2015 (5) TMI 606 - AT - Income Tax

Mark to market loss - revlauation of forward contract agreements on the closing date of accounting year - not a notional loss therefore allowable as per CIT(A) - Held that - The Hon ble Supreme Court in the case of ONGC Vs. CIT, 2010 (3) TMI 81 - SUPREME COURT , has reiterated the principles laid down in the case of Woodward Governor India Pvt (2007 (4) TMI 118 - HIGH COURT , DELHI) and observed that when the assessee maintained their accounts on mercantile system of accounting and there was no finding by the AO on the correctness or completeness of the account and that the assessee had complied with the accounting standards, laid down by the Central Government, can the loss suffered by it on account of fluctuation in the rate of reign exchange as on the date of balance sheet be allowed as expenditure under section 37(1) of the Act notwithstanding the fact that the liability had not been actually discharged in the year in which the fluctuation in the rate of foreign exchange had occurred and finally decided that the loss incurred on account of restatement of the liabilities in foreign exchange is allowable deduction. The detailed finding recorded by CIT(A) to the effect that loss on account of revaluation of pending forward contracts was revenue in nature, as per para 5 & 6, has not been controverted. Accordingly, we do not find any reason to interfere in the order of CIT(A) deleting the disallowance of loss on account of revaluation of pending forward contract. - Decided in favour of assessee.

Summary

Issues Involved:
1. Whether the mark-to-market loss arising from the revaluation of forward contract agreements on the closing date of the accounting year is a notional loss and therefore not allowable.

Detailed Analysis:

Issue 1: Mark-to-Market Loss on Forward Contracts

The only grievance of the revenue relates to CIT(A)'s action in holding that mark-to-market loss arising on revaluation of forward contract agreements on the closing date of the accounting year is not a notional loss and, therefore, allowable.

Rival contentions have been heard and record perused. Facts in brief are that the assessee is engaged in the business of import and export of diamonds. During the course of scrutiny assessment, the AO disallowed the loss arising on account of revaluation on forward contract agreements on the plea that it is a notional loss. By the impugned order, the CIT(A) deleted the disallowance made by AO after having the following observations:

The appellant is predominantly engaged in the business of import of rough diamonds, manufacturing (cutting & polishing) of diamonds, and exporting the polished diamonds. The appellant is exposed to risk arising out of fluctuation in exchange rates and, as a prudent businessman, likely to hedge its risk. Appellant has booked all the forward contracts in respect of export receivables only.

From Notes to the accounts under the heading "Significant Accounting policy followed & its disclosure", it is evident that the appellant is reporting all monetary items at the closing rate and recognizing the exchange rate difference in profit & loss account as expenses or income. Similarly, outstanding forward contracts are marked to market, and resulting loss or gain is being recognized as expenses or income in the profit & loss account. This method of recording transactions denominated in foreign currency is as per AS-11 and is consistently followed.

It is undisputed that the appellant is in the business of exports and has certain receivables in foreign exchange at any point of time during the year, constantly exposed to the risk arising out of the fluctuation in foreign exchange rates. The risk is integral to the appellant's business and arises out of and is associated with such business. The appellant has entered into forward exchange contracts with the intention to mitigate the risk associated with the business. The forward contract entered during the course of business creates a legal liability irrespective of whether it matures during the accounting year or beyond the accounting year. Therefore, it is not correct to state that the contract does not result in an asset or a liability and hence its revaluation does not arise.

The CIT(A) provided an example to illustrate this point and concluded that the AO cannot determine the nature and effect of a transaction based merely on its presentation, without going into its substance. When a legally tenable contract is in existence, duly supported by an underlying asset, and the contract having been entered during the course of business, the due effect of the contract at the year-end has to be considered while assessing the appellant's income. The entire gamut of the impugned transactions is integral to the appellant's business and cannot be called a contingent transaction. Therefore, whatever may be the result of the events listed out by the AO, such result has to be treated as a business result at the time of its happening, and hence the effect of the forward contract as at the year-end has to be considered for the purpose of arriving at the appellant's income.

The issue of notional loss is likely to arise in the context of the appellant's exposure to forward contracts exceeding the underlying assets/liabilities, which may be in the case of lump sum forward contracts. The appellant's AR explained that whenever a lump sum forward contract was entered, it was immediately covered by the value of subsequent exports, and the sum of such forward contracts never exceeded the value of the underlying debtors at any point of time during the year. The appellant has been consistently following the mercantile system of accounting and has been valuing the year-end outstanding foreign exchange transactions in terms of Accounting Standard AS-11.

The CIT(A) referred to judicial decisions, including the Hon. Delhi High Court in the case of Woodward Governor (294 ITR 451), which stated that the liability arises out of already concluded contracts and stands accrued the minute the contract was entered into. The Supreme Court in CIT v Woodward Governor India P Ltd (312 ITR 254) also upheld this view, stating that the incurring of the liability should be certain and it being estimated with reasonable certainty even if the exact quantification is not feasible.

The Special Bench of Jurisdictional Mumbai ITAT in the case of DCIT vis. Bank of Bahrain and Kuwait held that MTM losses in respect of forward foreign exchange contracts debited to the profit and loss account are allowable. They observed that a binding obligation accrued against the appellant the minute it entered into forward foreign exchange contracts and that a consistent method of accounting followed by the appellant cannot be disregarded.

The Supreme Court in the case of ONGC Vs CIT (322 ITR 180) reiterated the principles laid down in the case of Woodward Governor India Pvt Ltd and decided that the loss incurred on account of restatement of the liabilities in foreign exchange is allowable.

Thus, the judicial decisions of the Hon. Supreme Court and various other Authorities are clearly in favor of the appellant on this issue. The liabilities in foreign exchange were incurred during the normal course of the appellant's business, and the restatement of the forward contract obligations was done as per AS-11 in a consistent manner over the years. The gain earned on such revaluation was accepted and brought to tax in the respective years, and there is no reason to arrive at a different conclusion at present merely because there is a loss during the year. The AO's view that the appellant is not a dealer in foreign exchange and therefore the decision is not applicable to the facts of the case was dismissed. The Hon. Supreme Court upheld the same principles in the case of ONGC, where the business of ONGC is not that of a foreign exchange dealer. The forward contract transaction was entered during the course of the appellant's regular business and is not speculative in nature. The ITAT Mumbai bench in the case of M/s Bhavani Gems Vs ACIT CC-35 allowed the loss on account of revaluation of pending forward contracts as a business loss.

Accordingly, the CIT(A) held that the loss incurred by the appellant on the restatement of pending forward contract agreements at the year-end is an allowable business loss. The appellant succeeds on this ground.

Against the above order of CIT(A), the Revenue is in appeal before us.

We have considered rival contentions and carefully gone through the orders of the authorities below. From the record, we found that the assessee is engaged in the business of import and export of diamonds. Substantial amounts of its purchases and sales were denominated in foreign currency. It enjoys working capital facilities from banks, some of which are also denominated in foreign currency. It also carries currency risk in respect of its stock as it is most likely to be sold by way of exports. So, forward contracts in the instant case are entered into to hedge these currency risks associated with normal business transactions. These derivative contracts are entered within the framework of relevant RBI guidelines. The intent of entering into derivative contracts was to safeguard itself against exchange fluctuation risk on foreign currency receivables or payables. These derivative transactions have been either in respect of the sale of foreign currency in respect of its exposure to foreign currency receivables or purchase of foreign currency in respect of its exposure to foreign currency payables. These contracts generally have a maturity profile that coincides with expected dates of foreign currency receivables or payables, and the quantum involved in derivative contracts does not exceed the quantum of exposure to foreign currency receivables/payables. The assessee has been consistently following the accounting method wherein end restatement of Mark to Market gain or loss in respect of all assets or liabilities denominated in foreign currency is being recognized as gain or loss in the profit & loss account.

As per the assessee's nature of business being export, it has certain receivables on foreign exchange at any point of time during the year, thus, consistently exposed to the risk arising out of the fluctuation in foreign exchange rates. Such risk is integral to the assessee's business with the intention to mitigate the risk associated with the business the assessee has entered into foreign exchange contracts. Thus, what needs to be seen is whether the risk which the assessee has hedged by way of a forward contract has an underlying asset or a liability by way of debtors or creditors. Thus, the forward contract entered during the course of business creates a legal liability irrespective of whether it matures during the accounting year or beyond the accounting year. Since a legally tenable forward contract is in existence, duly supported by an underlying asset and the contract having been entered during the course of business and further that the exchange rate as on the date of entering the contract and as at the year-end being ascertainable, due effect of the contract at the year-end has to be considered while assessing the assessee's income. It is also not in dispute that the assessee has been consistently following the mercantile system of accounting and has been valuing the year-end outstanding foreign exchange transactions in terms of accounting standard AS-11.

The Hon'ble Supreme Court in the case of Woodward Governor India Pvt. Ltd., 312 ITR 254, observed that in order to find out if the expenditure is deductible, the following have to be taken into account: (i) whether the system of accounting followed by the assessee is mercantile system, which brings into debit the expenditure amount for which a legal liability has been incurred before it is actually disbursed and brings into credit what is due, immediately it becomes due and before it is actually received; (ii) whether the same system is followed by the assessee from the very beginning and if there was a change in the system, whether the change was bona fide; (iii) whether the assessee has given the same treatment to losses claimed to have accrued and to the gains that may accrue to it; (iv) whether the assessee has been consistent and definite in making entries in the account books in respect of losses and gains; (v) whether the method adopted by the assessee for making entries in the books both in respect of losses and gains is as per nationally accepted accounting standards; (vi) whether the system adopted by the assessee is fair and reasonable or is adopted only with a view to reducing the incidence of taxation.

The Hon'ble Supreme Court in the case of ONGC Vs. CIT, 322 ITR 180, reiterated the principles laid down in the case of Woodward Governor India Pvt (supra) and observed that when the assessee maintained their accounts on the mercantile system of accounting and there was no finding by the AO on the correctness or completeness of the account and that the assessee had complied with the accounting standards laid down by the Central Government, the "loss" suffered by it on account of fluctuation in the rate of foreign exchange as on the date of the balance sheet be allowed as expenditure under section 37(1) of the Act notwithstanding the fact that the liability had not been actually discharged in the year in which the fluctuation in the rate of foreign exchange had occurred and finally decided that the loss incurred on account of restatement of the liabilities in foreign exchange is an allowable deduction. The detailed finding recorded by CIT(A) to the effect that loss on account of revaluation of pending forward contracts was revenue in nature, as per para 5 & 6, has not been controverted. Accordingly, we do not find any reason to interfere in the order of CIT(A) deleting the disallowance of loss on account of revaluation of pending forward contracts.

As the facts and circumstances in ITA No.2611/Mum/2013 are exactly the same, following the reasoning given in ITA No.2610/Mum/2013, hereinabove, we do not find any reason to interfere in the order of CIT(A).

In the result, both appeals of the revenue are dismissed.

Order pronounced in the open court on this 27th March, 2015.