Unrealised Notional Profits From "Mark-To-Market" Instruments Not Exigible To Tax: Kerala High Court
Court noted that no prudent trader would account for anticipated profit in the form of appreciated value before it is actually realised.
The Kerala High Court has observed that "mark-to-market" gains from forward commodity derivative contracts remain unrealised and purely notional until the instrument's maturity, thereby exempting such hypothetical profits from being brought to tax during the interim accounting period. Adhering to the "real income" theory, the Court clarified that accounting entries showing anticipated profits do not automatically trigger tax liability if the actual accrual of such income remains contingent upon future fluctuations.
Dismissing the appeal by the Income Tax Department against the orders of the ITAT, the Court referring to Commissioner of Income Tax, Delhi v. Woodward Governor India (P.) Ltd. (2009) SCC OnLine SC 710 emphasised that no prudent trader would account for anticipated profit in the form of appreciated value before it is actually realised, as such gains can easily transmute into losses before the instrument expires.
Justice Devan Ramachandran and Justice Basant Balaji referring to Godhra Electricity Co. Ltd., Ahmedabad v. Commissioner of Income Tax, Gujarat-II (1997) 225 ITR 746 noted, “…the unrealized ‘mark-to-market’ gains made on Forward Exchange Contracts are not liable to tax, thus deleting the addition made by the Assessment Officer; which was then confirmed by the CIT (Appeals)”.
Advocate Jose Joseph appeared for the appellant and Advocate R. Jaikrishnan appeared for the respondent.
The respondent, Kalyan Jewellers India Ltd., had entered into Forward Contracts in Commodity Derivatives, involving "mark-to-market" instruments. For the relevant assessment year, the assessee included certain notional profits gained from these instruments in their accounts. The Assessing Officer initially treated these as taxable income, leading to an addition that was later challenged by the assessee.
The dispute originated from an assessment order under Section 143(3) of the Income Tax Act. After the Commissioner of Income Tax (Appeals) and subsequently the Income Tax Appellate Tribunal (ITAT), Cochin Bench, deleted the addition of unrealized "mark-to-market" gains, the Principal Commissioner of Income Tax moved the High Court in appeal.
The Court's reasoning relied heavily on the Supreme Court's judgment in Woodward Governor India (P.) Ltd. and Godhra Electricity Co. Ltd., which establish that income-tax is a levy on real income rather than hypothetical entries in book-keeping.
The Bench observed that in derivative contracts, profits and losses fluctuate continuously in a cycle until maturity. It held that the mere act of an assessee showing such notional gain in their accounts for a particular year does not make it exigible to tax, as the "real" accrual only happens upon the expiry of the instrument. The Court further noted that the method of accounting regularly employed by an assessee remains supreme unless modified by the Central Government through specific accounting standards under Section 145(2) of the Income Tax Act.
Refusing to accept the argument that when the assessee shows it as a profit in their account for the relevant year, it becomes exigible to tax, the Bench observed, “We are afraid that we cannot find favour with the afore argument for the singular reason that Woodward Governor India (Supra) answers the question to the contrary”.
The Court dismissed the appeal filed by the Revenue, thereby upholding the ITAT's order to delete the tax addition. However, it clarified that all legal consequences regarding taxability would apply at the stage of the instrument's actual maturity as per the law.
Cause Title: The Principal Commissioner of Income Tax (Central) v. Kalyan Jewellers India Ltd. [Neutral Citation: 2026:KER:21788]
Appearances:
Appellant: Jose Joseph and Navaneeth N. Nath, Advocates.
Respondent: R. Jaikrishnan, Kum. Narayani Harikrishnan, Akhil Shaji, C.S. Arun Shankar, Anish P., and K. Suresh Chandran, Advocates.