London Star Diamond Company (I) P. Ltd vs. DCIT (ITAT Mumbai)

Loss on foreign exchange forward contracts is incidental to the exports business and not a “speculation loss“. However, if the contract is prematurely cancelled, the assessee has to justify the loss

The assessee, an exporter of diamonds, entered into forward contracts with Banks to hedge the exchange loss, if any, in respect of the outstanding receivable in foreign currency. The assessee suffered a loss of Rs. 4.69 crore on account of the maturity & premature cancellation of the said forward contracts. The AO & CIT(A) held that the forward contracts constituted a “speculative transaction” u/s 43(5) and that the loss suffered thereon was a “speculation loss” which could not be set-off against the other income. On appeal by the assessee to the Tribunal HELD:

(i) Though a forward contract for purchase or sale of foreign currency falls in the definition of “speculation transaction” u/s 43(5) as it is settled otherwise than by the actual delivery or transfer of the commodity, it cannot be regarded as constituting a “speculation business” under Explanation 2 to s. 28. A forward contract, entered into with banks for hedging losses due to foreign exchange fluctuations on the export proceeds, is in the nature of a “hedging contract” and is integral or incidental to the export activity of the assessee and cannot be considered as an independent business activity. Therefore, the losses or gains constitute business loss or gains and do not arise from speculation activities. The fact that there is a premature cancellation of the forward contract does not alter the nature of the transaction. There is also no requirement in the law that there should be a 1:1 correlation between the forward contracts and the export invoices. So long as the total value of the forward contracts does not exceed the value of the invoices, the loss has to be treated as a business loss (Sooraj Mull Magarmull 129 ITR 169 (Cal), Badridas Gauridu 261 ITR 256 (Bom), Panchamahal Steel 215 Taxman 140 (Guj) and Friends and Friends Shipping (Guj) followed; contrary view in S. Vinodkumar Diamonds (ITAT Mum) referred);

(ii) On facts, the loss arising on cancellation of matured forward contracts is allowable as it is attributable to the genuine failure of the trade debtors to comply with the credit terms and conditions. As regards the loss arising on account of premature cancellation of the forward contracts, the assessee requires to explain the reason for the premature cancellation. The explanation that the maturity of date of some of such premature cancelled forward contracts fell during the week-end and therefore they were cancelled three days prior to the due date is acceptable and the loss is allowable. The explanation that some other forward contracts were prematurely cancelled due to business reasons and to avoid higher loss requires to be examined by the AO. The correspondence with the banks and the RBI guidelines on the issue as well as the accounting treatment by the banks also requires to be examined. The assessee’s alternative argument that the said loss is “damages” payable to the banks for breach of contracts or settlement of the contracts also requires examination by the AO.