1. At the instance of the revenue, the following question has been referred to us for our determination :
'Whether, on the facts and in the circumstances of the case, it was rightly held that the sum of Rs. 78,050 standing to the credit of Shree Nava Kapas and Rui Hedge Account did not represent any assessable income of the years under reference and was correctly carried forward and accounted for in the subsequent accounting year ?'
2. Arjan Khimji & Company, the assessee, is a partnership firm carrying on the wholesale cotton business and in effecting both ready and hedging transactions. The question referred to arises for the assessment year 1960-61, for which the relevant accounting year is S.Y. 2015. The assessee had two accounts in respect of the hedging transactions : (i) relating to profit or loss from hedging transactions pertaining to the year, and (ii) relating to the account styled as 'new Kapas and Rui and hedging account'. On the Diwali of S.Y. 2015 the latter account contained credit to the extent of Rs. 1,11,687.50 and debits to the extent of Rs. 33,637.50, which resulted in a difference of Rs. 78,050. In the balance-sheet this difference was shown as a liability.
3. The ITO in respect of the latter account of Rs. 78,050 which was shown on the balance-sheet as a liability considered the same as profit relating to the assessment year in question, as the books of account of the assessee were maintained on mercantile system.
4. In an appeal preferred by the assessee, the AAC confirmed the view taken by the ITO so far as this question was concerned. According to him, the items in this account pertain to amounts of income received as a result of contracts settled in the accounting year and were not mere notional figures. He took the view that they had to be considered only in the year of account. He felt that finding of his was confirmed by the manner in which this account was maintained by the assessee in the next year as the accounts showed clearly an opening profit brought down of Rs. 78,050. As this profit was received in the year of account, according to him, it was correctly included in the assessment.
5. Before the Tribunal copies of certain documents, which are enumerated in para. 4 of the statement of case, were placed in the paper book. It was the contention of the assessee before the Tribunal that the contracts in question were not contracts settled in the year of account. Even though the assessee-firm received the amount during the year, the transaction, according to him, would be complete only when the ready business in respect of which this hedging transaction was given effect to by ultimate delivery. It was pointed out on behalf of the assessee before the Tribunal that since in the case of the assessee the relevant delivery in respect of the ready transactions was beyond the year of account of the assessee, the corresponding hedging transactions would be finally determined only after the year of account. It was urged on his behalf that since all the contracted sales were entered into either in August or afterwards, the delivery date in accordance with the rules of the East India Cotton Association Ltd., by which the assessee was also bound, would be in March, and, therefore, it could rightly close this transaction in March. As the month of March fell beyond the accounting year, the assessee rightly did not take into account this amount of Rs. 78,050 as profit for the assessment year in question.
6. It was urged on behalf of the revenue before the Tribunal that in the year of account the assessee-firm had actually received the amount of Rs. 78,050, and, therefore, this sum should be treated as profit for the assessment year in question. It was also urged on behalf of the revenue that the ready contracts should not be mixed up with hedging contracts, though the hedging contracts were entered into with a view to protect the possible losses in the ready contracts. The contention of the revenue was that the profits received in hedging transactions would have to be considered for the assessment year in question independently.
7. The Tribunal accepted the contention urged on behalf of the assessee holding that the contracts for actual delivery and contracts entered into to guard against future price fluctuations should be considered as one act of operation in the nature of business carried on by the assessee and, therefore, the result of both the transactions must be combined.
8. After looking at the account under the heading 'Shree Kapas and Cotton Loose Hedge A/c.' for the S.Y. 2016, it was found that the total gains in respect of hedging contracts in question had been arrived at Rs. 2,64,141.50 and the total loss in ready cotton had been arrived at Rs. 4,14,525; the net result was a loss of Rs. 1,48,840. This conclusion was arrived at by the Tribunal on the footing that both ready and hedging contracts entered into should not be considered separately, but should be pooled together and the combined result alone should be considered for assessment, as followed by the assessee. The Tribunal felt that the method by which the loss of Rs. 1,48,140 was arrived at by the assessee was in order. In other words, the method of taking the profits into consideration only after the transactions are finally completed was considered by the Tribunal as a proper method of accounting. The Tribunal accepted the contention of the assessee that the sum of Rs. 78,050 was rightly not declared by the assessee as its profits in the assessment year in question.
9. It is from this order of the Tribunal that the above question has been referred to us for our determination.
10. Mr. Joshi, on behalf of the revenue, submitted that even though the object of the hedging contract may be to secure oneself against loss against speculation in business transactions, still they are independent transactions and simply because the profit or loss in respect of future delivery contracts can only be determined in the S.Y. 2016, it is not permissible to the assessee to treat the future delivery contracts as interconnected with and forming part and parcel of the hedging contracts which are normally entered into to secure oneself against loss on speculation. His submission was that, so far as hedging contracts were concerned, on every clearance day the profit or loss in respect of the contracts entered into was crystallised and determined and in respect of hedging contracts for S.Y. 2015, as indicated by the books of account maintained by the assessee in respect of the said contracts entered into relating to 'new kapas hedging account' there was a profit of Rs. 78,050 and both the taxing authorities were right in bringing this item to tax as income of the assessee for S.Y. 2015. He submitted that the Tribunal was in error in proceeding on the footing that the contracts for future delivery and hedging contracts to guard against future price fluctuations should be treated as part and parcel of one integrated scheme and the result of either of the contracts cannot be taken independently but must be taken cumulatively to have a net result in the transactions related to these contracts. He submitted that the Tribunal ought to have accepted the contention of the revenue that even though the object of a hedging contract may be to secure oneself against any speculative business loss, still they are independent types of business the result of which would be that each of them must be separately assessed. According to his submission, the Tribunal was in error in taking the view that the result of future delivery contracts and that of the hedging contracts should be taken together, because in hedging contracts profits and losses were determined from time to time practically twice in a month ever since the same were entered into.
11. Mr. Dastoor, on the other hand, on behalf of the assessee, contended that the view that has been taken by the taxing authorities is not proper and the view that has been taken by the Tribunal is consistent with the normal commercial practice. He submitted that, as the object of entering into a hedging contract is to protect oneself against the known risk, the Tribunal was right is taking the view that the result of the hedging contract and ready delivery contracts ought not to be considered independently, but the same must be taken cumulatively. In other words, the total result of both the future delivery contracts as well as the hedge contracts ought to be taken into consideration and the net result alone should be considered for assessment. He emphasised that, as in the present case, the delivery in the future delivery contract was to be given in the month of March after the Diwali of S.Y. 2015, it was not permissible to the revenue to split up the result of hedging contract as on Diwali of S.Y. 2015, but it ought to have considered the net result on the basis of the system of accounting maintained by the assessee right up to the month of March, when delivery under the contract was to be given and the combined result of the hedging transactions right up to that date as well as ready delivery contracts ought to have been treated as one integrated transaction and the profit or loss arising therefrom should have been considered for assessment. He emphasised that since the assessee maintained accounts in a particular manner as a result of which the total gain in respect of hedging contracts right from the inception was determined in S.Y. 2016 at Rs. 2,64,141.50, it is at that stage that this amount of profit should be considered against the loss sustained in the ready delivery transactions of cotton which was Rs. 4,14,525. So long as the method adopted by the Tribunal is not unreasonable, the Tribunal was justified in accepting the method of accounting maintained by the assessee. The system of maintenance of accounts by the assessee was on the footing that the hedging contract was not an independent transaction but was dependent on the ready delivery contract. While subjecting any assessee to tax, what is required to be determined is the real income and if the real income can be determined as a result of the combined effect of hedging contract and ready delivery contracts, then it would not be permissible to the taxing authorities to bring to tax the amount of profits earned up to the Diwali of S.Y. 2016. It is on the basis of the method of accounting maintained by the assessee that the taxing authorities are under an obligation to determine whether in a particular venture the assessee had suffered any loss or made any profit. In the alternative, he submitted that even if the profit in respect of hedging transaction up to Diwali of S.Y. 2015 would be Rs. 78,050 to the assessee, it was not shown by the assessee in that year under the method of accounting maintained by him, and the sum of Rs. 78,050 cannot be subjected to tax, but the liability of the assessee in respect of the bales to be delivered in respect of the outstanding contracts should be estimated as on Diwali of S.Y. 2015. He submitted that there was a possibility of difference of opinion as regards the quantum of liability, but there can be no difference of opinion as regards the existence of such liability. The liability as on Diwali of S.Y. 2015 in respect of future delivery contracts ought to be estimated and it is after taking this quantum of liability that the net income of profit for the year under assessment ought to be determined. He urged that if the assessee had not done anything which is so wrong as cannot be accepted, his method of maintenance of accounts is paramount and ought to be accepted. In short, his submission was that both the taxing authorities were in error in subjecting the assessee to tax in respect of profit made in respect of hedging contracts for the Diwali of S.Y. 2015 and in not permitting the assessee to have a cumulative effect of hedging contracts till the date when delivery was effected to the mills under the various contracts of future delivery.
12. There are two main methods of accounting, the cash system and the mercantile system, and it is not disputed that the assessee is maintaining his accounts on the mercantile system. In the accounts maintained on cash basis, a record is kept of actual receipts and actual payments. Entries are made only when money is actually collected or disbursed. If the profits of a business are accounted for in this way, the tax is payable on the difference of receipts and disbursements for the period in question. While, in the mercantile system of accounts, the net profit or loss is calculated after taking into account all the income and all the expenditure relating to the period, whether such income has been actually received or not and whether such expenditure has been actually incurred or not. In other words, the profit computed under the mercantile system of accounting is the profit actually earned, though not necessarily realised in cash, or the loss computed under this system is the loss actually sustained, though not necessarily paid in cash. The distinguishing feature of this method of accounting is that it brings into credit what is due immediately it becomes legally due and before it is actually received; and it brings into debit expenditure the amount for which a legal liability has been incurred before it is actually disbursed.
13. It is not disputed that the object of a hedging contract is to secure oneself against loss on speculative or future delivery contracts by component transactions on the other side. Reliance was placed by Mr. Dastoor on one of the definitions given in Webster's New International Dictionary, third edn., where a hedging transaction has been given the following meaning :
'a purchase or sale made not primarily for income or profit but as protection against a known risk.'
14. The future delivery contracts were entered into in the month of August, 1959, and thereafter delivery was to be effected, in some contracts in November and in some in December and the rest in January. At page 32 of the paper book are the particulars given of the various sales effected to the various mills and between August 24, 1959, and October 21, 1959, the assessee had entered into aggregate sale transactions for 11,500 bales. Hedging transactions were entered into by the assessee for the first time in the accounting year in question and in respect thereof he maintained two separate accounts, one relating to the profit or loss from hedging transactions pertaining to the year and the other relating to accounts styled as 'New Kapas and Rui and Hedging Account'. It is in respect of the latter account that we have to consider the question whether the profits in respect of this account are to be determined as of Diwali of S.Y. 2015 or the same should not be considered independently but the net result of the transactions in this account ought to be considered after delivery was effected in respect of the various contracts entered into with the mills by the assessee.
15. It appears from the statement of accounts filed by the assessee that in respect of hedging transaction there are two separate ledger accounts which have been brought on record : (i) one is headed 'Shree Kapas and Rui Hedge account' and the entries therein are from the month of Magsar of S.Y. 2015 to the month of Chaitar of the same Samvat Year, while the other account is headed 'Shree Nava Kapas and Rui Hedge account' of S.Y. 2015 and the entries therein are from the month of Shravan right up to the month of Asoj. So far as the first account is concerned, the net credit entry is treated as income of the year, but so far as the second account is concerned, even though there was a net credit balance of Rs. 75,050 on the Diwali of S.Y. 2015, the assessee has treated this amount as a liability in the balance-sheet for that Samvat Year. A short question that we have to consider in the present case is whether even though there was a net credit of Rs. 78,050 at the end of the Samvat Year, the assessee was justified in taking the same as a liability in the balance-sheet.
16. Having regard to the entries in the books of account, it cannot be disputed that the sum of Rs. 78,050 was the aggregate profit in the second account and the amount was actually received by the assessee as a result of the contract completely settled during the assessment year. They are not notional figures. As the assessee was maintaining his accounts on the mercantile basis actually in the present case, the profit is not only earned but actually received. In our opinion, the taxing authorities were right in treating it as income of the assessment year because that income not only accrued but was in fact received in S.Y. 2015. That this was the income received in this year is quite evident, if regard be had to the opening balance in the next year, because it starts with the opening profits brought down at the figure of Rs. 78,050.
17. Reference was made by Mr. Dastoor to the definition of the expression 'speculative transaction' given in s. 43(5) of the I.T. Act, 1961, which defines 'speculative transaction' as meaning 'a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise then by the actual delivery or transfer of the commodity or scrips.'
18. Specific attention was invited to prov. (a) to this definition, which says that for the purposes of this clause 'a contract in respect of raw materials or merchandise entered into by a person in the course of his manufacturing or merchanting business to guard against loss through future price fluctuations in respect of his contracts for actual delivery of goods manufactured by him or merchandise sold by him shall not be deemed to be speculative transaction'. This definition, in our opinion, is of no assistance to the assessee because it merely states that a hedging transaction is not to be regarded as a speculative transaction. Simply because the object of a hedging transaction may be to cover up oneself against a loss on speculation by a compensating transaction on the other side, both these transaction cannot be regarded as interconnected and each one is independent of the other and the profit arising from the same has to be considered separately. The Tribunal has fallen into an error when it relied upon prov. (a) to the definition of the expression 'speculative transaction' and construed to mean that effected a contract for actual delivery and a hedging contract, which is entered into to guard against a future price fluctuation, should be considered in method only. In fact, each is an independent transaction. So far as the profit or loss arising from future delivery contract is concerned, it will be effectively determined on the date of actual delivery irrespective of the date on which the contract was entered into. While in respect of a hedging contract, profit or loss arising therefrom can be ascertained or will become crystallised every fortnight or at every fixed interval of the term when the clearance takes place. Actually, from the statements produced by the assessee it could be noticed that twice in a month in respect of a hedging contract, either he has earned profit or suffered a loss. Contracts for delivery are entered into with different parties and hedging contracts are also entered into with different parties. In our opinion, the Tribunal fell into error when it held that hedging contracts and future delivery contracts should be treated as integrated transactions and the cumulative effect of such transactions ought to be determined when actual delivery under the future delivery contract is effected. There is no obligation upon a merchant to continue his hedging contract till the date of the actual delivery. It depends upon his sweet will and volition whether he should continue the transaction and in respect of what quantities of bales of cotton.
19. A large number of authorities were cited by Mr. Dastoor with a view to justify the conclusion that has been reached by the Tribunal in this case. Not one of the said authorities deal with a future delivery contract or a hedging contract as such. Reliance was placed by him upon the decision of this court on Gustad Dinshaw Irani v. CIT : 31ITR92(Bom) . This was a case of purchase and sale of a plot of land. This court has taken the view that in determining the profits made by an assessee in such a transaction, expenditure incurred by the assessee in respect of that transaction during the years prior to the year of account cannot be disallowed on the ground that it was not incurred in the year of account. If the real profits made by the assessee in the transaction from a commercial point of view can only be arrived at by taking into consideration the expenditure incurred in the previous years also, credit must be given to the assessee in respect of such expenditure even though it cannot strictly fall within the ambit of s. 10 of the Indian I.T. Act. It is difficult to see how the ratio of this decision is of any assistance to Mr. Dastoor in deciding the question with which we are concerned. Though the object of a hedging transaction is to secure oneself against loss in another independent transaction with a different party, still they are entirely independent transactions and the question of profits or losses arising in one transaction are not connected with profits or losses arising in the other transaction, except for the object with which the transactions are entered into. It should not be overlooked that hedging contract entered into by any person is not specifically connected with a particular sale. Actually from the statements filed by the assessee, it appears that whenever it is convenient to the assessee he deals in various types of purchases and sales in respect of the contracts, by way of sample, we have got a 'Clearance house settlement statement' dated October 23, 1957, whereunder the payment for oak was October 27, 1959. This statement shows that as a result of the earlier clearance on October 16, 1959, there was an outstanding purchase of 5,600 bales. In the course of the period between the two clearances, as and when it was convenient to the assessee, he had entered into various types of purchases and sales and the net result of these transactions as on October 23, 1959, was an outstanding purchase of 6,000 bales. This statement at a glance would show that various transactions which are effected between the period of the two clearances are in no way connected with any particular outstanding future delivery contract, but they are entered into by the assessee in such a manner as would result in a profitable bargain. This statement shows that in this clearance alone he has entered into various purchases and sales contracts as he considered them necessary.
20. In respect of hedging contracts between the two clearance dates, as a result of such transactions he had made either profit or loss depending upon the nature of the transactions he had entered into and there is nothing to indicate in this statement that these various transactions which were entered into can be regarded as having been specifically connected with any specific future delivery contract, even though in the various hedging contracts entered into by him after the month of August in S.Y. 2015, in some of them he had made profits while in others he has incurred losses. There is no indication in this statement to show any connection with future delivery contracts where delivery was to be effected later on. Thus, it is not possible for us to say that the profit or loss derived due to these transitions was really interconnected with the profit or loss in the future delivery contracts, where delivery was to be given after the end of the accounting year.
21. Reference was made by Mr. Dastoor to the decision of this court in H. M. Kashiparekh & Co. Ltd. v. CIT : 39ITR706(Bom) , in support of his contention that regard should always be had to the real income. This was a case where a managing agent gave up a part of commission that was due and payable to him at the end of the previous accounting year. The commission earned by the managing agent in the accounting year ending March 31, 1950, came to Rs. 1,17,644, but as a result of the resolutions passed by the managed company and the assessee-company, the assessee gave up a sum of Rs. 97,000 in December, 1950. A question that arose was whether the amount forgone should be treated as the income of the assessee. It was in this context that this court held that the real income of the assessee-company for the accounting year was liable to tax and that the real income could not be arrived at without taking into account the amount forgone by the assessee. We are not concerned with a question like this. There is no question of the assessee having given up any income which had accrued to him.
22. A number of cases were cited by Mr. Dastoor with a view to contend that in determining the assessable income of a particular assessee regard should be had to the method of accounting maintained by the assessee. We do not consider it necessary to refer to these cases because in the present case in Shree Nava Kapas account maintained by the assessee, he has shown a clear net profit at the end of S.Y. 2015 of Rs. 78,050. Even this profit has been carried forward to the next year in the account, however, only in the balance-sheet he has chosen not to describe it as a profit but has shown it as a liability. If actually in respect of this transaction, as indicated in the books of account, a profit is earned by the assessee by reason of a surplus credit of Rs. 78,050 it is difficult to understand how by any well recognised method of accounting it can be shown as a liability in the balance-sheet. Even if this account is kept in some suspense, it will not be permissible to a businessman to treat the profit of one year as a liability. Actually, so far as tax liability is concerned, the income of the assessee for a particular accounting year has to be determined and if he has made a profit in that year, then he would be assessed to income-tax in accordance with the provisions of the I.T. Act, and if he has suffered a loss, he would be entitled to carry forward the loss as may be permissible under the Act.
23. It was urged by Mr. Dastoor that the Tribunal has accepted the particular method of accounting which was followed by the assessee and has come to the conclusion that the assessee was justified in not declaring the sum of Rs. 78,050 as profit of the assessment year in question. This conclusion of the Tribunal is a surmise based upon wrong premise, because this conclusion is arrived at after observing where a contract runs for more than a year, in the case of an assessee following the mercantile system of account, the profit or loss is determined only when the contract is finally performed. These observations of the Tribunal proceed upon the transactions relating to various hedging contracts that have been entered into by the assessee. Actually during the two clearance periods several contracts of purchases and sales had been effected and even the outstanding balance does not tally with the outstanding balance at the beginning of the Vaiada. It is not as if that a particular hedging contract initiated much earlier was continued later on. A mere glance at the statement of a particular clearance indicates that the several transactions of purchases and sales were effected even during the short period of a week. Thus, the Tribunal was completely in error in combining the result accruing from the various hedging contracts from time to time with the ultimate liability that may arise under future delivery contracts.
24. That brings us to the last contention of Mr. Dastoor that even if the profit accrued as a result of the hedging contracts entered into in S.Y. 2015, is determined and the showing of the said amount as a liability in the balance-sheet is not accepted, the liability in respect of the bales to be delivered under future delivery contracts has to be estimated as on Diwali of S.Y. 2015. He submitted that even though it may be difficult to have definite information about the quantum of such liability, still since the liability existed, a proper estimate thereof ought to be made before the sum of Rs. 78,050 is regarded as an item of income for the current year.
25. It is difficult to understand the submission. So far as the deliveries were concerned, they were to be effected at any time within a period falling before Diwali of S.Y. 2015. Even in the case of a person maintaining accounts on a mercantile system, there is no liability as such by reason of the contracts that he has entered into for delivery after Diwali of S.Y. 2015. Only when the day of performance comes, the liability arising from a particular contract can be crystallised. Till then nobody knows whether in fact there will be profit or loss and the quantum thereof. So far as future delivery contracts were concerned, even on a mercantile system of accounting no liability has arisen on the Diwali day of S.Y. 2015 in respect of the contracts where delivery was to be given after the Diwali of that year. Our attention has not been drawn to any specific cast where even a contention like this has been considered and either accepted or rejected.
26. Reference was made by Mr. Dastoor to the decision of the Supreme Court in Calcutta Co. Ltd. v. CIT : 37ITR1(SC) , and the two decisions of the Gujarat High Court in CIT v. Tensile Steel Ltd. : 104ITR581(Guj) and Arvind Mills Ltd. v. CIT : 112ITR64(Guj) . None of these cases were even remotely concerned with the questions with which we have to deal with here. In Calcutta Co. Ltd.'s case : 37ITR1(SC) , the court was concerned with the estimate of an accrued liability to be discharged at a future date in the case of an assessee who had actually sold his land and was maintaining his accounts liability (sic), and the Supreme Court held that the estimated expenditure which would be incurred in discharging the same could be deducted from the profits and gains of the business, and the amount to be expended could be debited in accounts maintained in the mercantile system of accounting before it was actually disbursed.
27. In Tensile Steel Ltd.'s case : 104ITR581(Guj) , the Gujarat High Court was concerned with inclusion of the amount of interest payable in respect of deferred payment rates for calculation of depreciation and development rebate, and in Arvind Mills Ltd.'s case : 112ITR64(Guj) , the court was concerned with the calculation of development rebate by reason of additional liability in respect of repayment of loans borrowed by the assessee for acquiring imported machinery during the relevant previous year in view of the devaluation of the rupee. It is difficult to see how the principle laid down in any one of these case can even be remotely helpful to us in determining the question with which we are concerned.
28. As we have indicated earlier, even though the object of a hedging contract may be to secure oneself against the loss in a future delivery contract, these transactions are independent and if in respect of a hedging contract in any particular year a net profit or net loss has arisen, the same has to be taken into account in computing the income that should be assessable to tax. From that point of view, there can be no doubt that in respect of hedging contracts, which were entered in the accounts styled as 'New Kapas and Rui Hedge Accounts', on the Diwali of S.Y. 2015 a net profit of Rs. 78,050 had accrued to the assessee and, in our opinion, both the taxing authorities were right in subjecting this amount to tax.
29. There is not question of this profit being interconnected with the loss likely to arise in the future delivery contracts with the various mills. Thus, the answer to the question referred to us is as under :
30. In the negative in favour of the revenue.
31. The assessee shall pay the costs of the revenue.