Profits earned from forward contract not to be included in the profits of the business of the undertaking for computing deduction under Section 10B

Court :Bangalore bench of the Income-tax Appellate Tribunal

Citation : ACIT Vs. K. Mohan & Co.(Exports) (P.) Ltd [2010] 130 TTJ 719 (Bang)

Brief :Bangalore bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of ACIT v. K. Mohan & Co.(Exports) (P.) Ltd [2010] 130 TTJ 719 (Bang)  held that that profits earned from forward contracts cannot be included in the profits of the business of the undertaking for the purpose of computing deduction under Section 10B of the Income-tax Act, 1961(the Act) .

Further the Tribunal held that the deduction permissible under the provisions of the Act is in respect of “profit of the business of the undertaking”. The profit earned from forward contract is to be assessed as ‘Speculation business’ which is not the business of the undertaking.

Facts of the case

· The taxpayer, a 100 percent export oriented undertaking, was claiming deduction of profits as per section 10B of the Act.

• · The taxpayer, in order to protect the export sales from the exchange fluctuation, entered into forward contracts at an agreed rate for the export bills to be received. Further, the taxpayer claimed deduction under section 10B of the Act in respect of income earned from forward contracts.
• · The AO concluded that the taxpayer had indulged in hedging foreign currency risk and the transaction was ‘financial transaction’.

The AO therefore held that profit attributable to the forward contract was not profit derived from export and therefore not eligible for deduction under section 10B of the Act.

Taxpayer’s contentions

• The taxpayer contended that it had made an export turnover of $ 54.4 12 million from exports to USA, UK and Europe. Against this the taxpayer booked forward contracts for $ 25.150 million which is 46 per cent of the export turnover. This suggests that the taxpayer has not overbooked forward contracts in order to speculate.
• The taxpayer placed reliance on the decision of the Mumbai Tribunal in the case of D. Kishore Kumar & Co. v. DCIT (2005) 2 SOT 769 (Mum) wherein it was held that profit on cancellation of forward contracts effectively reduces cost of purchase in respect of imports and cannot be construed as independent of taxpayer’s business.
• The taxpayer also relied on the decision of Bangalore Tribunal in the case of ACIT v. Motorola India Electronics (P) Ltd. (2007) 112 TTJ 562 (Bang) in which it was held that interest income earned on deposits lying in EEFC account and out of advances of inter-corporate loans were to be included while computing deduction under section. 10A and 10B of the IT Act.

Tax department’s contentions

• · The tax department contended that the profit on account of cancellation of forward contract was not derived from export and such profit was not derived in foreign exchange. Therefore such profit cannot be part of the export turnover as per section 10B of the Act.
• · The tax department relied on the Supreme Court’s decision in the case of CIT v. Sterling Foods (1999) 237 ITR 579 (SC) in which it was held that the interest received by the taxpayer on the deposit made for the purpose of obtaining letters of credit was not having a direct nexus with industrial undertaking and therefore such interest cannot be said to have been derived from industrial undertaking.

Tribunal’s ruling

• As per section 43(5) of the Act, a transaction is speculative in case the contract is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity. In the case under consideration, it has been admitted by the taxpayer that profit credited was in respect of those forward contracts in which there has been no actual delivery.
• The Calcutta High Court in the case of Hoosen Kasam Dada (India) Ltd. v. CIT (1964) 52 ITR 171 (Cal) has held that the intention of the taxpayer of settling forward contract through actual delivery is not material and the only material thing is to see as to whether there has been actual delivery or not. When there is no delivery under a settlement contract, it is a speculative transaction.
• The Madras High Court in the case of Sri Ranga Vilas Ginning & Oil Mills v. CIT (1982) 133 ITR 85 (Mad) held that if the taxpayer is doing regular business in spot dealings in a commodity and also indulges in speculative transactions in the same commodity then speculative transactions are to be held as a distinct speculation business on account of explanation 2 to section 28 of the Act.
• The Rajasthan High Court in the case of CIT v. Shree Textiles (1994) 119 CTR 472 (Raj) had held that even a single speculative transaction can constitute speculation business. In the case under consideration, there are a number of transactions and the forward contracts have been taken in respect of 46 per cent of the export turnover which is more than an isolated transaction. Therefore in view of Explanation. 2 to section 28, the profit from the forward contract will have to be assessed as profit from speculation business.
• The deduction permissible under the provisions of the Act is in respect of “profit of the business of the undertaking”. The business of the undertaking is to manufacture and export ready made garments. The profit earned from forward contract is to be assessed as ‘Speculation business’ which is not the business of the undertaking. Hence, for the purpose of computing deduction under section 10B of the Act, speculation business cannot be considered as the business of the undertaking.
• Accordingly, the Tribunal held that profits earned from forward contract cannot be included in the profits of the business of the undertaking for the purpose of computing deduction under Section 10B of the Act.

Our comments

This is an important ruling by the Bangalore Tribunal which has held that profits earned from forward contract are to be assessed as “Speculation Business” and it cannot be included in the profits of the business of the undertaking for the purpose of computing deduction under Section 10B of the Act. The decision comes as a set back for EOU/STP units.

Incidentially, the Bombay High Court has in the case of Badridas CIT v. Badridas Gauridu (P) Ltd. [2003] 261ITR 256 (Bom) held that when a forward transaction for hedging foreign exchange fluctuation risk has been entered into and the same is in connection with the business of the taxpayer, it will not constitute a speculative transaction. In view thereof the Forex loss relating to forward contracts entered into by the taxpayer was allowed as business loss.

NF