2017 (12) TMI 593 - AT - Income Tax

Tribunal Orders Re-examination of Forward Contracts for Hedging (1)(iii)

The Tribunal directed the Assessing Officer to re-examine the nature of forward contracts to determine if they qualify as hedging transactions and to ... Disallowance of exchange fluctuation loss on forward contracts - nature of speculative transactions - whether the assessee is able to have one to one co-relation between forward contracts and its bills receivables / payables? - AO opined it to be in the nature of speculative transactions as defined u/s 43(5) - Held that:- In this case, it is an undisputed fact that the assessee has not carried out its forward contracts through recognized stock exchange. The assessee has entered into forward contracts with its bankers. Therefore, to ascertain forward contracts entered into by the assessee are hedging transactions or speculative transactions, forward contracts have to clear the basic test provided for examining the nature of transactions of hedging and speculative transactions. Case of the assessee is covered by the decision of Supreme Court in the case of Woodword Governor (I) Pvt Ltd (2009 (4) TMI 4 - SUPREME COURT) because the assessee has profit / loss on fluctuation in respect of its forward contracts on the basis o marked to market at the end of the financial year based on the prevailing exchange rate. However, the assessee has failed to prove the basic test provided for categorizing that its forward contracts are in the nature of hedging transactions. Even the lower authorities have failed to appreciate the facts in the right perspective in the light of the arguments of the assessee that its forward contracts cannot be linked to its export bills receivables / payables, but total value of its forward contracts is not more than its exposure to foreign currency in the form of receivables / payables. Therefore, we are of the considered view that the issue needs to be re-examined by the AO in the light of above discussions. Hence, we set aside the issue to the file of the AO and direct him to consider the issue afresh Disallowance of expenditure incurred in relation to exempt income u/s 14A r.w.r. 8D(2)(i) and 8D2)(iii) - Held that:- The assessee failed to bring on record any evidence to controvert the finding of the lower authorities. Though the Ld.AR contended that the AO has not established link between expenditure incurred by the assessee to earn exempt income, failed to prove that the assessee has not incurred any expenditure in the backdrop of the clear findings of the AO as well as the CIT(A) that the assessee has paid huge interest on borrowings and also incurred common expenditure like general administration and other expenses. Therefore, we are of the view that the CIT(A) was right in restricting disallowance to 5% of the value of investments. We do not find any error in the order of CIT(A). Hence, we are inclined to uphold the order of CIT(A) and dismiss the ground raised by the assessee. Disallowance of interest u/s 36(1)(iii) for diversion of interest bearing funds - Held that:- The assessee fails to bring on record any evidences to rebut the findings of facts recorded by the CIT(A). Though the assessee has relied upon the decision of Hon’ble Supreme Court in the case of Vardhman Polytex Ltd (2008 (1) TMI 26 - HIGH COURT, PUNJAB AND HARYANA), in the backdrop of the clear findings of the AO and CIT(A) that the assessee has failed to explain the availability of interest free funds to explain acquisition of capital asset, interest paid on loans borrowed has to be disallowed u/s 36(1)(iii) for diversion of funds for acquisition of capital asset. Therefore, we are inclined to uphold the order of the CIT(A) and reject the ground raised by the assessee. Issues Involved:1. Disallowance of exchange fluctuation loss on forward contracts.2. Disallowance of expenditure incurred in relation to exempt income under Section 14A read with Rule 8D.3. Disallowance of interest under Section 36(1)(iii) for diversion of interest-bearing funds.Issue-wise Detailed Analysis:1. Disallowance of Exchange Fluctuation Loss on Forward Contracts:The assessee, engaged in the import and export of diamonds, entered into forward contracts to hedge against foreign currency fluctuations. The AO disallowed the exchange fluctuation loss on these contracts, categorizing them as speculative transactions under Section 43(5) of the Income-tax Act, 1961, since the assessee failed to link these contracts to specific bills receivables/payables, and most contracts were settled without actual delivery.The assessee argued that these contracts were hedging transactions meant to mitigate currency risk and were consistently accounted for as per Accounting Standard 11 (AS-11) issued by ICAI. The assessee cited the Supreme Court decision in Woodward Governor vs CIT and the ITAT Special Bench decision in Bank of Bahrain & Kuwait to support their claim that such losses should be treated as business losses.The Tribunal noted that the assessee's exposure to foreign currency in the form of export receivables/payables was more than the value of forward contracts, even though a one-to-one correlation was not feasible. The Tribunal directed the AO to re-examine the issue, considering whether the forward contracts were indeed hedging transactions and not speculative, and to allow the loss if it met the criteria for hedging transactions.2. Disallowance of Expenditure Incurred in Relation to Exempt Income under Section 14A read with Rule 8D:The AO observed that the assessee had earned dividend income, which was exempt under Section 10(34), and had made significant investments in group companies. The AO disallowed a portion of the expenditure under Section 14A read with Rule 8D, as the assessee failed to provide evidence that interest-free funds were used for these investments and did not furnish details of other expenses related to earning the exempt income.The CIT(A) upheld the AO's decision but reduced the disallowance to 5% of the investment value, considering the possibility of indirect expenses like general administration costs. The Tribunal agreed with the CIT(A), noting the assessee's failure to provide evidence to counter the findings of the lower authorities and upheld the 5% disallowance.3. Disallowance of Interest under Section 36(1)(iii) for Diversion of Interest-Bearing Funds:The AO disallowed interest on loans under Section 36(1)(iii), stating that the assessee had used interest-bearing funds to acquire capital assets, which were not put to use during the relevant period. The CIT(A) upheld this disallowance, referencing the Punjab & Haryana High Court decisions in Power Drugs Ltd vs CIT and CIT vs Vardhman Polytex Ltd, which mandate capitalization of interest on borrowed funds used to acquire new assets until they are put to use.The Tribunal noted that the assessee failed to provide evidence to rebut the findings of the lower authorities and upheld the disallowance of interest under Section 36(1)(iii) for diversion of funds towards capital assets.Conclusion:The Tribunal partly allowed the appeals for statistical purposes, directing the AO to re-examine the nature of forward contracts to determine if they qualify as hedging transactions and to reconsider the disallowance of exchange fluctuation loss accordingly. The disallowances under Section 14A and Section 36(1)(iii) were upheld.