2013 (11) TMI 424 - AT - Income Tax

Forward contract a hedging transaction or a Forward transaction - Assessee is engaged in the business of trading and manufacturing of rough and polished diamonds and filed the return of income declaring the total income of Rs. 35,29,042/- - Assessing Officer made addition of Rs. 4,69,42,680/- - Assessee being an exporter, made export of diamonds and outstanding receivable in foreign currency and entered into forward contracts with the Banks to hedge the exchange loss if any - The total gain on account exchange difference on exports is Rs. 679.75 lacs on account of both actual realization and revaluation of outstanding receivables. The loss incurred on account of forward contracts to safeguard the outstanding receivables is Rs. 469.43 lacs. Accordingly, assessee set off the loss against the said gain and credited the net amount/ profit of Rs. 210.14 lacs to the profit and loss account Held that - These FCs are integral part or incidental to the core business of export of diamonds or the outstanding receivables of export proceeds, in principle, the impugned FCs constitute hedging transaction and not the speculative contracts - Banks do not entertain FCs of speculative nature with the customers like the assessee, the exporter - So long as the total FCs does not exceed the exports of the year plus outstanding export receivable, the FCs can constitute hedging transaction Disallowance of forward exchange loss of Rs. 4,69,42,680/- claimed by the appellant in the course of business incurred due to fluctuation in foreign exchange for which the appellant had booked forward contracts with the bank against their export receivables treating the same as speculation transaction & not hedging transactions - Three subdivisions of the impugned losses based on the timing of the cancellation of the FCs Held that - Loss on Cancellation of Matured FCs amounting to Rs 4,14,88,805/-relates to the FCs cancelled or terminated on or after the due date. In other words, the FCs booked as integral part of the export invoices lived its booking period in full and they were either terminated by the Bank on or after due date of maturity date of the contract as the actual realization were not received in time. These are not premature cancellations by the assessee and therefore, the said loss of Rs 4,14,88,805/-, being related to the FCs which are integral or incidental to the exports of the diamonds, should be allowed as business loss in view of the binding High Court or Tribunal decisions/judgments in the case of D Kishore kumar and Co 2005 (3) TMI 699 - ITAT MUMBAI . Loss on Cancellation of Pre-matured FCs is the other segment of loss relates to the FCs cancelled prior to the date of maturity - It is a settled issue that the assessee has to discharge the onus on why he had to resort to premature cancellation. In this case, the explanation of the assessee revolves around the fact that the maturity of date of some of such premature cancelled FCs fell during the week-end days and therefore, the assessee cancelled such FCs three days prior to the due date. Related loss is quantified at Rs 42,18,940/- - This part of the ground of the assessee is allowed as above without going into the alternate arguments relating to damages Decided in favor of Assessee. Loss of premature cancellation of FCs relates to the FCs cancelled prior to longer than three days - Held that - Assessee needs to answer as to why it went for premature termination and the onus is on the assessee as per the ratio of the SC judgment in the case of Joseph John (1967 (5) TMI 9 - SUPREME Court). Further, during the proceedings before us, on this issue, Ld Counsel for the assessee put forwarded various new arguments describing the impugned loss as damages payable to the Banks for breach of contracts or settlement of the contracts. These aspects are not emanating from the orders of the lower authorities. - matter remanded back on this issue.

Summary

Issues Involved:
1. Disallowance of Forward Exchange Loss as a speculative transaction.
2. Set off of Forward Exchange Loss against Profit and Gains from exchange fluctuations.
3. Applicability of Section 43(5) of the Income Tax Act, 1961.
4. Nature of Forward Contracts as hedging transactions or speculative transactions.
5. Correlation between Forward Contracts and export invoices.
6. Treatment of premature cancellation of Forward Contracts.
7. Classification of Foreign Exchange Contracts as commodities under Section 43(5).
8. Business loss versus speculative loss.

Issue-wise Detailed Analysis:

1. Disallowance of Forward Exchange Loss as a speculative transaction:
The CIT (A) confirmed the disallowance of Forward Exchange Loss of Rs. 4,69,42,680/- claimed by the appellant, treating the transactions as speculative rather than hedging. The assessee argued that these contracts were booked per RBI Regulations and should be considered hedging transactions under Section 43(5)(a) of the Income Tax Act, 1961.

2. Set off of Forward Exchange Loss against Profit and Gains from exchange fluctuations:
The assessee sought to set off the Forward Exchange Loss against the Profit and Gains on account of exchange fluctuations on realization/revaluation of export receivables. The AO denied this set-off, treating the loss as speculative and the profits as business income.

3. Applicability of Section 43(5) of the Income Tax Act, 1961:
Section 43(5) defines "speculative transaction" and provides exclusions under clauses (a) to (e). The AO concluded that the Forward Contracts did not meet the conditions of these exclusions, particularly clauses (a), (b), (c), and (d), thus treating the transactions as speculative.

4. Nature of Forward Contracts as hedging transactions or speculative transactions:
The Tribunal examined whether the Forward Contracts were integral to the export business or speculative. The Tribunal noted that the contracts aimed to hedge against foreign exchange fluctuations and were not speculative. The contracts' value never exceeded the outstanding receivables, supporting their classification as business transactions.

5. Correlation between Forward Contracts and export invoices:
The assessee argued that there was a broad correlation between the Forward Contracts and export invoices, though not precise to the last rupee. The Tribunal accepted this broad correlation, referencing judgments that supported the view that exact matching is not required.

6. Treatment of premature cancellation of Forward Contracts:
The Tribunal divided the loss from Forward Contracts into three categories based on the timing of cancellation:
- Loss on cancellation on or after the due date: Treated as business loss.
- Loss on cancellation three days prior to the due date: Accepted as business loss due to weekend considerations.
- Loss on cancellation more than three days prior: Remanded to AO for further examination and explanation by the assessee.

7. Classification of Foreign Exchange Contracts as commodities under Section 43(5):
The Tribunal considered the judgment of the Calcutta High Court in Sooraj Muill Magarmull, which treated Forward Contracts as commodities. Therefore, Forward Contracts fall under the definition of "speculation transaction" but can be excluded if they meet the conditions of hedging transactions under clause (a) of Section 43(5).

8. Business loss versus speculative loss:
The Tribunal concluded that the Forward Contracts were integral to the export business and constituted hedging transactions. Thus, the related losses were business losses and not speculative. The Tribunal allowed the set-off of these losses against the profits from foreign exchange fluctuations.

Conclusion:
The Tribunal partly allowed the appeal, recognizing the Forward Exchange Loss as a business loss for the contracts canceled on or after the due date and three days prior due to weekends. For other premature cancellations, the Tribunal remanded the matter to the AO for further examination. The Tribunal upheld the principle that Forward Contracts linked to export business should be treated as hedging transactions and not speculative.