Loss arising due to foreign exchange fluctuation on a forward contract is not a speculative loss.

Facts of the Case:

• Simona India Ltd. (the Assessee) is engaged in the business of providing engineering, consultancy and related services like engineering designing, construction and commissioning of plants and installations.
• The Assessee had entered into a forward contract to hedge the risk against foreign exchange fluctuations to cover exports and imports.
• Return of income was filed for AY 2009-10 and same was processed under Section 143(1) of the Income Tax Act, 1961 (hereafter “the Act”) however scrutiny assessment was initiated under Section 143 and an addition was made by the Assessing officer (hereafter referred to as “the AO”) for ₹9.20 crores towards loss due to foreign exchange fluctuations on forward contracts holding this loss as speculative loss.
• Aggrieved from the order passed by the AO, the Assessee preferred an appeal before the Ld. CI (A), who passed the order in favor of Assessee. Against such order, the department preferred an appeal before the Hon’ble ITAT, wherein the order of the CIT (A) has been upheld by the Tribunal. Hence, the revenue preferred an appeal before the Hon’ble High Court.
• The question put before the Hon’ble High Court was “Whether the losses on account of foreign exchange fluctuations on forward contracts are allowable undersection 37(1) of the Act and covered as hedging transactions under Section 43(5)(a) of the Act or should be disallowed as speculation losses under Section 43(5) of the Act in view of the CBDT Instruction No. 3/2010 dated 23.03.2010”?

Decision of the High Court:

• The High Court relied upon the Apex Court judgment in CIT v. Woodword Governor India Pvt. Ltd., where the court held that as per AS-11, “the exchange difference arising on foreign currency transactions are necessary to be recognized as income or expense in the period in which they arise, except in cases of exchange differences arising on repayment of liabilities for acquiring fixed assets. The Assessee has reinstated its debtors and creditors in connection with the execution of the contracts entered into with foreign entities on the basis of value of foreign exchange. Thus, the loss on account of Forward Contracts would require to be recognized as well.
• The High Court held that there is no dispute that the forward contracts were entered into by the Assessee to hedge against foreign exchange fluctuations. Also, the transaction falls within the exceptions of proviso (a) to Section 43(5) of the Act and should not be treated as a speculative transaction. The Court held that the forward contracts, in the present case, are hedging transactions to guard against any future exchange fluctuations in respect of inflows and outflows pertaining to the contracts for execution of the work entered into by the Assessee.

• Accordingly, the Court held that such losses cannot be construed as notional loss although prescribed by the CBDT Instruction No. 3/2010 as these instructions being contrary to the law are not binding in such a case. Thus, the High Court upheld the order of CIT(A) and the Tribunal in finding that the loss, on account of Forward Contracts cannot be considered as speculative, and the AO had erred in disallowing the same.

SW Point of View:

Marked to market losses arising on reinstatement of the forward contracts entered to hedge against the foreign exchange fluctuations due to business exigency is an allowable deduction under Section 37(1), even though such forward contracts have not matured at year-end.

Raju Kumar, Article Assistant, Direct Tax, SW India

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