Forex derivative transactions Loss is business loss can be set off against other business income

Where assessee, an exporter of garments, entered into forex derivative transactions through its bankers to hedge its foreign currency risk, loss incurred on such transactions could be considered as business loss which could be set off against other business income

Where assessee has acquired a business asset from country outside India in any previous year, any loss or gain arising out of foreign currency fluctuation after such acquisition shall be added to or deducted from actual cost of such asset

IN THE ITAT CHENNAI BENCH ‘C’

SCM Garments (P.) Ltd.

v.

Deputy Commissioner of Income-tax, Central Circle-III, Coimbatore

IT APPEAL NOS. 1645 & 1646 (MDS.) OF 2013, 2275 & 2313 (MDS.) OF 2014
[ASSESSMENT YEARS 2009-10 & 2010-11]

FEBRUARY  27, 2015

T. Banusekar, C.A for the Appellant. Pramod Nargia, CIT D.R. for the Respondent.

ORDER

A. Mohan Alankamony, Accountant Member – These are batch of four appeals consisting of two assessees M/s. SCM Garments (P) Ltd., and M/s. Gajaananda Jewellery Maart Pvt Ltd., (in which M/s. TCS Textiles (P) Ltd. has merged) and the Revenue. For the assessment year 2009-10 M/s. SCM garments (P) Ltd., the assessee, has filed the appeal, aggrieved by the order of the Ld. CIT (A) in ITA No. 222/11-12 dated 12.06.2013. For the assessment year 2010-11, the aforesaid assessee and the Revenue has filed the appeal, both aggrieved by the order of Ld. CIT (A) in ITA No. 112/13-14 dated 30.06.2014. For the assessment year 2009-10, M/s. Gajaananda Jewellery Maart Pvt Ltd., the assessee has filed the appeal aggrieved by the order of the Ld. CIT (A) in ITA No. 207/11-12 dated 12.06.2013. Since the issues in these appeals are common in nature, they are clubbed heard together and disposed of by this common order for the sake of convenience.

2. The concised grounds raised in all the appeals are listed below for adjudication.

2.A Assessee’s Appeal: M/s. SCM Garments (P) Ltd. (A.Ys. 2009-10 & 2010-11)in ITA Nos. 1645/13 & 2275/Mds/14:—

Common ground in both the above appeals

“The Revenue has erred in treating the loss incurred by the assessee on account of forex derivative contracts as speculative loss and thereby not allowing the assessee to set off the losses against its business income.”

2.B Revenue’s appeal: M/s. SCM Garments (P) Ltd. (A.Y.2010-11) in ITA No. 2313/Mds./14:—

“The Ld. CIT (A) has erred in holding that the assessee is entitled for deduction U/s. 80-IA of the Act”.

At the outset before us, both the parties fairly conceded that this issue is squarely covered by the Jurisdictional High Court in the case of Velayudhaswamy Spinning Mills (P.) Ltd. v. Asstt. CIT [2012] 340 ITR 477  in assessee’s favour. Therefore, respectively following the decision of Jurisdictional High Court (supra) we hereby confirm the order of the Ld. CIT (A) and allowed the deduction U/s. 80-IA of the Act amounting to Rs. 5,40,39,798/-

2.C Assessee’s Appeal: M/s. Gajaananda Jewellery Maart Pvt Ltd. (A.Y.2009-10 ) in ITA No. 1646/Mds./2013:—

1. “The Revenue has erred in treating the loss incurred by the assessee on account of forex derivative contracts as speculative loss and thereby not allowing the assessee to set off the losses against its business income.”

2. “The Ld. CIT (A) has erred in confirming the order of the Ld. Assessing Officer for disallowing the notional capital loss of Rs. 6,37,54,000/- as a revenue loss which had arisen due to the foreign currency fluctuation on the loan taken for the purchase of capital asset and capitalizing the actual loss incurred during the year on repayment of loan due to foreign currency fluctuation instead of treating the same as revenue loss.”

3. The first ground in all the assessee’s appeals is identical and therefore, for the sake of convenience the appeal by the assessee in ITA No. 1645/Mds./2013 for the assessment year 2009-10 is taken as a lead case for disposal.

4. M/s. SCM Garments Pvt. Ltd., Assessee’s Appeal in ITA No. 1645/Mds./2013 for the assessment year 2009-10.

The brief facts of the case are that the assessee is a private limited company engaged in the business of manufacture and export of garments and generation of electricity, filed it return of income on 30.09.2009 admitting an income of Rs. 12,75,09,300/-. The case was taken up for scrutiny and the assessment was completed U/s. 143(3) of the Act on 30.12.2011 wherein the Ld. Assessing Officer made one of the additions being disallowance of setoff of forex derivative loss Rs. 25,28,21,010/- against normal business income. During the course of assessment proceedings, the Ld. Assessing Officer observed that the assessee had debited forex derivative of loss of Rs. 25,28,21,010/-. It was the claim of the assessee that the loss incurred in derivative transaction during the year should be set off against the income from other business income. The argument of the assessee was that these transactions are not speculative nature because they are transacted in the normal course of business to hedge the loss from depreciation of rupee against the export receivables in foreign currency, which is in accordance with the regulations laid down by the Reserve Bank of India (RBI). Hence, it is not a transaction as stipulated U/s. 43(5) (a) & (d) of the Act. Before the Ld. Assessing Officer, the assessee has advanced the following submissions in support of its stand:—

4.1 However, the Ld. Assessing Officer, after analyzing derivatives and money market such as futures contract, forward contract and options contract and provisions of the Income Tax, observed as under:—

4.2 Further relying on certain decisions, the Ld. Assessing Officer concluded by rejecting the assessee’s claim and treating the loss of Rs. 25,28,21,010/- as speculation loss for the following reasons:—

4.3 On appeal to CIT (A), the Ld. CIT (A) after examining the issue made the following observations:—

4.4 With the above observation and relying on the order of the Ld. Assessing Officer, the Ld. CIT (A) held that the loss from derivatives contract suffered by the assessee is short time speculative transactions without any ‘hedge’, underlying on the regular export business of the assessee. Aggrieved by the order of the Ld. CIT (A), the assessee is in appeal before us.

5. Before us the Ld. AR made the following submissions.

6. On the other hand the Ld. DR argued in support of the order of the Ld. Assessing Officer and the Ld. CIT (Appeals) and submitted as follows:

It was therefore pleaded by the Ld. D.R that the order of the Revenue may be sustained.

7. We have heard the rival submissions and carefully perused the material on record and case laws relied by both the parties. In this case before us, one of the major business activities of the assessee is export of business garments as it appears from the financial statements submitted by the assessee. Therefore, it is obvious that the assessee would be having huge sundry debtors resulting from export of garments which are receivable in the foreign currency. These sundry debtors are exposed to currency fluctuation risk. One of the methods to protect loss against foreign currency fluctuation is by way of ‘hedging’. Hedging transactions are entered in order to protect against the loss due to compensatory price movement. It protects an asset or liability against fluctuation in foreign exchange rate. One of the tools for hedging the forex risk is by way of foreign currency derivatives. Section 45 of the Reserve Bank India Act, 1949 defines derivative as a financial instrument whose value depends on the value of the underlying exposures. In the case before us, the underlying exposure is the foreign currency. The commonly used forex derivatives are Forward contracts, Options contracts and Swap contracts. These instruments are used to hedge the currency risk on account of adverse currency movements. In the present case before us, the assessee has selected to book “Options Contract” as per the advice of its bankers in order to hedge its foreign exchange risk. “Options contract” is a right to exercise the option of buying or selling of a foreign currency at a particular price. However, the assessee is not compelled to buy or sell, if the spot market prices are favorable or not favorable. The cost of this “option” is called ‘Option Premium’. Upon the payment of the same, the exporter is hedged against adverse currency movement and also not liable to loose in case of favorable currency movement. Therefore, it is apparent in the case of the assessee that the assessee had entered into “Options Contract” (derivative) with the bank in order to hedge its foreign exchange risk. In the case of the assessee, what has happened is that due to adverse foreign exchange movement, the bank has debited the loss to the assessee’s account. Thus, the loss debited by the bank in the assessee’s account has crystallized and is a realistic loss suffered by the assessee. In these circumstances, the issue under consideration before us is that, whether loss on account forex derivates are to be considered as a business loss in parlance with Section 28 of the Act. Further, in the case of the assessee before us, the following facts emerge and the legal issues involved are discussed and summarized herein below:—

8. Further, it is pertinent to note that the foreign currency is neither commodity nor stock or shares. “Foreign currency” is nothing but currency printed in a different country. It is money of a country other than one’s own. “Currency” is a generally accepted form of money including coins and paper notes which is issued by a government and circulated within an economy. It is a medium based on the value of an underlying commodity. It is used as medium of exchange for goods and services. The currency value of one country with another country fluctuates according to the economic factors prevalent in those countries. Therefore holding foreign currency is placing reliance on the economic factors prevalent in that country and Stock/Shares is placing reliance in the economic strength and business policies of the company. Section 43(5) of the Act defines speculative transactions as under:—

Section 43 (Relevant provisions are highlighted herein below)

‘(5): “speculative transaction” means a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity or scrips:

Provided that for the purposes of this clause—

shall not be deemed to be a speculative transaction.

Explanation. — For the purposes of this clause, the expressions—

(i) “eligible transaction” means any transaction,—

(ii) “recognised stock exchange” means a recognised stock exchange as referred to in clause (f) of section 238 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and which fulfils such conditions as may be prescribed and notified 39 by the Central Government for this purpose;’

It is pertinent to note that banks have option to trade in foreign currency derivatives either through recognized stock exchange or through RBI. When the banks facilitates its clients to deal in foreign exchange derivatives through RBI, more stringent regulations are complied and therefore these transactions cannot be denied the benefits provided under the Act when traded through recognized stock exchange.

9. Now the question is whether to treat the foreign currency derivatives as commodities, or stocks and shares. If it is treated as commodities, Section 43(5)(a) of the Act comes to the rescue of the assessee because in the present case, the assessee is a manufacturer and exporter of garments and the assessee has entered into foreign currency derivative transactions to guard against future currency fluctuations which has a close proximity to the business of the assessee. On the other hand, if it is treated as stock/shares, such transactions will not be treated as speculative transactions if the transaction is carried out through a recognized stock exchange. The argument of the Revenue is that, if the transactions are made though banking sectors, then the same will fall within the scope of speculative transactions. This argument appears to be absurd and illogical because both Recognized Stock Exchange and Nationalized Banks are either Government regulatory body or extended arm of the Government. Further the characteristic of the currency and stock/shares are not the same and therefore, currency cannot be held as stock or shares. This view is also fortified with the various decisions.

10. Now let us examine the following decisions:—

A. In the case of Badridas Gauridu (P.) Ltd. (supra) wherein it was held that the assessee was not a dealer in foreign exchange. The assessee was a cotton exporter. The assessee was an export house. Therefore, foreign exchange contracts were booked only as incidental to the assessee’s regular course of business. The Tribunal has recorded a categorical finding to this effect in its order. The Assessing Officer has not considered these facts. Under s.43(5) of the IT Act, ‘Speculative transaction” has been defined to mean a transaction in which a contract for the purchase or sale of a commodity is settled otherwise than by the actual delivery or transfer of such commodity. However, as stated above, the assessee was not a dealer in foreign exchange. The assessee was an exporter of cotton. In order to hedge against losses, the assessee had booked foreign exchange in the forward market with the bank. However, the export contracts entered into by the assessee for export of cotton in some cases failed. In the circumstances, the assessee was entitled to claim deduction in respect to Rs. 13.50 lakhs as a business loss. This matter is squarely covered by the judgment of the Calcutta High Court, with which we agree, in the case of Ld.Soorajmull Nagarmull (supra).

B. In the case of Sooraj mull Nagarmull (supra) wherein it was held that the assessee used to carry on export and import of jute business. In the course of normal business it used to enter into foreign exchange contracts in order to cover up loss and difference in foreign exchange valuation. The assessee utilized part of the amount of the foreign exchange covered. This finding of fact has not been challenged, If in the course of normal carrying on of business certain loss or obligation or interest arise these must be deferrable to the carrying on of the business and these must be incidental to the carrying on of the business. Undoubtedly, the contract for foreign exchange as such can be treated as a contract for commodity. But the question here essentially is that the assessee was carrying on business of export and import of jute goods. In order to carry out these transactions, the assessee had to enter into foreign exchange contract in order to cover up these transactions. In those foreign exchange contracts, if any loss occurred then such loss was a loss referable to and related to the business carried on and arising out of the business of the assessee. Here there is no finding that entering into foreign exchange contract was the nature of the business operation for the export and import of the goods by the assessee. The assessee was not a dealer in foreign exchange contract as such. Here in this case, the contract was for a full amount and what the assessee paid in fulfilment of the obligation which was an implied term at the time of entering into the contract did not amount to breach of contract. The breach of contract did not come within the meaning of ‘contract settled’ as used in Expln.2 of s.24(1) of IT Act, 1922, ‘contract settled’ meant contract settled before breach. Where the money which the assessee paid was in settlement of the amount of damages suffered by the assessee by reason of breach of the contract to delivery, it is to be held that the payment was not a loss from a speculative transaction as defined in Expln.2 of s.24(1) of IT Act, 1922.

C. In the case of Cotton Blossoms (India) (P.) Ltd. v ACIT [IT Appeal No. 2032 (Mds.) of 2012, vide order dated 21-2-2013], also the Chennai Bench of the Tribunal held that, in respect of forex contracts entered into by the assessee in similar circumstances will not fall under the definition of speculative transaction.

D. In the case of Sutlej Cotton Mills Ltd. (supra) wherein it was held that loss on account of revaluation of foreign currency is a trading loss to the extent it does not relate to any capital asset and accordingly allowable.

E. In the case of Munjal Showa Ltd. (supra) wherein it was held that profit on cancellation of forward contract in foreign currency entered into for safeguarding against loss by fluctuation in foreign currency for purchase of plant and machinery with loan obtained in foreign exchange is capital receipt and not speculative profit.

F. In the case of CIT v. Vishindas Holaram [2015] 229 Taxman 30 (Bombay) it was held that once main business of assessee is identified, if some incidental activities or transactions or dealing in foreign exchange is undertaken but that is also related to some extent to main business activity, then, it could not be said that assessee is in speculative business.

G. In the case of CIT v. Climate System (P.) Ltd. 227 Taxman 174 (Delhi) (Mag.) Delhi High Court wherein it was held that exchange fluctuation arising on the revenue account transaction should be allowed as deductable expenditure.

11. Thus to sum up in the present case before us, the assessee is an exporter of garments who has entered into forex derivative transactions through its bankers with a view to effectively hedge its foreign currency risk. Therefore, these forex derivative transactions have a close proximity or rather incidental to the export business of the assessee, which cannot be considered as speculative. Moreover in the case of the assessee foreign currency contracts cannot be treated as wagering contracts for the reasons discussed herein above. Section-43(5) of the Act is applicable to transactions in commodity or stocks and shares. If currency is treated as commodity, then according to Section 43(5) (a) of the Act, such transaction shall not be deemed to be speculative transaction. Further currency cannot be treated as stock or shares because inherently they have different characteristic. Further, in the case of the assessees, the foreign exchange exposure for the “relevant period” specified by “R.B.I” regulations is quiet substantial in order to justify the forex derivative transactions made by the assessee through Government recognized channel, otherwise the RBI would not have entertained these transactions and would have restrained the banks from entering into such transaction with its clients. Thus considering the totality of the facts and circumstance of the case and the decisions relied upon herein above, we allow the grounds raised by the assessee’s on this issue for all the three appeals in favour of the assessee and accordingly we hereby direct the Revenue to set off of the losses incurred by the assessee on account of forex derivatives contracts against the business income of the assessee. Thus, the ground raised in the assessee M/s. SCM Garments Pvt Ltd in ITA Nos. 1645/13 & 2275/Mds./2014 for the assessment years 2009-10 & 2010-11 and the first ground raised by the assessee M/s. Gajaananda Jewellery Maart Pvt Ltd. in ITA No. 1646/Mds./2013 for the assessment year 2009-10 are allowed in their favour.

M/s. Gajaananda Jewellery Maart Pvt Ltd (A.Y 2009-10)

12.1 The first ground raised by the assessee is decided in favour of it as discussed supra.

12.2 The second ground of assessee’s appeal relates to disallowance of the notional loss due to foreign currency fluctuation on the loan obtained for acquiring capital assets amounting to Rs. 6,37,54,000/- whereas the Revenue has allowed to capitalize the actual loss amounting to Rs. 1,36,00,000/- resulting from repayment of loan during the relevant previous year and given the benefit of depreciation.

The brief facts of the issue is that the assessee had claimed Rs. 6,37,54,000/- as deduction being the notional loss incurred due to foreign currency fluctuation against the loans taken for purchase of capital loss. The Ld. Assessing Officer disallowed this claim of the assessee, however, allowed to capitalize the actual foreign currency fluctuation loss incurred by the assessee on repayment of foreign currency loan. The Ld. Assessing Officer had come to this conclusion based on the provisions of section 43A of the Act.

12.3 On appeal, the Ld. CIT (A) held as follows:—

“I am in agreement with the A.O that by applying the provisions of section 43A actual loss of forex fluctuation incurred on repayment of loan will be allowed and the claim of actual capital loss of Rs. 6,37,54,000/- will be treated as capital expenditure and disallowed. Necessary adjustments to the cost of acquisition regarding actual loss of Rs. 1,36,00,000/- will be made in the block of assets and depreciation will be allowed in the same.”

12.4 On reading Section 43A of the Act, it is abundantly clear that where the assessee has acquired an asset in any previous year from a country outside India for the purpose of his business or profession, any loss or gain arising out of the foreign currency fluctuation during any previous year after the acquisition of such asset shall be added or deducted from the actual cost of the asset on actual payment or repayment of foreign currency loan. In the case of the assessee, the actual loss on repayment of loan is Rs. 1,36,00,000/- and the Revenue has accordingly allowed the assessee to capitalize this amount and claim depreciation. Therefore, we do not find any infirmity in the order of the Ld. CIT (A). Therefore, this ground raised by the assessee is dismissed.

13. In the result,