Derivative Mark-to-Market Loss Allowed Despite CBDT Instruction: ITAT Mumbai

ECL Finance Ltd. Vs DCIT (ITAT Mumbai)

Summary: The Income Tax Appellate Tribunal, Mumbai “E” Bench, comprising Shri I.P. Bansal, Judicial Member, and Shri N.K. Billaiya, Accountant Member, decided four connected appeals involving ECL Finance Ltd., Edelweiss Capital Ltd. and Edelweiss Finance & Investments Ltd. for Assessment Year 2007-08. The appeals concerned two distinct tax issues: the determination of expenditure disallowable under Section 14A of the Income-tax Act, 1961 read with Rule 8D, and the allowability of a mark-to-market loss of ₹21,21,248 arising from derivative trading transactions. The Tribunal delivered its consolidated order on 30 January 2013, dismissing all four appeals.

The first three appeals, filed by ECL Finance Ltd., Edelweiss Capital Ltd. and Edelweiss Finance & Investments Ltd., challenged the treatment of disallowance under Section 14A. The Assessing Officer had applied Rule 8D to determine expenditure attributable to dividend income and other income not forming part of total taxable income. The assessees argued that they had already computed disallowance on a reasonable and scientific basis having regard to their accounts, and that their direct and indirect expenditure should be examined with reference to its actual connection with exempt income. Edelweiss Capital Ltd. additionally contended that amounts raised through fully convertible debentures issued to Lehman Brothers BV had been advanced to subsidiaries as interest-bearing loans, and that the corresponding interest expenditure was unrelated to exempt income.

The Commissioner of Income Tax (Appeals) accepted that Rule 8D could not be applied to AY 2007-08 in view of the Bombay High Court judgment in Godrej & Boyce Manufacturing Co. Ltd. Vs DCIT, reported in 328 ITR 81. However, the appellate authority did not accept the assessees’ calculations without further examination. Instead, it directed the Assessing Officer to determine a reasonable disallowance under Section 14A after examining the accounts, relevant expenditure and submissions of the assessees. The Tribunal upheld this approach, holding that for assessment years before AY 2008-09, expenditure relatable to exempt income must be determined reasonably rather than through retrospective application of Rule 8D.

The Revenue’s separate appeal concerned the deletion of ₹21,21,248 claimed as mark-to-market loss on derivative transactions. The Assessing Officer had disallowed the amount on the basis that a valuation loss recognised on 31 March did not represent a crystallised loss, since the underlying contracts had not been settled. The CIT(A), however, allowed the deduction by following the earlier Mumbai Tribunal decision in Edelweiss Capital Ltd. Vs ITO, ITA No. 5324/Mum/2007, dated 10 November 2010. The Revenue did not dispute that the earlier decision covered the issue but argued that the Tribunal had not considered CBDT Instruction No. 3/2010 dated 23 March 2010, which treated unsettled mark-to-market losses as contingent and instructed assessing authorities to add them back while computing taxable income.

The Tribunal examined the earlier decision in Edelweiss Capital Ltd., which explained that derivatives held as stock-in-trade were valued at cost or market price, whichever was lower. The underlying accounting policy recognised anticipated losses on open derivative positions without recognising unrealised gains. The quoted decision drew on the Supreme Court’s ruling in Chainrup Sampatram Vs CIT, (1953) 24 ITR 481, and the reasoning in Whimster & Co. Vs Commissioners of Inland Revenue, (1926) 12 Tax Cases 813. Under the accepted principle of prudence in stock valuation, a fall in closing stock value may be recognised even before the corresponding loss is realised through sale or settlement. Therefore, the anticipated loss on derivatives treated as stock-in-trade was not necessarily a contingent liability.

The Tribunal further observed that although CBDT instructions may bind income-tax authorities, they do not bind appellate authorities. It noted that the assessment order in the case had been passed on 31 December 2009, before Instruction No. 3/2010 was issued, and that the earlier coordinate Bench had already examined the accounting and legal principles governing derivative valuation. Following that decision, the Tribunal declined to interfere with the deduction allowed by the CIT(A). Consequently, all three assessee appeals relating to Section 14A and the Revenue’s appeal concerning derivative mark-to-market loss were dismissed. The decision establishes the Tribunal’s treatment of these issues for AY 2007-08 and should be read with the subsequent statutory framework applicable to later years.

Cases Discussed

1. Godrej & Boyce Manufacturing Co. Ltd. Vs DCIT — (2010) 328 ITR 81 (Bom.); Bombay High Court. Followed for the principle that Rule 8D applies prospectively from AY 2008-09 and that earlier-year Section 14A disallowances require a reasonable method after providing an opportunity of hearing. The hyperlink provides relevant TaxGuru coverage of the cited ruling.

2. Edelweiss Capital Ltd. Vs ITO — ITA No. 5324/Mum/2007; 10/11/2010; AY 2004-05; ITAT Mumbai. Expressly followed for allowing mark-to-market losses on derivative instruments held as stock-in-trade and valued at cost or market price, whichever is lower. Its substantive reasoning is reproduced in the present order.

3. Chainrup Sampatram Vs Commissioner of Income Tax, West Bengal — (1953) 24 ITR 481 (SC); Supreme Court. Discussed in the extracted Edelweiss Capital decision for the settled principle of valuation of closing stock at cost or market price, whichever is lower, including recognition of a fall in value before actual realisation.

4. Whimster & Co. Vs Commissioners of Inland Revenue — (1926) 12 Tax Cases 813. Discussed within the quoted Supreme Court reasoning concerning recognition of diminished market value of closing stock.

FULL TEXT OF THE ORDER OF ITAT MUMBAI

ITA Nos.6612/Mum/11 & 7656/Mum/11 are cross appeals and they are directed against order dated 7/7/2011 of CIT(A)-7, Mumbai for the assessment year 2007-08. ITA No.6607/Mum/11 & 6609/Mum/11 are directed against two separate orders dated 7/7/2011 passed by CIT(A)-7, Mumbai in the cases of captioned respective assessee’s in respect of assessment year 2007-08. Grounds of appeal in each of the appeals read as under:

Grounds of Appeal in ITA No.6612/Mum/11:

“1. The learned Commissioner of Income Tax (Appeals) erred in not adjudicating the various contentions of the appellant in relation to the disallowance I computed u/s. 14A of the Income Tax Act, 1961 and while doing so he amongst others failed to appreciate that:

a. The appellant, in the return of income filed, had computed the disallowance u/s. 14A on a reasonable and scientific basis having regard to the accounts maintained;

b. The expenditure disallowed u/s. 14A by the appellant in the return of income filed was after considering the direct & indirect expenditure incurred which had a proximate and immediate connection to the dividend income;”

Ground of Appeal in ITA No.7656/Mum/11:

1. “On the facts and in the circumstances of the case and in law, the Ld.CIT(A) has erred in deleting the addition of Rs.21,21,248/-, made by disallowing the mark-to-market loss claimed on account of trading in derivative transactions, without appreciating the fact that the loss claimed on the basis of value of derivative as on 31st March is merely a notional loss and the actual loss or the profit in respect of such derivative transactions would get crystallized only at the time of settlement of such transaction”.

Grounds of Appeal in ITA No.6607/Mum/11:

“1. The learned Commissioner of Income Tax (Appeals) erred in not adjudicating the various contentions of the appellant in relation to the disallowance computed u/s. 14A of the Income Tax Act, 1961 and while doing so he amongst others failed to appreciate that:

a. The appellant, in the return of income filed, had computed the disallowance u/s. 14A on a reasonable and scientific basis having regard to the accounts maintained;

b. The expenditure disallowed u/s. 14A by the appellant in the return of income filed was after considering the direct & indirect expenditure incurred which had a proximate and immediate connection to the dividend income;

c. The funds obtained on issuance of fully convertible debentures to Lehman Brothers BV were entirely deployed in advancing interest bearing loans to the subsidiary companies and hence the interest paid on debentures was not an expenditure incurred in relation to earning of income not chargeable to tax.”

Grounds of Appeal in ITA No.6607/Mum/11:

“1. The learned Commissioner of Income Tax (Appeals) erred in not adjudicating the various contentions of the appellant in relation to the disallowance I computed u/s. 14A of the Income Tax Act, 1961 and while doing so he amongst others failed to appreciate that:

a. The appellant, in the return of income filed, had computed the disallowance u/s. 14A on a reasonable and scientific basis having regard to the accounts maintained;

b. The expenditure disallowed u/s. 14A by the appellant in the return of income filed was after considering the direct & indirect expenditure incurred which had a proximate and immediate connection to the dividend income;”

2. Since common issues were involved and these appeals were represented by common representative, for the sake of convenience all these appeals are disposed of by this consolidated order. It may also be mentioned here that Bench required both the parties to inform whether there is any cross appeals in respect of ITA No.6607 & 6609/Mum/11. Both parties informed that there is no cross appeals in respect of those appeals.

3. The single issue involved in ITA No.6612/Mum/11, 6607/Mum/11 and 6609/Mum/11 is regarding disallowance made under section 14A. The grounds of appeal have already been reproduced. The AO while framing assessment order has resorted to Rule 8D for making the disallowance under section 14A. Before Ld. CIT(A) it was the contention of the assessees that in respect of assessment year 2007-08, Rule 8D could not be applied. Ld. CIT(A) accepted such contention of the assessee on the basis of decision of Hon’ble Bombay High Court in the case of Godrej & Boyce Manufacturing Co. Ltd. vs. DCIT, 328 ITR 81 (Bom). The language of the order of Ld. CIT(A) in all these appeals is common and he has directed the AO to work out the disallowance in accordance with the decision of Jurisdictional High Court in the case of Godrej & Boyce Manufacturing Co. Ltd (supra). For the sake of convenience concluding observation of Ld. CIT(A) are reproduced below:

“9.5 Thus, I find that the Hon’ble Bombay High Court in the case of Godrej and Boyce Manufacturing Co. Ltd. vs. DCIT (supra) has held that for the purpose of determining the expenditure which is incurred in relation to exempt income, which does not form part of the total income, the Assessing Officer is duty bound to determine such expenditure after affording a reasonable opportunity to the appellant. For the same, the Assessing Officer has to determine as to whether the assessee has incurred any expenditure (direct or indirect) in relation to dividend income/income from mutual funds which does not form part of the total income as contemplated under section 14A of the Act, in the ratio of Jurisdictional High Court decision as detailed in para (vii) extracted above. Hence I consider it proper and appropriate to direct the A.O. to provide a reasonable opportunity to the appellant and taking note of the decision of Jurisdictional High Court wherein the Hon’ble High Court has specifically laid down the principle to work out the disallowance of expenditure direct as well as indirect in its decision. The A.O. should accordingly workout such disallowance of expenditure direct! indirect in the spirit of the said decision of the Jurisdictional High Court of Godrej & Boyce Manufacturing Co. Ltd. While doing so, the A.O. should take note of the aforesaid observation of the Jurisdictional High Court on the issue involved in this ground of appeal. With this observation, the appellant this ground of appeal is partly allowed.

9.6 In view of the aforesaid proposition of Jurisdictional High Court, the other contention raised by the appellant company in the present appeal bare not adjudicated here as the A.O. has to take note of the appellant’s case while working out the said disallowance in relation to exempt income in the ratio of the decision of Jurisdictional High Court in the case of Godrej & Boyce Manufacturing Co. Ltd. vs. DCIT 328 ITR 81. With this observation, the appellant this ground of appeal is adjudicated”.

4. We have heard both parties on this issue. The Tribunal has taken a consistent view in respect of assessment years earlier to A.Y. 2008-09 that disallowance should be made by keeping in view the decision of Hon’ble Jurisdictional High Court in the case of Godrej & Boyce Manufacturing Company Ltd. (supra). Therefore, we do not find any infirmity in the directions given by ld. CIT(A) to AO. We decline to interfere and the appeals field by the assessee which involve this single issue are dismissed.

5. Now we are left with the departmental appeal i.e. ITA No.7656/Mum/11. The AO had disallowed mark- to- market loss claimed on account of trading in derivative transactions of Rs.21,21,248/-. The reason assigned by the AO was that loss on the last date of financial year was in the nature of non-crystallized loss. Before Ld. CIT(A) it was submitted that in the case of holding company namely Edelweiss Capital Ltd. Vs. ITO in ITA No.5423/M/2007 for A.Y 2004-05, vide order dated 10/11/2010 similar issue has been decided in favour of the assessee. Accordingly Ld. CIT(A) decided this issue in favour of assessee. The department is aggrieved by such deletion and has preferred the appeal as per grounds narrated above.

6. Ld. DR though not disputed that this issue is covered by the aforementioned decision of Tribunal in the case of holding company of the assessee, has submitted before us that in the aforementioned decision Tribunal did not consider Instruction No.3/2010 dated 23/3/2010 issued by CBDT, in which it has been instructed that such loss should be added back for the purpose of computing taxable income of an assessee. The relevant text is as under:

“ Mark to Market is in substance a methodology of assigning value to a position held in a financial instrument based on its market price on the closing day of the accounting or reporting record. Essentially, market to market is a concept under which financial instruments are valued at market rate so as to report their actual value on the reporting date. This is required from the point of view of transparent accounting practices for the benefit of the share holders of the company and its other stakeholders. Where companies make such an adjustment through their trading or profit/loss account, they book a corresponding loss (Le. the difference between the purchase price and the value as on the valuation date) in their accounts. This loss is a notional loss as no sale/conclusion/settlement of contract has taken place and the asset continues to be owned by the company.

A ‘mark to market’ loss may be given different accounting treatment by different assessees. Some may reflect such loss as a balance sheet item without making any corresponding adjustment in the P & L account Other may book the loss in the profit and loss account which may result in the reduction of book profit. In cases where no sale or settlement has actually taken place and the loss on market to market basis has resulted in reduction of book profits, such a notional loss would be contingent in nature and cannot be allowed to be set off against the taxable income The same should therefore be added back for the purpose of computing the taxable income of an assessee.”

7. On the other hand, Ld. AR relying upon the aforementioned decision of Tribunal submitted that this is a covered issued and the order passed by Ld. CIT(A) should be upheld.

8. We have carefully considered the rival submission in the light of material placed before us. This issue was considered by the Tribunal in the case of Edelweiss Capital Ltd. vs. ITO vide order dated 10/11/2010 in ITA No.5324/M/07. A copy of the said order is placed on our record. The issue was decided by the Tribunal in favour of assessee with the following observations.

“7. We have considered the facts and the rival contentions. In the Schedule annexed to and forming part of the Balance Sheet and Profit & Loss Account for the year under appeal (page 13 of the Paper Book), the assessee has made the following Note: –

“H. Equity Futures — Index / Stock

(a) “Initial Margin-Equity Derivative Instruments”, representing initial margin paid, and “Margin Deposits”, representing additional margin over and above initial margin, for entering into contracts for Equity Index / Stock Futures, which are released on final settlement / squaring-up of underlying contracts, are disclosed under Loans and Advances.

(b) Equity Index / Stock Futures are marked-to-market on a daily basis. Debit or credit balance disclosed under Loans and Advances or Current Liabilities, respectively, in the Mark-to- Market Margin – Equity Index / Stock Futures Account’, represents the net amount paid or received on the basis of movement in the prices of Index / Stock Futures till the Balance Sheet date. Amount paid to brokers in addition to Mark-to-Market Margins is disclosed as “Margin Deposits’ under Loans and Advances.

(c) As on the Balance Sheet date, profit/loss on open positions in Index / Stock Futures are accounted for as follows:

• • • Credit balance in the “Mark-to Market Margin — Equity Index / Stock Futures Account, being anticipated profit, is ignored and no credit for the same is taken in the Profit and Loss Account.
    • Debit balance in the “Mark-to-Market Margin — Equity Index / Stock Futures Account’, being anticipated loss, is adjusted in the Profit and Loss Account.

d) On final settlement or squaring-up of contracts for Equity Index / Stock Futures, the profit or loss is calculated as the difference between settlement / squaring-up price and contract price. Accordingly, debit or credit balance pertaining to the settled / squared-up contract in “Mark-to-Market Margin – Equity Index / Stock Futures Account” is recognized in the Profit and Loss Account.”

The aforesaid Note gives a fair picture of the nature of the provision. The provision in substance has been made to cover the anticipated loss in the derivates trading. There is no dispute that the assessee holds derivatives as its stock-in-trade and there is also no dispute that it follows the principle “cost or market price, whichever is lower” in valuing the derivatives. When the derivatives are held as stock-in-trade then whatever rules apply to the valuation of stock-in-trade will have to be necessarily apply to their valuation also. It is a well settled position in law that ‘while anticipated loss is taken into account in valuing the closing stock, anticipated profit in the shape of appreciated value of the closing stock is not brought into the account, as no prudent trader would care to show increased profit before its realization. This is the theory underlying the rule that the closing stock is to be valued at cost or market price whichever is the lower, and it is now generally accepted as an established rule of commercial practice and accountancy”. This is what the Supreme Court held in the case of Chainrup Sampatram vs. Commissioner of Income Tax, West Bengal (1953) 24 ITR 481 (SC), speaking through Hon’ble Justice Patanjali Sastri, the then Chief Justice of India (page 485 — 486 of the Report). At page 486 the Supreme Court further observed that “loss due to a fall in price below cost is allowed even if such loss has not been actually realized”. Quoting from the case of Whimster & Co. vs. Commissioners of Inland Revenue (1926) 12 Tax Cases 813, the Supreme Court observed that the profits that are chargeable to tax are those realized in the year and that an exception is recognized where a trader purchased and still holds goods which are fallen in value in which case though no loss has been realized nor it has occurred, nevertheless at the close of the year he is permitted to treat these goods as of their market value. This decision of the Supreme Court governs the facts of the present case. It is to the assessee’s strength that the Institute of Chartered Accountants of India in its guidelines have also approved of the rule of prudence which really means that while anticipated losses can be taken note of while valuing the closing stock, anticipated profits cannot be recognized. The anticipated loss, in the light of the judgment of the Supreme Court cited above, cannot be treated as a contingent liability.

8. The learned DR pointed out that the assessee has valued each scrip of the derivatives as at the end of the year. We do not see how this can make any difference to the legal principle. If the derivatives have been treated as stock-in-trade then there is nothing unusual in the assessee valuing each derivative by applying the rule cost or market whichever is lower.

9. We, therefore, direct the Assessing Officer to allow the provision as reflecting in substance the loss arising on account of valuation of the closing stock. The ground is allowed.”

9. The only objection raised by Ld. DR is that in the Instruction No.3/2010 dated 23/3/2010 CBDT has instructed Income Tax authorities to add back such amount while computing taxable income of an assessee. Such contention of Ld. DR cannot be accepted firstly on the ground that Instructions issued by CBDT though may be binding upon Income Tax authorities but are not binding on appellate authorities. The date of assessment order in the present case is 31/12/2009 when such instructions were not even existed. Further, when Tribunal had decided the issue in the case of Edelweiss Capital Ltd. (supra) the instructions were existing but not pleaded by the department. The Tribunal has considered each and every aspect in details which is clear from the observations reproduced in the earlier part of this order. Taking the consistent view as taken by the Co-ordinate Bench, we see no infirmity in the relief granted by Ld. CIT(A). We decline to interfere in the relief granted by him and departmental appeal is dismissed.

10. In the result, all these appeals are dismissed.

Order pronounced in the open court on the 30th day of Jan.2013