After the Reserve Bank of India [Get Quote], it is now the income tax authorities who have put banks and companies disclosing losses in their foreign exchange derivative structures under the scanner.

The income tax department reportedly discussed the issue with many banks and companies even before the advance tax payment for the fourth quarter of 2007-08.

"Banks and companies have been called to explain the extent of losses and structures initiated in both Indian and overseas markets through their branches and subsidiaries," a source said. The exercise was mainly undertaken to assess the tax impact of such losses.

While the effect on tax collections might be negligible this year, the possibility of a bigger impact in 2008-09 was not being ruled out. Sources said that tax officials are eagerly awaiting the 'notes to accounts' in the tax audits and financial statements of companies and banks.

Based on the disclosure, cases will be taken up for scrutiny. A scrutiny is undertaken to ascertain the genuineness of losses which are likely to be set off against income to reduce the taxable profit. A final decision on scrutiny would, however, depend on the guidelines to be issued by the Central Board of Direct Taxes at the beginning of next financial year.

Foreign exchange derivatives are used by banks and companies to hedge their foreign exchange risks arising from overseas operations. These operations include foreign currency loans and bonds to raise funds and export receivables denominated in dollars.

Besides forex derivatives, banks and companies are also exposed to credit derivatives including credit-linked notes based on loans and bonds raised in the overseas market.

The RBI has discovered that most banks have entered into derivatives transactions as purely speculative instruments and not for hedging their existing credit and investment portfolios. Speculative transactions are merely aimed at gaining from unwanted movements in currencies and interest rates without the benefit of underlying positions.

The portfolio of foreign exchange derivatives has turned red following turbulence in the global equity market and the adverse movement of stable currencies such as Swiss franc.

The tax department will try to ascertain whether banks and companies entered into transactions to hedge their portfolio or for purely speculative purposes.

Speculative gains or losses might not be allowed to be set off against business income for taxation purposes. Most Indian banks and companies have suffered severe losses in their exposure to foreign currency derivatives.