TDS liability cannot be imposed retrospectively based on subsequent Judgment

ACIT Vs Acer India Private Limited (ITAT Bangalore)

Conclusion: No disallowance under section 40(a)(i) could be made as there could not be a retrospective obligation to deduct tax at source and therefore as on the date when assessee made payments to the non-resident for acquiring off-the-shelf software, could not be regarded as in the nature of royalty and therefore, there was no obligation on the part of assessee to deduct tax at source.

Held: AO treated the purchases of computer software as payment in the nature of royalty. Since assessee did not deduct tax at source from the payments so made, AO disallowed the same u/s 40(a)(i). CIT(A) held that the payment made by assessee for purchase of software was in respect of copy righted article and accordingly held that disallowance u/s 40(a)(i) was not called for. Accordingly, he deleted the disallowance. In the case of Ingersoll Rand (India) Ltd. by the Bangalore Bench of the ITAT and it was held therein that prior to the decision of Hon’ble jurisdictional High Court in the case of CIT v. Samsung Electronics Co. Ltd. which was passed on 15.10.2011 transactions carried out on purchase of off the shelf software were not liable to TDS and hence there could be no disallowance u/s.40(a)(ia) based on subsequent development of law after the date on which payments were made. The instant case related to the financial year 2009-10 relevant to the assessment year 2010-11 and the payments had been made for purchase of software prior to the date of pronouncement of the decision by Hon’ble Karnataka High Court in the case of Samsung Electronics Company Ltd. (15.10.11) and also prior to the amendment of Sec. 9(1)(vi). Accordingly, following the above said decision rendered by the Tribunal, it was held that the disallowance u/s 40(a)(i) could not be made in the facts of the present case.

Loss from Forex forward contracts in respect of consideration for export proceeds allowable

As discussed earlier, in the case on hand, there has been an existing contract with a binding obligation accrued against the assessee when it entered into forex forward contracts. The forward contracts are in respect of consideration for export proceeds, which are revenue items. There is an actual contract for sale of merchandise. In this factual matrix, it is clear in our view that the transaction in question will not qualify to be called as speculative transaction. In view of the facts and circumstances of the case on hand, as discussed above, we hold that the provision on derivative contracts is allowable as expenditure.

FULL TEXT OF THE ITAT JUDGEMENT

This appeal filed by the revenue is directed against the order passed by Ld. CIT(A)-1, Bengaluru dated 29.10.2015 and it relates to the assessment year 2010-11. The grounds urged by the revenue relate to the following 3 issues:-

a. Disallowance made u/s 40(a)(i) of the Income-tax Act,1961 [‘the Act’ for short] in respect of software purchases.

b. Disallowance of provision for warranty expenses.

c. Disallowance on foreign exchange loss.

2. The assessee is engaged in the business of manufacture and trading of computer systems and peripherals.

3. The first issue relates to disallowance of purchase of software made by the A.O. u/s 40(a)(i) of the Act for non-deduction of tax at source. The A.O. treated the purchases of computer software as payment in the nature of royalty. Since the assessee did not deduct tax at source from the payments so made, the A.O. disallowed the same u/s 40(a)(i) of the Act. The Ld. CIT(A) held that the payment made by the assessee for purchase of software was in respect of copy righted article and accordingly held that disallowance u/s 40(a)(i) of the Act is not called for. Accordingly, he deleted the disallowance.

4. We heard the parties on this issue and perused the record. The Ld. D.R. submitted that the jurisdictional High Court has held in the case of Samsung Electronics Company Ltd. (345 ITR 494) that the payment made for software purchase is in the nature of payment of royalty. Accordingly, the Ld. D.R. submitted that the assessee should have deducted tax at source from the payment made for purchase of software. Accordingly, he submitted that the A.O. was justified in making disallowance u/s 40(a)(i) of the Act.

5. On the contrary, the Ld. A.R. submitted that the decision in the case of Samsung Electronics Company Ltd. was rendered by Hon’ble jurisdictional High Court on 15.10.2011. Prior to the said decision of Hon’ble High Court, certain Tribunal decisions were available to the effect that software purchases are not in the nature of royalty. One such decision is rendered by the Tribunal in the case of Sonata Information Technologies Ltd. Vs. ACIT 103 ITD 324.

The Ld. A.R. submitted that the payments made for purchases of software were made by the assessee during the year under consideration prior to the decision rendered by Hon’ble jurisdictional Karnataka High Court in the case of Samsung Electronics Company Ltd (supra). Hence the assessee was under bonafide belief that the payments made for purchases of software are not liable for TDS obligations, in view of the certain decisions holding so. In these kinds of cases, the coordinate benches of Tribunal have held that the assessee cannot be fastened that TDS liability on account of subsequent amendment or subsequent ruling of the Court and accordingly, the disallowance made u/s 40(a)(i) of the Act was deleted. In support of this submission, the Ld. A.R. relied on the following decisions in this regard:-

a. Teekays Interior Solutions P Ltd. (ITA No.400/Bang/2017)

b. Infineon Technologies India P Ltd. (IT(TP)A No.405/Bang/2015)

c. GE Medical Systems India P Ltd. (ITA 1368/Bang/2019)

d. WS Atkins India P Ltd. (2015) (41 ITR (T) 397) (Bang. Trib.)

6. We heard rival contentions on this issue and perused the record. We notice that an identical issue was examined in the case of Infenion Technologies Pvt. Ltd. (supra) and it was decided as under:

“25. We have carefully considered the rival submissions. The payment in question was made to the non-resident in the previous year relevant to AY. 10-11. Therefore the law as on 31.3.2010 the last date of the previous year was that payment for purchase of off shelf software was not in the nature of royalty. In Sonata Information Technology Ltd. v. ACIT (103 ITD 324) decision rendered on 31.1.2006, it was held that payments for software licenses do not constitute royalty under the provisions of the Act and hence disallowance under section40(a) (ia) of the Act would not be applicable. The change in the legal position on taxation of computer software was on account of the ruling of the Karnataka High Court in CIT v. Samsung Electronics Co. Ltd. (320 ITR 209), which was pronounced on 15.10.11 that is much later than the closure of the FY 2010-11. Subsequently, the Finance Act 2012 also introduced, retrospectively, Explanation 4 to section 9(1 (vi) of the Act to clarify that payments for, inter alia. License to use computer software would qualify as royalty. During the FY 10-11, the assessee did not have the benefit of clarification brought by the respective amendment. As such, for the FY 2010-11, in light of the provisions of section 9(1)(vi) of the Act read with judicial guidance on the taxation of computer software payments, tax was not required to be deducted at source. Given the practice in prior assessment years, the assessee was of the bona fide view that the payment of software license fee was not subject to tax deduction at source under section1941/195 of the Act. Liability to deduct tax at source cannot be fastened on the assessee on the basis of retrospective amendment to the Act (Finance Act 2012 amendment the definition of royalty with retrospective effect from 01.04.1976) or a subsequent ruling of a court (the Karnataka HC IT(TP)A Nos.405 & 474/Bang/2015 in CIT v Samsung Electronics Co. Ltd. (16 taxmann.com 141) was passed on October 15,2011). Courts have consistently upheld this principle as seen in:

♦ ITO v. Clear Water Technology Services (P.) Ltd. (52 taxmann.com 115)

♦ Kerala Vision Ltd. v. ACIT (46 taxmann.com 50)

♦ Sonic Biochem Extractions (P.) Ltd. v. ITO (35 taxmann.com 463)

♦ Channel Guide India Ltd. v. ACIT (25 taxmann.com 25)

♦ DCI v. Virola International (20 14(2) TMI 653)

♦ CIT v. Kotak Securities Ltd. (20 taxmann.com 846).

26. The above decisions have been considered and discussed in the case of Ingersoll Rand (India) Ltd. (supra) by the Bangalore Bench of the ITAT and it was held therein that prior to the decision of Hon’ble jurisdictional High Court in the case of CIT v. Samsung Electronics Co. Ltd. (supra) which was passed on 15.10.2011 transactions carried out on purchase of off the shelf software are not liable to TDS and hence there can be no disallowance u/s.40(a)(ia) of the Act based on subsequent development of law after the date on which payments are made.

27. we are of the view that in the light of law as laid down by this Tribunal in the case of Ingersoll Rand (I) Ltd. (supra), there cannot be a retrospective obligation to deduct tax at source and therefore as on the date when the assessee made payments to the non-resident for acquiring off-the-shelf software cannot be regarded as in the nature of royalty and therefore there was no obligation on the part of assessee to deduct tax at source. The payment would be in the nature of business profits in the hands of non-resident and since admittedly the non-resident does not have a Permanent Establishment in India, the sum in question is not chargeable to tax in the hands of non-resident. Consequently, the disallowance made IT(TP)A Nos.405 & 474/Bang/2015 u/s. 40(a)(ia) of the Act has to be deleted. We direct accordingly. Ground No.14 by the assessee is accordingly allowed.”

7. The instant case relates to the financial year 2009-10 relevant to the assessment year 2010-11 and the payments have been made for purchase of software prior to the date of pronouncement of the decision by Hon’ble Karnataka High Court in the case of Samsung Electronics Company Ltd. (15.10.11) and also prior to the amendment of Sec. 9(1)(vi) of the Act. Accordingly, following the above said decision rendered by the Tribunal, we hold that the disallowance u/s 40(a)(i) of the Act cannot be made in the facts of the present case. Accordingly, we confirm the decision rendered by Ld. CIT(A) on this issue on the above said reasoning.

8. The next issue relates to disallowance of provision for warranty. The A.O. noticed that the assessee has debited a sum of Rs.29.17 crores towards Provision for warranty in respect of goods sold by it. The A.O. noticed that the deductibility of provision for warranty has been examined by the Hon’ble Supreme Court in the case of Rotork Controls India P. Ltd. (Civil Appeal No.3506 – 3510 of 2009) and certain guidelines have been laid down. The A.O. noticed that the assessee is making provision for warranty of huge amount every year and also reversing the warranty provision in subsequent years, which was also of significant amount. Hence, the A.O. took the view that the assessee is not following scientific method for creating provision for warranty and accordingly, he disallowed the same.

9. The Ld. CIT(A) noticed that the A.O. had made identical disallowance in assessment years 2004-05 to 2006-07 and the jurisdictional Income Tax Tribunal had deleted the same. Accordingly, the Ld. CIT(A), following the decision rendered by ITAT, deleted the disallowance.

10. We heard the parties on this issue. The Ld. A.R. submitted that the issue relating to disallowance of provision of warranty in the assessee’s own case has since been decided in favour of the assessee by Hon’ble Karnataka High Court in ITA No.243/2012 dated 25.6.2018 passed for assessment year 2006-07.

11. We heard Ld. D.R. and perused the order passed by the Hon’ble Karnataka High Court. We notice that this issue has been decided in favour of the assessee by Hon’ble Karnataka High Court in the assessee’s own case. For the sake of convenience, we extract below the operative portion of the order passed by Hon’ble Karnataka High Court:-

“8. Having heard the learned Counsels for the parties, we are of the clear opinion that no substantial question of law arises in the present appeal filed by the Revenue. We are satisfied that the Respondent-Assessee company has consistently followed the similar practice with regard to making provision of warranty given to the customers for providing them free repairs and maintenance for the computers and hardware supplied to them, which in their ordinary course of business, the Respondent-Company gave such warrantees. The excess provision created by the Company itself has been reversed by the respondent-Company and only the provision to the extent of making an adequate provision for meeting such possible expenses for repairs and maintenance has been debited by the Assessee-Company in its books of accounts over the period of six years, the details of which are given by the Assessing Authority itself in the assessment order.

9. We are absolutely at a loss to understand how the Assessing Authority has found the said consistent practice of the Assessee-Company to be unscientific and untenable and then proceeded to disallow the entire claim of provision made by the Assessee-Company in this regard. Neither allowing the provision made for warrantees nor the actual expenses incurred by the company to be deducted from the profits of the company during the year is absolutely arbitrary and unscientific on the part of Assessing Authority, to say the least. There was absolutely no basis for the Assessing Authority to make both the disallowances of provision for warranty as well as actual expenses at the same time in the hands of the Respondent-Assessee. In view of the comparison of actual expenses and provisions made for warranty, the details of which are given in the Assessment Order itself, we do not find any abnormal fluctuation or excess provision made by the Assessee-Company on this account.

10. We express our concern and dissatisfaction at the manner in which the Assessing Authority in the present case has very casually disallowed the said claim in the hands of the Respondent-Assessee. Moreover, when the Higher Appellate Authorities have corrected the said approach of the Assessing Authority by the First Appellate Authority allowing the appeal of the Assessee and the Tribunal dismissing the appeal of the Revenue, we are all the more pained to see that the Revenue still felt dissatisfied and has brought up the matter before this Court under Section 260-A of the Act without actually any substantial question of law arising in the matter. This reflects the irresponsible manner in which the Revenue Department becomes a frivolous litigant in constitutional courts, by dragging such case, wasting public time and money.

11. As is well settled, the appeal under Section 260-A of the Act lies before this Court only on substantial questions of law. The final fact findings of the Tribunal under the Act are binding on this Court and cannot be disturbed unless they are found to be perverse on the basis of established material on record. We do not find any such case of Revenue in the present appeal.

12. Moreover, we are satisfied that the practice of making a provision for warranty in the present case has been found to be consistent, scientific and regular by the two Appellate Authorities below in consonance with the judgment of the Hon’ble Supreme Court in the case of Rotork Controls India (P) Ltd. (supra). The Hon’ble Supreme Court in the aforesaid case, discussed in detail how the accounting entries for product warranty are to be made by the Assessees. We quote below the relevant portion of the judgment for ready reference:

10. What is a provision? This is the question which needs to be answered. A provision is a liability which can be measured only by using a substantial degree of estimation. A provision is recognized when: (a) an enterprise has a present obligation as a result of a past event; (b) it is probable that an outflow of resources will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision can be recognized.

11. Liability is defined as a present obligation arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

12. A past event that leads to a present obligation is called as an obligating event. The obligating event is an event that creates an obligation which results in an outflow of resources. It is only those obligations arising from past events existing independently of the future conduct of the business of the enterprise that is recognized as provision. For a liability to qualify for recognition there must be not only present obligation but also the probability of an outflow of resources to settle that obligation. Where there are a number of obligations (e.g. product warranties or similar contracts) the probability that an outflow will be required in settlement, is determined by considering the said obligations as a whole. In this connection, it may be noted that in the case of a manufacture and sale of one single item the provision for warranty could constitute a contingent liability not entitled to deduction under Section 37 of the said Act. However, when there is manufacture and sale of an army of items running into thousands of units of sophisticated goods, the past event of defects being detected in some of such items leads to a present obligation which results in an enterprise having no alternative to settling that obligation. In the present case, the appellant has been manufacturing and selling Valve Actuators. They are in the business from assessment years 1983-84 onwards. Valve Actuators are sophisticated goods. Over the years appellant has been manufacturing Valve Actuators in large numbers. The statistical data indicates that every year some of these manufactured Actuators are found to be defective. The statistical data over the years also indicates that being sophisticated item no customer is prepared to buy Valve Actuator without a warranty. Therefore, warranty became integral part of the sale price of the Valve Actuator(s). In other words, warranty stood attached to the sale price of the product. These aspects are important. As stated above, obligations arising from past events have to be recognized as provisions. These past events are known as obligating events. In the present case, therefore, warranty provision needs to be recognized because the appellant is an enterprise having a present obligation as a result of past events resulting in an outflow of resources. Lastly, a reliable estimate can be made of the amount of the obligation. In short, all three conditions for recognition of a provision are satisfied in this case.

13. In this case we are concerned with Product Warranties. To give an example of Product Warranties, a company dealing in computers gives warranty for a period of 36 months from the date of supply. The said company considers following options : (a) account for warranty expense in the year in which it is incurred; (b) it makes a provision for warranty only when the customer makes a claim; and (c) it provides for warranty at 2% of turnover of the company based on past experience (historical trend). The first option is unsustainable since it would tantamount to accounting for warranty expenses on cash basis, which is prohibited both under the Companies Act as well as by the Accounting Standards which require accrual concept to be followed. In the present case, the Department is insisting on the first option which, as stated above, is erroneous as it rules out the accrual concept. The second option is also inappropriate since it does not reflect the expected warranty costs in respect of revenue already recognized (accrued). In other words, it is not based on matching concept. Under the matching concept, if revenue is recognized the cost incurred to earn that revenue including warranty costs has to be fully provided for. When Valve Actuators are sold and the warranty costs are an integral part of that sale price then the appellant has to provide for such warranty costs in its account for the relevant year, otherwise the matching concept fails. In such a case the second option is also inappropriate. Under the circumstances, the third option is most appropriate because it fulfills accrual concept as well as the matching concept. For determining an appropriate historical trend, it is important that the company has a proper accounting system for capturing relationship between the nature of the sales, the warranty provisions made and the actual expenses incurred against it subsequently. Thus, the decision on the warranty provision should be based on past experience of the company. A detailed assessment of the warranty provisioning policy is required particularly if the experience suggests that warranty provisions are generally reversed if they remained unutilized at the end of the period prescribed in the warranty. Therefore, the company should scrutinize the historical trend of warranty provisions made and the actual expenses incurred against it. On this basis a sensible estimate should be made. The warranty provision for the products should be based on the estimate at year end of future warranty expenses. Such estimates need reassessment every year. As one reaches close to the end of the warranty period, the probability that the warranty expenses will be incurred is considerably reduced and that should be reflected in the estimation amount. Whether this should be done through a pro rata reversal or otherwise would require assessment of historical trend. If warranty provisions are based on experience and historical trend(s) and if the working is robust then the question of reversal in the subsequent two years, in the above example, may not arise in a significant way. In our view, on the facts and circumstances of this case, provision for warranty is rightly made by the appellant-enterprise because it has incurred a present obligation as a result of past events. There is also an outflow of resources. A reliable estimate of the obligation was also possible. Therefore, the appellant has incurred a liability, on the facts and circumstances of this case, during the relevant assessment year which was entitled to deduction under Section 37 of the 1961 Act. Therefore, all the three conditions for recognizing a liability for the purposes of provisioning stands satisfied in this case. It is important to note that there are four important aspects of provisioning. They are – provisioning which relates to present obligation, it arises out of obligating events, it involves outflow of resources and lastly it involves reliable estimation of obligation. Keeping in mind all the four aspects, we are of the view that the High Court should not to have interfered with the decision of the Tribunal in this case.

13. We are, therefore, satisfied that both the Appellate Authorities below were justified in returning the proper findings of facts on the relevant material before them and have rightly found that the provisions of warranty made by the Respondent-Assessee Company was on the basis of the scientific and consistent method and therefore, the present appeal of the Revenue does not give rise to any substantial question of law and the same deserves to be dismissed and is accordingly dismissed.”

12. In view of the binding decision rendered by Hon’ble Karnataka High Court on an identical issue in the assessee’s own case, we uphold the order passed by Ld. CIT(A) on this issue.

13. The next issue relates to disallowance of foreign exchange loss arising on revaluation of foreign exchange exposures as at the year end. The A.O. noticed that the assessee has revalued its assets and liabilities with foreign exchange exposure as at the year end on marked to market basis and declared net gain of Rs.6.97 crores. The breakup details are given below:

14. The A.O. disallowed the loss of Rs.11.60 crores claimed by the assessee by holding that it is contingent in nature. The Ld. CIT(A) noticed that the Bengaluru bench of ITAT has allowed foreign exchange losses as deduction in the case of Quality Engineering and Software Technologies Pvt. Ltd. 52 Taxmann.com 515 and also in the case of ACIT Vs. Hanuman Weaving Factory (ITA No.1112/2012). Accordingly, the Ld. CIT(A) deleted disallowance made by the A.O.

15. We heard the parties on this issue and perused the record. The Ld. A.R. submitted that the A.O. has assessed the foreign exchange gains arising on account of revaluation of creditors and other trading items. He submitted that the forward contracts have been entered by the assessee in respect of revenue items only. He further submitted that the assessee has not imported any fixed assets during the year under consideration and hence, there did not exist any forward contract on capital account. He submitted that revaluation of forward contract relating to revenue item is allowable as deduction as held by the Bengaluru bench of ITAT in the caseof Quality Engineering & Software Technologies Pvt. Ltd.

16. The Ld. D.R. submitted that marked to market losses have been held as notional loss by the CBDT instruction No.3/2010 dated 23.3.2010. Accordingly, he submitted that the A.O. was justified in making the disallowance.

17. We heard the parties on this issue and perused the record. We notice that this issue has been decided in favour of the assessee by coordinate bench of Tribunal in the case of Quality Engineering & Software Technologies Pvt. Ltd. (supra). For the sake of convenience we extract below the decision rendered by the coordinate bench in the above said case:

4.5.8 In the case on hand, it is not in dispute that the forward contracts have been entered into by the assessee in order to protect its interest against fluctuations in foreign currency, in respect of consideration for export proceeds, which is a revenue item. Therefore, in sum and substance, it has the trappings of stock-in-trade and the assessee has to restate or revalue the same as on the Balance Sheet date. The consequent effect of this accounting treatment was to recognize the exchange fluctuation gain or loss in the profit and loss account as on the valuation date. In view of the facts and circumstances of the case as discussed above, we are of the considered view that the appeal of the assessee on this issue, succeeds for the following reasons:—

(i) A binding obligation accrued against the assessee when it entered into foreign exchange forward contracts;

(ii) The forward contracts are in respect of consideration for export proceeds, which are revenue items;

(iii) The liability is determinable with reasonable certainty when an obligation is pending on the balance sheet date and such a liability cannot be said to be a contingent liability.

(iv) The accounting treatment is as per Accounting Standards and the ICAI Guidelines.

(v) The principles enunciated by the Hon’ble Apex Court in the case of Woodward Governor India (P.) Ltd. (supra) are applicable to the facts of the case on hand.

4.5.9 We had earlier observed that the Assessing Officer had relied on the CBDTs Instruction No.3/2010. Paras 1 and 3 of this Instruction reads as under :—

“1.Foreign Exchange derivative transactions entered into by the corporate sector in India have witnessed a substantial growth in recent years. This combined with extreme volatility in the foreign exchange market in the last financial year is reported to have resulted in substantial losses to an assessee on account of trading in forex-derivatives. A large number of assesses are said to be reporting such losses on ‘marked to market’ basis either suo motu or in compliance of the Accounting Standard or advisory circular issued by the Institute of Chartered Accountants. The issue whether such losses on account of forex-derivatives can be allowed against the taxable income of an assessee has been considered by the Board. In this connection, I am directed to say that the Assessing Officers may follow the guidelines given below:

2……

3. Treatment of loss from actual transactions in forex-derivatives. In a case where a loss on a forex-derivative transaction arises on actual settlement / conclusion of contract and is not a notional or marked to market book entry, a further question will arise as to whether such a loss is on account of a speculative transaction as contemplated in Section 43(5) of the Income tax Act. For determining whether loss from a transaction in respect of a forex-derivative is a speculation loss or not, the Assessing Officers may refer to Proviso (d) below sub-section (5) of Section 43 inserted by the Finance Act, 2005, with effect from 1.4.2006. It lays down that any ‘eligible transaction’ in respect of trading in derivatives referred to in clause (ac) of section 2 of the Securities Contracts (Regulation) Act, 1956, that has been carried out in a recognized stock exchange shall not be treated as a speculative transaction. Further, an ‘eligible transaction’ for this purpose would be one that fulfils the conditions laid down in Explanation to Section 43(5)(d). Any loss in a speculative transaction can be set off only against profit from speculative transactions.

In the case on hand, as discussed earlier, a contract has been concluded and a liability has crystallized. In this factual matrix, from the wordings of the Instruction, it follows that the loss arising out of the forward contract is not notional. In such a case, the CBDT Instruction requires the Assessing Officer to examine whether such a loss is on account of a speculative transaction as contemplated in section 43(5) of the Act.”

4.5.10 The issue of speculative transactions and hedging transactions has been examined and analysed in detail in the decision of the ITAT, Mumbai in the case of S. Vinodkumar Diamonds (P) Ltd. v. Addl. CIT [2013] 35 taxmann.com 337/59 SOT 124. The relevant paragraphs of this order are extracted hereunder and read as follows :

” 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 inter­connected. 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 crystallised 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 favourable 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,

(7) The hedging contract need not necessarily be in the same variety of the commodity they could be in connected commodities, e.g., one type of cotton against another type of cotton. In other words unless the assessee shows that there was some existing contract in respect of which he was likely to suffer a loss because of future price fluctuations and that it was to safeguard against such loss that he entered into the forward contracts of sale, he could not claim the benefit of clause (a) of the proviso to section

43(5). With regard to speculative / hedging transactions we had benefit of perusing the judgments of M. G. Bros. v. CIT [1985] 154 ITR 695/20 Taxman 90 (AP), Nuddea Mills Co. Ltd. v. CIT [1988] 171 ITR 169/[1987] 35 Taxman 3  (Cal.), Delhi Flour Mills Co. Ltd. v CIT [1974] 95 ITR 151  (Delhi) and Pankaj Oil Mills v CIT [1978] 115 ITR 824 (Guj.) delivered by the Hon’ble High Courts of Andhra Pradesh, Calcutta, Delhi and Gujarat respectively.”

4.5.11 As discussed earlier, in the case on hand, there has been an existing contract with a binding obligation accrued against the assessee when it entered into forex forward contracts. The forward contracts are in respect of consideration for export proceeds, which are revenue items. There is an actual contract for sale of merchandise. In this factual matrix, it is clear in our view that the transaction in question will not qualify to be called as speculative transaction. In view of the facts and circumstances of the case on hand, as discussed above, we hold that the provision on derivative contracts is allowable as expenditure. We, accordingly allow the Grounds at S. Nos. 1 to 9 raised by the assessee.”

18. Since Ld. CIT(A) has rendered the decision following the decision rendered by ITAT, we do not find any infirmity in his order passed on this issue.

19. In the result, the appeal filed by the revenue is dismissed.

Order pronounced in the open court on 2nd Dec, 2020