business must be computed in a single-line format as follows:

Turnover = (Total of Favourable Differences) + (Total of Unfavourable Differences) + (Premium Received on Sale of Options) + (Differences on Reverse Trades)

Explanation:

• Favourable and Unfavourable Differences: You sum up the absolute values of all profits and losses across trades. For instance, a profit of Rs. 10,000 and a loss of Rs. 12,000 contribute Rs. 22,000 to the turnover.
• Option Premium: The premium received on the sale of options is directly included in the turnover.
• Reverse Trades: Any difference arising from reverse trades is also added to the turnover.

Scheme of Taxation Options

A taxpayer trading in ETCD has two choices for offering income to tax:

1. Normal Scheme of Taxation: Income is computed by maintaining full books of accounts and deducting actual business expenses, with net profits taxed at standard slab/corporate rates.
2. Presumptive Taxation Scheme under Section 44AD: Taxpayers with a total turnover below the prescribed threshold can opt for this simplified scheme.

Salient Features of Presumptive Taxation (Section 44AD)

• Eligibility Turnover Limit: Total turnover must not exceed Rs. 2 crores.
• FY 2024-25 Budget Update: The Union Budget for FY 2024-25 has increased this presumptive turnover limit to Rs. 3 crores, subject to the condition that at least 95% of the gross receipts are received through online/digital modes.
• Presumptive Profit Rates:
  • 6% of Turnover: Applicable for receipts received through digital or banking channels (which is the case for ETCD as exchange transactions must go through banking channels).
  • 8% of Turnover: Applicable for cash receipts.
• No Deductions Allowed: The presumptive profit (6% of computed turnover) is treated as the final taxable business income. No further business expenses are allowed as a deduction, and no expenses are disallowed.
• Exemption from Bookkeeping and Audit: Taxpayers opting for Section 44AD are exempt from the mandatory requirement of maintaining detailed books of accounts under Section 44AA and getting them audited under Section 44AB.
• Advance Tax Relief: The taxpayer can pay 100% of their advance tax liability in a single installment on or before 15th March of the relevant financial year.

Mandatory Tax Audit Threshold

A tax audit under Section 44AB is legally mandatory if:

• The taxpayer does not opt for presumptive taxation, and the computed derivative turnover exceeds Rs. 2 crores.
• Under the FY 2024-25 budget, this limit is raised to Rs. 3 crores if 95% of transactions/receipts are processed through online/digital modes.

6. Set-Off and Carry Forward of Losses

Specific income tax rules govern how trading losses from ETCD are treated and carried forward to subsequent financial years.

Set-Off Rules in the Current Year

• Head of Income Set-Off: Since ETCD losses are classified as normal (non-speculative) business losses, they can be set off against taxable income under any other head of income during the same financial year (such as House Property income or Capital Gains).
• Salary Restriction: Business losses from ETCD cannot be set off against "Salary" income under any circumstances.

Carry Forward Rules

• Unabsorbed Losses: If the ETCD loss cannot be fully set off in the current year, the remaining unabsorbed business loss can be carried forward.
• Time Limit: Unabsorbed business losses can be carried forward for a maximum of 8 assessment years immediately succeeding the assessment year in which the loss was first incurred.
• Subsequent Set-Off: In all subsequent years, the carried-forward loss can only be set off against business income (PGBP). It cannot be set off against any other head of income.
• Mandatory Filing Deadline: To carry forward business losses, the taxpayer must file their return of income on or before the prescribed due date under Section 139(1). If the tax return is filed late, the right to carry forward and set off the loss is permanently lost.

7. Exam-Relevant Sample Questions and Answers

Use these questions to test your understanding of Chapter 9 topics:

1. Which types of hedging models are recognized for hedge accounting under the ICAI Guidance Notes on Accounting for Derivatives Contracts?

• a. Fair value hedge accounting model
• b. The cash flow hedge accounting model
• c. The hedge of a net investment in a foreign operation
• d. All of the above
• Answer: d

2. Which of the following accounting standards governs the recognition and measurement of financial instruments (including derivatives) for Ind AS-compliant companies in India?

• a. IAS 6
• b. IAS 30
• c. IAS 104
• d. IAS 109 (referred to as Ind AS 109)
• Answer: d

3. Usually, income or gains arising to a normal domestic resident from trading in Exchange-Traded Currency Derivatives (ETCD) on a recognized stock exchange is treated as:

• a. Business income (Non-speculative)
• b. Income from other sources
• c. Salary income
• d. None of the above
• Answer: a

4. A normal business loss on derivative transactions carried out on a recognized stock exchange can be set off against any other head of income during the current year except:

• a. Business income
• b. Income from other sources
• c. Salary income
• d. None of the above
• Answer: c

5. Losses arising from non-speculative derivative transactions on a recognized stock exchange can be carried forward for a maximum period of how many assessment years?

• a. 5
• b. 6
• c. 7
• d. 8
• Answer: d

Key Summary of Terms

• Exit Price: The standard definition of fair value; represents the price received to transfer an asset or paid to transfer a liability in an orderly transaction.
• Non-Speculative Transaction: A derivative trade executed on a recognized stock exchange, excluded from speculative classification under Section 43(5), allowing standard business loss treatments.
• Section 44AD: The presumptive taxation section in India, allowing simplified tax filing on turnover below specified limits.
• Ind AS 109: The IFRS 9-aligned accounting standard mandatory for roadmap companies, defining financial instruments accounting.

Chapter 8: Accounting and Disclosure Requirements for Currency Derivatives

Core Accounting Heads

To systematically track margin transactions, a client must maintain two distinct accounting heads in their books of accounts:

1. Initial Margin – Currency Futures
2. Mark to Market – Currency Futures

Accounting Entries for Live Positions

The ledger entries differ based on whether there is a cash outflow (pay-out) or a cash inflow (pay-in) while positions are live and active:

• For Pay-out (Cash Outflow): Any cash laid out on account of the initial margin or daily mark-to-market margin is debited to the respective margin account (Initial Margin – Currency Futures or Mark to Market – Currency Futures), and the Bank Account is credited.
• For Pay-in (Cash Inflow): Any daily mark-to-market settlement profit received is debited to the Bank Account and credited to the Mark to Market – Currency Futures account.

Accounting Entries for Expired or Cancelled Positions

At the expiration of a currency futures series, the final profit or loss must be recognized in the financial statements:

• P&L Transfer: The net profit or loss is calculated as the difference between the final settlement price and the contract entry prices for all contracts in that series. This net difference is transferred directly to the client's Profit and Loss (P&L) statement.
• Handling Provisions: If the client has previously created a provision account for anticipated losses, any loss realized upon final settlement is first charged against this provision account. Any remaining unabsorbed loss is then charged to the P&L account.

Accounting Entries in Case of Client Default

If a client defaults on daily settlement obligations, their contract is closed out, and the unpaid settlement amount is adjusted against their initial margin balance. To reflect this adjustment in the client's books, the adjusted amount is debited to the Mark to Market Currency Futures Account and credited to the Initial Margin – Currency Futures Account.