DCIT vs. Bank of Bahrain & Kuwait (ITAT Mumbai Special Bench)

Exchange Fluctuation loss on pending forward contracts is an “accrued” loss

The assessee, a foreign bank carrying on business in India, entered into forward contracts with its clients to buy or sell foreign exchange at an agreed price on a future date. On the date of maturity, the contract was executed which resulted in either profits or losses to the assessee. There was no dispute that the loss was on revenue account and that loss arising on execution of the contracts in the same year were allowable as a deduction. With respect to contracts where the date of maturity fell beyond the accounting period, the assessee valued the forward contracts on the last day of the accounting period on the basis of rate of foreign exchange prevailing on that date and accounted for the loss or profit, as the case may be. The AO taxed the profits on such contracts though he disallowed the losses on the ground that they were “notional”. The Special Bench had to consider whether the loss was a “notional” or “contingent” loss or whether it was an “accrued” loss. HELD deciding in favour of the assessee:

(i) The Act allows a deduction in respect of crystallized liabilities. While as per commercial principles of policy of prudence, all anticipated liabilities have to be accounted for, as per the Act only “accrued” liabilities are allowable. While anticipated liabilities which are contingent in nature are not allowable, an anticipated liability coupled with a present obligation can be said to be a crystallized liability. A contingent liability depends purely on the happening or not happening of an event whereas if an event has already taken place, such as the entering into the contract and undertaking of an obligation to meet the liability, and only consequential effect of the same is to be determined, then, the liability is not a contingent liability (Woodward Governor 312 ITR 254 (SC) & Bharat Earth Movers 245 ITR 428 (SC) followed, Principles of law on accrual of income & loss summarized);

(ii) Accounting Standard -11 (AS-11) issued by the ICAI is mandatory and provides that if foreign exchange transactions are not settled in the same accounting period, the effect of exchange difference has to be recorded on 31st March;

(iii) On facts, the foreign currency was the assessee’s stock-in-trade and the forward foreign exchange contracts entered into by it created a continuing binding obligation on the date of contract against the assessee to fulfill the same on the date of maturity. The assessee has consistently followed the same method of accounting in regard to recognition of profit and loss. The AO, having assessed the profits, could not have disallowed the loss;

(iv) Accordingly, where a forward contract is entered into by the assessee to sell foreign currency at an agreed price at a future date falling beyond the last date of accounting period, a loss is incurred by the assessee on account of valuation of the contract on the last date of the accounting period and before the date of maturity of the forward contract.