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Income Tax Appellate Tribunal, MUMBAI BENCH “A”, MUMBAI
Before: Shri Mahavir Singh & Shri G Manjunatha
O R D E R Per G Manjunatha, AM : These two appeals filed by the assessee are directed against separate but identical orders of the CIT(A)-9, Mumbai dated 17-11-2011 and 24-09-2012 for the assessment year 2007-08 and 2008-09, respectively. Since facts are identical and the issues are common, for the sake of convenience, these appeals were heard together and are disposed of by this common order. 2. The brief facts of the case, as extracted from are that the assessee company engaged in the business of import of rough
2 ITA 8612/um/2011 & 6991/Mum/2012 diamonds, polishing and export of polished diamonds, filed its return of income for the assessment year 2007-08 on 18-10-2007 declaring total income of Rs.26,13,41,450. The case was selected for scrutiny and statutory notices u/s 143(2) and 142(1) were issued. In response to notices, the authorized representative of the assessee appeared from time to time and furnished the details, as called for. The assessment was completed u/s 143(3) on 29-12-2012 determining the total income at Rs.28,27,65,840 interalia making disallowances u/s 14A, disallowance of interest u/s 36(1)(iii) and disallowance of speculation loss. Aggrieved by the assessment order, the assessee preferred appeal before CIT(A).
The CIT(A), for the detailed reasons recorded in his order dated 17-11- 2011, partly allowed appeal filed by the assessee wherein he restricted disallowance of expenditure incurred in relation to exempt income u/s 14A r.w.r. 8D of Rs.29,82,050 out of total disallowance worked out by the AO at Rs.31,91,936. Insofar as disallowance of loss incurred on foreign exchange, the CIT(A) confirmed disallowance made by the AO by holding that the loss incurred by the assessee on account of forward contracts is in the nature of speculative transactions covered u/s 43(5) of the Income-tax Act, 1961.
Aggrieved by the order of CIT(A), the assessee is in appeal before us. 4. The first issue that came up for our consideration is disallowance of 3 ITA 8612/um/2011 & 6991/Mum/2012 exchange fluctuation loss on forward contracts. The factual matrix of the case which leads to the impugned dispute are that the assessee is in the business of import and export of diamonds, has entered into forward contracts with its bankers to mitigate the possible loss on account of fluctuation in foreign currency and the resultant loss on account of pre-closure / maturity of forward contracts and marked to market losses at the end of the financial year of outstanding forward contracts has been treated as business loss. As stated earlier, the assessee is in the business of import of rough diamonds and re- export of polished diamonds. During the financial year relevant to AY 2007-08, the assessee achieved turnover of Rs.1,018.83 crores. The assessee has entered into 2,280 forward contracts transactions with regard to export receivables and import payables. The assessee has earned gain on forward contracts which has been treated as business profit. The assessee also incurred fluctuation loss in respect of forward contracts which has been treated as business loss and the net effect of gains / loss has been either treated as foreign exchange loss or gain. During the course of assessment proceedings, the AO called upon the assessee to explain as to why exchange fluctuation loss cannot be disallowed as speculation loss within the meaning of section 43(5) of the I.T. Act, 1961. In response to notice, the assessee submitted that it is in the business of import / export of diamonds and to 4 ITA 8612/um/2011 & 6991/Mum/2012 hedge its export receivables and payables enters into forward contract with its bankers to mitigate possible loss on account of fluctuation in foreign currency and the resultant gains / loss has been treated as business loss. The assessee further submitted that it is consistently following the accounting method wherein marked to market gain / loss in respect of all assets or liabilities denominated in foreign currency is being consistently recognized in the books of account. The assessee further submitted that the term marked to market (MTM) loss in connection with forward contract refers to gain or losses computed on a particular date with reference to prevailing exchange rate in respect of forward contracts. In other words, the term crystallized loss refers to the losses crystallized and debited to P&L Account, whereas marked to market losses are provision created in the books of account towards loss / gain in fluctuation in currency as on the valuation date. The assessee further submitted that its forward contracts are entered into to hedge the currency risk associated with the normal business transactions. These derivative contracts are entered into within the framework of relevant RBI guidelines including quantum limits set by RBI. The intent of entering into derivative contracts was to safeguard interest against exchange rate fluctuation risk on foreign currency receivable / payable and not to carry on separate business activity in dealing with currency. The assessee further submitted that these
5 ITA 8612/um/2011 & 6991/Mum/2012 transactions are directly linked to normal business activity and have direct and proximate nexus to the business of the assessee. Though it is difficult to make one to one co-relation between forward contracts and its export receivable / payable, the total value of forward contracts entered during the period does not exceed its exposure in foreign currency in the form of export receivables / export payables and other foreign currency transactions in the form of loans, etc. Therefore, it has rightly treated loss incurred on forward contracts as its business loss. In support of its arguments, the assessee relied upon plethora of decisions including the decision of Hon’ble Supreme Court, in the case of Woodward Governor vs CIT 312 ITR 254(SC) and also the Special Bench of the ITAT, in the case of Bank of Bahrain & Kuwait (2010) 5 ITR (Trib) 301 (Mum).
The AO, after considering the explanations given by the assessee observed that the assessee failed to link any of the transactions in forward contracts with specific bills receivables / bills payables so as to characterize them as hedging transactions. All the contracts were either cancelled or matured otherwise than by taking actual delivery. The AO further observed that though the assessee has import and export activity and obligation in foreign currency in the form of export receivables / import payables, failed to link any of its bills to the forward contracts. Therefore, he opined that the assessee was conducting systematic and organized activity of forward and 6 ITA 8612/um/2011 & 6991/Mum/2012 option contracts and the assessee’s forward contracts are in the category of speculative transactions. The AO further referring to the circular of CBDT ,dated 23-10-2010 observed that as per this circular of CBDT any eligible transaction in respect of trading in derivatives referred to in clause (ac) of section (2) of Securities’ Contracts (Regulations) Act, 1956, that has been carried out in a recognized stock exchange shall not be treated as speculative transactions. The assessee had not carried out any transaction in recognized stock exchange. Therefore, he opined that they are in the nature of speculative transactions as provided in section 43(5) and hence, loss incurred on forward contracts cannot be allowed as deduction against business profits.
The AO has extensively discussed the provisions of section 43(5) of the Act, the circular issued by the Board and certain decisions to come to the conclusion that forward contracts entered into by the assessee with its bankers are settled otherwise than delivery and majority of them were forward and option contracts where delivery was not taken. The AO further observed that hedging transactions take place normally to guard against possible loss in foreign currency movements, whereas speculative transactions are normally entered into to make profit by speculation or camouflaging; therefore, there is a difference between hedging transactions and speculative transactions. The facts clearly indicate that forward contracts entered into by the assessee are 7 ITA 8612/um/2011 & 6991/Mum/2012 clearly in the nature of speculative transactions, therefore, loss on such forward contracts cannot be allowed as deduction; accordingly the AO disallowed exchange loss and added back to the total income of the assessee.
The Ld.AR for the assessee submitted that the Ld.AO, on a mistaken fact that loss incurred by the assessee on account of forward contracts represent loss in respect of cancellation of forward contracts and being speculative in nature is not allowable as per the provisions of section 43(5) of the Act. But in reality, this loss is on account of outstanding forward contracts (marked to market) at the year end in accordance with method of accounting regularly followed by the assessee, as per Accounting Standard 11 issued by Institute of Chartered Accountants of India (ICAI). The Ld.AR further submitted that the assessee has entered into forward contracts to hedge its export receivables / payables to mitigate possible loss on account of fluctuation in foreign currency which are in the nature of hedging transactions, therefore, the AO was erred in treating the forward contracts as speculative transactions u/s 43(5) of the Act.
The Ld.AR referring to the paper book filed submitted that the assessee has entered into various forward contracts and the total value of such contracts does not exceed its exposure to foreign currency in the form of export receivables / payables. Though the assessee is not able to have one to one co- relation between forward contracts and its export bills receivables / payables,
8 ITA 8612/um/2011 & 6991/Mum/2012 at any point of time, value of its forward contracts does not exceed total receivables / payables from its business. It is further submitted that the assessee has recognized loss on forward contracts terminated / matured as crystallized losses are debited to the P&L Account. In respect of forward contracts which are outstanding at the year end has been marked to market based on the prevailing exchange rate on the valuation date in accordance with the consistent accounting practices followed as per the AS-11 issued by ICAI. The assessee has furnished all the details in respect of its forward contracts to prove that its forward contracts are in the nature of hedging transactions, but not speculative transactions as defined u/s 43(5)(d). The AO ignored all the evidences filed by the assessee to treat forward contract as speculative transactions merely on the sole ground that the assessee has not filed one to one co-relation between forward contracts and its bills receivables / payables. In this regard, he relied upon the decision of Hon’ble Supreme Court in the case of Woodward Governor (I) Pvt Ltd vs CIT (supra) and ITAT Special Bench, in the case of Bank of Bahrain & Kuwait (supra).
On the other hand, the Ld.DR strongly supported order of the CIT(A) and submitted that the assessee has failed to link any of its forward contracts with specific bills so as to be categorized them as hedging transactions. All the contracts are cancelled otherwise than by taking actual delivery. The AO has 9 ITA 8612/um/2011 & 6991/Mum/2012 brought out the clear facts to the effect that forward contracts entered into by the assessee are not covered under exceptions provided in section 43(5)(d) nor in the Board’s Circular No.3 of 2010 dated 23-10-2010 as derivatives referred to in clause (ac) of section 2 of Securities’ Contracts (Regulations) Act, 1956, has been carried out in a recognized stock exchange. Therefore, the AO has rightly treated the loss incurred on forward contracts as speculative loss and his order should be upheld.
We have heard both the parties, perused the materials available on record and gone through the orders of authorities below. The AO disallowed exchange loss incurred by the assessee on forward contracts on the ground that the forward contracts are in the nature of speculative transactions covered by provisions of section 43(5) of the Income-tax Act, 1961. The AO further observed that the assessee is not able to link one to one co-relation between forward contracts and export bills receivables / payables. According to the AO, a loss incurred on unmatured outstanding forward contracts at the end of the financial year is a notional loss which is marked to market as per the prevailing exchange rate as on the valuation date which is a contingent liability but not an ascertained liability and hence, cannot be allowed as deduction.
The AO further observed that the assessee is carrying out speculative transactions by entering into forward contracts in organized and systematic
10 ITA 8612/um/2011 & 6991/Mum/2012 manner. It was further observed that in order to characterize a particular transaction under hedging, it should be linked to bills receivables or payables in respect of its export business. The AO has extensively discussed provisions of section 43(5), hedging transactions, speculative transactions and circular of Board to come to the conclusion that forward contracts entered into by the assessee are not in the nature of hedging transactions entered in order to minimize exchange fluctuation loss in currency movement. The AO finally concluded tht forward contracts entered into by the assessee are in the nature of speculative transactions. According to the AO only those forward contracts which are settled by delivery are in the nature of derivative transactions, which comes under hedging. In other words, if forward contracts are closed / matured otherwise than by way of actual delivery than they are in the nature of speculative transactions.
10. The basic fact with regard to the nature of business of the assessee and its export receivables / payables are not disputed. The assessee is in the business of import of rough diamonds and export of polished diamonds. During the financial year relevant to AY 2007-08, the assessee has achieved more than 1018 crores export turnover. The assessee also has outstanding bills receivables from its exports and outstanding payables for import of diamonds.
The assessee claims that at any point of time its export receivables / payables
11 ITA 8612/um/2011 & 6991/Mum/2012 (exposure to foreign currency) is more than total value of its forward contracts; however, accepts that one to one co-relation between forward contracts and outstanding bills receivables / payables is not feasible. We find that the assessee has entered into more than 2200 forward contracts in the year.
However, the total value of such forward contracts are not readily available.
Even both the lower authorities orders are silent about value of total forward contracts. The AO is only on the point that forward contracts entered into by the assessee are settled otherwise than by actual delivery and the assessee is not able to have one to one co-relation between export bills receivables / payables. The AO never disputed the fact that the assessee’s exposure in foreign currency in the form of bills receivables / payables is not more than its value of forward contracts. Therefore, one has to see the nature of forward contracts entered into by the assessee are fit into the definition of hedging transactions entered into to mitigate the possible loss in fluctuation in currency movement of / or speculative transaction as defined in section 43(5).
The assessee claims that loss incurred on maturity / closure of forward contracts has been treated as crystallized liability and debited to the P & L Account. Loss incurred in respect of contracts outstanding at the year end has been marked to market based on the prevailing exchange rate in accordance with the method of accounting regularly followed in its business as per AS-11
12 ITA 8612/um/2011 & 6991/Mum/2012 issued by ICAI. The assessee further contended that it is following this method of accounting consistently for the past several years. The assessee further contended that it is not the case of the AO that only loss incurred on forward contracts has been treated as business los,s but even gain on forward contracts has been treated as business profits. The AO conveniently ignored the gain on forward contracts and has disallowed loss incurred on forward contracts on the ground that these are in the nature of speculative transactions as defined in section 43(5).
The provisions of section 43(5) deals with speculative transactions. As per section 43(5), speculative transaction means a transaction in which a contract for the purchase / sale of any commodity including stock and shares is periodically or ultimately settled otherwise than by actual delivery or transfer of the commodity or scrips. The proviso provided to section 43(5) excludes a contract in respect of raw materials or merchandise entered into by a person in the course of its manufacturing or merchanting business to guard against loss through future price fluctuations in respect of his contracts for actual delivery of goods manufactured by him or by merchandise sold by him.
Similarly clause (d) of proviso provides for exclusion of an eligible transaction in respect of trading in derivatives referred to in clause (ac) of section (2) of Securities Contracts (Regulations) Act, 1956 carried out in a recognised stock
13 ITA 8612/um/2011 & 6991/Mum/2012 exchange. Therefore, in order to categorise that a particular forward contracts are in the nature transaction is in the nature of speculative transaction or hedging transaction, one has to see the nature of business of the assessee and its exposure to foreign currency. In case the assessee is able to link one to one co-relation between its forward contracts with its bills receivables / payables then certainly, the forward contracts entered by the assessee are definitely in the nature of hedging transactions which cannot be categorised as speculative transactions. In case the assessee is not able to have one to one co-relation then atleast its exposure to foreign currency during the relevant period should be more than the value of its forward contracts.
In this case, there is no dispute with regard to the exposure to foreign currency. The assessee is having exposure to foreign currency in the form of export receivable / import payables. The only dispute is with regard to whether the assessee is able to have one to one co-relation between forward contracts and its bills receivables / payables. The AO opined that they are in the nature of speculative transactions as defined u/s 43(5) of the Act.
The assessee has filed paper book which contains the details of forward contracts entered into during the year, export receivables / payables and total turnover from its export activities. Both the lower authorities did not throw any light on the aspect of turnover of the assessee from its export activity, its 14 ITA 8612/um/2011 & 6991/Mum/2012 exposure to foreign currency in the form of bills receivables / payables and obligations. Though the assessee has filed a chart explaining the export turnover, value of forward contracts, its export receivables / payables to contend that at any point of time, its exposure to foreign currency is more than value of forward contracts entered into during the relevant period, the fact remains that the assessee is not able to file one to one co-relation between its forward contracts and export receivables / payables. Since the AO as well as the CIT(A) have not considered the claim of the assessee that its exposure to foreign currency is more than the value of its forward contracts. It is also an admitted fact that the assessee’s case is not covered by the exception provided u/s 43(5)(d) of the Income-tax Act, 1961. The sub clause (d) of section 43(5) deals with cases of derivative transactions carried out in the recognized stock exchange. In this case, it is an undisputed fact that the assessee has not carried out its forward contracts through recognized stock exchange. The assessee has entered into forward contracts with its bankers. Therefore, to ascertain forward contracts entered into by the assessee are hedging transactions or speculative transactions, forward contracts have to clear the basic test provided for examining the nature of transactions of hedging and speculative transactions.
The Ld.AR for the assessee heavily relied upon the decision of Hon’ble
15 ITA 8612/um/2011 & 6991/Mum/2012 Supreme Court in the case of Woodword Governor (I) Pvt Ltd (supra) and argued that loss incurred on foreign exchange fluctuation of revenue account on marked to market basis is not notional loss and the same is allowable u/s 37 of the Income-tax Act, 1961. No doubt, the Hon’ble Supreme Court has considered the issue of marked to market losses incurred on foreign exchange fluctuation on revenue account and gave a categorical finding that if the assessee provides loss on forward contracts on the basis of marked to market by following the method of accounting regularly followed in its business as prescribed by AS-11 issued by ICAI then the same cannot be treated as notional loss. However, the basic questions with regard to nature of transactions whether a particular transaction is a speculative transaction or hedging transaction, is not disputed by the Hon’ble Court. First of all, the assessee has to prove that its forward contracts are in the nature of hedging transactions entered into to mitigate possible loss on fluctuation in foreign currency, but not speculative transaction entered into trading in currency.
Therefore, we are of the view that prima facie the case of the assessee is covered by the decision of Supreme Court in the case of Woodword Governor (I) Pvt Ltd (supra) because the assessee has profit / loss on fluctuation in respect of its forward contracts on the basis o marked to market at the end of the financial year based on the prevailing exchange rate. However, the 16 ITA 8612/um/2011 & 6991/Mum/2012 assessee has failed to prove the basic test provided for categorizing that its forward contracts are in the nature of hedging transactions. Even the lower authorities have failed to appreciate the facts in the right perspective in the light of the arguments of the assessee that its forward contracts cannot be linked to its export bills receivables / payables, but total value of its forward contracts is not more than its exposure to foreign currency in the form of receivables / payables. Therefore, we are of the considered view that the issue needs to be re-examined by the AO in the light of above discussions. Hence, we set aside the issue to the file of the AO and direct him to consider the issue afresh after affording opportunity of hearing to the assessee for the AY 2007- 08 and 2008-09.
The next issue that came up for our consideration is disallowance of expenditure incurred in relation to exempt income u/s 14A r.w.r. 8D(2)(i) and 8D2)(iii) of I.T. Rules, 1962. During the course of assessment proceedings, the AO noticed that the assessee has earned dividend income of Rs.1,60,00,000 from group companies which has been claimed as exempt u/s 10(34). The AO further observed that the assessee has made investment in group companies at Rs.5,96,41,000. As per the financial statements, the assessee has taken secured loans of Rs.469.30 crores and has paid interest of Rs.44 crores.
Therefore, issued a show cause notice and asked as to why expenditure
17 ITA 8612/um/2011 & 6991/Mum/2012 incurred in relation to exempt income shall not be disallowed u/s 14A r.w.r.
8d(2)(i) and (iii). In response to notice, the assessee, vide its letter dated 23- 12-2-2010 has stated that no direct expenditure has been incurred on earning exempt income. The assessee further stated that no specific borrowings were made for making investments and that no interest expense has been directly attributable to any particular income or receipt. The AO, after considering the explanations of the assessee observed that the assessee has not been able to corroborate with relevant evidence with the investment made in exempt income yielding products have been made out from the interest free funds. No casah flow valuation statement or any other working has been furnished to explain the availability of interest free funds to make investments in group companies. As regards the other expenses, considering the volume of the investments made and income earned, it is not possible for the assessee to earn income in vacuum without allocating considerable resources including the time and the management of the manpower. Therefore, he invoked provisions of section 14A and worked out the disallowance as per the formula prescribed in Rule 8D and determined disallowance of Rs.31,91,936.
Aggrieved by the assessment order, the assessee preferred appeal before CIT(A). Before CIT(A), assessee reiterated the submissions made before the AO. The assessee further contended that no interest bearing funds has been 18 ITA 8612/um/2011 & 6991/Mum/2012 used for making investments in companies which yielded dividend income.
Therefore, the AO was incorrect in disallowing interest u/s 14A. As regards expenditure, the assessee has not incurred any specific expenditure in relation to investments made in companies, which yielded dividend income, therefore, the question of disallowance of expenditure u/r 8D(2)(iii) does not arise. The CIT(A), after considering the relevant submissions of the assessee and also by relying upon the decision of Hon’ble Bombay High Court in the case of Godrej & Boyce Mfg Co. Ltd reported in 234 DTR 1 observed that wef AY 2008-09 disallowance provided u/s 14A should be determined in accordance with Rule 8D. The CIT(A) further observed that in respect of AY 2007-08 though the rule is not directly applicable, the AO is bound to determine expenditure incurred in relation to exempt income having regard to the facts and circumstances of the case. In this case, the assessee has failed to prove the availability of interest free funds to explain the investments which yielded exempt income.
Though the assessee has claimed that no specific expenditure has been incurred in relation to exempt income, the possibility of expenditure in the form of general administration and other expenses cannot be ruled out. Since the assessee has not furnished any details with regard to the expenditure incurred in relation to exempt income, the possibility of expenditure in the form of general administration and other expenses cannot be ruled out. Since
19 ITA 8612/um/2011 & 6991/Mum/2012 the assessee has not furnished any details with regard to expenditure incurred in relation to exempt income, the AO was right in application of reasonable method in determining disallowances having regard to all the facts and circumstances of the case. With these observations, he restricted the disallowance to 5% of the investment made in shares and worked out disallowance of Rs.29,82,050 as against disallowance worked out by the AO at Rs.31,99,936.
Facts remain unchanged. The assessee failed to bring on record any evidence to controvert the finding of the lower authorities. Though the Ld.AR contended that the AO has not established link between expenditure incurred by the assessee to earn exempt income, failed to prove that the assessee has not incurred any expenditure in the backdrop of the clear findings of the AO as well as the CIT(A) that the assessee has paid huge interest on borrowings and also incurred common expenditure like general administration and other expenses. Therefore, we are of the view that the CIT(A) was right in restricting disallowance to 5% of the value of investments. We do not find any error in the order of CIT(A). Hence, we are inclined to uphold the order of CIT(A) and dismiss the ground raised
by the assessee.
17. The next issue that came up for our consideration for AY 2008-09 is disallowance of interest u/s 36(1)(iii) for diversion of interest bearing funds.
20 ITA 8612/um/2011 & 6991/Mum/2012 The AO disallowed interest on loans u/s 36(1)(iii) on the ground that the assessee had invested interest bearing funds of Rs.5,38,90,790 for acquiring capital assets. The AO further observed that the assessee has paid huge interest expenses of Rsa.44 crores on loans borrowed from banks and financial institutions. Therefore, he opined that interest paid on loans borrowed to the extent of fund diversion for acquiring capital assets cannot be allowed as deduction u/s 36(1)(iii) of the Income-tax Act, 1961. The CIT(A), after considering the relevant facts and also relying upon the provisions of section 36(1)(iii) and also relying upon the decision of Hon’ble Punjab & Haryana High Court in the case of Power Drugs Ltd vs CIGT (2011) 245 ctr 623 & CIT vs Vardhman Polytex Ltd 214 CTR 561 held that no deductions will be allowed in respect of any amount of interest paid for the period beginning from the date on which the capital asset was borrowed for the acquisition of the asset till the date on which such asset was first put to use. Admittedly, in the case the relevant premises were never put to use; hence, interest for the initial idle period is inadmissible. The relevant portion of the CIT(A)’s order is extracted below:-
“5.2.7 In CIT Vs Vardhman Polytex Limited (2008) 214 CTR (P&H) (FB) 561, Hon'ble Full Bench of P&H High Court held that provisions of s. 36(1)(iii) and Expln 8 to s. 43(1) have to be read in conjunction with each other and therefore, interest paid on amount borrowed for acquisition of new assets for the period before such assets
21 ITA 8612/um/2011 & 6991/Mum/2012 are first put to use is to be capitalized. Proviso to Sec 36(1)(iii) is clarifactory and has made explicit what was implicit. Having regard to the facts and circumstances, the disallowance of interest of Rs.49,47,188/- as disallowed by the LAO, vide para no. 5 of the impugned assessment order, is confirmed. Ground of appeal no.1 is dismissed.”
18. Facts remain unchanged. The assessee fails to bring on record any evidences to rebut the findings of facts recorded by the CIT(A). Though the assessee has relied upon the decision of Hon’ble Supreme Court in the case of Vardhman Polytex Ltd (supra), in the backdrop of the clear findings of the AO and CIT(A) that the assessee has failed to explain the availability of interest free funds to explain acquisition of capital asset, interest paid on loans borrowed has to be disallowed u/s 36(1)(iii) for diversion of funds for acquisition of capital asset. Therefore, we are inclined to uphold the order of the CIT(A) and reject the ground raised by the assessee.
19. With regard to appeal in AY 2008-09, identical grounds are taken by the assessee. There is no change in facts and circumstances of this year, too. Therefore, the discussion and the decisions arrived at above, while dealing with the appeal for AY 2007-08 equally apply to this appeal.
In the result, both the appeals filed by the assessee are partly allowed, for statistical purpose.
22 ITA 8612/um/2011 & 6991/Mum/2012 Order pronounced in the open court on 04th October, 2017.