IT APPEAL NOS. 7319 AND 7449 (MUM.) OF 2011
[ASSESSMENT YEARS 2004-05 AND 2008-09]

G.S. PANNU, ACCOUNTANT MEMBER 
AND AMIT SHUKLA, JUDICIAL MEMBER

Vijay Mehta for the Appellant. 
N.P. Singh for the Respondent.

ORDER

Amit Shukla, Judicial Member - The aforesaid cross appeals have been filed by the revenue as well as by the assessee against the impugned order dated 25.08.2011 passed by CIT (Appeals)-9, Mumbai for the quantum of assessment passed under section 143(3), for the assessment years 2008-09.

2. We will take-up assessee's appeal wherein the assessee has raised following two grounds:—

3. The assessee is a Star Trading House engaged in the business of diamonds. The main activities of the assessee consists of purchase of rough and polished diamonds mainly through import from various countries, manufacturing of rough diamonds into polished diamonds and sell polished diamonds mainly by way of export to various countries. The brief facts qua the issue of disallowance under section 14A of Rs. 25,85,318/- as raised vide ground no.1 are that, the assessee has earned dividend income of Rs. 62,92,640/- which was claimed as exempt under section 10(34). The assessee had not attributed any expenses for the earning of such an exempt income and accordingly, no disallowance was offered in the computation. The AO observed that, assessee has common pool of funds and composite books of accounts from where it is not possible to exactly identify the expenses attributable to earning of this exempt income. In response to the show cause notice as to why the disallowance under section 14A should not be made as per Rule 8D, the assessee submitted that, all the loans taken were utilized for the business purpose and also gave the details of payment of interest on various kinds of loans. Thus, the entire interest payment was stated to be for the various business purposes including that of export. The Ld. AO, did not accept completely the assessee's contention and held that only the interest on packaging credit, post shipment credit, specific overdraft and bill discounting should be excluded from the calculation of disallowance of interest under Rule 8D. He also held that, since assessee was unable to produce any fund flow statement or bank statement proving the nexus between investment and income yielding products, disallowance under section 14A has to be made. Accordingly, he worked out the disallowance of interest at Rs. 14,000,41/- as per the working given at page 4 of his order. With regard to indirect expenses, he calculated the disallowance of 0.5% of the average value of investments which worked out to Rs. 11,85,278/-. Accordingly, the disallowance u/s. 14A aggregated to Rs. 25,83,318/-.

4. The Ld. CIT (A) confirmed the said disallowance by holding that, now in view of the decision of Hon'ble Bombay High Court in the case of Godrej Boyce Mfg. Co. Ltd, the disallowance has to be made under Rule 8D. Thus, he dismissed the assessee's ground on this point.

5. Before us, the Ld. Counsel Shri Vijay Mehta, submitted that assessee has own surplus funds of more than Rs. 190 crores and substantial interest free borrowings from the directors, which far exceeded the investment made by the assessee. Hence, no disallowance of interest should be made in the light of the decision of CIT v. Reliance Utilities & Power Ltd. [2009] 313 ITR 340/178 Taxman 135 (Bom.) and CIT v. HDFC Bank [2014] 366 ITR 505/226 Taxman 132 (Mag.)/49 taxmann.com 335 (Bom.). Regarding disallowance of indirect expenditure of Rs. 11,85,278/- worked in accordance with Rule 8D(2)(iii), he submitted that, firstly, the most of the investments were made by way of 'strategic investment' in subsidiaries and associated companies and, therefore, it cannot be held that they were meant for earning of exempt income and secondly, only those investment which has yielded dividend or tax free during the year should only be considered for working of the disallowance under section 14A under Rule 8D(2)(iii).

6. On the other hand, Ld. DR strongly relied upon the order of the AO and CIT (A) and submitted that, disallowance has to be made in accordance with the Rule 8D, because the assessee could not substantiate its claim before the AO properly.

7. We have heard the rival submissions and also perused the relevant finding given in the impugned order and material placed on record. The disallowance under section 14A consists of disallowance of interest under Rule 8D(2)(ii) of Rs. 14,000,41/- and disallowance of indirect expenditure under Rule 8D(2)(iii) of Rs. 11,85,278/-, aggregating to Rs. 25,85,318/-. So far as the disallowance of interest is concerned, it has been submitted before us that the surplus and interest free funds available with the assessee far exceeded the investment made by the assessee. This contention of the assessee appears to be correct from the perusal of the Balance-sheet as on 31st March, 2008 from where it is evident that, the share capital and reserve & surplus itself was at Rs. 183,33,70,726/- whereas, the investment which has been made are at Rs. 48,29,02,642/-. Thus, it can be safely be presumed that investments have been made from surplus/interest free funds. This proposition has been upheld by the Hon'ble Bombay High Court in various other Courts several times including that of Reliance Utilities and HDFC Bank (supra), that when assessee has surplus funds and interest bearing funds, then presumption is that assessee must have made the investments from surplus/interest free funds . Thus, respectfully following the ratio and principle laid down by the Hon'ble jurisdictional High Court, we hold that no disallowance of interest under Rule 8D(2)(ii) can be made and accordingly, the same is directed to be deleted.

8. So far as the disallowance of indirect expenditure, under Rule 8D(2)(iii), by taking 0.5% of the average value of investments, the contention of the assessee before us is twofold, firstly, most of the investments have been made in the subsidiary and associated companies as a strategic investment and, therefore, same should not be the part of working of the disallowance while taking the average value of investments and; secondly, the investment which has not yielded income during the year should not be included for the purpose of disallowance under Rule 8D(2)(iii). So far as contention that, assessee has made strategic investment by way of business necessity in the case of associated and subsidiary companies, we agree with the contention of the Ld. Counsel that, same should not be part of the investment for the purpose of disallowance, because the said investment cannot be said to be made for the purpose of earning the exempt income but for business and strategic compulsions which falls within the realm of 'business purpose' and this view has been upheld by the Tribunal in various decisions including that of Hon'ble Delhi High Court in the case of Cheminvest Ltd. v. CIT [2015] 378 ITR 33/234 Taxman 761/61 taxmann.com 118. Thus, we direct the AO to exclude the strategic investment made in subsidiary companies for the purpose of working the disallowance of value of the investment.

9. However, so far as other contention that the investments which has not yielded dividend or tax free income during the year should only be included, no supporting decision has been placed before us by the ld. Counsel before us that only the investments which have not yielded the exempt income during the year has to be excluded. Rule 8D(2)(iii) lays down that, "an amount equal to ½% of the average value of the investment, income from which does not or shall not form part of the total income, as appearing in the Balance-sheet of the assessee ,on the first day and the last day of the previous year" shall be taken. What is required to be seen is, whether the income from the investment which "does not" or "shall not" form part of the income. The phrase "does not" conveys something done or to be done in present, that is, 'income during the year"; and "shall not" conveys something about in future, a strong assertion or intention, that is, 'not earned income in future'. Hence in our opinion, the phrase "shall not" covers a situation where income earned in future or whenever it is earned, then it shall not form part of the total income at any time. Thus, this contention of the assessee prima facie does not appears to be in correct interpretation or in line with the Rule 8D(2)(iii). Accordingly, we direct the AO to remove the strategic investments only from the working and from the balance, he should work out the disallowance as per Rule 8D (2)(iii). With this direction, ground No.1 is treated as partly allowed.

10. The brief facts qua the second ground are that, the assessee had debited a sum of Rs. 26,18,34,176/- on account of foreign exchange rate difference (net) under the head "raw materials consumed/trading goods utilized". The break-up of this head was given in Schedul-17 to the audited account. On the perusal of the exchange difference, it was found that the assessee has reduced the sum of Rs. 49,23,25,597/- pertaining to loss on account of foreign currency forward/option contracts. The computation of this net figure was given by the assessee in the following manner:—

AO further noted that, this loss of Rs. 49,23,23,597/- is actually suffered by the assessee on account of its forward and option contract any foreign currency which are not deliverables at first place. He further noted that, no break-up of currency forward/option contract, however, it is given by the assessee but he admitted that majority of the contracts on which this loss was suffered is of "forward and option contracts". The contract-wise details of the loss as furnished by the assessee have been incorporated by the AO form pages 7 to 17 of the assessment order. After analyzing the provision of section 43(5), the AO considered the loss incurred by the assessee on foreign exchange derivative transaction as speculation loss primarily on the following grounds:—

11. The Ld. CIT (A) after considering the observations and finding of the AO as well as submissions made by the assessee held that, loss of Rs. 8,33,76,649/- would be considered as speculation loss and loss of Rs. 40,89,46,448/- is to be considered as business loss. The sum and substance of assessee's submissions before CIT (A) are as under:—

12. After considering the submissions of the assessee, the Ld. CIT (A) held that foreign currency is not a commodity and appreciating the facts of the case that assessee is in the business of import and export of diamonds having risks of fluctuations in foreign exchange exposure and entered into hedging contracts with clear underlying of its import or export commitments and loss arising on cancellation of such hedged contracts is nothing but part and parcel of the regular diamond business, he came to the conclusion that the said loss should be considered as normal business loss and not a speculative loss. However, out of total losses of Rs. 49,23,23,597/- incurred by the assessee, he held that, assessee has been able to substantiate the underlying exposure for the derivative contracts to the tune of loss of Rs. 40,89,46,948/- on month-wise bill to bill basis and for the balance loss of Rs. 8,33,76,649/- he observed that assessee could not substantiate with respect to its underlying risk exposure and accordingly he held that loss of Rs. 8,33,76,649/- is to be considered as speculation loss and balance loss of Rs. 40,89,46,948/- is to be considered as business loss.

13. Before us, the Ld. Counsel, Shri Vijay Mehta submitted that assessee has entered into these transactions in order to hedge against the risk of currency fluctuation for its imports and exports. This issue had also come-up for consideration before the Tribunal in assessee's own case in the AYs 2001-02 to 2004-05, wherein Tribunal has decided this issue in favour, which now has been affirmed by the Hon'ble Bombay High Court also vide order dated 17.01.2011, following the decision of Bombay High Court in the case of CIT v. Badridas Gauridu (P.) Ltd. [2003] 261 ITR 256/[2004] 134 Taxman 376. He further submitted that, transactions are carried out as per the Foreign Management Act, 1999 as well as circular issued by the RBI. So far as allegation of the AO that, break-up of option and contracts and position on date of contract and cancellation has not been provided, he submitted that it is not correct observation, because the complete details were furnished which is evident from para 1.7 page 24 of the assessment order itself, wherein, he has incorporated the reply of the assessee highlighting furnishing of details of transactions. The position of exposure on respective dates were also given before the AO vide letter dated 14.12.2010. In any case, the same where produced before the Ld. CIT (A) also. The assessee is in the business of diamonds and not in the business of currency sales and, therefore, the hedging cannot be done in the currency. In support, reliance was placed on the decision of Bombay High Court in the case of Badridas Gauridu (supra). The hedging of value of diamond which is subject to variation in foreign exchange, thus, hedging of currency is nothing but hedging in the value of diamond, because it is connected with the commodities. In support of his contention he relied upon the following decisions:—

14. Ld. DR on the other hand, strongly relied upon the order of the AO and submitted that, ultimately, the gain or loss to the assessee is on account of hedging only.

15. We have carefully considered rival submissions and also perused the relevant findings given in the impugned orders as well as materials placed before us. The assessee imports rough diamonds which are its principle raw material for manufacturing of polished diamonds, procured mainly form Diamond Trading Company which allocates and indicates on annual basis in advance for supply of rough diamonds through 'intention to offer'. The assessee also exports finished goods (polished diamonds) to various parties on credit and credit term ranges from 90 to 150 days. It is part and parcel of the assessee's business strategy to receive foreign currency for exports and pay foreign currency for imports. The assessee also meets its working capital by way of foreign currency loan from the bankers. Thus, the assessee's receipts and payments are in the form of foreign currency and hence it is integral and inseparable part of its business. In this process, the assessee is not only exposed to the risk of adverse price movements in the goods it deals in, but also wide fluctuations in foreign exchange rates in international markets having major impact on its revenue, receivables and payables. It is clearly evident that, due to large import and export of diamonds, which is the main business activity of the assessee, it is exposed to high risk of foreign exchange gain or loss which is arising only because of the said business only. In other words, all its receipts, payments, receivables and payables are in foreign currency which is inseparable and inextricably linked with the diamond business carried out by the assessee and, therefore, risk associated with the fluctuation of foreign currency also forms part and parcel of same business. To mitigate the foreign currency loss, RBI introduced the regulations so that exporters and importers can hedge the same through authorized dealers, mostly Banks. The assessee had entered into hedging transaction through banks and the amount for which the hedging transactions are entered are within the amount of the underlying transactions of imports and exports. There is no independent transaction of foreign exchange on standalone basis. The details of transaction on which the assessee has made profit and loss on various foreign exchange contracts has already been discussed in the impugned orders along with the copy of the contract entered with the banks. Thus, such a loss cannot be in any manner equated with hedging of foreign currency alone, but ceases to fall within the realm of 'speculation' albeit it is inextricable linked with the business of the assessee. This matter had already been decided by the Tribunal in the assessee's own case in the earlier years which has been upheld by the Hon'ble Bombay High Court following the ratio and principle laid down in the case of Badridas Gauridu (supra). We find that this issue is no longer res integra, because in various decisions as relied upon by Ld. Counsel before us, it has been consistently held that, if the assessee is not dealing in foreign exchange per se but has hedged against the foreign exchange loss in the forward market with the bank, then any loss or gain thereto is to be treated as business loss or business gain only. The Hon'ble Bombay High Court in the case of Badridas Gauridu (supra), held that, if the assessee is not dealer in foreign exchange but an exporter and has hedged against the foreign exchange losses and for that purpose it had booked foreign exchange in the forward market with the bank, then the losses incurred on foreign exchange would be considered as business loss, because the foreign exchange contract is only incidental to the assessee's regular course of the business. While coming to this conclusion, the Hon'ble High Court relied upon the decision of Hon'ble Calcutta High Court in the case of CIT v. Soorajmull Nagarmull [1981] 129 ITR 169/5 Taxman 289. That apart, Hon'ble Gujarat High Court in the case of Friends and Friends Shipping (P.) Ltd. (supra) came to the same conclusion and finding. ITAT Mumbai Bench in the case of London Star Diamond Co. (I) (P.) Ltd. (supra) had also held and relied upon aforesaid decisions and held that, if the assessee is not a dealer in foreign exchange but in regular business of import and export then fluctuation in foreign exchange during the forward contract with the banks for the export would be business transaction and for the business purpose only and will not be in the category of speculation u/s. 43(5). In the said case, the Hon'ble Tribunal after detailed discussion and relying upon various case laws, held that foreign exchange loss in the course of the business occurred due to hedging transactions through advance is nothing but business gain or loss. Accordingly, in view of the myriad precedence, we also hold that, here in this case the foreign exchange loss of Rs. 49,23,23,597/- is nothing but business loss which needs to be allowed.

16. So far as the CIT (A)'s contention that assessee has been unable to substantiate the underlying exposure of derivative contracts to the tune of Rs. 8,23,26,649/- and, therefore, it should be substantiated, the assessee before us, has contended that in any genuine hedging transaction where there is huge volume of purchase exposure and sales exposure, the hedging transaction keeps on fluctuating. The Ld. CIT (A) has upheld the disallowance keeping in mind the fact that in any particular month the hedging transactions were higher than foreign exchange exposure, the excess cannot be accepted as for the purpose of business transaction. We find that such an observation in general may not prevail in every case, because in normal business practice the hedging is often done based on actual estimated exposure looking to the past transactions undertaken and based on that, hedging is done in respect of transaction yet to be done in the near future. Bill to bill or one to one basis exposure of hedging cannot be done in a continuum business and nothing has been brought on record that RBI puts such kind of condition or bar for hedging of foreign currency based on actual bill to bill exposure. Hedging contracts need not succeed the contract for sale and actual goods manufactured but may get settled within a reasonable time. Quantity and timing may not be relevant for a short period in a continuous transaction as long as transaction construed is based on genuine hedging and finally it coincides with the actual exposure undertaken. It is only at the year end that one can still reconcile the hedging transactions with the actual exposure or delivery and come to a conclusion whether hedging contract exceeded the actual exposure or not but certainly not on week to week or month to month basis. Thus, the disallowance of loss sustained by the Ld. CIT (A) of Rs. 8,23,26,649/- cannot be upheld simply on the ground that the exposure do not tally with the month-wise transaction. In view of our above conclusion, we allow the claim of Rs. 8,23,26,649/- and accordingly, the grounds raised by the assessee is allowed.

17. Now we come to the revenue's appeal, in the grounds of appeal following ground has been raised:—

"On the facts and in the circumstances of the case and in law, the Ld. CIT (A) erred in directing the Assessing Officer to treat only Rs. 83,376,349/- as speculation loss instead of Rs. 492,323,597/- without appreciating that the assessee used foreign currency derivative contract to hedge risk and ignoring that the provisions of section 43(5)(d) are not clearly attracted".

Admittedly, this ground is similar to ground which has been decided above, therefore, in view or our finding given above, the revenue's ground does not survive and accordingly the same is dismissed. Resultantly, revenue's appeal stands dismissed.

To sum-up:

Assessee's appeal stands partly allowed and that of the revenue stands dismissed.