Loss on foreign currency forward contracts which is not in respect of specified export or import is speculation loss

Forward transactions in commodities may fall within proviso (a) to section 43(5) of the Act, it is necessary that the raw materials or merchandise in respect of which the forward transactions have been made by the assessee must have a direct connection with the goods manufactured or the merchandise sold by him.

In other words raw material in respect of which the assessee has entered into forward transactions must be the same raw material which is used by him in his manufacturing business. We find that in the case under consideration assessee was not dealing in Foreign Exchange, therefore transactions entered into by it in Foreign Exchange cannot be held to be hedging transactions. Assessee is dealing in diamonds and FC entered into only for diamonds would have been covered by the proviso (a) to the section 43(5)of the Act. As held by the Hon’ble High Court of Calcutta in the matter of Gourepore Co. Ltd.(135 ITR 606) onus was on the assessee to prove that the transactions in question were not of a speculative nature. We are of the opinion that the assessee has failed to discharge the onus cast upon him by the statute. Assessee was also not able to contradict the finding of fact that booking and cancellation of FC of exchange were not in respect of specified export or import. Besides, finding of fact given by the Revenue Authorities remained un-contravened that loss shown by the assessee pertained to these FCs transctions, against which no actual delivery of foreign exchange was made. On appreciation of the facts surrounding the transaction we have reached at the conclusion that transactions entered in to by the assessee were not hedging transaction, but same were speculative and thus the case of the assessee is not covered by proviso(a) of the section 43(5) of the Act.Now we would like to discuss the cases relied upon by the AR. In the case of Ramchandra Shivnarain (supra) question decided by the Hon’ble Court was about applicability of proviso to manufacturing business/ to a business of sale of goods. Hon’ble court held that ‘proviso was not confined to contracts in respect of raw materials entered into by persons in the course of their manufacturing business, that it applied equally to cases of persons carrying on manufacturing as well as persons carrying on business of selling goods, that there was no scope to confine it to manufacturers.’ Thus, facts of the matter of Ramchandra Shivnarain(supra) are not applicable to the case under consideration. In the instant case booking and cancellation of forward contracts of exchange were not in respect of specified export or import orders and all contracts had been cancelled. Not only this, there was no actual delivery of Foreing Exchange. In these circumstances, we are of the opinion that finding of the FAA does not suffer from any legal infirmity. In the case of Pali Ram Bhadarmal (supra), it is found that loss suffered by the assessee, in forward contracts, was directly related to the merchandised goods dealt with by assessee. It was in this context and factual position that ITAT Jodhpur had decided the issue in favour of the assesssee holding that transaction was not speculative loss in view of cl. (a) of proviso to sec.43 (5). In the case under consideration FCs were entered into with regard to Foreign Exchange and assessee is not businesss of foreign exchange, as stated earlier. It is also a fact that loss shown by the assessee was due to FCs against which no actual delivery of foreign exchange was made. As per the settled law FCs are to be settled either by delivery of the difference has to credited/debited by the Bankers. As in the case under consideration all the FCs were cancelled, so they were not settled by actual delivery or transfer of the commodity. Therefore, in our opinion cases relied upon by the AR of no help.

INCOME TAX APPELLATE TRIBUNAL
MUMBAI BENCHES “E” MUMBAI

ITA No. 506/Mum/2013

Assessment Year 2008-09

S. Vinodkumar Diamonds Pvt. Ltd.,

Vs.

Addl. C.I.T. Range – 5(3)

Date of Hearing : 18-03-2013

Date of Pronouncement : 03-05-2013

OR D E R

PER RAJENDRA, A.M.

The present appeal is directed against the order dt.04.10.2012 passed by the CIT(A)-9, Mumbai. Following Grounds of Appeal have been raised by the assessee­company:

1. i. The Learned Commissioner of Income Tax (Appeals) erred in confirming disallowance of proportionate interest expenditure of Rs.13,52, 741/- by applying proviso to section 36(1)(iii) read with explanation 8 to section 43(1) of the Income Tax Act,1 961.

ii. He erred in holding that interest bearing funds were utilized for purchasing the office premises at Bharat Diamond Bourse (BDB) without appreciating that the appellant had utilized its own funds to acquire the property and the borrowings were used only for business purpose.

iii. He failed to appreciate that the borrowings of the appellant had reduced during the year as compared to the preceding year.iv. Without prejudice to above,He erred in confirming the calculation of proportionate disallowance of interest of Rs. 13,52,741/- wherein the entire investment in the property (Rs. 2,48,41,884/-) is considered instead of investment made during the year (Rs. 40,01,199/-).

2. i. The Learned Commissioner of Income Tax (Appeal) grossly erred on facts in confirming dis allowance of mark to market loss of Rs. 4,02,96,635/- on account of outstanding forward contracts.

ii. He erred in applying instruction No. 3/2010 dated 23.3.10 with respect to notional loss on speculative transactions and forex derivatives without appreciating that the appellant had a binding obligation under such forward contracts and the liability at year end is determinable with reasonable certainty.
iii. He failed to appreciate that the recognition of gain/loss on outstanding forward contracts at year end on mark to market basis is regularly followed by the appellant and accepted in the past.iv. He erred in treating the loss on mark to market forward contracts as dis allowable whereas profits on such transactions were fully taxed.

v. Without prejudice to above,

He failed to issue directions for reduction of impugned notional loss from the subsequent years income, as the same was upon maturity included in arriving at subsequent year’s taxable income.

3. The appellant craves leave to add, after, amend or delete any of the above referred ground or appeal.

2. Assessee- company, dealing in diamonds, filed its return of income on 29.09.20008 declaring total income of Rs.26.80 Crores. Assessment was finalised by the Assessing Officer (AO) u/s. 143(3) of the Act on 26.12.2011 determining the income at Rs.30.96 Crores.

3. First Ground of appeal pertains to disallowance of proportionate interest expenditure of Rs. 13,52,741/-. During the assessment proceedings, AO found that assessee it had given advance of Rs. 2,08,40,685/- on 31-03-2007 for purchase of office premises at Bharat Diamond Bourse (BDB), that the said investment increased to Rs.2.48 Crores on 31-03-2008, that possession of the premises had not been handed over to the assessee till the end of the AY. Vide order sheet entry dt.05- 10-2011, he called for explanation from the asses see for proportionate disallowance of interest for advance given for office at BDB. After considering the reply filed by the assessee he held that the interest expenditure incurred by the assessee in respect of the above investment needed to be capitalised as per the proviso of Section 36(iii) of the Act, that no proof that non-interest bearing funds were diverted for the purpose of the above investment were filed by the assessee, that the said asset was not put to use during the year under consideration. Therefore, he disallowed an amount of Rs. 13,52,741/- out of the interest expenditure claimed by the assessee.3.1. Against the order of the AO assessee preferred an appeal before the First Appeal Authority (FAA). After considering the submissions of the assessee, FAA held that the appellant had invested a sum of Rs.2,48,41,894/- for buying an office premises at BDB that was not put to use, that the appellant had continued the payment in the current year, that it had paid Rs. 40,01,199/- during the year, that the appellant had incurred finance cost of Rs. 26,40,76,813/- on working capital borrowing from bank in the form of past shipment and packing credit and an unsecured loans, that the appell -ant had never put the said BDB office to use during the FY. 2007-08, that interest from 01-04-2008 to 26-08-2008 even after capitalisation would form a part of cost of impugned property for calculation of actual cost, that the appellant had failed to furnish the fund flow statement, or the periodical profit and loss account in support of its proposition that interest free funds were given out of appellant’s own funds and out of internal accruals, that the AO had not to prove the nexus between the interest bearing funds raised by the appellant and interest free funds advanced by the appell­ant,that the burden lied on the appellant to prove that the amount advanced to the concerns came out of appellant’s own funds.

3.2. Before us, Authorized Representative (AR) submitted that assessee had adequate interest free funds during the year under consideration, that proviso to section 36(1) (vii) read with expl.8 to section 43(1) of the Act was not applicable to the facts of the case, that during the year, investment amounting to Rs. 40.01 lakhs was made, that even if dis allowance had to made it should have been restricted to the investment made in the year. Departmental Representative (DR) supported the orders of the AO and the FAA.

3.3. We have heard the rival submission and perused the material on record. We are of the opinion that proviso to section 36(1) (iii) is applicable in the case under consideration. As per the provision, any amount of the interest paid, in respect of capital borrowed for acquisition of an asset for extension of existing business or profession (whether capitalized in the books of account or not); for any period beginning from the date on which the capital was borrowed for acquisition of the asset till the date on which such asset was first put to use, shall not be allowed as deduction. We find that neither before the AO nor before the FAA assessee had proved that interest free funds were given out of appellant’s own funds out of internal accruals. Both the authorities have given a categorical finding that no evidence was produced before them in this regard. We have perused page nos.43,53-55 of the paper book submitted by the assessee. It has been submitted dis allowance should be restricted to the investment made during the year under consideration. In our opinion AO and FAA had rightly disallowed the interest payment. But, we are of the opinion that there is need for recalculating the exact amount of interest dis allowance. Matter is restored back to the file of the AO to calculate interest for the investment made during the year only and not to consider full investment made till the last date of the year under consideration.

Ground No. 1 is partly decided in favor of the asses see.

4. Next Ground of appeal pertains to marked to market (M to M) losses amounting to Rs.4.02 Crores. During the assessment proceedings AO found that the appellant had claimed a loss of Rs. 4,02,96,635/-on account of exchange rate fluctuation of outstanding debtors and creditors for sale and purchase of foreign currency considering the exchange rate as on 31.3.2008, that the assessee had cancelled forward contracts in US Dollars which were booked during accounting year relevant to assessment year 2008-09, that such cancellation resulted into net loss, that the appellant has entered into forward contracts in US dollars only not in cotton yarn. Relying on the provision of sub-section 5 of Section 43 of the Act and the provisions of Section 73 r.w. Instruction No.3 of 2010 dated 23.03.2010 issued by the CBDT, AO held that the disputed loss on account of cancellation of forward exchange contract was not allowable business loss. AO also examined the claim of hedging, made by the assessee, in the light of CBDT’s circular No.23 of 1960 dated 12.09.1960 wherein hedging transaction were defined. He held that as per the answer to point No.3 of the said Circular of the CBDT, only in the cases of bona fide ready delivery contract; having been settled by actual delivery the transactions; were not required to be treated as speculative transactions. As per the AO in the case under consideration all transaction were settled without actual delivery. He further held that losses incurred by the assessee during the year on account of change in value of currencies at the time of payment was allowed while finalizing the assessment, that M to M losses were of notional losses and contingent in nature. Finally, loss on a/c. of outstanding forward contract as on 3 1.03.2008 were disallowed by him.

4.1. Assessee preferred an appeal before the FAA. After considering the submissions of the assessee-company and the assessment order he held that assessee was engaged in the business of manufacture and export of diamonds, that it had entered into forward contract in respect of foreign exchange to be received as a result of export in respect of export of diamonds, that said step was taken up to avoid the risk of loss due to foreign exchange fluctuation, that the assessee at the time of agreeing to export took into consideration its cost in rupees and also considered the spot price of rupee against foreign exchange, that loss shown by it was exclusively due to forward contracts against which no actual delivery of foreign exchange was made, that forward contracts entered in to by the assessee were to be settled either by delivery or the difference was to be credited /debited by the banker, that assessee had cancelled all forward contracts, that contracts were never settled by actual delivery nor by transfer of the commodity. Making a reference to Sub-section 5 to Section 43 of the Act he held that in the case under consideration loss debited on account of forward contract was in respect of such forward contracts in which there had not been any actual delivery. He referred to the cases of Sri Ranga Vilas Ginning & Oil Mills(133ITR 85), Puttaiah Seshaiash and Company (146 ITR 168) to highlight the basic features of speculation business/speculation loss and considering the facts of the case he held that in the case under consideration contracts were in respect of foreign exchange, that foreign exchange could not termed ‘goods manufactured by the assessee’, that transaction of settlement of foreign exchange contract, settled without actual delivery, could not be considered as covered by proviso to section 43(5).He also made a reference to Explanation 2 to section 28 which stipulates that where speculative transactions carried on by an assessee are of such a nature as to constitute a business, the business (hereinafter referred to as speculation business)shall be deemed to be distinct and separate from any other business. After analysing the provisions of the said section he held that there were a number of transactions and forward contracts had been taken by the appellant and cancelled, that transaction were not an isolated transactions, that in view of Expln. 2 to s. 28, the profit from the forward contract was to be assessed as profit from speculation business. Relying upon various case laws he further held that for allowance of any tax liability it had to be crystallized in a particular AY, that in the case under consideration crystallization of expenditure had not taken place during the year. Finally, confirming the order of the AO and dismissing the appeal of the assessee, he held that M to M loss of Rs.4,02,96,435/- could not be allowed.

5. Before us, AR submitted that the exchange difference credited to the profit and loss account included loss on account of forward contract taken and squared up during the year and also the conversion of outstanding forward contract at the closing rate, that conversion at the dosing rate of foreign exchange assets and liabilities was regularly employed accounting treatment, that assessee was exposed to the risk of fluctuation in the prices of foreign exchange, that as a prudent business policy the assessee always hedged the risk by taking forward cover to safeguard against the losses due to fluctuation in foreign currency rates, that losses in the forward contract conversion were purely hedging loss and could not be considered to be speculative nature, that instruction issued by the CBDT was applicable to M to M loss in respect of Foreign Exchange Derivative transaction, that in the case under consideration forward contract entered to hedge was non-derivative financial instrument for hedging of foreign currency risk, that instruction of the CBDT was not applicable in transaction under consideration, that assessee was in manufacturing and merchanting business, that clause (a) to proviso was applicable in its case, that losses in forward contract meant for hedging were not speculative in nature and as such should be allowed. He relied upon the cases of Ramchandra Shivnarain (201 ITR 862) and Pali Ram Bhadarmal (95 TTJ1 114) delivered by the Hon’ble Bombay High Court and ITAT, Jodhpur respectively. DR supported the orders of the AO and the FAA.

5.1. We have heard the rival submissions and perused the material before us.
Undisputed facts of the case are that

i) the assessee is in the business of diamond export

ii) it entered into forward contract in respect of foreign exchange,

iii) assessee entered into forward contracts of foreign exchange,

iv) assessee claimed that it had suffered loss because of such forward contracts of foreign exchange

v) AO and the FAA disallowed the claim made by the assessee, as they were of the opinion that transactions entered in to by the assessee were of speculative nature.

5.2. Before proceeding further we would like to discuss the concept of forward contract (FC) briefly. It is said that a forward contract is an agreement between a buyer and seller getting the seller to deliver a specified asset of specified quality and quantity to the buyer on a specified date at a specified place and the buyer in turn is obligated to pay the seller a pre-negotiated price in exchange of the delivery. FC can be entered in to for exports also. In such transactions when the actual export is made, spot price may differ from the spot price on the date on which the appellant expected an export order. On the date or receipt of foreign exchange, if the spot price of rupee against foreign exchange increases/decreases then the assessee may make profits or suffer losses. As per the details available assessee had entered into such transaction during the year under consideration. It was claimed on behalf of the assessee that these transaction were hedging contracts and not speculative transactions as held by the departmental authorities. Concepts of speculative transaction/hedging transactions are not new concepts of tax laws. Distinction between the two is vital and both have consequences in determining the tax liability arising out of them.

5.2.1. The definition of ‘speculative transaction’ in section 43(5) of the Act, gives a simple test for deciding for the purpose of income-tax what a speculative transaction means. If a contract for sale or purchase is ultimately settled and no actual delivery of the goods was effected under the settlement then it is a speculative transaction. The requirement of section 30 of the Indian Contract Act of the existence of the intention of the parties even at the time of the original contract not to give or take delivery of the goods in order to make it a speculative/wagering transaction is dispensed with for the purpose of the Act and if actual delivery is not given/taken under the settlement of contract, then the intention of the parties at the time of the contract becomes im-material. Thus, the true test is delivery of commodities/goods as per the contract, including a forwarding contract. Profit/loss in respect of unperformed contracts is considered speculation profit/loss. In short, in order that a transaction may fall within the scope of the expression ‘speculative transaction’, it must be a transaction in which a contract for purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity or scrips.

5.2.2. Here, it would be useful to appreciate in proper perspective how hedge transactions are commercially understood before determining the true scope, width and nature of proviso (a) to section43(5). Hedge contracts are those contracts which hedge against prejudicial price fluctuations. In speculative transactions the modus operandi of persons indulging in them is that when one enters into a contract of purchase, he also simultaneously enters into one or more contracts of sale against the same quantity deliverable at the same time either to the original vendor or to someone else, so as either to secure profit or to minimize loss, before the Vaida day ; and similarly when he enters into a contract of sale, he simultaneously enters into one or more contracts to purchase the same quantity before the Vaida day. The result of such dealings, when the sale and purchase are to and from the same person, has the effect of cancelling the contracts leaving only differences to be paid. The technique of hedge trading can be understood in simple terms. It is said that the hedge contract is so called because it enables the persons dealing with the actual commodity to hedge themselves, i.e., to insure themselves against adverse price fluctuations. A dealer or a merchant enters into a hedge contract when he sells or purchases a commodity in the forward market for delivery at a future date. His transaction in the forward market may correspond to a previous purchase or sale in the ready market or he may propose to cover it later by a corresponding transaction in the ready market, or he may offset it by a reverse transaction on the forward market itself. Hedging contracts need not succeed the contracts for sale and actual delivery of goods manufactured, but the latter may be subsequently entered into, provided they are within reasonable time. In order to be genuine and valid hedging contracts of sales, the total of such transactions should not exceed the total stocks of the raw materials or the merchandise on hand which would include existing stocks as well as the stocks acquired under the firm contracts of purchase. As per the accepted commercial norms object of a hedging contract is to secure oneself against loss in a future delivery contract, but such transactions cannot be regarded as inter-connected. Each one is independent of the other. So far as the profit or loss arising from a future delivery contract is concerned, it is determined on the date of actual delivery irrespective of the date on which the contract was entered into. In respect of a hedging contract, profit/loss arising there from can be ascertained or crystallized at fixed intervals of the term when the clearance takes place.

5.2.2.a. By resorting to counterbalancing transactions in the market for the ready commodity on the one hand and in the hedge market on the other hand, the hedger seeks to safeguard his position. The movement of prices in the two markets may not always follow an identical course and the hedger might at times gain and at times lose but such a gain or loss would be marginal and far less than what it would be if the person had not hedged at all. While, however, the hedging operation protects the hedger against loss arising from adverse fluctuations in prices, it also prevents him from making windfall profit owing to favorable fluctuations in prices as well. The forgoing of such a possible windfall profit is the price which he pays for the insurance against loss. This well-known technique, of hedge trading clearly implies forward contracts both ways, namely, for sale and purchase with a view to guarding against adverse price fluctuations. These forward contracts by way of hedge transactions usually afford a cover to a trader inasmuch as his loss in the ready market is offset by a profit in the forward market and vice versa. It, therefore, follows that in order to effectively hedge against adverse price fluctuations of the manufactured goods or merchandise, a manufacturer or merchant has necessarily to enter into forward transactions of sale and purchase both, and without these contracts of sale and purchase constituting hedge transactions, there would be no effective insurance against the risk of loss in the price fluctuations of the commodity, manufactured or the merchandise sold.

5.3. Hedging contracts are dealt in Clause (a) of the proviso to section 43(5) of the Act. From the above discussion it can safely stated that the said clause applies, if following conditions are fulfilled:

(1) There is a contract for actual delivery of goods manufactured by the assessee /a merchandise sold by it,

(2) Assessee must be a subsequent transaction intend to guard against losses through future price fluctuations in respect of such contract,

(3) Transaction in question must be a contract entered into in respect of raw materials or merchandise in the course of the assessee’s manufacturing business and it should have been settled otherwise than by actual delivery of goods,

(4) Hedging contracts may be both with regard to sales and purchases,

(5) Hedging contracts need not succeed the contracts for sale and actual delivery of goods manufactured, but the latter may be subsequently entered into, provided they are within the reasonable time not exceeding generally the assessment year,

(6) In order to be genuine and valid hedging contracts of sales, the total of such transactions should not exceed the total stocks of the raw materials or the merchandise on hand which would include existing stocks as well as the stocks acquired under the firm contracts of purchases,