OCEAN SPARKLE LIMITED,HYDERABAD vs. DCIT., CIRCLE 5(1), HYDERABAD

4 ITA.No.1030/Hyd./2024 and in case, the assessee could not produce evidence on record, directed the Assessing Officer to add back the disallowable items.

7 ITA.No.1030/Hyd./2024 6. Sri Sourabh Soparkar, Advocate-Learned Counsel for the Assessee submitted that, the learned CIT(A) was erred in upholding the addition of forex gain on derivatives for Rs.1,39,93,231/- without considering the fact that, the same is notional in nature and is un-realised amount and not a real income and hence, it is not taxable and not covered in terms of section 43A of the Income Tax Act, 1961. Learned Counsel for the Assessee further referring to the chart submitted by the assessee submitted that, although, the assessee has treated forex gain on account of restatement of liabilities existed as on the balance-sheet date as income or expenses in the books of accounts, but, by following the CBDT Circular 3/2010, dated 23.03.2010 has excluded the said income while computing income from business and profession because, it is notional in nature. Although, the assessee has explained this fact to the learned CIT(A), but, the learned CIT(A) had given a different finding in light of certain judicial precedents, even though, the said decisions are on the issue of forex gain, whether it is capital or revenue. The Learned Counsel for the Assessee

8 ITA.No.1030/Hyd./2024 further referring to the accounting policies of the assessee submitted that, right from the beginning, the assessee is following mercantile system of accounting, where forex gain or loss on account of monetary transactions in respect of foreign currency liability has been treated as income or expenditure upon crystallization of said liability either on settlement or cancellation. The learned CIT(A) without appreciating the relevant facts, has simply held that, it is capital in nature and needs to be capitalised, even though, it pertains to the trading liability and since the liability is not accrued to the assessee and it is only a notional entry for adjustment of foreign currency fluctuation in books of accounts in terms of AS-11, the assessee has accounted gain in the books of accounts. In this regard, he relied upon the decision of ITAT, Hyderabad Bench in the case of DCIT vs., Cyient Ltd., [2018] 91 taxmann.com 353 [Hyd.-Tribu.]

9 ITA.No.1030/Hyd./2024 Governor India (P.) Ltd., (supra), where the issue has been settled and according to the decision of Hon’ble Supreme Court, forex gain or loss on account of restatement of liability should be recognised as income or expenses and accordingly, the learned CIT(A) after considering the relevant facts and by following certain judicial precedents, has rightly sustained the addition made by the Assessing Officer. Therefore, he submitted that, the addition made by the Assessing Officer should be upheld.

11 ITA.No.1030/Hyd./2024 for the Assessee for the simple reason that, as per AS-11 which deals with giving accounting treatment for the effect of changes in foreign exchange transactions very categorically stated that, exchange difference arising on foreign currency transactions have to be recognised as income or as expenses in the period in which they arise. Further, AS-11 stipulates that, effects of changes in exchange rate vis-a-vis monetary items denominated in foreign currency to be taken into account for giving accounting treatment on the balance-sheet date. Therefore, an enterprise has to report the outstanding liability denominated in foreign currency by using closing rate of exchange. Any difference, the loss or gain arising on conversion of the said liability at the closing rate, should be recognised in the P and L A/c for the relevant period. From the method of accounting followed by the assessee and the AS-11 issued by the ICAI, it is undisputedly clear that, any difference, loss or gain arising on account of restatement of existing liability in the books of accounts as on the balance-

12 ITA.No.1030/Hyd./2024 sheet date, should be recognised as income or expenses on the reporting date.

13 ITA.No.1030/Hyd./2024 Circular no.3/2010, dated 23.03.2010 is devoid of merit because, first of all, the method of accounting followed by the assessee is not relevant to determining the income for the purpose of taxation which is very clear from the decision of Hon’bnle Supreme Court in the case of Sutlej Cotton Mills Limited vs., CIT [1979] 116 ITR 1 (SC). Further, as per AS- 11 issued by the ICAI, it is mandatory for the assessee to recognise, any difference, gain or loss on account of restatement of liability, as income or as expenses for reporting period. Since the assessee is following mercantile system of accounting and further AS-11 mandates recognition of difference in monetary transaction of foreign currency as on the date of balance-sheet as income or expenses, in our considered view, the method of accounting followed by the assessee does not change the position of law as explained by the Hon’ble Supreme Court in the case of CIT vs., Woodward Governor India (P.) Ltd., (supra). Therefore we reject the arguments of Counsel for assessee.

14 ITA.No.1030/Hyd./2024 Supreme Court in the case of CIT vs., Woodward Governor India (P.) Ltd., (supra), wherein the Hon’ble Supreme Court held as under :

“There was no dispute that in the previous years, whenever the dollar rate stood reduced, the department had taxed the gains which accrued to the assessee on the basis of accrual and it was only in the year in question when the dollar rate stood increased resulting in a loss, that the department had disallowed the deduction/debu That fact was important. It indicated the double standard adopted by the department. [Para 10]

The word 'expenditure" is not defined in the Act. The word 'expenditure' is, therefore, required to be understood in the context in which it is used. Section 37 enjoins that any expenditure not being expenditure of the nature described in sections 30 to 36 laid out or expended wholly and exclusively for the purpose of the business, should be allowed in computing the income chargeable under the head profits and gains of business. In sections 30 to 36, the expression 'expenses incurred as well as 'allowances and depreciation' have also been used. For example, depreciation and allowances are dealt with in section 32. Therefore, the Parliament has used the expression 'any expenditure in section 37 to cover both. Therefore, the expression 'expenditure' as used in section 37 may, in the circumstances of a particular case, cover an amount which is really a "loss', even though said amount has not gone out from the pocket of the assessee. [Para 13)

15 ITA.No.1030/Hyd./2024

The provisions of section 145 recognise the rights of a trader to adopt either the cash system or the mercantile system of accounting. The quantum of allowances permitted to be deducted under diverse heads under sections 30 to 43C from the income, profits and gains of a business would differ according to the system adopted. This is made clear by defining the word 'paid in section 43(2), which is used in several sections from sections 30 to 43C, as meaning actually paid or incurred according to the method of accounting upon the basis of which profits or gains are computed under section 28/29. That is why, in deciding the question, as to whether the word "expenditure in section 37(1) includes the word 'loss', one has to read section 37(1) with sections 28, 29 and 145(1). Accounts regularly maintained in the course of business are to be taken as correct, unless there are strong and sufficient reasons to indicate that they are unreliable. Under section 28(0, one needs to decide the profits and gains of any business which is carried on by the assessee during the previous year. Therefore, one hat to take into account stock-in- trade for determination of profits. The Act makes no provision with regard to valuation of stock. But the ordinary principle of commercial accounting requires that in the profit and loss account, the value of the stock-in-trade at the beginning and at the end of the year should be entered at cost or market price, whichever is lower. This is how business profits arising during the year need to be computed. This a one more reason for reading section 37(1) with section 145. For valuing the closing stock at the end of a particular year, the value prevailing on the last date is relevant, because profits/loss is embedded in the closing stock. While anticipated loss is taken into account, anticipated profit in the shape of appreciated value of the closing stock is not brought into account, as no prudent trader would care to show increase in 16 ITA.No.1030/Hyd./2024 profits before actual 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. As profits for Income Tax purpose are to be computed in accordance with ordinary principles of commercial accounting, unless such principles stand superseded or modified by legislative enactments, unrealized profits in the shape of appreciated value of goods remaining unsold at the end of the accounting year and carried over to the following year's account in a continuing business are not brought to charge as a matter of practice, though loss due to fall in the price below cost is allowed even though such loss has not been realized actually. The said system of commercial accounting can be superseded or modified by legislative enactment. Under section 145(2), the Central Government is empowered to notify from time-to-time the Accounting Standards to be followed by any class of the assessees or in respect of any class of income. Accordingly, under section 209 of the Companies Act, mercantile system of accounting has been made mandatory for companies. In other words, Accounting Standard, which is continuously adopted by an assessee, can be superseded or modified by legislative intervention. However, but for such intervention or in cases falling under section 145(3), the method of accounting undertaken by the assessee continuously is supreme. In the instant case, there was no finding given by the Assessing Officer on the correctness or completeness of the accounts of the assessee. Equally, there was no finding given by the Assessing Officer stating that the assessee had not complied with the Accounting Standards. [Para 14]

Therefore, in the instant case, the loss suffered by the assessee on account of the exchange difference as on the date of the 17 ITA.No.1030/Hyd./2024 balance sheet was an item of expenditure under section 37(1). [Para 15]

Thus, it is clear that profits and gains of the previous year are required to be computed in accordance with the relevant accounting standard. It is important to bear in mind that the basis on which stock-in-trade is valued is part of the method of accounting. It is well-established that on general principles of commercial accounting, in the profit and loss account, the value of the stock-in-trade at the beginning and at the end of the accounting year should be entered at cost or market value, whichever is lower the market value being ascertained as on the last date of the accounting year and not as on any intermediate date between the commencement and the closing of the year, failing which it is not possible to ascertain the true and correct state of affairs. No gain or profit can arise until a balance is struck between the cost of acquisition and the proceeds of sale. The word 'profit' implies comparison between the state of business at two specific dates, usually separated by an interval of twelve months. Stock-in-trade is an asset. It is a trading asset. Therefore, the concept of profit and gains made by business during the year can only materialize when a comparison of the assets of the business at two different dates is taken into account. Section 145(1) enacts that for the purpose of sections 28 and 56 alone, income, profits and gains must be computed in accordance with the method of accounting regularly employed by the assessee. Therefore, section 145(1) was attracted to the facts of the instant case. Under the mercantile system of accounting, what is due is brought into credit before it is actually received, it brings into debit an expenditure for which a legal liability has been incurred before it was actually disbursed. Therefore, the accounting method followed by an assessee continuously for a 18 ITA.No.1030/Hyd./2024 given period of time needs to be presumed to be correct till the Assessing Officer would come to the conclusion for reasons to be given that the system do not reflect true and correct profits. In the instant case, there was no finding given by the Assessing Officer on the correctness of the accounting standard followed by the assessee. [Para 16]

AS-II deals with giving of accounting treatment for the effects of changes in foreign exchange rates. In case of the revenue items falling under section 37(1), para 9 of AS-II, which deals with recognition of exchange differences, needs to be considered. Under this para, exchange differences arising on foreign currency transactions have to be recognized as income or as expense in the period in which they arise. The important point to be noted is that AS-11 stipulates effect of changes in exchange rate vis-a-vis monetary items denominated in a foreign currency to be taken into account for giving accounting treatment on the balance sheet date. Therefore, an enterprise has to report the outstanding liability relating to import of raw materials using closing rate of exchange. Any difference, loss or gain arising on conversion of the said liability at the closing rate, should be recognized in the profit and loss account for the reporting period. [Para 18]

In conclusion, it may be stated that in order to find out if an expenditure is deductible, the following factors have to be taken into account (1) whether the system of accounting followed by the assessee is mercantile system, which brings into debit the expenditure amount for which a legal liability has been incurred before it is actually disbursed and brings into credit what is due, immediately it becomes due and before it is actually received, (ii) whether the same system is followed by the assessee from the very beginning and if there was a change in the system, whether

19 ITA.No.1030/Hyd./2024 the change was bona fide; (iii) whether the assessee has given the same treatment to losses claimed to have accrued and to the gains that may accrue to it; (iv) whether the assessee has been consistent and definite in making entries in the account books in respect of losses and gains; (v) whether the method adopted by the assessee for making entries in the books both in respect of losses and gains as per nationally accepted Accounting Standards; (vi) whether the system adopted by the assessee is fair and reasonable or is adopted only with a view to reduce the incidence of taxation.”

20 ITA.No.1030/Hyd./2024 date, also to be taxed. The relevant observations of ITAT, Mumbai Bench, Mumbai are as under :

"We have perused the records and considered the rival contentions carefully. The dispute is regarding allow ability of loss on account of foreign exchange fluctuation in respect of foreign currency loan taken by the assessee. The assessee had been restating foreign exchange loan liability on the balance- sheet date which resulted into loss which has been claimed as deduction. The loss/gain on account of foreign exchange fluctuation on restatement of the loan liability on the balance- sheet date is required to be taken into account in computation of income if the loan is on revenue account or is a working capital loan. Loss is allowable as deduction under section 37(1) as held by the Honorable Supreme Court in the case of Woodward Governor India (P.) Ltd. (supra). The loan in this case had been taken as working capital loan as is clear from the loan agreement wherein the purpose of the loan is clearly mentioned to use it as a working capital to finance the activities of the company. As held by the Honorable Supreme Court in the case of Sutlej Cotton Mills Ltd. v. CIT [1979] 116 ITR 1. foreign currency fluctuation loss is allowable as deduction if the foreign currency is held on revenue account or as trading asset or as part of circulating capital employed in the business. As regards the year of allow ability, the claim has to be allowed on the basis of restatement of the liability on the balance-sheet date as held by the Honorable Supreme Court in the case of Woodward Governor India (P.) Ltd. (supra). Thus, the claim of the assessee is allowable. In case there is gain in a year and the assessee has not offered it to tax, the Revenue is free to take action under law. In these years, admittedly there is loss which is allowable as deduction. We,

21 ITA.No.1030/Hyd./2024 therefore, set aside the order of the Commissioner of Income-tax (Appeals) and allow the claim of the assessee."

22 ITA.No.1030/Hyd./2024 by the Assessing Officer and the learned CIT(A) to make the addition towards forex gain on account of restatement of liability as on the balance-sheet date as income of the assessee. Thus, we are inclined to uphold the order of the learned CIT(A) and dismiss the appeal filed by the assessee.

Order pronounced in the open Court on 06.08.2025.