[2015]

53 taxmann.com 429 (Bangalore - Trib.)/[2015] 67

SOT 210 (Bangalore - Trib.) (URO)[17-10-2014]

IT: Provision for losses created on foreign exchange

option contracts as on Balance Sheet date does not
constitute an ascertained liability and, thus,
deduction could not be allowed in respect of same as
business loss
IT: Where assessee, engaged in trading of goods,
entered into 'foreign currency swap option',
provision for loss pertained to those foreign
currency transactions, without supported by actual
delivery, being speculative in nature, assessee's case
was not covered by proviso (a) to section 43(5)

■■■

[2015] 53 taxmann.com 429 (Bangalore - Trib.)

IN THE ITAT BANGALORE BENCH 'B'
Shankara Infrastructure Materials Ltd.
v.
Assistant Commissioner of Income-tax, Circle-12 (3),
Bangalore*
N.V. VASUDEVAN, JUDICIAL MEMBER
AND JASON P. BOAZ, ACCOUNTANT MEMBER
IT APPEAL NO. 85 (BANG.) OF 2013
[ASSESSMENT YEAR 2008-09]
OCTOBER 17, 2014

Section 28(i) of the Income-tax Act, 1961 - Business

loss/deductions - Allowable as (Foreign exchange option
contracts) - Assessment year 2008-09 - Whether provision
for losses created on foreign exchange option contracts as
on Balance Sheet date does not constitute an ascertained
liability and, thus, deduction could not be allowed in
respect of same as business loss - Held, yes [Para 4.3.6] [In
favour of revenue]
Section 43(5) of the Income-tax Act, 1961 - Speculative
transactions (Hedge transactions) - Assessment year 2008-
09 - Whether where assessee engaged in trading of steel
tubes, pipes, PVC, etc., entered into 'foreign currency swap
option', provision for loss shown by assessee pertained to
those foreign currency transactions, against which no
actual delivery of foreign exchange was made, were not
hedging transactions, but same were speculative in nature
and, therefore, assessee's case was not covered by proviso
(a) to section 43(5) - Held, yes [Para 4.3.11A] [In favour of
revenue]
Circulars & Notifications - Instruction No. 3/2010, dated
23-3-2010
FACTS

■ The assessee was in the business of dealing/trading in steel
tubes, pipes, PVC, etc.
■ The assessee had raised a bank loan and had entered into a
'foreign currency swap option', reportedly as a measure to
reduce the interest cost on the loan. According to the
assessee, by entering into such a foreign currency swap
option, the assesee got twin advantages in the form of
comparative foreign currency fluctuation advantage and
interest advantage.
■ In the course of assessment proceedings, the Assessing
Officer noted that the assessee had shown certain amount as
provision for FCNR fluctuation loss in the Balance Sheet and
treated this amount as a notional loss from speculation
business in the original return of income. However, said
amount was treated as a revenue loss and was claimed as a
deduction in the revised return of income filed by the
assessee.
■ After examining the details of the transaction, the Assessing
Officer held the loss to be notional in nature and disallowed
the assessee's claim of said loss being revenue loss.
■ The Commissioner (Appeals) upheld the order of Assessing
Officer.
■ On second appeal:

HELD

■ It may be useful and relevant to briefly analyse the concept of
'derivatives' and the underlying nature of such transactions,
before deciding whether they do or do not constitute
'speculative transactions' and whether they represent
'notional loss' or real loss. Put simply, a derivative is a
financial instrument whose value depends on the value of the
underlying exposure. The underlying exposure in foreign
exchange derivatives is the foreign exchange rates. The
common foreign exchange derivatives are 'Forward
Contracts', 'Option Contracts', 'Swap Contracts' etc. These
instruments are used to hedge the currency risks on account
of adverse currency movements.
■ The term 'Marked to Market' losses ('MTM') refers to losses
computed as on a particulate date with reference to prevailing
exchange rate in respect of contracts that have not matured
(viz open contracts). As per the prescribed Accounting
Standards, companies are required to account for 'MTM'
losses in their books of account despite the fact that the
contract has not yet matured as on the Balance Sheet date.
[Para 4.3.5]
■ The assessee has submitted copies of quotations of the option
contracts as additional evidences in terms of Rule 29 of the
ITAT Rules. The documents submitted give the indicative
terms and conditions for the FCNR hedge taken by the
assessee. The trade date is not specified, indicating that the
date can be decided by the assessee at a later date. There is
no certainty of the trade date, which can be chosen by the
assessee at its option. From the details given for pay off, it is
seen that the pay off is not firmed up or certain but would
depend on the currency trading position.
■ Therefore, neither the pay off date nor the pay off amount is
firmed up or certain. It follows that the provision created as
on the Balance Sheet date therefore cannot be called as an
ascertained liability. In this view of the matter, it is clear that
the provision for losses created on the foreign exchange
option contracts as on Balance Sheet date did not constitute
an ascertained liability. [Para 4.3.6]
■ Further, it is necessary to decide whether the transaction in
question is a speculative transaction as is the view of revenue
or a hedging transaction,as contended by the assessee. [Para
4.3.11]
■ The assessee in the case on hand, has entered into a
derivative contract of option, whereas the business of the
assessee is trading in steel tubes, pipes, PVC, etc. It is not in
dispute that the option transactions were not in respect of
specified imports or exports. It is also not in dispute that the
provision for loss shown by the assessee pertained to those
foreign currency transactions, against which no actual
delivery of foreign exchange was made. On an appreciation of
the facts surrounding the transactions in question, it is held
that the transactions entered into by the assessee were not
hedging transactions, but the same were speculative and
therefore the assessee's case was not covered by proviso (a)
to section 43(5) [Para 4.3.11A]

■ In view of the above discussion of the facts and circumstances

of the case, it is concluded that the transactions in question in
the case on hand are speculative transactions and therefore,
the Commissioner (Appeals) was right in upholding the
decision of the Assessing Officer that the transaction entered
into by the assessee is speculative in nature; the losses shown
are notional in character and, therefore, the provision for loss
claimed as a deduction is liable to be disallowed. [Para 4.3.14]
■ As regards the alternate contention of the assessee that if the
transaction in question is held to be speculative in nature,
then the provision for loss should be allowed as a deduction
from the gains reported from such transactions, the said
contention of the assessee cannot be accepted. It is nobody's
case that the assessee is engaged in the business of
speculation. It has also been held that the loss shown is a
 notional loss only and such notional loss is not liable to be
adjusted against the profit actually earned by the assessee.
The stage for adjustment arises only when the loss/liability
actually crystallises. [Para 5]
■ In the result, the assessee's appeal is dismissed. [Para 7]

CASE REVIEW

CIT v. Woodward Governor India (P.) Ltd. [2007] 312 ITR 254/179
Taxman 326 (SC) (para 4.3.10) and ABN Amro Securities India
(P.) Ltd. v. ITO [2011] 133 ITD 343/15 taxmann.com 177 (Mum.)
(para 4.3.13) distinguished.
CIT v. Bharat R Ruia (HUF) [2011] 337 ITR 452/199 Taxman
87/10 taxmann.com 265 (Bom.) (para 4.3.12) followed.
CASES REFERRED TO

CIT v. Woodword Governor India (P.) Ltd. [2009] 312 ITR 254/179
Taxman 326 (SC) (para 2.3), Vinod Kumar Diamonds (P.) Ltd. v.
Addl. CIT [2013] 35 taxmann.com 337/59 SOT 124 (Mum. - Trib.)
(para 4.3), ABN Amro Securities India (P.) Ltd. v. ITD [2011] 133
ITD 343/15 taxmann.com 177 (Mum.) (para 4.3.4) and CIT v.
Bharat R. Ruia (HUF) [2011] 337 ITR 452/199 Taxman 87/10
taxmann.com 265 (Bom.) (para 4.3.12).
Banushekar, C.A. for the Appellant. L.V. Bhaskar Reddy, J. CIT
DR. for the Respondent.
ORDER

Jason P. Boaz, Accountant Member - This appeal by the
assessee is directed against the order of the Commissioner of
Income Tax (Appeals)-III, Bangalore dt.31.10.2012 for
Assessment Year 2008-09.
2. The facts of the case, briefly, are as under :—
2.1 The assessee a company engaged in the business of trading
in steel tubes, pipes,PVC, etc. filed its return of income for
assessment year 2008-09 on 23.9.2008 declaring total income of
Rs.24,27,56,572. Subsequently, on 22.3.2010 a revised return of
income was filed wherein the income declared was
Rs.22,47,57,192. The case was selected for scrutiny and the
assessment was completed u/s. 143(3) of the Income Tax Act,
1961 (hereinafter referred to as 'the Act') by order dt.28.12.2010
wherein the total income was determined at Rs.24,27,69,660 in
view of the following additions/disallowances to the returned
income ;—

(i) Disallowance towards provision for FCNR loss ; Rs.

1,79,99,380.
(ii) Disallowance u/s.l4A : Rs.13,087.
2.2 In the course of assessment proceedings, the Assessing
Officer observed that the assessee had shown an amount of
Rs.1,79,99,380 as provision for FCNR fluctuation loss in the
Balance Sheet and treated this amount as a notional loss from
speculation business in the original return of income filed.
However, this amount was treated as a revenue loss and was
claimed as a deduction in the revised return of income filed by
the assessee. After examining the details of the transaction, the
Assessing Officer held the loss to be notional in nature and
disallowed the assessee's claim of this loss being revenue
expenditure.
2.3 Aggrieved by the order of assessment for Assessment Year
2008-09 dt.28.12.2010, the assessee preferred an appeal before
the CIT(Appeals) - III, Bangalore. The learned CIT (Appeals)
called for a remand report from the Assessing Officer on the
submissions of the assessee. After examining the views and
contentions of both parties, the learned CIT (Appeals) vide order
dt. 31.10.2012, upheld the decision of the Assessing Officer in
disallowing the assessee's claim for, deduction in respecl of the
loss of Rs.1,79,99,380, making the following
observations/findings ;—

(i) The contentions of the assessee that the foreign currency

swap options are towards decreasing the interest cost is
not borne out of the facts as the assessee has earned
surplus from such transactions.
(ii) Entering into such transactions is not the business of the
assessee and arises out of a speculative strategy and
therefore cannot be treated as business transactions;
(iii) The facts of the assessee's case are clearly
 distinguishable from the facts of the case of CIT v.
Woodward Governor India (P.) Ltd. [2009] 312 ITR
254/179 Taxman 326 (SC) relied on by the assessee;
(iv) The Assessing Officer is correct in holding that the loss
claimed is an entirely notional one and such a notional
loss is not eligible for deduction as expenditure.
The learned CIT (Appeals) also rejected the alternate
contention of the assessee that, in case the losses
claimed are to be treated as speculative losses, it should
be allowed to be set off against the speculation income
earned during the same year.
3. Aggrieved by the order of the CIT(Appeals) - III, Bangalore for
Assessment Year 2008-09 dt.31.10.2012, the assessee is in appeal
before this Tribunal raising the following grounds ;—

"1. that the order of the Commissioner of Income Tax

(Appeals) is contrary to law, facts and circumstances of
the case and at any rate is opposed to the principles of
equity, natural justice and fair play.
2. For that the Commissioner of Income Tax (Appeals)
failed to appreciate that the order of the Assessing
Officer is without jurisdiction.
3. For that the Commissioner of Income Tax (Appeals) erred
in upholding the disallowance of Rs. l,79,99,380 as
speculative loss.
4. For that the Commissioner of Income Tax (Appeals) erred
in concluding that the foreign currency swap option
exercised by the appellant cannot be treated as a normal
business transaction for the purpose of section 37(1).
5. For that the Commissioner of Income Tax (Appeals)
failed to appreciate that the sum of Rs. 1,79,99,380
charged to profit and loss account had been computed
based on the provisions of Accounting Standard 11 and
hence the accounting treatment of the same is
undisputable.

6. For that the CIT (Appeals) failed to appreciate that the

swap transaction was a hedging arrangement and not a
 speculative transaction.
7. For that the CIT (Appeals) failed to appreciate that the
exchange loss resulting on account of translation of
foreign currency obligation outstanding on the balance
sheet date and which is accounted as per AS 11 is a
deductible expenditure.
8. For that assuming without conceding that the
transaction is a speculative transaction, the CIT
(Appeals) failed to appreciate that one single transaction
does not constitute a business.
9. For that the CIT (Appeals) ought to have appreciated
that section 73 of I. T. Act, 1961 speaks about
speculative business and not speculative transaction.
10. For that without prejudice to the above, if the loss is to
be treated as a speculative loss then the same should be
set off against the speculative income earned during the
year.
11. For these grounds and such other grounds that may be
urged before or during the hearing of the appeal it is
most humbly prayed that the Hon 'ble Tribunal may be
pleased to -

a. Delete the disallowance of claim of Rs.l,79,99,380

as expenditure.
b. Pass such other orders as the Hon 'ble Tribunal
may deem fit."
4. Allowability of FCNR Loss
4.1 The issue of the allowability or otherwise of the FCNR Loss of
Rs.1,79,99,380 treated by the assessee as revenue loss and
claimed as a deduction in its revised return of income is the main
issue for adjudication before us in this appeal.
4.2 Before us, the learned Authorised Representative of the
assessee made elaborate submissions, essentially reiterating the
submissions made before the learned CIT (Appeals). The learned
Authorised Representative of the assessee also submitted written
submissions and relied on various case law, which are taken on
record. The assessee also submitted additional evidence under
Rule 29 of the ITAT Rules, which were the copies of quotations
related to the options entered into by the assessee.
4.3 Per contra, the learned Departmental Representative
strongly supported the order of the learned CIT (Appeals) and
placed reliance on the decision in the case of S. Vinod Kumar
Diamonds (P) Ltd. v Addl. CIT [2013] 35 taxmann.com 337/59
SOT 124 (Mum. - Tribunal).
4.3.1 We have heard both parties at length and perused and
carefully considered the material on record, including the judicial
decisions cited and placed reliance upon by both parties.
4.3.2 The undisputed facts in the case on hand are that the
assessee is in the business of dealing/trading in steel tubes,
pipes, PVC, etc. and is not in the business of entering into such
option transactions. The assessee had raised a bank loan and had
entered into a "foreign currency swap option", reportedly as a
measure to reduce the interest cost on the loan. According to the
assessee, by entering into such a foreign currency swap option,
the assessee gets twin advantages in the form of comparative
foreign currency fluctuation advantage and interest advantage.
As per the assessee;

(i) it had entered into an option contract in August, 2006 for

a period of 12 months for Rs.5 Crores; which was the
loan amount taken by the assessee, (A)
(ii) Subsequently, in Nov., 2006, when the bank loan was
raised to Rs.10 Crores, the assessee entered into another
foreign currency'swap option for a period of 6 months on
this amount of Rs.10 Crores; (B)
(iii) The second foreign currency swap option of Rs. 10
Crores was rolled over on 17.8.2007 for a period of 12
months (Rollover);
(iv) The foreign currency swap option contracts at (A) and
(B) were settled in Financial Year 2007-08 which
resulted in gains to the assessee company;
(v) The settlement date of the option B rollover fell in the
next financial year. As on the date of closing of the year
under consideration, the option B rollover subsisted.
4.3.3 It was the assessee's contention that as per the
requirement of the Accounting Standards ('AS') - 11 dealing with
"Accounting with effect of changes in Foreign Exchange Rates",
the assessee is required to provide for losses in respect of all
outstanding option contracts at the Balance Sheet date by
marking them to market. This marking to market losses has been
provided as per the accounting requirements. The assessee
contends that, in the above mentioned factual matrix, such a
provision for losses is deductible under the provisions of the Act.
4.3.4 Opposing the view of Revenue, the assessee made
submissions that :—

(i) Section 43(5) of the Act does not cover foreign currency
swap option transactions;
(ii) Since the learned CIT (Appeals) has observed that
entering into such transactions is not the business of the
assessee, the provisions of section 43(5) and Explanation
2 to section 28 of the Act do not apply to the assessee;
(iii) The foreign currency swap option transactions have been
entered into in the course of business in order to cut
down the interest costs;
(iv) Without prejudice to the contention that the foreign
currency swap option transaction is only a hedging
measure entered into in the course of business, the legal
fiction created by section 45(3) of the Act is not
applicable to the assessee's case;
(v) There are only two limbs to the options arrangement and
the loss has arisen only on the hedging limb, which is not
a speculative transaction;
(vi) On the issue of notional loss, the assessee is following
the mercantile method of accounting regularly employed
as required by the Accounting Standards. As per AS-11,
monetary items have to be restated; which proposition
has been upheld by the Hon'ble Apex Court in the case of
Woodward Governor India (P.) Ltd.(supra).
(vii) In the case of ABN Amro Securities India (P.) Ltd. v ITO
[2011] 133 ITD 343/15 taxmann.com 177 (Mum.) the
Tribunal has held that loss on restatement of interest
swap rate at the year end is to be allowed as a
 deduction;
(viii) The CBDT Instruction No.03/2010 dt.23.3.2010,
directing the Assessing Officer to add back the " marked
to market" loss is contrary to the decision of the Hon'ble
Apex Court in Woodward Governor India (P.) Ltd. (supra)
and therefore the decision of the Hon'ble Apex Court
supersedes the CBDT's Instruction,
(ix) If the loss arising out of foreign exchange swap option
transactions is held to be speculation loss, then without
prejudice to the assessee's contentions to the contrary,
the loss should be allowed to be adjusted against the
speculation income from such transactions.
4.3.5 It may be useful and relevant to briefly analyse the concept
of "derivatives" and the underlying nature of such transactions,
before deciding whether they do or do not constitute "speculative
transactions" and whether they represent" notional loss " or real
loss. Put simply, a derivative is a financial instrument whose
value depends on the value of the underlying exposure. The
'underlying exposure' in foreign exchange derivatives is the
foreign exchange rates. The common foreign exchange
derivatives are 'Forward Contracts', 'Option Contracts', 'Swap
Contracts' etc. These instruments are used to hedge the currency
risks on account of adverse, currency movements. The term
'Marked to Market' losses ('MTM') refers to losses computed as
on a particular date with reference to prevailing exchange rate in
respect of contracts that have not matured (viz. open contracts).
As per the prescribed Accounting Standards, companies are
required to account for MTM losses in their books of account
despite the fact that the contract has not yet matured as on the
Balance Sheet date.
4.3.6 In the light of these basic principles, we proceed to
examine the facts of the case on hand. The assessee has
submitted copies of quotations of the option contracts as
additional evidences in terms of Rule 29 of the ITAT Rules. The
documents submitted gives the indicative terms and conditions
for the FCNR hedge taken by the assessee. The trade date is not
specified, indicating that the date can be decided by the assessee
at a later date. There is no certainty of the trade date, which can
be chosen by the assessee at its option, From the details given for
pay off, it is seen that the payoff is not firmed up or certain but
would depend on the currency trading position. Therefore,
neither the pay off date nor the pay off amount is firmed up or
certain. It follows that the provision created as on the Balance
Sheet date therefore cannot be called as an ascertained liability.
In this view of the matter, it is clear that the provision for losses
created on the foreign exchange option contracts as on the
Balance Sheet dates does not constitute an ascertained liability.
4.3.7 The assessee contends that such a liability is to be allowed
as a deduction as per the decision of the Hon'ble Apex Court in
the case of Woodward Governor India (P.) Ltd. (supra). Per
contra, it is the contention of Revenue that the facts of the case
on hand are distinguishable from that of the Hon'ble Apex Court
in Woodward Governor India (P.) Ltd. (supra).
4.3.8 In this context, we proceed to examine the decision of the
Hon'ble Apex Court in the case of Woodward Governor Ltd.
(supra). The substantial questions of law decided by the Hon'ble
Apex Court in that case, as extracted from para 3 of the order,
are as under :—

"(i) Whether on the facts and circumstances of the case and

in law, the additional liability arising on account of
fluctuation in the rate of exchange in respect of loans
taken for revenue purposes could be allowed as
deduction under section 37(1) in the year of fluctuation
in the rate of exchange or whether the same could only
be allowed in the year of repayment of such loans ?
(ii) Whether the assessee is entitled to adjust the actual cast
of imported assets acquired in foreign currency on
account of fluctuation in the rate of exchange at each
balance sheet date, pending actual payment of the varied
liability ? "
The above questions of law were elaborated in para 4 of the
order as under :—
"4. At the outset, for the sake of convenience, we may state
that in this batch of civil appeals broadly we have before us
two categories. In the first category, we are concerned with
exchange differences arising in foreign currency transaction
on revenue items. In such category, we are concerned with
the assessee(s) incurring loss on revenue account. In that
category, we are concerned with the provisions of ss. 28, 29,
 37(1) and 145 of the IT Act, 1961. In the second category of
cases, we are concerned with exchange differences arising on
repayment of liabilities incurred for the purpose of acquiring
fixed assets. In other words, in the second category of cases,
we are concerned with the assessee(s) incurring liabilities on
capital account. In such cases, we are required to consider
the provisions of s. 43(1), 43A (both, before and after
amendment vide Finance Act, 2002)."
4.3.9 The Hon'ble Apex Court had analysed the issue and
decided as under :—
'13. As stated above, one of the main arguments advanced by
the learned Additional Solicitor General on behalf of the
Department before us was that the word "expenditure" in
Section 37(1) connotes "what is paid out" and that which has
gone irretrievably. In this connection, heavy reliance was
placed on the judgment of this Court in the case of Indian
Molasses Company (supra). Relying on the said judgment, it
was sought to be argued that the increase in liability at any
point of time prior to the date of payment cannot be said to
have gone irretrievably as it can always come back.
According to the learned counsel, in the case of increase in
liability due to foreign exchange fluctuations, if there is a
revaluation of the rupee vis-a-vis foreign exchange at or prior
to the point of payment, then there would be no question of
money having gone irretrievably and consequently, the
requirement of "expenditure" is not met. Consequently, the
additional liability arising on account of fluctuation in the rate
of foreign exchange was merely a contingent/notional liability
which does not crystallize till payment. In that case, the
Supreme Court was considering the meaning of the
expression "expenditure incurred" white dealing with the
question as to whether there was a distinction between the
actual liability in presenti and a liability de futuro. The word
"expenditure" is not defined in the 1961 Act. The word
"expenditure" is, therefore, required to be understood in the
context in which it is used. Section 37 enjoins that any
expenditure not being expenditure of the nature described in
Sections 30 to 36 laid out or expended wholly and exclusively
for the purposes of the business should be allowed in
computing the income chargeable under the head "profits and
gains of business". In Sections 30 to 36, the expressions
"expenses incurred" as well as "allowances and depreciation"
has also been used. For example, depreciation and allowances
are dealt with in Section 32. Therefore, Parliament has used
the expression "any expenditure" in Section 37 to cover both.
Therefore, the expression "expenditure" as used in Section 37
may, in the circumstances of a particular case, cover an
amount which is realty a "loss" even though the said amount
has not gone out from the pocket of the assessee.
14. In the case of M.P. Financial Corporation v. CIT reported
in 165 ITR 765 the Madhya Pradesh High Court has held that
the expression "expenditure" as used in Section 37 may, in
the circumstances of a particular case, cover an amount
which is a "loss" even though the said amount has not gone
out from the pocket of the assessee. This view of the Madhya
Pradesh High Court has been approved by this Court in the
case of Madras Industrial Investment Corporation Ltd. v. CIT
reported in 225 ITR 802. According to the Law and Practice
of Income Tax by Kanga and Palkhivala, Section 3 7(1) is a
residuary section extending the allowance to items of
business expenditure not covered by Sections 30 to 36. This
Section, according to the learned Author, covers cases of
business expenditure only, and not of business losses which
are, however, deductible on ordinary principles of commercial
accounting, (see page 617 of the eighth edition). It is this
principle which attracts the provisions of Section 145. That
section recognizes the rights of a trader to adopt either the
cash system or the mercantile system of accounting. The
quantum of allowances permitted to be deducted under
diverse heads under Sections 30 to 43C from the income,
profits and gains of a business would differ according to the
system adopted. This is made clear by defining the word
"paid" in Section 43(2), which is used in several Sections 30
to 43C, as meaning actually paid or incurred according to the
method of accounting upon the basis on which profits or
gains are computed under Section 28/29. That is why in
deciding the question as to whether the word "expenditure"
in Section 37(1) includes the word "loss" one has to read
Section 37(1) with Section 28, Section 29 and Section 145(1).
One more principle needs to he kept in mind. Accounts
regularly maintained in the course of business are to be taken
as correct unless there are strong and sufficient reasons to
indicate that they are unreliable. One more aspect needs to
be highlighted. Under Section 28(i), one needs to decide the
profits and gains of any business which is carried on by the
assessee during the previous year. Therefore, one has to take
into account stock-in-trade for determination of profits. The
1961 Act makes no provision with regard to valuation of
stock. But the ordinary principle of commercial accounting
requires that in the P&L account the value of the stock-in-
trade at the beginning and at the end of the year should be
entered at cost or market price which ever is the lower. This
is how business profits arising during the year needs to be
computed. This is one more reason for reading Section 37(1)
with Section 145. For valuing the closing stock at the end of a
particular year, the value prevailing on the last date is
relevant. This is because profits/loss is embedded in the
closing stock. While anticipated loss is taken into account,
anticipated profit in the shape of appreciated value of the
closing stock is not brought into account, as no prudent
trader would care to show increase profits before actual
realization. This is the theory underlying the Rule that closing
stock is to be valued at cost or market price, whichever is the
lower. As profits for income-tax purposes are to be computed
in accordance with ordinary principles of commercial
accounting, unless, such principles stand superseded or
modified by legislative enactments, unrealized profits in the
shape of appreciated value of goods remaining unsold at the
end of the accounting year and carried over to the following
years account in a continuing business are not brought to the
charge as a matter of practice, though, as stated above, loss
due to fall in the price below cost is allowed even though such
loss has not been realized actually. At this stage, we need to
emphasise once again that the above system of commercial
accounting can be superseded or modified by legislative
enactment. This is where Section J45(2) comes into play.
Under that section, the Central Government is empowered to
notify from time to time the Accounting Standards to be
followed by any class of assessees or in respect of any class of
income. Accordingly, under Section 209 of the Companies
Act, mercantile system of accounting is made mandatory for
companies. In other words, accounting standard which is
continuously adopted by an assessee can be superseded or
modified by Legislative intervention. However, but for such
intervention or in cases falling under Section 145(3), the
method of accounting undertaken by the assessee
continuously is supreme. In the present batch of cases, there
is no finding given by the AO on the correctness or
completeness of the accounts of the assessee. Equally, there
is no finding given by the AO stating that the assessee has not
complied with the accounting standards.
15. For the reasons given hereinabove, we hold that, in the
present case, the "loss " suffered by the assessee on account
of the exchange difference as on the date of the balance sheet
is an item of expenditure under Section 37(1) of the 1961 Act.
16. In the light of what is stated hereinabove, it is clear that
profits and gains of the previous year are required to be
computed in accordance with the relevant accounting
standard. It is important to bear in mind that the basis on
which stock- in-trade is valued is part of the method of
accounting. It is well established, that, on general principles
of commercial accounting, in the P&L account, the values of
the stock-in-trade at the beginning and at the end of the
accounting year should be entered at cost or market value,
whichever is lower - the market value being ascertained as on
the last dale of the accounting year and not as on any
intermediate date between the commencement and the
closing of the year, failing which it would not be possible to
ascertain the true and correct state of affairs. No gain or
profit can arise until a balance is struck between the cost of
acquisition and the proceeds of sale. The word "profit"
implies a comparison between the state of business at two
specific dates, usually separated by an interval of twelve
months. Stock-in-trade is an asset. It is a trading asset.
Therefore, the concept of profit and gains made by business
during the year can only materialize when a comparison of
the assets of the business at two different dates is taken into
account. Section 145(1) enacts that for the purpose of Section
28 and Section 56 alone, income, profits and gains must be
computed in accordance with the method of accounting
regularly employed by the assessee. In this case, we are
concerned with Section 28. Therefore, section 145(l) is
attracted to the facts of the present case. Under the
mercantile system of accounting, what is due is brought into
credit before it is actually received; it brings into debit an
expenditure for which a legal liability has been incurred
before it is actually disbursed, (see judgment of this Court in
the case of United Commercial Bank v. CIT reported in 240
ITR 355). Therefore, the accounting method followed by an
assessee continuously for a given period of time needs to be
presumed to be correct till the AG comes to the conclusion for
reasons to be given that the system does not reflect true and
correct profits. As stated, there is no finding given by the AO
on the correctness of the accounting standard followed by the
assessee(s) in this batch of Civil Appeals.
17. Having come to the conclusion that valuation is a part of
the accounting system and having come to the conclusion
that business losses are deductible under Section 37(1) on
the basis of ordinary principles of commercial accounting and
having come to the conclusion that the Central Government
has made Accounting Standard-11 mandatory, we are now
required to examine the said Accounting Standard ("AS").
18. AS-11 deals with giving of accounting treatment for the
effect so changes in, foreign exchange rates. AS-11 deals with
effects of Exchange Differences. Under para 2, reporting
currency is defined to mean the currency used in presenting
the financial statements. Similarly, the words "monetary
items" are defined to mean money held and assets and
liabilities to be received or paid in fixed amounts, e.g., cash,
receivables and payables. The word "paid" is defined under
Section 43(2). This has been discussed earlier. Similarly, it is
important to note that foreign currency notes, balance in
bank accounts denominated in a foreign currency, and
receivables/payables and loans denominated in a foreign
currency as well as sundry creditor's are all monetary items
which have to be valued at the closing rate under AS-11.
Under para 5, a transaction in a foreign currency has to be
recorded in the reporting currency by applying to the foreign
currency amount the exchange rate between the reporting
currency and the foreign currency at the date of the
transaction. This is known as recording of transaction on
Initial Recognition. Para 7 of AS-11 deals with reporting of
the effects of changes in exchange rates subsequent to initial
recognition. Para 7(a) inter alia states that on each balance
sheet date monetary items, enumerated above, denominated
in a foreign currency should be reported using the closing
rate. In case of revenue items falling under Section 37(1),
para 9 of AS-11 which deals with recognition of exchange
differences, needs to he considered. Under that para,
exchange differences arising on foreign currency transactions
have to be recognized as income or as expense in the period
in which they arise, except as stated in para 10 and para 11
which deals with exchange differences arising on repayment
of liabilities incurred for the purpose of acquiring fixed
assets, which topic falls under Section 43 A of the 1961 Act.
At this stage, we are concerned only with para 9 which deals
with revenue items. Para 9 of AS-11 recognises exchange
differences as income or expense. In cases' where, e.g., the
rate of dollar rises vis-a-vis the Indian rupee, there is an
expense during that period. 'The important point to be noted
is that AS-11 stipulates effect of changes in exchange rate
vis-a-vis monetary items denominated in a foreign currency to
be taken into account for giving accounting treatment on the
balance sheet date. Therefore, an enterprise has to report the
outstanding liability relating to import of raw materials using
closing rate of exchange. Any difference, loss or gain, arising
on conversion of the said liability at the closing rate, should
be recognized in the P&L account for the reporting period.
19. A company imports raw material worth US $ 250000 on
15.1.2002 when the exchange rate was Rs. 46 per US $. The
company records the transaction at that rate. The payment
for the imports is made on 15.4.2002 when the exchange rate
is Rs. 49 per US $. However, on the balance sheet date
31.3.2002, the rate of exchange is Rs. 50 per US $, In such a
case, in terms of AS-11, the effect of the exchange difference
has to be taken in to P & L account. Sundry creditors is a
monetary item and hence such item has to he valued at the
closing rate, i.e. Rs. 50 at 31.3.2002, irrespective of the
payment for the sale subsequently at a lower rate. The
difference of Rs. 4 (50-46) per US $ is to he shown as an
exchange loss in the P&L account and is not to be adjusted
against the cost of raw materials.
20. In the case of Sutluj Cotton Mills Ltd. v. CIT reported in
116 ITR 1 this Court has observed as under:
"The law may, therefore, now he taken to be well settled that
where profit or loss arises to an assessee on account of
appreciation or depreciation in the value of foreign currency
held by it, on conversion into another currency, such profit or
 loss would ordinarily be a trading profit or loss if the foreign
currency is held by the assessee on revenue account or as a
trading asset or as a part of circulating capital embarked in
the business. But, if on the other hand, the foreign currency
is held as a capital asset or as fixed capital, such profit or loss
would be of capital nature. "(emphasis supplied)
21. In conclusion, we may state that in order to find out if an
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 hooks 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."'
4.3.10 As can be seen from the above, the decision in the case of
Woodward Governor India (P.) Ltd. (supra) has been rendered in
respect of "monetary items" denominated in foreign currency,
which include in its meaning, money held and assets and
liabilities to be received or paid in fixed amounts, e.g. cash,
foreign currency, balances in bank accounts denominated in a
foreign currency, sundry creditors, etc., all monetary items.
Further, the citied decision (supra) is rendered in relation to
transactions in which a legal liability has been incurred before it
is actually disbursed. In the case on hand, however, as discussed
earlier, the liability has neither been ascertained nor crystallised
as on the Balance Sheet date. Further, the transaction in
'question is not related to monetary items, as the underlying
exposure behind the transaction is only foreign exchange. In this
view of the matter, we are in agreement with the decision of the
learned CIT (Appeals) that the decision of the Hon'ble Apex Court
in the case of Woodward Governor India (P.) Ltd. (supra) does not
apply to the facts of the case on hand.
4.3.11 Having decided and held that the decision of the Hon'ble
Apex Court in the case of Woodward Governor India (P.) Ltd.
(supra) is not applicable to the facts of the case on hand, we
proceed to decide whether the transaction in question is a
speculative transaction as is the view of Revenue or a hedging
transaction, as contended by the assessee. This issue of
speculative transaction has been well analysed in the decision of
the ITAT, Mumbai Bench in the case of S. Vinod Kumar Diamonds
(P) Ltd. (supra), relied on by the learned Departmental
Representative. The relevant paragraphs of this order at 5.2.1 to
5.4 there of are extracted here under :—
'5.2.1. The definition of 'speculative transaction' in section
43(5) of the Act, gives a simple test for deciding for the
purpose of income-tax what a speculative transaction means.
If a contract for sale or purchase is ultimately settled and no
actual delivery of the goods was effected under the
settlement then it is a speculative transaction. The
requirement of section 30 of the Indian Contract goods in
order to make it a speculative/wagering transaction is
dispensed with for the purpose of the Act and if actual
delivery is not given/taken under the settlement of contract,
then the intention of the parties at the time of the contract
becomes im-materlal. Thus, the true test is delivery of
commodities/goods as per the contract, including a
forwarding contract. Profit loss in respect of unperformed
contracts is considered speculation profit/loss. In short, in
order that a transaction may fall within the scope of the
expression 'speculative transaction', it must be a transaction
in which a contract for 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.
5.2.2. Here, it would be useful to appreciate in proper
perspective how hedge transactions are commercially
understood before determining the true scope, width and
nature of proviso (a) to section 43(5). Hedge contracts are
those contracts which hedge against prejudicial price
fluctuations. In speculative transactions the modus operandi
of persons indulging in them is that when one enters into a
contract of purchase, he also simultaneously enters into one
or more contracts of sale against the same quantity
deliverable at the same time either to the original vendor or
to someone else, so as either to secure profit or to minimize
loss, before the Vaida day; and similarly when he enters into a
contract of sale, he simultaneously enters into one or more
contracts to purchase the same quantity before the Vaida day.
The result of such dealings, when the sale and purchase are
to and from the same person, has the effect of cancelling the
contracts leaving only differences to be paid. The technique
of hedge trading can be understood in simple terms. It is said
that the hedge contract is so called because it enables the
persons dealing with the actual commodity to hedge
themselves, i.e., to insure themselves against adverse price
fluctuations. A dealer or a merchant enters into a hedge
contract when he sells or purchases a commodity in the
forward market for delivery at a future date. His transaction
in the forward market may correspond to a previous purchase
or sale in the ready market or he may propose to cover it
later by a corresponding transaction in the ready market, or
he may offset it by a reverse transaction on the forward
market itself. Hedging contracts need not succeed the
contracts for sale and actual delivery of goods manufactured,
but the latter may be subsequently entered into, provided
they are within reasonable time. In order to be genuine and
valid hedging contracts of sales, the total of such transactions
should not exceed the total stocks of the raw materials or the
merchandise on hand which would include existing stocks as
well as the stocks acquired under the firm contracts of
purchase. As per the accepted commercial norms object of a
hedging contract is to secure oneself against loss in a future
delivery contract, but such transactions cannot be regarded
as inter-connected. Each one is independent of the other. So
far as the profit or loss arising from a, future delivery
contract is concerned, it is determined on the date of actual
delivery irrespective of the date on which the contract was
entered into. In respect of a hedging contract, profit/loss
arising there from can be ascertained or crystallised at fixed
intervals of the term when the clearance takes place.
5.2.2.a. By resorting to counterbalancing transactions in the
market for the ready commodity on the one hand and in the
hedge market on the other hand, the hedger seeks to
safeguard his position. The movement of prices in the two
markets may not always follow an identical course and the
hedger might at times gain and at times lose but such a gain
or loss would be marginal and far less than what it would be
if the person had not hedged at all. While, however, the
hedging operation protects the hedger against loss arising
from adverse fluctuations in prices, it also prevents him from
making windfall profit owing to favourable fluctuations in
prices as well. The forgoing of such a possible windfall profit
is the price which he pays for the insurance against loss. This
well-known technique, of hedge trading clearly implies
forward contracts both ways, namely, for sale and purchase
with a view to guarding against adverse price fluctuations.
These forward contracts by way of hedge transactions usually
afford a cover to a trader inasmuch as his loss in the ready
market is offset by a profit in the forward market and vice
versa. It, therefore, follows that in order to effectively hedge
against adverse price fluctuations of the manufactured goods
or merchandise, a manufacturer or merchant has necessarily
to enter into forward transactions of sale and purchase both,
and without these contracts of sale and purchase constituting
hedge transactions, there would be no effective insurance
against the risk of loss in the price fluctuations of the
commodity, manufactured or the merchandise sold.
5.3. Hedging contracts are dealt in Clause (a) of the proviso
to section 43(5) of the Act. From the above discussion it can
safely stated that the said clause applies, if following
conditions are fulfilled:

(1) There is a contract for actual delivery of goods

manufactured by the assessee/a merchandise sold by it,
(2) Assessee must be a subsequent transaction intend to
guard against losses through future price fluctuations in
respect of such contract,
(3) Transaction in question must be a contract entered into
in respect of raw materials or merchandise in the course
of the assessee's manufacturing business and it should
have been settled otherwise than by actual delivery of
goods,
(4) Hedging contracts may be both with regard to sales and
purchases,
(5) Hedging contracts need not succeed the contracts for
sale and actual delivery of goods manufactured, but the
latter may be subsequently entered into, provided they
are within the reasonable time not exceeding generally
the assessment year,
(6) In order to be genuine and valid hedging contracts of
sales, the total of such transactions should not exceed
the total stocks of the raw materials or the merchandise
on hand which would include existing stocks as well as
the stocks acquired under the firm contracts of
purchases.
(7) The hedging contract need not necessary be in the same
variety of the commodity they could be in connected
commodities, e.g., one type of cotton against another
type of cotton.

In other words unless the assessee shows that there was

some existing contract in respect of which he was likely to
suffer a loss because of future price fluctuations and that it
was to safeguard against such loss that he entered into the
forward contracts of sale, he could not claim the benefit of
clause (a) of the proviso to section 43(5). With regard to
speculative/hedging transactions we had benefit of perusing
the judgments of M.G. Brothers (154 ITR 695), Nuddea Mills
Co. Ltd. (171 ITR 169), Delhi Flour Milts Co. Ltd. (95 ITR 151)
and Pankaj Oil Mills, (115 ITR 824) delivered by the Hon'ble
High Courts of Andhra Pradesh, Calcutta, Delhi and Gujarat
respectively.
5.4. From the principles laid down by these judgments one
thing becomes clear that for hedging transaction commodity
dealt should be the same. If the subject matter of the
transactions is different it cannot be termed a hedging
transaction. In the case of M. G. Brothers (supra) assessee-
firm was carrying on business of the manufacturing and sale
of groundnut oil and its by-products. For the AY.1973-74, the
assessee filed its return declaring an income of Rs. 2,90,807/-
and claimed a loss of Rs. 1,60,946/- in respect of certain
transactions which it had entered into in cotton seed oil and
neem oil. The assessee claimed that said transactions were
hedging transactions. Matter finally travelled up to the
Hon'ble High Court of AP. Deciding the issue against the
assessee Hon'ble Court held as under;
"....the forward contracts entered into by the assessee in
cotton seed oil and neem oil were not covered by cl (a) of the
proviso to s. 43(5) and were not hedging transactions. The
forward transactions were speculative in character and the
loss arising there from could not be set off against the
assessee's income from the business in the manufacture and
sale of groundnut oil. " Similarly, In the case of Nuddea Mills
Co. Ltd (supra) assessee was manufacturer of jute goods and
it has entered into forward contracts of sale of Standard jute
goods. In view of overseas offer, it decided to manufacture
special quality jute goods. Assessee entered in to forward
purchases of standard jute goods and purchase back of
forward contracts of sale. Assessee incurred loss in covering
its forward contracts of sale. In the appeal filed by the
assessee Hon'ble Calcutta High Court, confirming the order
of the ITAT, held that losses suffered by the assessee were
result of the speculative transactions. In the case of Delhi
Flour Mills Co. Ltd. (supra) Hon'ble Delhi High Court held
that forward transactions made by the assessee in respect of
matra (a substitute of gram) could not be treated as hedging
transactions and the loss sustained by the assessee in such
transactions could not be set off against its profits in the
business of manufacturing atta (wheat flour) and other wheat
products. Hon'ble Allahabad High Court, while deciding the
appeal of M.P. Sugar Mills (P.) Ltd. (148 ITR 203) has held as
under:
"Section 43(5)(a) of the Income-tax Act, 1961, which excludes
hedging contracts from the definition of speculative
transactions, contemplates contracts entered into by two
classes of persons, namely, (1) persons who manufacture
goods from raw materials; and (2) merchants. Whereas in the
case of a manufacturer it is the contract entered into by him,
in respect of raw materials used in the course of his
manufacturing business, to guard against any loss through
future price fluctuations in respect of his contracts for actual
delivery of goods manufactured by him, that are taken out of
 the ambit of speculative transactions, the contracts taken out
of the scope of such transactions in the case of merchants are
those which he enters into in respect of his merchandise with
a view to safeguard loss through future price fluctuations in
respect of contracts for actual delivery of the merchandise
sold by him. It wilt depend upon the facts of each case
whether a particular transaction by way of forward sale,
which is mutually settled otherwise than by actual delivery of
the said goods, has been entered into with a view to
safeguard against loss through price fluctuation in respect of
the contract for actual delivery of the goods manufactured."
In order that forward transactions in commodities may fall
within proviso (a) to section 43(5) of the Act, it is necessary
that the raw materials or merchandise in respect of which the
forward transactions have been made by the assessee must
have a direct connection with the goods manufactured or the
merchandise sold by him. In other words raw material in
respect of which the assessee has entered into forward
transactions must be the same raw material which is used by
him in his manufacturing business. We find that in the case
under consideration assessee was not dealing in Foreign
Exchange, therefore transactions entered into by it in foreign
Exchange cannot be held to be hedging transactions.'
4.3.11A The facts of the above cited case of S. Vinodkumar
Diamonds (P.) Ltd. (supra) are very similar to the facts of the case
on hand. The assessee in the case on hand, has entered into a
derivative contract of option, whereas the business of the
assessee is trading in steel tubes, pipes, PVC, etc. It is not in
dispute that the option transactions were not in respect of
specified imports or exports. It is also not in dispute that the
provision for loss shown by the assessee pertained to these
foreign currency transactions, against which no actual delivery of
foreign exchange was made. On an appreciation of the facts
surrounding the transactions in question. We are of the
considered view that the transactions entered into by the
assessee were not hedging transactions, but the same were
speculative and therefore the assessee's case is not covered by
proviso (a) to section 43(5) of the Act.
4.3.12 In the written submissions filed, the assessee has referred
to the decision of the Hon'ble Bombay High Court in the case of
CIT v. Bharat R Ruia, (HUF) [2011] 337 ITR 452/199 Taxman
87/10 taxmann.com 265. In that case, the Hon'ble Bombay High
Court has held that the future contracts for purchase/sale of an
underlying security settled otherwise than by actual delivery
would be speculative transactions under section 43(5) of the Act.
The relevant paragraphs of the said order at paras 26, 28, 33 and
34 thereof are extracted as under :—
'26. Section 43(5) of the Act defines the expression
"speculative transaction" to mean 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.

27. ** ** **

28. The expression "commodity" is not defined under the Act,

Therefore, the expression "commodity" in section 43(5) has to
be given meaning as understood in common parlance

29 to 32. ** ** **

33.... Moreover, section 43(5) of the Act provides that a

transaction for purchase/sale of any commodity would be a
speculative transaction if it is settled otherwise than by actual
delivery. For the purposes of section 43(5), it is not necessary
that the commodity agreed to be purchased or sold must be
capable of actual delivery. Therefore, future contracts for
purchase/sale of an underlying security permitted to be
traded on the stock exchange and settled otherwise than by
actual delivery would be speculative transactions under
section 43(5) of the Act.
34. It is contended that the expression "commodity" does not
include "stocks and shares", however, for the purposes of
section 43(5), the expression "commodity" has been expanded
to include "stocks and shares" and since transactions in
derivatives are not specifically included in section 43(5), the
same would fall outside the purview of section 43(5). We see
no merit in the above connections. The expression
"commodity" would cover all articles of trade including stocks
and shares. Even under section 43(5), the expression
"commodity" is not expanded to include "stocks and shares".
 In fact, the use of "comma" in between, the word
"commodity" and the words "including stocks and shares" in
section 43(5) make it clear that transactions for purchase of
any commodity would include transaction for purchase or sale
of stocks and shares. In other words, section 43(5) does not
seek to expand the scope of the expression "commodity" but
merely emphasizes that the transaction in commodity
includes transactions in stocks and shares. Therefore,
transactions in futures contracts like transactions in stocks
and shares when settled otherwise than by actual delivery
would be speculative transactions under section 43(5) of the
Act.'
The finding rendered in the afore cited decision in the case of
Bharat R Ruia (HUF) (supra) for future contracts would, in our
considered view, apply equally to the option contract entered into
by the assessee, as both these are derivative transactions.
4.3.13 The assessee has relied on the decision of the ITAT,
Mumbai Bench in the case of ABN Amro Securities India (P.) Ltd.
(supra) for Assessment Year 2003-04. On a perusal thereof, we
find that the facts of the cited case are different from that of the
assessee's in the case on hand. In that case, the tax payer was in
the business of dealing in derivatives, whereas, admittedly, the
undisputed factual position in the case on hand is that the
assessee is not in the business of dealing in derivatives.
Therefore, the aforesaid decision in the case of ABN Amro
Securities India (P.) Ltd. (supra) would not be of any help to the
assessee.
4.3.14 In view of the above discussion of the facts and
circumstances of the case from paras 4.3.1 to 4.3.13 of this order,
we conclude that the transactions in question in the case on hand
are speculative transactions and therefore, the learned CIT
(Appeals) was right in upholding the decision of the Assessing
Officer that the transaction entered into by the assessee is
speculative in nature; the losses shown are notional in character
and therefore the provision for loss claimed as a deduction is
liable to be disallowed.
5. As regards the alternate contention of the assessee that if the
transaction in question is held to be speculative in nature, then
the provision for loss should be allowed as a deduction from the
gains reported from such transactions, we are unable to agree
with the contention of the assessee in this regard. It is nobody's
case that the assessee is engaged in the business of speculation.
It has also been held that the loss shown is a notional loss only
and such notional loss is not liable to be adjusted against the
profit actually earned by the assessee. The stage for adjustment
arises only when the loss/liability actually crystallises.
6. In view of our findings above, we dismiss the assessee's
grounds raised at S.Nos. 1 to 11.
7. In the result, the assessee's appeal is dismissed.
SUNIL

*In favour of revenue.