ITO 16(2)(4), MUMBAI vs. SURYA GEMS, MUMBAI

Before us, the ld Sr counsel for the assessee has submitted that the assessee earned 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 export or 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 ld Sr counsel has further contended that dealing in foreign exchange being treasury transaction is not permitted by the RBI and therefore, the gain arising from the forward contract 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 Pvt v ACIT in in the case of Bombay Diamond Co Ltd vs DCIT in ITANo.7488/Mum/07; in the case of ITO vs Badradas Gauridu P Ltd, reported in 261 ITR 256(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 arsing on cancellation or renewal of forward exchange contract is recognized as income or as expenses. 9.1. The ld 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 ld 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.

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 hadging of foreign currency exposure on export and import of diamonds with AEs. Therefore, the hadging of foreign currency hasnexus 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; “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).”

Before ld CIT (A), it was contended that the assessee was required to revalue its outstanding forward foreign exchange contracts as per the rates of exchange notified by the Foreign Exchange Dealer‘s Association of India on March 31, every year as per RBI guidelines. The gain or loss on revaluation of the outstanding contracts was booked in the profit and loss account as per the mandatory requirements of RBI guidelines. The assessee relied on the decision of the Hon‘ble Supreme Court in the case of United Commercial Bank v CIT,240 ITR 355 and also on following decisions:-

Ld CIT D.R. Shri Ajit Kumar Sinha submitted that the assessee is carrying on banking business in India and it is not the assessee‘s business to deal in forward contracts. It entered into forward contracts with its clients to buy or sell foreign currency at an agreed price on a future date in order to protect the interest of the bank. He submitted that it is a tool to safeguard the assessee‘s interest. Ld CIT D.R. submitted that these contracts are entered into in order to avoid wide fluctuation in foreign currency. He submitted that there is no dispute in regard to contracts which matured during the year in which they were entered into and the loss/profit was claimed as deduction/income, had been allowed/taxed, accordingly. The dispute is only in regard to those forward contracts, date of maturity of which fall after the end of the accounting year. The assessee revalued its profit/loss on notional basis as per rate of exchange prevailing on the balance sheet date and claimed the same. Ld CIT D.R. submitted that the reference to the Special Bench has been made because the decision of ITAT in the case of Deutsche Bank A.G., 86 ITD 431(supra) and that of the decision of the Hon‘ble Bombay High Court in the case of Bank of India, 218 ITR 371 relied upon by the assessee proceeded on the footing that the securities were stock-in-trade but as far as the forward contract is concerned, the same is not stock-in-trade and, therefore, those decisions are not applicable. He pointed out that there is no material to prove that forward contract to buy or sell foreign currency itself constitutes the stock-in-trade as the assessee does not trade in such forward contract. He, therefore, submitted that the decision which proceeded on the basis of foreign currency being stock-in-trade cannot be relied upon in the present set of facts. He further pointed out that thesetransactions are not recorded in the books of account and hence, there cannot be any liability from income tax point of view. Thus, there cannot be any question of computing any notional loss for the purposes of income tax. He submitted that the foreign exchange contract cannot be considered on the same footing on which foreign exchange currency being stock-in-trade is considered. In this regard, Ld CIT D.R. referred to the decision of the Hon‘ble Supreme Court in the case of CIT v. Woodward Governor of India, 312 ITR 254 (SC) and pointed out that in para 18, while considering the applicability of AS-11, the Hon‘ble Supreme Court noted that exchange difference arising on foreign currency transaction have to be recognized as income or as expenses in the period for which they arise, except as stated in paras 10 & 11, which deals with exchange difference on repayment of liabilities incurred for the purpose of acquiring fixed asset. It was, inter alia, observed that AS-11 stipulates effect of changes in exchange rate vis-à-vis monetary items denominated in a foreign currency to be taken into account for giving accounting treatment on the balance sheet date. Ld CIT D.R. pointed out that in the present case, since no transaction has been entered into in the books of account, there was no monetary item requiring adjustment of exchange rate difference. Ld CIT D.R.thus, submitted that the manner of holding foreign currency is relevant and if the same is held as stock-in-trade then in view of the decision of the Hon‘ble Supreme Court in the case of Woodward Governor of India(supra), the exchange rate difference on the balance sheet date has to be considered for tax purposes. Ld CIT D.R.referred to the decision of the Hon‘ble Bombay High Court in the case of CIT v. Kamani Metals and Alloys Ltd, 208 ITR 1017(Bom), wherein, the facts were that the assessee had entered into a contract with MMTC on August 27, 1974 for purchase of 49,981 kgs copper cathodes at the rate of Rs.33,825/- per M.T. The assessee had opened an irrevocable letter of credit on 28th September, 1974. However, till the end of the relevant accounting year, no material was received by the assessee. The MMTC announced price of copper cathodes at Rs.25,461/- per M.T. for the quarter January to March, 1975. The assessee received the material on 12.3.1975. In the backdrop of these facts, the assessee made a provision amounting to Rs.4,18,021/- for the anticipated loss in the purchase account representing the difference between the contract price and the market price on the date of receipt of the material as the market price of the copper cathodes was less than the contract price. The assessee‘s claim wasallowed by the Tribunal . However, when the matter traveled before the Hon‘ble High Court, it was held that under the contract in question, no raw material was in fact purchased by the assessee during the relevant accounting year. The material was received in the next accounting period on 12.3.1975. The Hon‘ble High Court held that since there was no closing stock of the material in the hands of the assessee and only contract with MMTC was there, therefore, the material contracted to be purchased could not be regarded as assessee‘s stock-in-trade and hence, could not be valued in the accounts as such. Accordingly, the anticipated loss was disallowed by the Hon‘ble High Court. Ld CIT D.R.relying on this decision submitted that this covers the issue before us and on same parity of reasoning; the forward foreign exchange contract remaining unsettled at the closing balance sheet date could not be treated as stock-in-trade.

Ld CIT D.R. further submitted that the decision in the case of Deutsche Bank A.G. (supra) relied upon by ld CIT (A) is not applicable as the same proceeds on a wrong premise that unsettled forward foreign exchange contracts as on balance sheet date constitute the stock-in-trade. Thus, the very premise is wrong on which the decision was delivered. He submitted that the circular No.664 dated 5.10.93 referred to in the case of Deutsche Bank (supra) talks only about securities and not forward contracts. Therefore, the said circular is not applicable in the present facts. Ld CIT D.R.further referred to the decision of the Hon‘ble Supreme Court in the case of Indian Molasses Co. Ltd v CIT, 37 ITR 66 (SC), wherein, the Hon‘ble Supreme Court, inter alia, observed that income tax law does not allow as expenses all the deductions a prudent trader would make in computing his profits. It was further held that in finding out what profits there be, the normal accountancy practice may be to allow as expense any sum in respect of liabilities which have accrued over the accounting period and to deduct such sums from profits. He, therefore, submitted that unless the liability actually accrued on maturity of the contracts, there could not be any allowable expense on account of variation in the rate of exchange as compared to contracted rate at the end of the financial year.

As regards the assessee‘s submissions that the valuation was done as per the guidelines of FEDAI, Ld CIT D.R.submitted that the income or expense is to bedetermined as per the requirements of Income tax Act and as per the guidelines prescribed for preparation of accounts.

Ld CIT D.R.further referred to the decision of the ITAT Calcutta Bench Third Member in the case of Eveready Industries India Ltd v. DCIT, 78 ITD 175 (Cal)™, wherein, it was held that exchange fluctuation loss of un-matured forward covers (i.e. forward contract) could not be allowed on accrual basis. However, since the assessee claimed that such contract got settled during the year and only remittance was made, the issue was set aside to the AO to ascertain the fact and reconsider the claim of the assessee in accordance with law. Ld CIT D.R.referred to section 145 of the I.T.Act and pointed out that as per sub-section (3), if the AO is not satisfied about the correctness or completeness of the accounts of the assessee, or where the method of accounting or accounting standard have not been regularly followed, then the AO can make assessment u/s.144. He submitted that the main object of section 145 is to compute the correct profits and if the correct profits cannot be deduced from the accounts then he has to compute the profits on his own. Ld CIT D.R.further referred to the decision of the Hon‘ble Calcutta High Court in the case of Bestobell India Ltd, 117 ITR 789(Cal), wherein, the facts were that the loan of £ 37,500, being about Rs.5 lakhs was taken by the assessee from its subsidiary company to be repaid at the expiry of one year or earlier. However, the loan could not be repaid within the stipulated period and on account of devaluation of Rupee, there was increase in loan liability on account of sterling loan. It was held that increase in liability was inextricably connected with assessee‘s indebtedness and was capital in nature. Thus, in sum and sub stance, the arguments of Ld CIT D.R.are as under:- i) Unsettled forward foreign exchange contracts does not constitute stock- intrade and, therefore, there is no question of its valuation. ii) No transaction has been recorded in the books of account in regard to unsettled forward foreign exchange contracts and, therefore, there is no question of its valuation being done at the end of the accounting year. iii) The anticipated loss is primarily in the nature of notional liability and, therefore, does not accrue/arise at the end of the previous year and hence, not allowable. iv) The liability accrues or arise only on the date of maturity of the contract and prior to that purely on the basis of estimated liability as per FEDAI guidelines it cannot be allowed under I.T.Act. v) Various decisions relied upon by ld CIT (A) relate to stock-in-trade and not to unsettled forward foreign exchange contract. vi) The issue is squarely covered by the following decisions:-

Shri F.V.Irani, ld Counsel for the assessee submitted that there is no dispute regarding allowability of assessee‘s claim and the only dispute is regarding timing i.e. year of allowability. The whole controversy is whether on the balance sheet date the estimated loss as per the FEDAI notification as per RBI guidelines is accrued loss or notional loss. Ld Counsel for the assessee referred to page 8 para 5.3 of ld CIT (A)‘s order for A.Y. 1998-99 and pointed out that he has taken note of the fact that as per the RBI guidelines, the assessee was required to revalue its outstanding foreign exchange forward contract as per the rates notified by the FEDAI on March 31st every year. Ld Counsel submitted that the assessee had to re-assess the anticipated loss at the end of the year in accordance with the method of accounting consistently followed by it. Therefore, it was allowable. Ld counsel submitted that now the issue stands settled bythe decision of the Hon‘ble Supreme Court in the case of Woodward Governor of India Ltd., 312 ITR 254(SC). Ld Counsel pointed out that the Hon‘ble Supreme Court has affirmed the decision of the Hon‘ble Delhi High Court in the case of CIT v. Woodward Governor of India Ltd., 294 ITR 451 (Del). In this regard, ld Counsel referred to page 469 and pointed out that in regard to revenue account cases, the Hon‘ble Delhi High Court has, inter alia, observed in para 32 that the liability stands accrued the minute the contract was entered into. In support of his contention, ld Counsel has advanced various propositions before us which are discussed herein-below.

The loss claimed by the assessee is in accordance with a recognized method of accounting. The AO, admittedly, not having invoked the provisions of section 145(3) of the Act, is bound by the assessee‘s aforesaid method and, therefore, is obliged to allow the loss.

In this regard, ld Counsel for the assessee referred to the assessment order for the assessment year 1998-99 and pointed out that in para 5.2 at page 5, the AO observed as under: ―In case foreign exchange is a current asset, the easier method of accounting would be to book the sale when this is done and the purchase when it is executed.‖ Ld Counsel further referred to page 1 of the assessment order and pointed out that the AO has taken note of the fact that the assessee was following mercantile system of accounting. He further pointed out that the assessment has been completed u/s.143(3) and, thus, it is clear that the assessee‘s books of account have not been rejected. Ld Counsel for the assessee referred to the decision of the Hon‘ble Supreme Court in the case of Investment Ltd v CIT, 77 ITR 533 (SC), wherein, it has been held at pages 537 to 538 that the method of accounting consistently and regularly followed by the assessee cannot be discarded by the departmental authorities on the view that he should have adopted a different method of keeping account or of valuation. The method of accounting regularly employed may be discarded only if, in the opinion of the taxing authorities, income of the trade cannot be properly deduced therefrom. He further referred to the decision of the Hon‘ble Bombay High Court in the case of CIT v. TISCO, 106 ITR 363 (Bom), wherein also, similar view was taken. In support of this proposition, he also relied on the decision of the Hon‘ble Supreme Court in the case of CIT v. Woodward Governor India P. Ltd., 312 ITR 254 (SC), wherein, the Hon‘ble Supreme Court has, inter alia, observed as under:- ――For the reasons given hereinabove, we hold that, in the present case, the "loss" suffered by the assessee on account of the exchange difference as on the date of the balance sheet is an item of expenditure under s. 37(1) of the 1961 Act. In the light of what is stated hereinabove, it is clear that profits and gains of the previous year required to be computed in accordance with the relevant Accounting Standard. It is important bear in mind that the basis on which stockin-trade is valued is part of the method of accounting. It is well established, that, on general principles of commercial accounting, in the P&L account, the values 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 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 would not be 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 a 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. Sec. 145(1) enacts that for the purpose of s. 28 and s. 56 alone, income, profits and gains must be computed in accordance with the method of accounting regularly employed by the assessee. In this case, we are concerned with s.

Therefore, s. 145 is attracted to the facts of the present 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 legal liability has been incurred before it is actually disbursed. (See judgment of this Court in the case of United Commercial Bank vs. CIT (1999) 156 CTR (SC) 380 : (1999) 240 ITR 355 (SC). Therefore, the accounting method followed by an assessee continuously for a given period of time needs to be presumed to be correct till the AO comes to the conclusion for reasons to be given that system does not reflect true and correct profits. As stated, there is no finding given by the AO the correctness of the Accounting Standard followed by the assessee(s) in this batch of civil appeals.‖ 40.1 Ld Counsel also relied on the decision of the ITAT Delhi Bench in the case of DCIT v Maruti Udyog Ltd., 99 ITD 666 (Del) and ONGC v DCIT, 83 ITD 151 (Del)(SB), wherein also, it was, inter alia, held that additional liability incurred by the assessee onaccount of variation in foreign exchange rate was an allowable trading liability where borrowed foreign currency was utilized to meet need of working capital. Ld Counsel for the assessee submitted that there is no distinction between the loan transaction and foreign contract and these decisions are squarely applicable to the present set of facts because the contract had already been entered into in the relevant previous year. (2) The loss claimed by the assessee is not a notional/contingent loss, but is an actual loss which it is entitled to as a deduction. 40.2 Ld Counsel for the assessee pointed out this aspect is evident from the fact that the loss of Rs.1,52,20,000/- disallowed by the AO in A.Y. 1998-99 has been allowed by the AO as a revenue deduction in assessment year 1999-2000. Ld Counsel for the assessee referred to the written submissions filed by ld CIT (DR) and pointed out that one of the definitions of forward foreign exchange contract is as under:- ―Agreement to exchange at a given future date currencies of different countries at a specified rate (forward rate). A forward contract is a foreign currency transaction. The gain or loss on the contract is typically included in determining net income. The amount of gain or loss, except on a speculative forward contract (designed as a risky investment rather than as a hedge), is computed by multiplying the foreign currency amount of the forward contract by the difference between the spot rate at the balance sheet date and the spot rate at the date of inception of the contract.” “Agreement that obligates an investor to deliver a specified quantity of one currency in return for a specified amount of another currency. Forward exchange contracts. A forward exchange contract (or forward contract) 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. Summary A forward contract is an obligation to buy or sell a certain amount of foreign currency at a pre-determined date. Even if your requirements change over the term of the forward contract, you are still obliged to deal. A forward contract obliges you to deal at a specific rate – you are not in a position to benefit from any favourable movements in exchange rates between booking the contract and completing the deal. No premium is payable.”

In the rejoinder, Ld CIT D.R. submitted that the decision in the case of Woodward Governor of India Ltd, 312 ITR 254 (SC) and 294 ITR 541 (Del) and ONGC (supra) has to be considered in the context in which the same is delivered. He pointed out that the Hon‘ble Supreme Court in the case of Woodward Governor (supra) held that the foreign currency notes, balance in bank accounts denominated in foreign currency and receivables/payables and loans denominated in foreign currency as well as sundry creditors are all ‗monetary items‘, which have to be valued at closing rate at the end of the accounting year as per AS-11. He pointed out that this judgment is mainly with reference to stock-in-trade and applies to foreign exchange liabilities in respect of raw materials or stock-in-trade and at the most it can be extended to monetary items noted above. But in the present case, forward foreign exchange contracts are not similar to this specified item. He submitted that in forward foreign exchange contract, no investment of foreign currency was made at any time prior to the date of its maturity and, therefore, it cannot even be said that such contracts indirectly represent stock-intrade or trading assets of the assessee. Further, no accounting entry had been made before the settlement of contract. He submitted that the following decisions relied upon by ld Counsel for the assessee proceeded on the assumptions that there was stock-intrade: i) Bank of India, 218 ITR 371 (Bom) – Here foreign exchange held in its foreign branches constituted stock-in-trade. ii) Bank of Tokyo, 13 ITD 32 (Cal) – Proceeded on the assumption that foreign exchange contract constitute stock-in- trade which is not correct. iii) State Bank of Mysore, 114 ITR 704 (Kar) – delivered in respect of foreign currency held by bank. iv) Nedungadi Bank ltd., 264 ITR 545 (Ker)- delivered in the context whether Government securities can be treated as stock- in-trade or not. v) Mashreque bank, 18 SOT 233 (Mum). This case proceeded on wrong assumption that forward foreign exchange contracts constitute stock- intrade. vi) United Commercial Bank, 240 ITR 355 (SC). The question was whether government securities held by bank are stock- in- trade or not. vii) Brockhoven BV (ITA No.8344/B/90. In this case, the question before the Hon‘ble Bombay High court was loss on account of difference in foreign exchange rate in respect of amount due by the assessee to its head office, which was held to be allowable.

We have considered the rival submissions and perused the record of the case. There is no dispute that if the date of maturity of the contract falls within the same financial year then the difference between the exchange rate as prevailing on the balance sheet date and contracted rate is an allowable deduction. The moot point for consideration is whether keeping in view the nature of contract, can it be said that a liability accrued on 31st March in respect of unmatured forward foreign exchange contract on account of fluctuation in rate of foreign currency or not. Therefore, it is necessary to first examine the nature of contract entered into by the assessee. Forward Foreign exchange contract means an agreement to exchange different currencies at a forward rate. Forward rate is a specified rate for exchange of currency at a specified date. The assessee enters into forward contract with clients to buy or sell foreign exchange at an agreed price at a future date in order to hedge against the possible future financial loss on account of wide fluctuation in the rate of foreign currency. Thus, firstly, forward foreign exchange contract creates a continuing binding obligation on thedate of contract against the assessee to fulfill the same on the date of maturity and secondly, it is in the nature of hedging contract because it is a contract entered into against possible financial losses . Let us take a hypothetical example. Suppose ‗X & Co.‘ is assessee‘s client. It entered into a contract with ‗Y & Co.‗ on 15.2.2010 for supply of goods at 1,00,000 $, for which payment was to be made after three months on 15.5.2010. Suppose, on the date of contract, the value of Dollar vis-à-vis Rupee was Rs.45. After three months, ‗X & Co.‘, keeping in view the prevailing economic conditions etc., anticipated wide fluctuation in exchange rate. Therefore, it entered into with its bank (assessee) to purchase 1,00,000 $ on 15.5.2010 at say Rs.47/-. Thus ‗X & Co.‘ had hedged the loss at Rs.2/- which it distributed over two periods. However, as far as the assessee was concerned, it came to know of actual loss/profit only on 15.5.2010 and not prior to that date. However, at the same time it could anticipate the loss on 31st March with reasonable accuracy, keeping in view the day to day fluctuation in the foreign currency rates and also that as prevailing on 31st march. The assessee-bank, accordingly, makes provision in its accounts on 31st March in line with the prudent commercial accounting principles, which requires that all accrued losses have to be taken into consideration on 31st March. Having considered the nature of contract, we will examine whether on account of existing obligation, a liability accrues as per I.T. provisions on 31st March or not. In order to find answer to this intricate issue, we have to keep in mind certain settled accounting propositions which have received judicial recognition. They can briefly be summed up as under:-

The assessee‘s contention is that this contract has to be revalued in accordance with FEDAI guidelines as notified by RBI and, therefore, the assessee had no option but to determine the profit/loss in regard to unmatured forward foreign exchange contracts in accordance with the currency rate prevailing on 31st March. Further, a binding obligation had also accrued against the assessee . Ld CIT D.R. has rightly submitted that this treatment in books of account per se does not give right to the assessee to claim the loss under Income tax Act. However, ld CIT D.R.‘s contention needs to be examined having regard to fundamental commercial principles which have received judicial recognition. It is settled principle that deduction is allowable under the Income-tax Act in respect of those liabilities which crystalise during the previous year. Therefore, the concept of crystalisation of liability under Income-tax Act assumes significance vis-à-vis commercial principles in vogue. As per the commercial principles of policy of prudence, all anticipated liabilities have to be accounted for but as per I.T.Act, only that liability will be allowed which has actually accrued. As a matter of fact, Courts have time and again given due weightage to commercial principles in deciding such issues. However, 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 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. 43.1 We have to bear in mind that the issues relating to accrual of income cannot be decided on the same footing and considerations on which the issues relating to loss/expense is to be decided. In case of loss/expense, it is the concept of reasonable certainty to meet an existing obligation which comes into play which in legal terminology is said to be ‗crystalisation of liability‘. When outflow of economic resources in settlement of present obligation can be anticipated with reasonable accuracy then it is to be recognized as crystalised liability. This is in consonance with the principle of prudence as considered by the Hon‘ble Supreme Court in the case of Woodward Governor of India Pvt.Ltd. (supra). The revenue‘s main contention is that liability can arise only when the contract matures. This plea, in our humble opinion, is completely divorce of the principles of commercial accounting and, therefore, cannot be accepted. Both legal obligation and commercial principles have to be taken into consideration for deciding such issues.

From the above discussion, 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. In this regard we may refer to the observations of Hon‘ble Supreme Court in the case of Bharat Earth Movers, 245 ITR 428 (SC): ―. The law is settled; 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 also be capable of being estimated with reasonable certainty though the actual quantification may not be possible. If these requirements are satisfied the liability is not a contingent one. The liability is in praesenti though it will be discharged at a future date. It does not make any difference if the future date on which the liability shall have to be discharged is not certain.

In Metal Box Co. of India Ltd. vs. Their Workmen (1969) 73 ITR 53 (SC) the appellant company estimated its liability under two gratuity schemes framed by the company and the amount of liability was deducted from the gross receipts in the P&L a/c. The company had worked out on an actuarial valuation its estimated liability and made provision for such liability not all at once but spread over a number of years. The practice followed by the company was that every year the company worked out the additional liability incurred by it on the employees putting in every additional year of service. The gratuity was payable on the termination of an employee ‘ s service either due to retirement, death or termination of service—the exact time of occurrence of the latter two eventsbeing not determinable with exactitude beforehand. A few principles were laid down by this Court, the relevant of which for our purpose are extracted and reproduced as under : (i) For an assessee maintaining his accounts on mercantile system, a liability already accrued, though to be discharged at a 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 practice and accountancy. It is not as if such deduction is permissible only in case of amounts actually expended or paid; (ii) Just as receipts, though not actual receipts but accrued 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; (iii) A condition subsequent, the fulfilment 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. (iv) A trader computing his taxable profits for a particular year may properly deduct not only the payments actually made to his employees but also the present value of any payments in respect of their services in that year to be made in a subsequent year if it can be satisfactorily estimated. So is the view taken in Calcutta Co. Ltd. vs. CIT (1959) 37 ITR 1 (SC) : TC 16R.197 wherein this Court has held that the liability on the assessee having been imported, the liability would be an accrued liability and would not convert into a conditional one merely because the liability was to be discharged at a future date. There may be some difficulty in the estimation thereof but that would not convert the accrued liability into a conditional one; it was always open to the tax authorities concerned to arrive at a proper estimate of the liability having regard to all the circumstances of the case.‖ 45. One more aspect which needs to be discussed with reference to commercial accounting principles is with reference to the arguments of Ld CIT D.R. that no transaction has been recorded in the books of account before the date of maturity of contract and, therefore, there is no question of any liability accruing on 31st March. The elements of financial statement can be broadly divided into following five groups, viz; assets, liabilities, equity, income/gains & expenses/loss. These items are recognized in a financial statement if both the following criteria are met: a) Future economic benefit will be there from the said events, b) The event can be measured in monetary terms. In the present case, the AO himself has observed in the assessment order that at the time of entering into the contract, the assessee has recorded the income/loss on the basis of difference between the contracted rate and the spot rate. Thus, to say that the contract was incapable of being recognized in the books of account, is not correct. The assessee recorded only the net effect of the transaction and not the entire transaction. Whether the deduction is allowable or not, therefore, cannot be guided by this factor.

With regard to observations of the AO regarding method of accounting, we may observe that it is well settled law that a method of accounting regularly employed by the assessee cannot be disregarded unless AO is of the opinion that profits are not correctly deductible from such method of accounting as per the provisions of section 145(3) of the Act. The AO cannot reject the method of accounting followed by the assessee merely on the ground that a better method of accounting could be the alternate one. However, in the present case, though observations have been made by the AO to this effect but actual disallowance has been made by treating the impugned amount as contingent liability.

Now, we will consider the issue with reference to Accounting Standard -11 (AS- 11). The Hon‘ble Supreme Court in the case of Chellapali Sugar Mills, 98 ITR 167 and the Hon‘ble Delhi High court in the case of Woodward Governor of India P.Ltd (supra) observed that the accounting standards issued by the Institute of Chartered Accountants of India required that accounting policies must be governed by the principle of prudence. Accounting Standards are prepared by ICAI keeping in view of the principle of prudence and this principle has received judicial recognition. In other words, provisions should be made for loan liabilities and losses even though the amount cannot be determined with certainty and represents only the basic estimate in the light of available information. The Accounting Standard issued by ICAI which are mandatory for preparation of financial statements and have to be followed inasmuch as the deviation from the same is to be reported in the audit report. Section 145(2) gives power to the Central Government to notify the accounting standards to be followed by any class of assesses or in respect of any class of income.

The Hon‘ble Supreme Court in the case of Woodward Governor of India (P) Ltd.,((supra) has observed at page 265 para 17 that the Central Government has made AS-11 mandatory. Therefore, compliance with this has to be made.

We find that in AS-11 in paras 9 to 12, it has been observed as under: ―9. Exchange differences arising on foreign currency transactions should be recognized as income or as expense in the period in which they arise, except as stated in paras 10 and 11 below.

The carrying amount of fixed assets which are carried in terms of revalued amounts should also be adjusted in the manner described in para 10 above. However, such adjustment should not result in the net book value of a class of revalued fixed assets exceeding the recoverable amount of assets of that class, the remaining amount of the increase in liability, if any, being debited to the revaluation reserve, or to the profit and loss statement in the event of inadequacy or absence of the revaluation reserve.

An exchange difference results 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 transaction. When the transaction is settled within the same accounting period as that in which it occurred, the entire exchange difference arises in that period. However, 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.‖ 50. Therefore, this Accounting Standard mandates that in a situation like in the present case, since the transaction is not settled in the same accounting period, the effect of exchange difference has to be recorded on 31st March. Ld CIT D.R. has rightly pointed out that the expenses required to be charged against revenue as per accounting standard do not ipso facto imply that the same are always deductible for Income-tax purposes but at the same time its relevance does not, in any manner, gets mitigated. The Hon‘ble Supreme Court in the case of Woodward Governor of India (P) Ltd.,((supra) with reference to working capital loan, which was also repayable after the end of accounting period, has held that loss occurred to the assessee, on account of fluctuation in the rate of foreign exchange, as on the date of the balance sheet, is an item of expenditure u/s.28(i) of the I.T.Act. Hon‘ble Supreme Court observes as under:- ―Under section 28(i), one needs to decide the profits and gains of any business which is carried on by the assessee during the previous year. Therefore, one has to take into account stock-in-trade for determination of profits. The 1961 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 the lower. This is how business profits arising during the year need to be computed. This is 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. This is 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 increased profits before actual realization. This is the theory underlying the rule that closings stock is to be valued at cost or market price, whichever is the lower. As profits for income tax purposes 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 the charge as a matter of practice, though, as stated above, loss due to fall in the price below cost is allowed even though such loss has not been realized actually.‖ Ld CIT D.R.‘s submission is that this decision is with reference to monetary items as referred to in AS-11 and since forward foreign exchange contracts do not come within the monetary items, therefore, the said decision cannot be applied. However, we have already discussed in the concept of recognition of various events in financial statements and have noted that the assessee , in fact, has recorded net effect in its profit and loss account. Therefore, on this count, the department‘s plea cannot be accepted. Thus, in view of the decision of the Supreme Court in the case of Chellapali Sugar Mills (supra), and also in view of decision of the the Hon‘ble Supreme Court in the case of Woodward Governor India (P)Ltd., (supra), assessee‘s plea deserves to be accepted.

Now, coming to the objection of ld CIT D.R. with reference to various decisions relied upon by ld counsel for the assessee on the ground that in the said decisions, the issue was relating to stock-in-trade but in the present case, there is no stock-in-trade. Admittedly, the assessee has not shown any closing stock of unmatured forward foreign exchange contracts as on balance sheet date and has only booked the profit and loss inthat regard. There is no dispute that the foreign exchange currency held by the assessee bank is its stock-in-trade and as is evident from the hypothetical example considered earlier, the assessee had entered into forward foreign exchange contracts in order to protect its interest against the wide fluctuation in the foreign currency itself. Therefore, this contract was incidental to assessee‘s holding of the foreign currency as current asset. Therefore, in substance, it cannot be said that the forward contract had no trappings of the stock-in-trade. Ld Counsel has rightly relied upon the decision of the Calcutta ITAT (SB) in the case of Shree Capital Services Limited,(supra) in this regard and, therefore, the various decisions relied upon by ld Counsel for the assessee as discussed in his submissions are applicable to the facts of the case.

Now coming to the argument of ld CIT (DR) with reference to the decision in the case of Indian Overseas Bank (supra), we find that the said decision was rendered with reference to taxing of notional profits and not with reference to anticipated losses, as is the case before us. The department is trying to draw analogy from the said decision but the said decision cannot be applied as the considerations are entirely different in regard to the issue relating to notional profits vis-à-vis anticipated losses. Profits are considered only when actual debt is created in favour of assessee but in case of anticipated losses, if an existing binding obligation, though dischargeable at a future date, is determinable with reasonable certainty, then the same is allowable.

Ld CIT D.R. has also heavily relied on the decision of the Hon‘ble Bombay High Court in the case of CIT v. Kamani Metals and Alloys Ltd (supra). This decision, in our opinion, is of little help to the department inasmuch as the same has been rendered with reference to contract for purchase of raw material. The contracted price was more than the market price as the price went down and the material had not been received at the end of the accounting year. Under these facts, the Hon‘ble High court held that notional loss claimed by the assessee on the balance sheet date was not allowable because there was merely the contract to purchase the material at a future date. Neither any payment was made by the assessee nor any material was received. This case, in our opinion, cannot be applied to the facts of the present case as in the present case, we are concerned about the anticipated loss booked by the assessee on account of foreign exchange rate fluctuation as on balance sheet date, which was in accordance with RBI guidelines as well as in accordance with AS-11. Moreover, a binding obligation arose the minute the contract was entered into. However, now the decision of the Hon‘ble Supreme Court in the case of Woodward Governor India P. ltd (supra) covers the issue on account of variation in foreign exchange rate with reference to current assets. The facts in the case of CIT v. Kamani Metals and Alloys Ltd (supra) are more akin to such a situation where the assessee has simply ordered for purchase of material at a particular rate but the material has not been supplied by the seller by the end of the accounting period. No liability is accounted for in respect of such ordered goods because the basic elements of contract have not been fulfilled. In the present case, we have already observed that the forward contract is incidental to the foreign currency held by the assessee as stock-in-trade and, therefore, the decision in the case of CIT v. Kamani Metals and Alloys Ltd (supra) is clearly distinguishable on facts.

Ld CIT D.R. has also relied on the decision in the case of Eveready Industries (supra). The view expressed in the said decision also cannot be upheld in view of the decision of the Hon‘ble Supreme Court in the case of Woodward Governor India P.Ltd (supra). The facts in the case of Indian Molasses‘ case(supra) are entirely different. The said decision proceeded on the premise that till the date of retirement of Managing Director, the assessee company itself had dominion over the sum paid through trustees and insurance society and there was no irrecoverable liability created. Thus, the impugned amounts were treated as part of profits set apart to meet a contingency by the assessee without any corresponding liability being there as the liability was only contingent in nature. There cannot be any quarrel with the proposition that the liability in praesenti is an allowable deduction but a liability in futuro, which for the time being is only contingent, is not allowable. As already pointed out this principle is to be applied keeping in view the principles of prudence and applicable Accounting Standards. In our opinion, the complete answer has been given long back by the Hon‘ble Supreme Court in the case of Bharat Earth Movers Ltd, 245 ITR 428 (SC), wherein, it was held that the provision made by the assessee for meeting the liability incurred by it under the leave encashment scheme proportionate with the entitlement earned by the employees of the company was entitled to deduction out of the gross receipts of the accounting year in which the provisions were made.

Ld CIT D.R. has also relied on the decision of the Hon‘ble Calcutta High Court in the case of Bestobell India Ltd ((supra), which decision has been considered in detail by the Hon‘ble Delhi High Court in the case of Woodward Governor India (P)Ltd (supra), wherein, it has been observed as under:- ―The revenue relied upon the decision of the Calcutta High Court in Bestobell (India) Ltd.,(1979) 117 ITR 789 in support of the submission that the increased liability on repayment of a loan borrowed in foreign exchange for business purposes as a result of exchange rate fluctuation would be a capital loss and not a trading loss. What weighed with the Calcutta High Court there appears to be that there was no outflow of funds during the year, as has been urged by the revenue before us. However, a closer scrutiny of the said decision indicates that the Calcutta High Court in this case relied upon its earlier judgement in Sutlej Cottons Mills Ltd v CIT (1971) 81 ITR 641. It will be recalled that the Hon‘ble Supreme Court in Sutlej Cotton Mills Ltd v CIT(1979) 116 ITR 1 reversed the aforesaid decision of the Calcutta High Court on this point and held that such liability would be treated as a trading loss. In that view of the matter, the reliance placed by the revenue on the judgement of the Calcutta High Court in Bestobell (India Ltd., (1979) 117 ITR 789 appears misplaced.‖ 56. The controversy stands now resolved in view of the decision of the Supreme Court in the case of Sutlej Cotton Mills Ltd., 116 ITR 1 (SC), wherein, it has been held that fluctuation on account of foreign exchange rate is an allowable deduction and is not capital in nature. The observation of the Hon‘ble Supreme Court is as under:- ―The law may, therefore, now be taken to be well settled that where profit or loss arises to an 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(emphasis supplied)‖ 57. At the end we may further observe that when profits are being taxed by the department in respect of such unmatured forward foreign exchange contracts then there was no reason to disallow the loss as claimed by assessee in respect of same contractson the same footing. In this regard, we may refer to the details furnished by assessee vide their letter dt. August 05, 2010 to establish that the Department has assessed the B ank in respect of the profit shown by the Bank on restatement of outstanding forward foreign exchange contracts for A.Ys.2002-03 and 2003- 04. There is no dispute on this count and, therefore, we refrain from referring the details.

In view of the above discussion, we allow the assessee‘s appeal for the following reasons:- i) A binding obligation accrued against the assessee the minute it entered into forward foreign exchange contracts. ii) A consistent method of accounting followed by assessee cannot be disregarded only on the ground that a better method could be adopted. iii) The assessee 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. iv) A liability is said to have crystalised when a pending obligation on the balance sheet date is determinable with reasonable certainity. The considerations for accounting the income are entirely on different footing. v) As per AS-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. vi) The forward foreign exchange contracts have all the trappings of stockin-trade. vii) In view of the decision of Hon‘ble Supreme Court in the case of Woodward Governor India (I) P.Ltd., the assessee‘s claim is allowable. viii) In the ultimate analysis, there is no revenue effect and it is only the timing of taxation of loss/profit.

We, accordingly, hold that 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 ofevaluation of the contract on the last date of the accounting period i.e. before the date of maturity of the forward contract.‖ 2.3. It is also noted that the Hon'ble Delhi High Court in the case of Woodward Governor India Pvt. Ltd. 294 ITR 451 (Del.) observed as under:- “The contention that if the argument of the assessee were to be accepted then the cost of the asset will have to be reworked every time there is a fluctuation has no merit. The ICAI standards clearly indicate the manner in which the cost of the asset has to be reworked. The accepted method appears to be to rework the cost with reference to the rate prevailing on the last date of the financial year in which the fluctuation occurs. Further, the net effect as a result of the increase or decrease in the liability, either with reference to the last date of the financial year or with reference to every date when a fluctuation occurs, is the same. In the capital account cases where the cost of asset has been either paid fully or in part prior to the fluctuation in the rate of foreign exchange, the cost of the asset is to be reworked for purposes of repayment or depreciation or investment allowance, as the case may be, with reference to the rate prevailing on the last date of the financial year in which the fluctuation occurs.—CIT vs. Paper Products Ltd. (2004) 271 ITR 472 (Del) and CIT vs. IFFCO Ltd. (2004) 192 CTR (Del) 547 : (2005) 142 Taxman 466 (Del) followed; Padamjee Pulp & Paper Mills Ltd. vs. CIT (1994) 117 CTR (Bom) 288 : (1994) 210 ITR 97 (Bom) and Associated Bearing Co. Ltd. vs. CIT (2006) 205 CTR (Bom) 150 concurred with. (Paras 39 & 40) Amended s. 43A now provides that the amount by which the liability is increased or reduced as a result of change in the rate of exchange "during any previous year after the acquisition of such asset" would be taken into account "at the time of making the payment, irrespective of the method of an accounting adopted by the assessee." The effect of the amendment is plainly to negate the benefit that was extended to the assessee as a result of the interpretation placed on the provisions as it stood prior to the amendment. The amendment itself makes it clear that it is w.e.f. 1st April, 2003. This has further been clarified by the CBDT Circular No. 8 of 2002 which in no uncertain terms states in para 34.5 that "the amendment will take effect from 1st April, 2003 and will, accordingly, apply in relation to the asst. yr. 2003-04 and subsequent years." Accordingly, there is no scope for entertaining the plea of the Revenue that the amendment is declaratory and, therefore, retrospective. Accepting such a plea would be negating the express terms of the amendment and that is clearly impermissible. Secondly, the amendment itself makes it clear that it is prospective.—CWT vs. Sharvan Kumar Swarup & Sons (1994) 122 CTR (SC) 380 : (1994) 210 ITR 886 (SC), CIT vs. Podar Cement (P) Ltd., etc. (1997) 141 CTR (SC) 67 : (1997) 226 ITR 625 (SC), H.H. Sir Rama Varma vs. CIT (1994) 116 CTR (SC) 55 : (1994) 205 ITR 433 (SC) and Lohia Machines Ltd. vs. Union of India (1985) 44 CTR (SC) 328 : (1985) 152 ITR 308 (SC) distinguished. (Paras 41 & 42) A number of High Courts have consistently upheld the contentions of the assessees similar to the contentions advanced by them. This is definitely one other reason to hold in favour of the assessees in these cases.—CIT vs. P.J. Chemicals Ltd. (1994) 121 CTR (SC) 201 : (1994) 210 ITR 830 (SC) applied. (Para 44) Conclusion : Where the cost of asset has been either paid fully or in part prior to the fluctuation in the rate of foreign exchange, the cost of the asset is to be reworked for purposes of depreciation or investment allowance, as the case may be, with reference to the rate prevailing on the last date of the financial year in which the fluctuation occurs; amendment to s. 43A made by the Finance Act, 2002, is effective from 1st April, 2003, and is not retrospective.

Therefore, Parliament has used the expression "any expenditure" in s. 37 to cover both. Therefore, the expression "expenditure" as used in s. 37 may, in the circumstances of a particular case, cover an amount which is really a "loss" even though the said amount has not gone out from the pocket of the assessee.—Madras Industrial Investment Corporation Ltd. vs. CIT (1997) 139 CTR (SC) 555 : (1997) 225 ITR 802 (SC) relied on. (Para 13) The quantum of allowances permitted to be deducted under diverse heads under ss. 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 s. 43(2), which is used in several ss.

Under s. 145(2), the Central Government is empowered to notify from time to time the Accounting Standards to be followed by any class of assessees or in respect of any class of income. Accordingly, under s. 209 of the Companies Act, mercantile system of accounting is 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 s. 145(3), the method of accounting undertaken by the assessee continuously is supreme. In the present batch of cases, there is no finding given by the AO on the correctness or completeness of the accounts of the assessee. Equally, there is no finding given by the AO stating that the assessee has not complied with the Accounting Standards. For the reasons given hereinabove, the "loss" suffered by the assessee on account of the exchange difference as on the date of the balance sheet is an item of expenditure under s. 37(1). (Paras 14 & 15) It is important to note that foreign currency notes, balance in bank accounts denominated in a foreign currency, and receivables/payables and loans denominated in a foreign currency as well as sundry creditors are all monetary items which have to be valued at the closing rate under AS-11. Under para 5, a transaction in a foreign currency has to be recorded in the reporting currency by applying to the foreign currency amount the exchange rate between the reporting currency and the foreign currency at the date of the transaction. This is known as recording of transaction on initial recognition. Para 7 of AS-11 deals with reporting of the effects of changes in exchange rates subsequent to initial recognition. Para 7(a) inter alia states that on each balance sheet date monetary items, enumerated above, denominated in a foreign currency should be reported using the closing rate. In case of revenue items falling under s. 37(1), para 9 of AS-11 which deals with recognition of exchange differences, needs to be considered. Under that para, exchange differences arising on foreign currency transactions have to be recognized as income or as expense in the period in which they arise, except as stated in para 10 and para 11 which deals with exchange differences arising on repayment of liabilities incurred for the purpose of acquiring fixed assets, which topic falls under s. 43A. Para 9 of AS-11 recognises exchange differences as income or expense. In cases where, e.g., the rate of dollar rises vis-a-vis the Indian rupee, there is an expense during that period. 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 P&L account for the reporting period.—CIT vs. Woodward Governor India (P) Ltd. & Ors. (2007) 210 CTR (Del) 354 affirmed.” 2.5. Considering the ratio laid down in aforesaid orders, the restatement of forward contract obligations was done as per AS-11, in a consistent manner over the years and the gain earned on such revaluation was offered to tax and accepted by the Assessing Officer in the respective years, therefore, there is no reason deviate from the same merely because, there was a loss during the year. The Tribunal in the case of M/s Bhavani Gems vs ACIT (supra) held that loss was allowed as business loss by holding that the issue is covered by the decision of the Special Bench in the case of DCIT vs Bank of Behrain. Considering the totality of facts, we find no infirmity in the conclusion of the Ld. Commissioner of Income Tax (Appeal). His order is affirmed. Finally, the appeal of the Revenue is dismissed. This Order was pronounced in the open court in the presence of ld. DR at the conclusion of the hearing on 14/02/2017.