2025 (5) TMI 495 - AT - Income Tax

Revision u/s 263 - allowance of loss incurred by the assessee on foreign currency derivative transactions ( FCDT for amounting short) which the ld.Pr.CIT found to be marked to market loss ( M2M for short) and noting the same to be notional loss contingent in nature and not allowable in terms of the CBDT Instruction No.3/2010 dated 23.03.2010 ( Board Instruction ) - CIT said AO to have allowed this claim erroneously without examining the issue and conducting due enquiries with regard to the same. HELD THAT - With respect to the portion of the loss claimed by the assessee on account of exchange difference in respect of outstanding balance of creditors this fact undoubtedly had been brought to the notice of the AO and CIT also during the revisionary proceedings. The assessee had also demonstrated that the claim of this loss had been made following the AS-11 recommended by the ICAI for this purpose; that it was also pointed out that the Hon ble Apex Court in a series of the decisions beginning with CIT Vs. Woodward Governor P.Ltd. 2009 (4) TMI 4 - SUPREME COURT and ONGC 2010 (3) TMI 81 - SUPREME COURT had held such identical claims to be allowable in terms of section 37(1) of the Act. CIT we agree with the assessee has found the claim to be wrongly allowed by the AO completely misappreciating the facts of the present case and noting it to be on account of loss on forward contract of FCDT . Noting this incorrect fact he has held the transaction to be speculative in terms of section 43(5) of the Act and noting this incorrect fact alone he has distinguished the decision the assessee had cited as applicable in the facts of the case. Therefore we agree with assessee that the finding of the error by the ld.Pr.CIT on account of incorrect allowance of claim of loss on account of foreign exchange difference in relation to outstanding creditors was an incorrect finding of the error based on incorrect appreciation of the facts and therefore the same is held to be not sustainable. Other component of the loss admittedly the same was on account of forward contract of FCDT but the assessee had pointed out that the loss was a settled loss and not an M2M loss. CIT we find still goes on to record an incorrect finding that the loss was an unsettled M2M loss and hence not allowable in terms of CBDT Instruction No. 3 of 2010 (supra). On the second issue also we find that the ld.Pr.CIT has failed to appreciate the correct facts of the case while finding the assessment order erroneous. The assessee had demonstrated the loss claimed to be not an M2M loss but a settled loss and the ld.Pr.CIT we find however goes on to record fact to the contrary that it was an M2M loss. Basis this incorrect fact noted by him the PCIT we find went on hold the assessment order erroneous causing prejudice to the Revenue for having allowed such M2M loss in contradiction/in violation of the Instruction issued by the CBDT in this regard. Assessee had explained such loss to have been incurred while hedging its foreign currency transaction from fluctuations which transactions were entered into in the course of carrying out its business activities for importing raw-material and had also pointed out that in various judicial decisions such losses were held to be allowable. CIT we find has failed to appreciate this contention of the assessee and has merely noted the fact that the loss booked by the assessee was a notional/contingent loss on account of unsettled transaction which as we have noted above was an incorrect finding of the fact by the ld.Pr.CIT. Therefore the second issue also of loss on forward contract of foreign currency derivatives booked by the assessee of Rs. 82.91 lakhs being wrongly allowed by the AO the finding of the error by the ld.Pr.CIT is again based on mis-appreciation of the facts of the case before it and also by not appreciating the judicial decisions cited by the assessee to it. The finding of the error by the ld.Pr.CIT on the loss on forward contract of FCDT of Rs. 82.91 lakhs is also held to be not sustainable. CIT has alternatively held that even if transactions entered into by the assessee has not treated as speculative the Explanation to section 73 of the Act was applicable to the facts of the present case as per which the assessee would not be entitled to set off any loss on transaction of buy and sale of US dollar through brokers as in the facts of the present case. The AO has not examined the issue from this perspective and therefore rendering the assessment erroneous - Admittedly the applicability of provisions of section 73 of the Act was never confronted to the assessee during the revisionary proceedings. Therefore holding the assessment order erroneous on account of the applicability of a provision which was never confronted to the assessee is we agree with the assessee in gross violation of principles of natural justice. Besides we have gone through the order of the CIT and we find that there is no clarity in the order of the ld.Pr.CIT as to how the Explanation to section 73 would disentitle the assessee to set off any loss on transactions on trading in foreign currency. CIT has merely reproduced the Explanation below the section 73 and on perusing the contents of the same we fail to understand how it can be derived therefrom that loss on transaction in FCDT is not allowed to be set off in terms of the said section. Even the order of the ld.Pr.CIT gives no clarity on how the Explanation is so interpreted by him. As gone through the provisions of section 73 and we find that it has absolutely no applicability to the facts of the present case. In the facts of the present case the ld.Pr.CIT has alternatively applied section 73 stating that if the FCDT transactions are not treated as speculative then section 73 will be applicable. But since section 73 applies only to loss incurred in speculative business this interpretation of the ld.Pr.CIT we find is incorrect. Coming to the Explanation to section 73 which the ld.Pr.CIT has invoked what it merely states is that if a company indulges in the business of trading in shares primarily such transactions would be treated as speculative business. Thus the Explanation to section 73 deems the transactions in trading of shares in specific circumstances to be speculative in nature. The facts of the present case are not that the transactions entered into by the assessee were in relation to trading of shares. There is no question therefore for the Explanation to section 73 being attracted. Therefore we find that the ld.Pr.CIT had grossly erred in holding that the Explanation to section 73 would be attracted in the facts of the present case. We hold that the order passed by the ld.Pr.CIT under section 263 of the Act is not sustainable - Assessee appeal allowed.

Summary

The core legal questions considered by the Appellate Tribunal (AT) pertain to the exercise of revisionary powers under section 263 of the Income Tax Act, 1961 ("the Act") by the Principal Commissioner of Income Tax (Pr.CIT). The issues arise from the Pr.CIT's order holding the assessment orders for assessment years 2014-15 and 2015-16 erroneous and prejudicial to the Revenue. The primary legal issues examined are:

1. Whether the loss claimed by the assessee on foreign currency derivative transactions (FCDT) amounting to Rs. 1,50,12,699/- is allowable as a business loss or disallowable as a notional "marked to market" (M2M) loss under the CBDT Instruction No. 3/2010 dated 23.03.2010.

2. Whether the loss on exchange rate difference of Rs. 53.49 lakhs in respect of outstanding payment to creditors in foreign currency is allowable as business expenditure under Accounting Standard (AS) 11 and judicial precedents.

3. Whether the foreign currency derivative transactions entered into by the assessee are speculative transactions under section 43(5) of the Act and thus losses arising therefrom are disallowable or restricted under the provisions governing speculative transactions.

4. Whether the Explanation to section 73 of the Act is applicable to the assessee's transactions, thereby restricting the set-off of losses incurred on such transactions.

5. Whether the Pr.CIT's order under section 263 is sustainable considering the scope of revisionary powers, principles of natural justice, and proper appreciation of facts and law.

Issue-wise Detailed Analysis

1. Allowability of Loss on Foreign Currency Derivative Transactions (FCDT) as Business Loss or M2M Loss

The legal framework involves section 263 of the Act (revisionary powers), section 43(5) defining speculative transactions, CBDT Instruction No. 3/2010 on tax implications of forex derivatives, and judicial precedents interpreting these provisions.

The Pr.CIT held that the loss allowed by the Assessing Officer (AO) was a "marked to market" (M2M) loss which is notional and contingent in nature and hence disallowed under the CBDT Instruction No. 3/2010. The Instruction clarifies that M2M losses, which are unrealized and booked for accounting transparency, are not allowable for tax purposes. Only losses on actual settlement of contracts are potentially allowable subject to their speculative nature under section 43(5).

The assessee contended that the loss of Rs. 82.91 lakhs on FCDT was a settled loss incurred on forward contracts entered into on MCX Stock Exchange Ltd., a recognized stock exchange as per SEBI and the Companies Act, and thus qualifies as an "eligible transaction" under section 43(5)(d) or (e). The loss was not an M2M loss but a realized loss on settlement. The assessee also demonstrated compliance with regulatory and accounting standards and relied on judicial decisions holding such losses allowable as business expenditure.

The Tribunal examined the nature of the transactions and found that the assessee had explained the loss was on settled contracts, supported by contract notes and broker statements. The transactions were carried out electronically on a recognized stock exchange, fulfilling conditions under section 43(5) exceptions to speculative transactions. The Tribunal noted that the Pr.CIT erred by treating the entire loss as M2M loss without appreciating the distinction between settled and notional losses.

Further, the Tribunal referred to the definition of "marked to market" and the accounting principles involved, emphasizing that M2M losses are unrealized and contingent, whereas the assessee's loss was on actual settlement. The Tribunal also considered the detailed submissions and documents demonstrating the bona fide nature of the transactions as hedging activities in the normal course of business.

2. Allowability of Loss on Exchange Rate Difference of Creditors under AS-11

The assessee claimed a loss of Rs. 53.49 lakhs on account of exchange rate difference on outstanding payments to foreign creditors, recorded following AS-11 "The Effects of Changes in Foreign Exchange Rates" issued by the ICAI. The Hon'ble Supreme Court decisions in CIT Vs. Woodward Governor P. Ltd. and ONGC Vs. CIT were cited, which held such foreign exchange fluctuation losses allowable as business expenditure under section 37(1) of the Act.

The Pr.CIT treated this loss as part of the M2M loss and disallowed it under the CBDT Instruction No. 3/2010, incorrectly categorizing it as a forward contract loss. The Tribunal found this to be a misappreciation of facts, noting that the loss was not on any forward contract but on restatement of outstanding liabilities, a revenue loss allowable under law and accounting standards.

The Tribunal held that the Pr.CIT's finding of error on this ground was unsustainable as it was based on incorrect factual assumptions and failure to appreciate binding judicial precedents.

3. Speculative Nature of Foreign Currency Derivative Transactions under Section 43(5)

Section 43(5) defines speculative transactions and carves out exceptions for certain contracts, including eligible transactions in derivatives carried out on recognized stock exchanges (clause d) and commodity derivatives on recognized associations (clause e). Explanation 1 to section 43(5) defines "eligible transaction" and "recognized stock exchange".

The Pr.CIT held that the assessee's FCDT transactions were speculative and thus losses disallowable. The assessee demonstrated that the transactions were entered on MCX Stock Exchange Ltd., a recognized stock exchange notified under relevant provisions, and supported by time-stamped contract notes, fulfilling the criteria of eligible transactions under section 43(5)(d).

The Tribunal examined the contract notes, broker details, and regulatory approvals, concluding that the transactions qualified as eligible and were not speculative. The Tribunal found the Pr.CIT's conclusion to the contrary was based on a flawed factual premise and incorrect legal interpretation.

4. Applicability of Explanation to Section 73 of the Act

The Pr.CIT alternatively held that even if the transactions were not speculative under section 43(5), the Explanation to section 73 would apply, restricting the set-off of losses on such transactions. Section 73 deals with the set-off and carry-forward of losses from speculative business, and its Explanation deems companies engaged primarily in trading shares to be carrying on speculation business to the extent of such trading.

The assessee argued that this provision was never raised or confronted during revisionary proceedings, violating principles of natural justice. Further, the Tribunal noted that section 73 applies only to losses from speculation business and the Explanation relates specifically to trading in shares, which is not the case here.

The Tribunal found that the Pr.CIT's invocation of section 73 was without basis, lacked clarity, and was not sustainable in law or fact. The Tribunal emphasized that the assessee was not engaged in trading shares, and section 73 had no applicability to foreign currency derivative transactions.

5. Exercise of Revisionary Powers under Section 263 and Principles of Natural Justice

The Tribunal observed that the scope of adjudication was limited to whether the Pr.CIT rightly found the assessment orders erroneous causing prejudice to the Revenue. The Pr.CIT's order was based on incorrect appreciation of facts, misapplication of legal provisions, and failure to consider judicial precedents cited by the assessee.

The Tribunal also noted that the Pr.CIT introduced new grounds such as the applicability of section 73 without giving the assessee an opportunity to respond, violating principles of natural justice. The Tribunal emphasized that revisionary powers under section 263 must be exercised judiciously and not on incorrect factual or legal premises.

Significant Holdings

"The finding of the error by the ld.Pr.CIT in the order of the AO is not based on correct appreciation of both the facts of the case on record and the judicial interpretation of the provision of law in this regard."

"The ld.Pr.CIT has found the assessment order passed in the case of the assessee to be erroneous proceeding on the factual premise that entire loss claimed by the assessee of Rs. 1,50,12,699/- pertained to forward contracts in foreign currency derivative transactions. And this despite the assessee clearly pointing out that entire loss booked by the assessee was not on account of foreign currency derivative transactions but partly on account of the exchange rate difference of outstanding balance of creditors and part on account of forward contracts in derivatives transactions."

"The finding of the error by the ld.Pr.CIT on account of incorrect allowance of claim of loss on account of foreign exchange difference in relation to outstanding creditors of Rs. 53.49 lakhs was an incorrect finding of the error based on incorrect appreciation of the facts, and therefore, the same is held to be not sustainable."

"The ld.Pr.CIT has failed to appreciate the correct facts of the case, while finding the assessment order erroneous. The assessee had demonstrated the loss claimed to be not an M2M loss, but a settled loss, and the ld.Pr.CIT, we find, however goes on to record fact to the contrary that it was an M2M loss. Basis this incorrect fact noted by him, the Ld.PCIT, we find, went on hold the assessment order erroneous causing prejudice to the Revenue for having allowed such M2M loss in contradiction/in violation of the Instruction issued by the CBDT in this regard."

"The Explanation to section 73 deems the transactions in trading of shares in specific circumstances to be speculative in nature. The facts of the present case are not that the transactions entered into by the assessee were in relation to trading of shares. There is no question, therefore, for the Explanation to section 73 being attracted."

"The order passed by the ld.Pr.CIT under section 263 of the Act is not sustainable, and therefore, directed to be quashed."

Core Principles Established

- Losses on foreign currency derivative transactions that are settled and entered into on recognized stock exchanges, fulfilling conditions of section 43(5)(d) or (e), are allowable as business losses and not speculative losses.

- Losses arising from exchange rate differences on outstanding foreign currency liabilities, accounted for under AS-11, are allowable business expenditures under section 37(1) and judicial precedents.

- Marked to market losses, being notional and contingent, are not allowable for tax purposes as per CBDT Instruction No. 3/2010.

- Revisionary powers under section 263 must be exercised on correct appreciation of facts and law, and in accordance with principles of natural justice.

- Section 73 and its Explanation apply only to losses from speculative business primarily involving trading in shares and do not apply to foreign currency derivative transactions in the facts of this case.

Final Determinations

The Tribunal quashed the order passed by the Pr.CIT under section 263 for both assessment years 2014-15 and 2015-16, holding that the assessment orders were not erroneous and that the losses claimed by the assessee on foreign currency derivative transactions and exchange rate differences were rightly allowed by the AO. The findings of the Pr.CIT were based on incorrect appreciation of facts and law, and the invocation of section 73 without confronting the assessee violated natural justice. Consequently, both appeals filed by the assessee were allowed.