2017 (1) TMI 447 - AT - Income Tax

Foreign exchange rate loss on account of outstanding transactions (marked to market) being unsettled forward foreign exchange contracts and loss being exchange rate difference relating to marked to market losses on unsettled forward foreign exchange contracts - assessee is engaged in the business of tiles and sanitary ware and also as a part of business does import of raw material for manufacture of tiles and sanitary wares - Held that - We have observed that the assessee has entered into forward foreign exchange contracts which have remained unsettled at the year end and loss has occurred on the same due to foreign exchange rate variation as at year end. The revenue has disallowed the same at threshold on the ground that the same is a notional loss . No finding of fact is recorded that the said foreign exchange forward contracts were entered into by the assessee to hedge against its business activity of import of raw material for manufacturing of tiles and sanitary wares and these forward foreign exchange contracts are backed with foreign exchange exposure of the assessee towards foreign currency liability outstanding as at year end towards import payables dues for import of tiles and sanitary wares. In our considered view , the matter needs to be set aside and restored to the file of the AO for denovo determination of the issue on merits after satisfying that the assessee has hedge the underlying exposure in foreign currency towards import of raw material payable outstandings at year end by entering into forward contracts in foreign exchange and as such, the forward contracts entered were for the purpose of the business to hedge against the forex loss and that the assessee has not entered into the forward contracts with an intention to earn any gain due to fluctuation in foreign currency rate but it is necessary for it to enter into such forward contracts to hedge against foreign exchange rate fluctuation i.e. to verify that this is an integral part of the business undertaken by the assessee and incidental to the import business of the assessee as in the absence of such forward contracts, the assessee may sustain huge losses and hence it became essential for the assessee to book such forward contracts as a prudent business practices to safeguard against losses which may be sustained by the assessee towards import obligation in foreign currency outstanding as at year end. Matter restored before the AO for reconsideration.

Summary

Issues:
Disallowance of marked to market loss on open derivative contracts for assessment year 2008-09.

Analysis:
The appeal by the Revenue challenges the deletion of disallowance of marked to market loss on open derivative contracts by the CIT(A). The Revenue contended that such losses are not allowable under section 37(1) of the Income-tax Act, 1961. The Revenue also argued that the disallowance was made in accordance with CBDT's Instruction No.3/2010 dated 23.03.2010. However, the CIT(A) accepted the assessee's contentions, emphasizing that the foreign exchange loss was a business loss accrued due to fluctuation in exchange rates. The CIT(A) relied on the decision of the Supreme Court in CIT v. Woodward Governor India Pvt. Ltd. and the Tribunal's decision in Mashreq Bank v. DDIT to support the allowance of the loss.

The core issue revolves around the treatment of foreign exchange rate losses on unsettled forward contracts. The assessee, engaged in the business of tiles and sanitary ware, claimed the losses as business expenses due to fluctuation in foreign exchange rates. The AO disallowed the losses, citing them as notional and relying on CBDT's Instruction No. 3/2010. However, the CIT(A) upheld the assessee's claim, highlighting the accrual basis of accounting followed by the assessee and the statutory requirement under the Companies Act to value open forward contracts at year-end exchange rates. The CIT(A) emphasized that the losses were allowable deductions, in line with the Supreme Court's decision in Woodward Governor India Pvt. Ltd. case.

The Tribunal, after considering both parties' contentions, found that the forward contracts were integral to the assessee's import activities for raw materials, serving as a hedge against foreign exchange rate fluctuations. The Tribunal emphasized that the losses were not notional but incurred as part of the business operations. Referring to the Woodward Governor India Pvt. Ltd. case and the assessee's consistent accounting practices accepted by the Revenue, the Tribunal allowed the Revenue's appeal for statistical purposes, indicating that the losses were allowable deductions for the assessment year 2008-09.

In conclusion, the Tribunal's decision overturned the CIT(A)'s order and allowed the Revenue's appeal, emphasizing the integral nature of the forward contracts to the assessee's business activities and the applicability of the Woodward Governor India Pvt. Ltd. case in allowing the foreign exchange losses as business deductions for the assessment year 2008-09.