Business Expenditure — S. 42(1) — Special provisions for prospecting for mineral oil — Production sharing contract accounts is an independent accounting regime — Foreign exchange losses on account of foreign currency transaction is allowable as a deductio

[CIT v. Enron Oil and Gas India Ltd.,
(2008) 305 ITR 75 (SC)]

The respondent-Enron Oil and Gas India Ltd. (‘the
EOGIL’), a company incorporated in Cayman Islands was engaged in the business
of oil exploration. In 1993, the Government of India through the Petroleum
Ministry invited bids for development of concessional blocks. EOGIL offered
its bid for the development of concessional blocks. A consortium of EOGIL with
RIL was given the contract. Later on, ONGC joined. EOGIL with RIL and ONGC
executed a production sharing contract (PSC) with the Government of India.
EOGIL was entitled to a participating interest of 30% in the rights and
obligations arising under the PSC. RIL was also entitled to participating
interest of 30%. ONGC was entitled to a participating interest of 40%. EOGIL
was designated as the operator under the said PSC.

Vide Notification No. 1997, dated March 8, 1996,
u/s.293A of the Income-tax Act, 1961 (‘the 1961 Act’), each co-venturer was
liable to be assessed for his own share of income. They were not to be treated
as an association of persons.

EOGIL filed its return of income for the
assessment year 1999-2000 declaring its taxable income of Rs. 71,19,50,013
u/s.115JA.

During the year, EOGIL debited its profit and
loss account by exchange loss of Rs.38,63,38,980. The Assessing Officer
disallowed this loss on the ground that it was a mere book entry and actually
no loss stood incurred by the assessee.

The decision of the Assessing Officer was
challenged in appeal by EOGIL before the Commissioner of Income-tax (Appeals),
who after analysing PSC held that each co-venturer in this case had made
contribution at a certain rate, whereas the expenditure incurred out of the
said contribution stood converted on the basis of the previous month’s average
daily means for the buying and selling rates of exchange which exercise
resulted in loss/profit on conversion. Under the circumstances, according to
the Commissioner of Income-tax (Appeals), it could not be said that the
assessee had incurred notional loss. In fact, during the course of
proceedings, the Commissioner of Income-tax (Appeals) found that during the
A.Ys. 1995-96 and 1996-97 the assessee had earned profits which stood taxed by
the Department. He further found that one co-venturer (ONGC) had gained
Rs.293.73 crores during the A.Y. 1997-98 because the Indian rupee had
appreciated as compared to foreign currency and the Department had taxed the
same, but when during the assessment year in question there is a loss on
account of such conversion, the Department has refused to allow the deduction
for such conversion losses. According to the Commissioner of Income-tax
(Appeals), the Department cannot blow hot and cold. Consequently, it was held
that just as the foreign exchange gain was taxable, loss was allowable
u/s.42(1) of the Income-tax Act in terms of the PSC. Therefore, the
Commissioner of Income-tax (Appeals) allowed as deduction, the loss of Rs.
38,63,38,980.

Aggrieved by the order passed by the Commissioner
of Income-tax (Appeals), the Department carried the matter in appeal to the
Income-tax Appellate Tribunal objecting to the deletion made by the
Commissioner of Income-tax (Appeals) on the ground that the loss was only a
book entry. Before the Tribunal the matter pertained to the A.Ys. 1999-2000,
199899, 2000-01 and 1996-97. However, for the sake of convenience, the
Tribunal focussed its attention on the facts and figures given for the A.Y.
1999-2000. Before the Tribunal, the Department contended that the assessee
borrows in USD and repays in the same currency for the preparation of the
balance sheet. The loans, according to the Department, were stated at
prevalent exchange rates and the loss arrived at was charged to the profit and
loss account. Therefore, according to the Department, the said loss was a book
entry and it was not an actual loss in foreign exchange caused to the assessee.
This argument of the Department was rejected by the Tribunal. It was held that
the assessee was a foreign company. It carried out business activity in India.
It had to maintain its accounts in rupees for the purpose of income-tax, that
the PSC had to be read with S. 42(1) of the Income-tax Act, which entitled the
assessee to claim conversion loss as deduction, particularly when the said PSC
provided for realised and unrealised gains/losses from the exchange currency.
According to the Tribunal, the assessee was maintaining its accounts in rupees
and such accounts had to reflect the loan liability under consideration as the
loan had been taken for the Indian activity. Therefore, according to the
Tribunal, the liability arising as a consequence of depreciation of the rupee
had to be considered both for accounting and tax purposes. Accordingly, the
Tribunal refused to interfere with the findings returned by the Commissioner
of Income-tax (Appeals).

The above concurrent finding stood confirmed by
the judgment delivered by the Uttarakhand High Court.

On further appeal, the Supreme Court observed
that the only question which needed consideration was whether the assessee was
entitled to claim deduction for foreign exchange losses on account of foreign
currency translation. In other words, whether loss arising on account of
foreign currency translation is allowable deduction or not and conversely
whether the gains on account of foreign currency translation is to be treated
as a receipt liable to tax. Analysing the provisions of S. 42(1), the Supreme
Court held that it was clear that the said Section was a special provision for
deductions in the case of business of prospecting, extraction/production of
mineral oils. S. 42(1) provides for admissibility in respect of three types of
allowances provided they are specified in the PSC. They relate to expenditure
incurred on account of abortive exploration, expenditure incurred before or
after the commencement of commercial production in respect of drilling or
exploration activities and expenses incurred in relation to depletion of
mineral oil in the mining area. If one reads S. 42(1) carefully, it becomes
clear that the above three allowances are admissible only if they are so
specified in the PSC.

Accordingly, the Supreme Court noted that the PSC
in question provided for both capital and revenue expenditures. It also
provided for a method in which the said expenses had to be accounted for. The
Supreme Court held that the said PSC was an independent accounting regime
which included tax treatment of costs, expenses, incomes, profits, etc. It
prescribed a separate rule of accounting. In normal accounting, in the case of fixed assets, generally when currency fluctuation results in an exchange loss, addition is made to the value of the asset for depreciation. However, under the PSC, instead of increasing the value of expenditure incurred on account of currency variation in the expenses itself, EOGIL was required to book losses separately. The said PSC prescribed a special manner of accounting which was at variance with the normal accountingstandards. The said ‘PSC accounting’ obliterated the difference between capital and revenue expenditure. It made all kinds of expenditure chargeable to the profit and loss account without reference to their capital or revenue nature. But for the PSC accounting there would have been disputes as to whetherthe expenses were of revenue or capital nature. In view of the special accounting procedure prescribed by the PSC, Accounting Standard 11 had to be ruled out.

The Supreme Court observed that Appendix C pre-scribed the manner in which a contractor is required to maintain his accounts. It stipulated that each of the co-venturers had to follow the computation of Income-tax under the 1961 Act. Clause 1.6.1. of appendix C referred to currency exchange rates. It stated that for translation purposes between USD and INR, the previous month’s average of the daily means of buying and selling rates of exchange as quoted by SBI shall be used for the month in which revenue, costs, expenditure, receipts or incomes are recorded. The Supreme Court therefore, held that clause 1.6.1 of appendix C provided for translation. The Supreme Court noted that subsequent to the award of the concession, EOGIL along with RIL and ONGC executed the PSC with the Government of India. Under the said PSC, each co-venturer remitted money, known as cash call to the bank account of the operator in the USA. The expenditure for the joint venture was made out of the said account. The trial balance was required to be prepared at the end of the month in USD, which was then required to be translated on the basis of accounting procedure mentioned in Appendix C to the PSC. The Supreme Court held that the cash call in other words was not a loan. Cash cali was a contribution. It was made by each co-venturer at a certain rate, whereas the expenditure against it had to be converted on the basis of the exchange rates as provided for in the PSC, which stated that the same had to be converted on the basis of the previous month’s average of the daily means of buying and selling rates of exchange. The above analysis showed that the capital contribution had to be converted under the PSC at one rate, whereas the expenditure had to be converted at a different rate. This exercise resulted in loss/ profit on conversion. Under the PSC, the respondent had to convert revenue, costs, receipts and incomes. If EOGIL had a choice to prepare its accounts only in USD, there would have been no loss/profit on account of currency translation. It is because of the specific provision in the PSC for currency translation that loss/profit accrued to EOGIL. The Supreme Court further held that in the PSC, the foreign company provides the capital investment and cost and the first proportion of oil extracted is generally allocated to the company which uses oil sales to recoup its costs and capital investment. The oil used for that purpose is termed ‘cost oil’. Often a company obtains profit not just from the ‘profit oil’, but also from the ‘cost oil’. Such profits cannot be ascertained without taking into account translation losses. Moreover, taxes are embedded in the profit oil. If these concepts are kept in mind, then it cannot be said that ‘translation losses’ under the PSC are illusory losses.