ITAT allows foreign currency derivative transaction losses against CIT revision order under section 263

ITAT Ahmedabad allowed assessee's appeal against CIT's revision order u/s 263. CIT had found AO's allowance of foreign currency derivative transaction losses erroneous, treating them as notional marked-to-market losses prohibited under CBDT Instruction 3/2010. ITAT held CIT misappreciated facts - losses were settled losses on exchange differences for outstanding creditors (allowable under AS-11 and Supreme Court precedents) and actual losses on forward contracts, not M2M losses. CIT's alternative application of section 73 explanation was incorrect as it applies only to share trading, not foreign currency transactions. Revision order unsustainable due to factual misappreciation and violation of natural justice principles.

---

---

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.

---