2014 (11) TMI 284 - AT - Income Tax

Tribunal overturns unrealized loss disallowance & challenges arm's length price adjustment

The appeal was allowed by the Tribunal. The disallowance of unrealized loss on commodity derivatives was overturned, emphasizing the principle of ... Unrealized loss on the commodity derivatives - Regular method of accounting followed by assessee – Held that:- While anticipated profit for forward contracts are not taken into account but anticipated losses are duly taken into account in computation of business profits – in DCIT v. Bank of Bahrain & Kuwait [2010 (8) TMI 578 - ITAT, MUMBAI] – it has been held that binding obligation accrued against the assessee the minute it entered into forward foreign exchange contracts - a consistent method of accounting followed by assessee cannot be disregarded only on the ground that a better method could be adopted - The assessee has consistently followed the same method of accounting in regard to recognition of profit or loss both, in respect of forward foreign exchange contract as per the rate prevailing on 31st March - A liability is said to have crystallised when a pending obligation on the balance sheet date is determinable with reasonable certainty. The considerations for accounting the income are entirely on different footing - As per AS-11, when the transaction is not settled in the same accounting period as that in which it occurred, the exchange difference arises over more than one accounting period - The forward foreign exchange contracts have all the trappings of stock-in-trade - where a forward contract is entered into by the assessee to sell the foreign currency at an agreed price at a future date falling beyond the last date of accounting period, the loss is incurred to the assessee on account of evaluation of the contract on the last date of the accounting period i.e. before the date of maturity of the forward contract. Even when loss has not yet crystallized, a deduction is to be granted in respect of a reasonably anticipated loss - Since the provisions for anticipated losses are reversed in the beginning of the next year, these deductions are completely tax neutral and the impact is confined to the timing of deduction - there cannot be a double deduction of the same loss- first one at the end of this accounting period and second one at the point of time when the transaction is finally settled - as long as the assessee has reversed this provision in the beginning of next year and thus effectively adjusted this loss against loss or profit finally realized commodity derivatives, no objection can be taken to this claim – thus, the matter is remitted back to the AO – Decided in favour of assessee. Transfer pricing adjustment – Determination of ALP - Service received or benefit and/or services received duplicate in nature or not – Held that:- The very foundation of the action of the TPO is thus devoid of legally sustainable merits - the payments are made under an arrangement with the AE to provide certain services - it is a call taken by the assessee whether the services are commercially expedient or not and all that the TPO can see is at what price similar services, whatever be the worth of such services, are actually rendered in the uncontrolled conditions - as for the evidence for each of the service stated in the agreement, it is not even necessary that each of the service, which is specifically stated in the agreement, is rendered in every financial period - The actual use of services depends on whether or not use of such services was warranted by the business situations whereas payments under contracts are made for all such services as the user may require during the period covered - As long as agreement is not found to be a sham agreement, the value of the services covered under the agreement cannot be taken as 'nil' just because these services were not actually required by the assessee - the services were actually rendered under the agreement and the services did justify the payments - in the absence of prerequisites for application of CUP methods being absent, it was not open to the TPO to disregard the TNMM employed by the assessee - No defects have been pointed out in application or relevance of TNMM in this case – the order of the TPO is set aside –Decided in favour of assessee. Issues Involved:1. Disallowance of unrealized loss on commodity derivatives.2. Arm's length price determination for international transactions related to management services.Detailed Analysis:Issue 1: Disallowance of Unrealized Loss on Commodity Derivatives3. The assessee is aggrieved that 'the learned and DRP have erred in facts and on law in disallowing Rs. 1,60,369 on account of unrealized loss on the commodity derivatives claimed in accordance with regular method of accounting followed by the appellant'.4. During the assessment proceedings, the Assessing Officer (AO) noticed that Rs. 57,82,954 disclosed by the assessee as gain on commodity derivatives was a net figure after adjusting an unrealized loss of Rs. 1,60,369. The AO required the assessee to show cause why this adjustment should not be disallowed. The assessee explained that the amount represented a loss on open positions in trading transactions of commodity derivatives and relied on several judicial precedents, including Chainrup Sampatram v. CIT (24 ITR 481), and accounting standards to support the claim. However, the AO was not convinced and disallowed the unrealized loss. The assessee's appeal to the Dispute Resolution Panel (DRP) was unsuccessful, leading to this appeal.6. The principle of conservatism requires anticipated losses to be accounted for when they can be reasonably estimated, while anticipated profits are deferred until realized. This principle is recognized by the Hon'ble Supreme Court in Chainrup Sampathram (supra), which states that anticipated losses should be accounted for even if not realized, whereas anticipated profits are not accounted for until realized.7. The Tribunal, in the case of DCIT v. Bank of Bahrain & Kuwait (41 SOT 290), allowed the assessee's appeal on similar grounds, stating that a binding obligation accrues when a forward foreign exchange contract is entered into, and a consistent method of accounting cannot be disregarded.8. Even if the loss has not crystallized, a deduction is to be granted for a reasonably anticipated loss. These provisions for anticipated losses are reversed in the next year, making the deductions tax neutral. The AO is to verify if the provision has been reversed in the next year and adjust the loss accordingly. The matter is restored to the AO for this limited verification.9. Ground No. 3 is allowed for statistical purposes as indicated.Issue 2: Arm's Length Price Determination for International Transactions Related to Management Services11. The assessee raised grievances regarding the DRP and TPO/AO's failure to appreciate the business model and realities, questioning the commercial decisions of the appellant, and determining the arm's length price (ALP) of international transactions at 'nil'.12. The assessee, engaged in trading food grains, entered into an international transaction with its Associated Enterprises (AEs) for payment of Rs. 58,20,571 towards 'management services'. The Transfer Pricing Officer (TPO) viewed that the benefit of some services availed was not commensurate with the payments made and applied the Comparable Uncontrolled Price (CUP) method, assigning 'nil' value to these services.13. The AO proposed to disallow payments aggregating to Rs. 31,23,325, leading to the assessee's appeal to the DRP, which was unsuccessful. The DRP confirmed the TPO's stand, and the assessee appealed.15. The basic precondition for using the CUP method is the availability of the price of the same product or service in uncontrolled conditions. The TPO's perception that the services were worthless is irrelevant. A business enterprise incurs expenditure based on commercial expediency, and the TPO cannot question this. The Hon'ble jurisdictional High Court in CIT v. EKL Appliances Limited (345 ITR 241) held that Rule 10B(1)(a) does not authorize disallowance of expenditure on the ground that it was not necessary or prudent for the assessee to have incurred it.16. The TPO's action lacked legally sustainable merits. Payments were made under an arrangement with the AE for specific services. The TPO's view that the services were useless or not evidenced is irrelevant. The value of services cannot be taken as 'nil' just because they were not required by the assessee in every financial period.18. The TPO's action to disregard the Transactional Net Margin Method (TNMM) employed by the assessee was not justified. No defects were pointed out in the application or relevance of TNMM.19. The Tribunal upheld the assessee's grievance and directed the AO to delete the ALP adjustment of Rs. 31,23,325.20. Ground Nos. 5 to 9 are allowed.Conclusion:21. The appeal is allowed.