Question: Whether loss on Forex derivative can be set off against business income ?
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Loss incurred by exporter on forex derivative wasn’t speculative; could 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
Forex derivative transactions had a close proximity or rather incidental to export business of assessee, which could not be considered as speculative and, therefore, loss on account of forex derivative contract was to be considered as a business loss and could be set off against income from other business.
Question : What will be the treatment of gain or loss on foreign currency fluctuation of business asset acquired outside India ?
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
Circulars and Notifications : CBDT Instruction No. 3/2010, dated 23-3-2010
FACTS
■ The assessee-company was engaged in the business of manufacture and export of garments and had entered into foreign currency derivative transactions to guard against future currency fluctuations.
■ It incurred certain loss on account of forex derivative contracts and claimed that the same should be set off against normal business income contending that these transactions were not of speculative nature because they were transacted in the normal course of business to hedge the loss from depreciation of rupee against the export receivables in foreign currency, which was in accordance with the regulations laid down by the Reserve Bank of India.
■ The Assessing Officer rejected the assessee’s claim and treated the loss as speculative loss holding that the proportion of loss incurred in options contract was eight times more than forex exchange loss and in the year in which the option contract was entered, the foreign currency fluctuation loss was very minimal. The transactions transacted by the assessee were in the nature of derivatives referred to in sub-clause (d) of section 43(5) and the conditions stipulated inExplanation to the said sub-clause for treating it as a non-speculative transaction were not met.
■ On appeal, the Commissioner (Appeals) upheld the order of the Assessing Officer holding that the loss from derivatives contract suffered by the assessee was short time speculative transactions without any hedge underlying on the regular export business of the assessee.
■ On further appeal:
HELD
■ In the instant case 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 of India Act, 1949 defines derivative as a financial instrument whose value depends on the value of the underlying exposures. In the instant case, 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 instant case, 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 favourable or not favourable. The cost of the ‘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 favourable 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 crystalised and is a realistic loss suffered by the assessee. In these circumstances, the issue under consideration, whether loss on account of forex derivatives is to be considered as a business loss in parlance with section 28. In the case of the assessee, the following facts emerge and the legal issues involved are summarized herein below:—
(i) The assessee has entered into forex derivative transactions only in order to contain the foreign currency fluctuation risk.
(ii) Thus, the loss on account forex derivative transactions are directly attributable to the normal business of the assessee.
(iii) The loss incurred by the assessee is realistic and not notinal.
(iv) Only money changers and banks are allowed to trade in foreign currency and the assessee is neither a money changer nor a bank.
(v) The assessee has only utilized the service of nationalized bank in order to iron out the loss arising out of foreign currency fluctuation risk by entering into forex derivative contract.
(vi) The Special Bench of the ITAT, Kolkata Bench in the case of Shree Capital Services Ltd. v. Asstt. CIT [2009] 121 ITD 498 has held that foreign currency is neither commodity nor shares as defined under section 43(5).
(vii) The CBDT Instruction No. 03/2010 dated 23-3-2010 has recognized the loss out of forex derivatives on actual settlement/conclusion of contracts as allowable business loss, however they have directed the revenue to examine whether the transactions would fall under section 43(5)(d), and if so to treat the same as non-speculative transaction. By the above directions, it appears that though the CBDT has recognized the loss arising out of forex derivatives on actual settlement of the contracts, it directed the revenue to treat the same as speculative transaction when they are transacted through nationalised banks and as not speculative, when these transactions are transacted through recognised stock exchange.
(viii) The bankers act as an advisory agent to the assessee in order to protect them from foreign exchange exposure by using their expertise and these services cannot be obtained by the assessee in the stock exchange where their scope of service is very limited.
(ix) In the instant case the assessee has taken a hedging position to the extent of Rs. 1.05 crores and USD Rs. 3 crores during the period 2007-09 based on the RBI guidelines. The guidelines permitted hedging to the extent of last three years, annual average turnover, or current year’s actual export turnover whichever is higher. Where exact amount of underline transaction was not ascertainable according to the RBI guidelines, the contract could be booked on the basis of reasonable estimate. The assessee has taken its hedging position in accordance with the guidelines of the RBI and the same is not disputed.
(x) The claim of the assessee was that the underlying exposure both in respect of Euro and USD is more than adequate to cover the hedging positions taken in respect of cross currency derivative contracts entered into by the assessee. The revenue has not brought out any material on record to controvert to this claim of the assessee.
(xi) Since the assessee has entered into foreign currency derivative contract adequate enough to cover the overall exposures of foreign currency, the contention of the revenue that the proportion of the loss in derivatives is eight times more than the loss from currency fluctuation does not have any merits.
(xii) The forex derivative transactions transacted by the assessee are through nationalised banks in compliance with the RBI Regulations. These Regulations permit the assessee to enter into such derivative transactions only by fulfilling certain conditions in the course of the business of the assessee. These regulations do not permit the assessee to enter into forex derivative contract as a separate business.
(xiii) Section 73(1) restricts the set off of speculation loss against the other business income in only those cases where speculative transactions carried on by the assessee are of such nature so as to constitute a business by itself. The RBI does not permit any bank under its umbrella to entertain its client in any separate business of forex derivative transactions. Permission is granted only for the clients of the bank to hedge on foreign exchange in order to minimize the risk of the foreign currency exposure arising out of import and export trade.
(xiv) The jurisdictional Madras High Court in the case Rajashree sugars and Chemicals Ltd. v. Axis Bank 8 MLJ 261 has held that derivative transactions ceased to be speculative transactions or wages because pricing of the deal follows a scientific pattern on the basis of financial mathematics. Just as actuaries scientifically determined the value of insurance risk and the premium payable, Financial Mathematician/Portfolio Managers evaluated the price of these derivatives. [Para 7]
■ 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.
■ The banks have option to trade in foreign currency derivatives either through recognised stock exchange or through RBI. When the bank 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. [Para 8]
■ 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) comes to the rescue of the assessee because in the instant case, the assessee is a manufacturer and exporter of garments and it 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 recognised 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 nationalised 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. [Para 9]
■ 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) is applicable to transactions in commodity or stocks and shares. If currency is treated as commodity, then according to section 43(5)(a) 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 assessee, the foreign exchange exposure for the ‘relevant period’ specified by ‘RBI’ regulations is quite 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, the grounds raised by the assessee are allowed on this issue. The revenue is directed to set off the losses incurred by the assessee on account of forex derivatives contracts against the business income of the assessee. [Para 11]