ASST CIT 19(1), MUMBAI vs. DHARAMCHAND PARASCHAND EXPORTS, MUMBAI

आदेश / O R D E R PER R.C.SHARMA (A.M):

M/s. Dharamchand Paraschand Exports 6.1 AO considered the disallowance on the ground that the forward contract loss is a notional loss on valuation of a liability that has not yet crystalised which is contingent in nature. It is stated that the decision of the Hon'ble ITAT is not accepted by the Department and is before the Hon'ble High Court, Mumbai. Thus the forward contract loss of ₹. 1,99,35,578/- claimed by the appellant is disallowed and added to the income of the appellant. 6.2 Per contra, the appellant submitted that they have accounted several types of exchange differences in the books of account as per AS 11 and transaction gain/ loss on outstanding foreign exchange forward contract loss of ₹.1,99,35,578/- arising from such accounting was only disallowed by the AO stating the reason that the same is a notional loss on valuation of a liability which has not yet been crystalised and is a contingent liability. It is submitted that a forward contract is an absolutely binding legal contract in terms of various stipulation mentioned in the forward contract agreement which is entered with reputed commercial banks supervised by the RBI and also governed by various international laws of commerce and also national and international forums. Banks are specifying in its loan sanction letters the upper limit that can be entered into by the importer / exporter for booking the forward contracts which clearly shows that forward contracts is a firm asset / liability legally binding on both the parties and though outcome is not crystalised on the date of balance sheet, definitely it will result in to some gain / loss on maturity. Thus, it is an asset / liability which is in existence on the balance sheet date but its final quantification is determined only on maturity date. Even if the importer / exporter cancel the contract, it is required to pay the difference between booking date and cancellation date. It is argued that, if loss on open forward contracts is not allowable as deduction then corresponding translation gain booked on open receivables also should not be considered as income since forward contracts are entered only based on the strength of the underlying receivables / payables. 6.2.1 From the legal front, the appellant submitted that the assessee is regularly following mercantile system of accounting and is regularly following Accounting Standard No. 11 which deals with the Effects of Changes in Foreign Exchange Rates (AS 11) issued by the ICAI regarding accounting of foreign currency transactions. Para 11 of AS 11 requires foreign currency monetary items to be reported using the closing rate. Accordingly, outstanding sundry debtors / creditors in foreign currency is translated into Indian Rupees at the closing rate and the resultant profit/loss is accounted in the books and taxes thereon are paid. Profit/loss arising on re-statement of outstanding foreign currency transactions at the year-end rate is nothing but exchange difference. Para 14 of AS 11 states that an exchange difference results M/s. Dharamchand Paraschand Exports when there is a change in the exchange rate between the transaction date and the date of settlement of any monetary items arising from a foreign currency transactions, when the transaction is settled in a subsequent accounting period, the exchange difference recognized in each intervening period up to the period of settlement is determined by the change in exchange rates during that period. Thus, it is stated that accounting profit / loss on foreign currency transaction is nothing but the exchange difference. A foreign exchange contract (or forward contract) arising out of foreign currency transaction is a binding obligation to buy or sell a certain amount of foreign currency at a pre-agreed rate of exchange, on a certain future date. Even if requirements of the Assessee changes over the term of the forward contract, it is still obliged to honour the contract. Thus, marked to market profit / loss accounted by the Assessee in line with AS 11 is nothing but exchange difference on the Forward Contracts outstanding at the end of the year. Like any other year end outstanding asset or liability (i.e. Debtors or Creditors), Forward Contracts" is also one type of commitments / obligations arising out of foreign currency transaction outstanding at the year end and profit / loss arising on translation thereof at the year-end (similar to Debtors, Creditors) is nothing but regular business profit / loss. Assessee is following mercantile system of accounting and has booked year end marked to market profit / loss only due the compulsion it had in terms of Para 37 of the AS 11. CBDT Instruction No 3 dated March 23, 2010 states that loss accounted on marked to market basis (i.e. comparing open position with the market rate) notional loss would be contingent in nature and cannot be allowed to be set off against the taxable income and the same should therefore be added back for the purpose of computing the taxable income of an assessee. It is also submitted that CBDT Instruction is not binding on the Assessee. Further, the Instruction was issued with the background that "corporates have suffered substantial losses on account of trading in forex derivatives". It may be noted that Assessee has not at all traded in the derivative contracts. In fact RBI guidelines on booking and cancellation of Forward Contracts do not allow assessee to trade in the risk mitigating products. Thus, CBDT Instructions is not at all applicable to the Assessee, it is stated. 6.2.3 The appellant drawn the attention to the Supreme Court decision in the case of Woodward Governor India Pvt Ltd (294 ITR 451). In this case, Assessee had debited to its Profit & Loss Account a sum of ₹. 41,06,746 out of which a sum of ₹.29,49,088 was the unrealized loss due to foreign exchange fluctuation on the last date of the accounting year. The AO held that the liability as on the last date of the previous- year under consideration was a contingent liability, it was not an ascertained liability and consequently it had to be added back to the total income of the assessee. Accordingly, he added back ₹.29,49,088 being the unrealized loss due to foreign exchange fluctuation. In other M/s. Dharamchand Paraschand Exports words, the debit to the P&L account was disallowed. Supreme Court approved the claim of the Assessee and the appellant submits that the profit/loss accounted by the assessee in line with AS 11 on conversion of outstanding foreign exchange contract liability is nothing but the exchange difference relating to the year under consideration. In the case of Sutlej Cotton Mills Ltd. reported in 116 UR 1 Supreme Court has held assessee on account of appreciation or depreciation in the value of foreign currency held by it, on conversion into another currency, such profit or loss would ordinarily be a trading profit or loss if the foreign currency is held by the- assessee on revenue account or as a trading asset or as a part of circulating capital embarked in the business. But, if on the other hand, the foreign currency is held as a capital asset or as fixed capital, such profit or loss would be of capital nature. The appellant also cited the Special Bench of the Mumbai Tribunal in the case of Bank of Bahrain and Kuwait (I.T.A No.4404 & 1883/Mum/2004) wherein it is held that a binding obligation accrued against the assessee the minute it entered into forward foreign exchange contracts; a liability is said to have crystalised when a pending obligation on the balance sheet date is determinable with reasonable certainity. where a forward contract is entered into by the assessee to sell the foreign currency at an agreed price at a future date falling beyond the last date of accounting period, the loss is incurred to the assessee on account of evaluation of the contract on the last date of the accounting period i.e. before the date of maturity of the forward contract. TTAT Mumbai in the case of Deutsche Bank A.G (86 ITD 431) has held that income / loss on revaluation of forward foreign exchange contracts is not notional in nature and, therefore, needs to be considered in preparing computation of total income of the assessee. Delhi Special Bench in the case of ONGC (83 ITD 151) inter alia, observed that "Before concluding, we would like to point out that the assessee's claim for loss arising as a result of fluctuation in foreign exchange rates on the closing day of the year has been disallowed by the AO, inter alia, on the ground that this liability was a contingent liability and the loss was a notional one. The main ingredient of a contingent liability is that it depends upon happening of a certain event. We are of the considered opinion that in the case of the assessee, the "event" i.e. the change in the value of foreign currency in relation to Indian currency has already taken place in the current year. Therefore, the loss incurred by the assessee is a fait accompli and not a notional one. The decision in the case of ONGC was affirmed by the Supreme Court vide its judgement dated 15 March 2010. 6.2.4 The appellant argued that those anticipated liabilities are not allowable which are contingent in nature but, if an anticipated liability is coupled with present obligation and only quantification can vary depending upon the terms of contract, then a liability is said to have crystalised on the balance sheet date. It is in conformity with the M/s. Dharamchand Paraschand Exports principles of prudence also. A contingent liability depends purely on the happening or not happening of an event whereas if an event has already taken place, which, in the present case, is of entering into the contract and undertaking of obligation to meet the liability, and only consequential effect of the same is to be determined, then, it cannot be said that it is in the nature of contingent liability. It is evident that the anticipated losses on account of existing obligation as on 31st March, determinable with reasonable accuracy, being in the nature of expenditure/accrued liability, have to be taken into account while preparing financial statements. 6.2.5 In view of the above, it is submitted that results of the appellant needs to be accepted as claimed by them and proper and consistent effect be given to gain/loss on account of forward contracts and relief be granted in respect of ground of appeal as prayed for. Without Prejudice the appellant submitted that, in case the aforesaid loss on translation is disallowed, then ₹.1,59,09,008/- and Income of Asst, Year 2013-2014 needs to be reduced by ₹. 65,44,478/-. 6.3 I have carefully considered the rival contentions on the issue on hand and the material available on record. Ground No. 1 is in respect of the disallowance made by the Ld. AO, being the loss on account of revaluation of outstanding '"foreign exchange forward contract amounting to ₹.1,99,35,578/- by holding that it was an unascertained liability being notional loss. 6.3.1 It is stated by the appellant that they are following the Accounting Standard AS-11 issued by the Institute of Chartered Accountants of India. The Institute of Chartered Accountants of India, the legal apex body on accounting matters has issued the Accounting standard "Accounting for the effects of changes in foreign exchange rates (AS- 11) (revised)" which is required to be compulsorily followed from 1st April 1995. In accordance with the stipulations of this standard, all the monetary items are required to be valued at the closing rate and the profit or loss arising there from is required to be debited or credited to the profit and loss account as can be seen from the following excerpts: w At each balance sheet date:

1. Monetary items denominated in a foreign currency (e.g. foreign currency notes and loans denominated in a foreign currency) should be reported using the dosing rate.

2. Exchange difference arising on foreign currency transactions should be recognized as income or as expense in the period in which they arise." 6.3.2 The International Accounting standard (IAS - 21) also stipulates the same methodology as can be seen from the following excerpts; M/s. Dharamchand Paraschand Exports “3. At each Balance sheet date, the foreign currency monetary items that result from transactions of the entity should be reported at the dosing rate 4. Exchange difference arising on reporting an entity's long term foreign currency monetary items at rates different from those at which they were recorded during the period or presented in previous financial statements should normally be recognized in income for the period." 6.3.3 In a nutshell, the summary of the appellant's submissions are as under: i) In the first place, the Id. AO has failed to appreciate the characteristics of a Forward contract. Each Forward contract is always assigned with a value that is contracted with creation of a fettered obligation on the assessee to execute and meet at a future contracted date. All the contracts are always enforceable, in as much as realisable. ii) The point that the Id. AO was making was that anticipated liabilities are not allowable, which are notional in nature. But, the distinction in case of Forward contracts is that if an anticipated liability is coupled with present obligation and only quantification can vary depending upon the terms of contract, then a liability is said to have crystallized on the reporting date i.e 31st March. iii) Argument of the Id. AO that an event of contract maturity can only quantify contract value is tenuous and weak. In reality, Forward contracts losses / profits accrue on daily basis depending on the fluctuation of US$ and Indian Rupee. Any prudent person would constantly monitor the position of forward contract value on daily basis to assess the impact of profit or loss. It may be appreciated that values of outstanding position of Forward contract is clearly measurable based on daily position of spot rate of US $ against the Rupee, so is it also measurable with complete accuracy, as on the last date of the Balance sheet. iv) Cut-off of 31st March splits profits / losses of outstanding position of forward contracts into two different accounting periods, and that is the only rational way to evaluate profit / loss in a given period. Loss, although purported to be stated by the Id. AO to be notional, is actual and quantifiable. Loss had occurred and accrued, as a result of conversion. Only thing is that such a loss in the subsequent period would get either further aggravated or get placid, depending upon the foreign exchange fluctuation that may happen against the rupee. v) Foreign exchange loss as a result of conversion of outstanding position of Forward contracts is – M/s. Dharamchand Paraschand Exports • real • quantifiable with precision • based on commercial accounting principles • as a result of cut-off • in consonance with the Accounting standard -11 issued by the Institute of Chartered Accountants of India • allowable 6.3.4 With regard to the claim of loss of ? 1,99,35,578/- on account of revaluation of outstanding foreign exchange forward contract, I am inclined to agree with the submissions of the appellant as these are backed by the binding judicial decisions that apply on all fours to the facts obtaining in the impugned .appeal before me. 6.3.5 Similar question arose in the case of CIT "v. Woodward Governor India (P) Ltd., [2009] 312 ITR 254 (SC) that whether the loss arising on fluctuation of exchange in respect of loan taken for revenue purpose is allowable as deduction in the year of fluctuation of exchange rate or whether the same could be allowed only in the year of repayment of such loan. The Supreme Court held that the loss suffered by the assessee on account of exchange difference on the balance sheet date is an item of expenditure as on balance sheet date. It further held that profits or losses as per mercantile system of accounting and as per the applicable accounting standard is allowable as deduction unless the system of accounting is superseded or modified by the legislative enactment. It also held that the method of accounting continuously undertaken by the assessee is supreme as there is no finding given by the AO on the correctness and completeness of accounts or any finding to the contrary that the assessee has not complied with the accounting standards. It was, inter alia, concluded as under: "......, in order to find out if an expenditure is deductible the following have to be taken into account: (i) 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 assessee from the very beginning and if there was a change in the system, whether the change was bona fide; (Hi) 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 account books both in respect of losses and gains is as M/s. Dharamchand Paraschand Exports per nationally accepted accounting standards; (vi) whether the system adopted by assessee is fair and reasonable or is adopted only with a view to reducing the incidence of taxation." 6.3.6 In the case of Dy. CTT (International Taxation) v. Bank of Bahrain & Kuwait [2010] 41 SOT 290 , Hon'ble Special Bench of Mumbai Tribunal held that losses incurred by the appellant on account of revaluation of the contract on the last date of the relevant accounting period based on the RBI guidelines/applicable accounting standard is allowable as deduction. It held that such loss is neither notional nor contingent liability in which the moment binding contract is enacted, it becomes allowable. In this case, forward contracts were entered of an amount to fluctuations in the foreign currency held as stock-in-trade. Forward contracts value entered by Bank of Bahrain & Kuwait had nothing to do with the foreign currency held as stock-in-trade except protecting fluctuations, while of course dealing with reporting in Indian currency. On the same footing, in the instant case of the appellant stock as we!! as receivable mainly are dollar denominated and are realizable in foreign currency. To hedge possible fluctuations in US$ denominated stock, as well as resultant debtors out of such stock, the appellant had entered into forward contracts. The proposition in that case, as well as in this case is starkly similar. They being bank had "Money" lying in foreign currency as their stock-in-trade, which required translation into Indian currency for the purpose of Indian reporting and Indian taxation, which would naturally expose them to fluctuation risk. To hedge such risk, they had entered into forward contracts, and had made year-end conversion on outstanding position of the forward contracts, although such forward contracts were never reflected in their Balance sheet, and losses so incurred as a result of transfer had unrealized at the point of conversion. On the same analogy, the appellant's stock, eventually although gets realized mostly in terms of foreign currency, they needed to translate the same into Indian currency for Indian reporting and Indian taxation. This exposed them to the exchange fluctuation risk, if the Rupee would appreciate against the US$. In both the cases, that is of Bank of Bahrain & Kuwait and the present appellant, foreign currency positions were hedged by entering into Forward contracts, and had incurred year-end forward contract conversion losses. Further reliance is placed on Bharat Earth Moversv. O7~[2000] 245 ITR 428/ 112 Taxman 61. 6.3.7 In the case of BHARAT EARTH MOVERS LTD (supra), the court has differentiated between what is accrued liability and contingent liability. The relevant portion of the principles laid down by the Hon'ble court is reproduced as under:  For an assesses maintaining his account on the mercantile system, a liability already accrued, through to be discharged at M/s. Dharamchand Paraschand Exports future date would be a proper deduction while working out the profits and gains of his business, regard being had to the accepted principles of commercial and accountancy. It is t as if such deduction is permissible only in the case of amount actually expended or paid.  Just as receipts though not actual receipts but accrued and due are brought in for income tax assessment so also liabilities accrued due would be taken into account while working out the profits and gains of the business.  A condition subsequent, the fulfillment of which may result in the reduction or even extinction of the liability, would not have the effect of converting that liability into a contingent liability.  Distinguishing and differentiating contingent and accrued liability, it was held that; • If a business liability has definitely arisen in the accounting year, the deduction should be allowed although the liability may have to be quantified and discharged at a future date. • What should be certain is the incurring of the liability. • It should be also be capable of being estimated with reasonable certainty though the actual quantification may not be possible. 6.3.8 Further, in the case of Rusabh Diamonds v. Assistant Commissioner of Income-tax - 15(1), Mumbai [2013] 34 taxmann.com 160 (Mumbai - Trib.), in dated April 26, 2013, it has been, inter alia, held as under: "8.1 The assessee considered Rs. 5,20,70,149 as operating income on account of foreign exchange gain arising on forward contracts. The assessee contended that the exchange gain arising on cancellation of forward contracts are to be considered as part of operating profit since it is an integral part of the business of buying and selling of the diamonds and hence, is an operating income. The TPO did not accept the claim of the assessee for the reason that the exchange gain earned are against cancellation of forward contracts and the assessee has separately disclosed as profits and gains from foreign exchange fluctuations, which are not included in purchases and sales. Further, the TPO was of the view that this constitutes speculative and therefore, the same cannot be treated as part of the main business activity of manufacturing of diamonds of the assessee. 8.2 The DRP concurred with the view of the TPO on the ground that the foreign exchange earnings are against cancellation of forward contracts and not integral part of the assessee's business. 9 . Before us, the Id Sr counsel for the assessee has submitted that the assessee earned M/s. Dharamchand Paraschand Exports foreign exchange on cancellation of forward contracts which are connection of its purchase/sales of diamonds. Foreign exchange gain is directly dependent on the activity of import undertaken by the assessee. The assessee has entered into forward contracts for the purpose of reducing the foreign exchange risk faced by it in respect of its transactions with AEs. He has further submitted that foreign exchange fluctuation gain has been earned by the assessee under the hedging contract which is duly backed by the sales and purchase contract /orders in respect of diamonds. The Id Sr counsel has further contended that dealing in foreign exchange being treasury transaction is not permitted by the RB1 and therefore, the gain arising from the forward contracts is part and parcel of operating profit of the assessee. In support of his contention he has relied upon the decision of the Bangalore Benches of the Tribunal in the case of SAP Labs India (P.) v ACIT in in the case of Bombay Diamond Co Ltd. v. Dy. CIT in ITA No.7488/Mum/O7; in the case of CIT v. Badridas Gauridu (P.) Ltd. f20O37 261ITR 256 /[20041134 Tax/nan 376 (Bom). He has further submitted that the premium or discount arising at the inception of forward exchange contracts is amortized as expense or income over the life of contract. The exchange difference on such contract are recognized in the profit & loss account for the year in which the exchange rate changes resulting in the profit or loss arising on cancellation or renewal of forward exchange contract is recognized as income or as expenses. 9.1 The Id DR on the other hand has submitted that as per OECD guidelines on the Transfer Pricing, the foreign exchange gain or loss should be excluded or included depends on whether or not the tested party is responsible for the same. He has referred paras 2.82 of the OECD guidelines and submitted that when, as per the contract between and assessee and the AE, the AE has assumed the risk of foreign exchange fluctuation; then exchange gain cannot be included in the profit of the assessee for the purpose of determination of net margin. The Id DR has referred the TP study at page 10 of the paper book and submitted that risk of foreign exchange fluctuation upto 3% in USD is to be earned by the AE. Therefore, the same cannot be included to the profit of the assessee for the purpose of computation of operating profit of the assessee.

10. We have considered the rival submissions as well as the relevant material on record. The assessee has entered into forward contracts for the purpose of hedging of foreign • currency exposure on export and import of diamonds with AEs. Therefore, the hedging of foreign currency has nexus with the export and import activity of the assessee and the exposure of the assessee in relation to the export and import. The OECD guidelines in para 2.82 are as under; M/s. Dharamchand Paraschand Exports "2.82 Whether foreign exchange gains and losses should be included or excluded from the determination of the net profit indicator raises a number of difficult comparability issues. First, it needs to be considered whether the foreign exchange gains and losses are of a trading nature (e.g. exchange gain or loss on a trace receivable or payable) and whether or not the tested party is responsible for them. Second, any hedging of foreign currency exposure on the underlying trade receivable or payable also needs to be considered and treated in the same way in determining the net profit. In effect, if a transactional net margin applied to a transaction in which the foreign exchange risk is borne by the tested party, foreign exchange gains or losses should be consistently accounted for (either in the calculation of the net profit indicator or separately)." 10.1 It is clear that in case of hedging of foreign currency exposure on the underlining trade receivable or payable the profit of loss will be treated in the same way in determining the net pro fit. 10.2 In view of the facts that the assessee has entered into forward contracts for the purpose of hedging of foreign currency exposure on the export and import of diamond, the gain or loss arising of the said, will be treated as part and parcel of the operating profit" (Emphasis supplied) 6.3.9 In the decision rendered on 9th January, 2013 in the case of Society General (2013-ITS-737-ITAT), the Hon'ble Mumbai Tribunal has allowed a similar claim of the assessee for the loss of Rs. 9.16 crores on foreign exchange contracts outstanding as on 31-3-1998 holding that this issue is squarely covered in favour of the assessee by the decision of the Special Bench of HAT in the case of Bank of Bahrain & Kuwait (supra). 6.3.10. Hon'ble Mumbai ITAT "H" bench in the case of H. Dipak & Co., Mumbai on 30 April, 2013 has held that- "We have heard the arguments of both the sides and also perused the relevant material available on record. It is observed that a simitar claim for marked to market loss claimed by the assessee in respect of forward foreign exchange contract debited to the P&L account has been allowed by the Special Bench of this Tribunal in the case of Bank of Bahrain & Kuwait (supra) after discussing and considering all the relevant aspects of the matter and the relevant observations of the tribunal recorded in this context are summarized as under:- (i) A binding obligation accrued against the Appellant the minutes(sic) it entered into forward foreign exchange contracts.

M/s. Dharamchand Paraschand Exports (ii) A consistent method of accounting followed by the Appellant cannot be disregarded. The Appellant has consistently followed the same method of accounting in regard to recognition of profit or loss both, in respect of forward foreign exchange contract as per the rate prevailing on March, 31. (iii) A liability is said to have crystallized when a pending obligation on the balance sheet date is determinable with reasonable certainty. (iv) As per A5-11 when the transaction is not settled in the same accounting period as that in which it occurred, the exchange difference arises over more than one accounting period. (v) In view of the decision of the Supreme Court in the case of Woodward Governor India (I) P. Ltd., the Appellant's claim is allowable. (vi) In the ultimate analysis, there is no revenue effect and it is only the timing of taxation of loss/profit." 6.3.11 Further, the issue of allowing the loss on account of revaluation of pending forward contracts is covered by the Honble. ITAT Mumbai bench in the case of M/s Bhavani Gems Vs ACIT CC-35 in dated 30/3/2011 for A.Y 2006-07 and the said loss was allowed as business loss and the issue was held to be covered by Special Bench decision in the case of DOT Vs. Bank of Bahrain. 6.3.12 In the case of DIT(IT)-I vs. Citi Bank N.A. in ITA No 330 of 2013 dated 11-03-2015, Hon'ble Bombay High Court has held as under: "11. The question as formulated by the Revenue has been allowed by the Tribunal in the impugned order by following the decision of its Special Bench in DOT v/s. Bank of Bahrain & Kuwait 132 TTJ/(Mum.)/505. Mr. Tejveer Singh, Counsel appearing for Revenue states that Revenue has not filed any Appeal against decision of the Special Bench in the case of Bank of Bahrain and Kuwait (supra). However, there is no ground made out in the appeal memo or in any affidavit as to why the Revenue is preferring an Appeal against the impugned order on the above issue when an identical question decided by the Special Bench of Tribunal in Bank of Bahrain and Kuwait(supra) has been accepted by the Revenue. Therefore, for the reasons indicated while dealing with Question (b) above, the appeal need not be entertained.