Introduction :
1.1 With the increase in cross-border transactions in the business, transactions entered into Foreign Currency are required to be reported in Indian Rupees. This raises various accounting and tax issues. Primarily, in most cases, accounting treatment of such transactions is guided by Accounting Standard 11, issued by the Institute of Chartered Accountants of India (ICAI) under the title ‘The Effects of Changes in Foreign Exchange Rates’. In the case of companies, the Companies Accounting Standards Rules, 2006 prescribe various Accounting Standards, in which also similar Accounting Standard 11 (hereinafter referred to as AS 11) has been prescribed, which is largely similar to the one issued by the ICAI. The recent amendment made in such Accounting Standard prescribed under the said Companies Rules (which made major difference with the Accounting Standard of the ICAI) is not relevant for the purpose of this write-up and hence not referred to in this write-up.
1.2 Primarily, with some exceptions, as per AS 11, at the initial stage, a foreign currency transaction is required to be reported in rupee terms by applying the exchange rate on the date of transaction and at the balance sheet date, Foreign Currency Monetary items are required to be reported at the closing rate. On account of this, exchange difference may result in the same year due to change in the exchange rate between the transaction date and the date of settlement/re-settlement of such monetary items on the balance sheet date. If such transaction is settled in the subsequent year, generally, the exchange difference also results in the current year on account of difference in the exchange rate between the date of transaction and the date of restatement of monetary items at the closing rate on the balance sheet date and such difference (as well as the exchange difference due to settlement of such transaction in same year with which we are not concerned in this write-up), under the accounting treatment are required to be recognised in the year of transaction. We are not concerned with the effect of exchange difference in the subsequent year in this write-up. Likewise, as stated earlier, in this write-up, we are also not concerned with the amendment made in the accounting standard prescribed under the Companies rules.
1.3 So far as the Income-tax Act (the Act) is concerned, it is a settled position that fluctuations in the rates of foreign exchange resulting into gain or loss are on revenue account, if the foreign currency is held by the assessee on revenue account or a trading account or as a part of circulating capital used in the business (hereinafter such cases are referred to as Revenue Account Cases) and accordingly, in such cases, any appreciation or depreciation in the value of the foreign currency is regarded either as profit or loss on trading/revenue account. On the other hand, if the foreign exchange liability arises in relation to acquisition of fixed asset, the corresponding gain or loss is regarded as of a capital nature (hereinafter referred to as Capital Account Cases).
1.4 The loss arising on account of difference in the foreign exchange rate prevailing on the date of transaction and the closing rate on the date of balance sheet (when the transaction is settled for the subsequent year) on account of re-statement of outstanding loans on the balance sheet date is merely a notional or contingent loss or should be considered as accrued and allowable, for tax purposes, is an issue that the department had kept alive by taking a stand that such loss should be deductible in the year of actual payment. The issue relates to Revenue Account Cases. So far as Capital Account Cases are concerned, effectively, the same should be governed by the provisions of S. 43A, with some exceptional cases which are ignored for the purpose of this write-up as we intend to deal with the effect of Revenue Account Cases only. This issue with regard to effect of such exchange difference was dealt by the Delhi High Court (294 ITR 451) in the batch of cases with the lead case of Woodward Governor India P. Ltd. (and other appeals) in which the contention of the department was not accepted.
1.5 Primarily, the effect of exchange difference in Capital Account Cases under the Act is governed by the specific provisions of S. 43A. Effectively, in substance, S. 43A of the Act deals with the adjustment in the actual cost of the relevant asset (for the purpose of depreciation, computation of capital gain etc.), if change in liability has taken place on Capital Account Cases. The Apex Court in the case of Arvind Mills (193 ITR 255) has held that S. 43A lays down, firstly, that the increase or decrease in liability should be taken into account to modify the figure of actual costs, and secondly, that such adjustment should be made in the year in which the increase or decrease in liability arises on account of fluctuation in the rate of exchange. Subsequently, an amendment has been made in S. 43A by the Finance Act, 2002 (w.e.f. the A.Y. 2003-04) to effectively provide that such necessary adjustments under the said provisions should be made in the year of actual payment of liability.
1.6 Recently, the Apex Court had an occasion to consider the issue referred to in Para 1.4 above and the judgment of the Delhi High Court referred to therein and the issue now gets settled. Considering the importance and usefulness of the same, it is thought fit to consider the same in this column. However, in the said Delhi High Court judgment as well as in the judgment of the Apex Court, the issue relating to the effect of exchange difference in Capital Account Cases has also been decided in the context of the provisions of S. 43A, prior to its amendment by the Finance Act, 2002, which is not dealt with in this write-up, as the same would primarily be governed by the amended provisions of S. 43A of the Act.
CIT v. Woodward India P. Ltd., 312 ITR 254 (SC) :
2.1 A batch of various appeals was taken-up by the Apex Court with the above lead case to decide the following question:
“(i) Whether, on the facts and circumstances of the case and in law, the additional liability arising on account of fluctuation in the rate of exchange in respect of loans taken for revenue purposes could be allowed as deduction ul s.37(1) in the year of fluctuation in the rate of exchange or whether the same could only be allowed in the year of repayment of such loans ?:
2.1.1 In addition to the above, a question with regard to the effect of exchange difference in Capital Account Cases was also before the Court. However, as stated in para 1.6 above, we are not concerned with the same in this write-up.
2.2 In the above case, the brief facts of the lead case were: The assessee had claimed deduction of Rs.29,49,088 on account of loss due to foreign exchange fluctuations on the last date of the accounting year by debiting to the Profit & Loss Account. In the earlier years, there were gains on similar account, which were taxed as income by the Department. The assessee was following the Mercantile System of Accounting. There was no dispute that such loss was on revenue account. The Assessing Officer (AO) took a view that the liability as on the last day of the previous year was contingent liability, it was not a certain liability and hence it was disallowed as unrealised loss due to foreign ex change fluctuations. This view was confirmed by the First Appellate Authority. When the matter came-up before the Appellate Tribunal, the issue was decided in favour of the assessee relying on the decision of the Tribunal in the case ‘of the assessee in the earlier years. The decision of the Appellate Tribunal was confirmed by the judgment of the Delhi High Court referred to in para 1.4 above. Accordingly, at the instance of the Department, the issue referred in para 1.4 above came up for consideration before the Apex Court.
2.3 On behalf of the Department,it was, inter alia, contended that: The assessee’s claim is u/s.37, there being no specific provision dealing with the adjustment due to foreign exchange fluctuations on revenue account, as S. 43A deals with such adjustment in Capital Account Cases. For deductibility under’ S. 37, the increase in liability must fulfil the twin requirements of ‘expenditure’ and the factum of such expenditure having been ‘laid out or expended’. The expression ‘expenditure’ is ‘what is paid out’ and ‘some thing, which is gone irretrievably’. The increase in liability at any point of time prior to payment cannot fall within the meaning of the word ‘expenditure’ in S. 37(1). In short, it was effectively contended that the requirement of S. 37(1) are not satisfied in the case of additional liability arising on account of such fluctuation in foreign exchange rate and hence the same is not deductible.
2.4 On behalf of the appellant in the lead case, it was, inter alia, contended that: The assessee has been following the Mercantile System of Accounting, under which whenever an amount is credited to the account of the creditor, the liability has been incurred though it is not actually paid, for which reliance was also placed on the term ‘paid’ as defined in S. 43(2). In the earlier years, the gain arising on similar account has been taxed by the Department. Therefore, when it comes to ‘income’, the Department takes one stand, but when it comes to ‘loss’, the Department takes exactly the contrary stand and hence such double standards cannot be permitted. The effect was also explained by giving hypothetical example.
2.4.1 Another counsel (appearing for M/s. Maruti Udyog Ltd.) adopted similar arguments and, inter alia, further contended that: In the earlier year, in the case of his assessee, similar loss has been allowed as the deduction and gain on similar account has been taxed as income. Accordingly, the Department having accepted the system of accounting of the assessee, it was not open to the Department to introduce new system of accounting. It was further contended that liability to repay the loan in foreign currency accrues, the moment the contract is entered into and it has nothing to do with the time of payment/repayment. According to him, S. 145 of the Act ties down the AO to the accounting system consistently followed by the assessee and if the AO seeks to introduce a new system of accounting, he has to give reasons in his order pointing out defects in the existing accounting system and there is no such finding in the assessment order. The existence of liability stands crystallised on the date of contract and it has nothing to do with the time of payment.
2.5 Having considered the contentions raised on behalf of both the sides, before proceeding to decide the issue, the Court observed as under (pages 260/ 261): “As stated above, on the facts in the cases of M/s. Woodward Governor India P. Ltd., the De-partment has disallowed the deduction/debit to the profit and loss account made by the assessee in the sum of Rs.29,49,088being unrealised loss due to for-eign exchange fluctuation. At the very outset, it may be stated that there is no dispute that in the previ-ous years whenever the dollar rate stood reduced, the Department had taxed the gains which accrued to the assessee on the basis of accrual and it is only in the year in question when the dollar rate stood increased, resulting in loss that the Department has disallowed the deduction/ debit. This fact is important. It indicates the double standards adopted by the Department”.
2.6 The Court then noted that the dispute in this batch of the cases, centres around the year in which deduction would be admissible for the increased liability u/s.37(1). The Court then noted the relevant Sections, namely S. 28(i), S. 29, S. 37(1) and S. 145.
2.7 For the purpose of deciding the issue, the Court noted one of the main arguments raised on behalf of the Department to the effect that such a loss is not an ‘expenditure’, which has gone irretrievably as contemplated in S. 37(1) and conse-quently, the additional liability arising on account of fluctuation in the rate of foreign exchange was merely a contingent/notional liability which does not crystallise till payment. The Court then stated that the word ‘expenditure’ is not defined in the Act and therefore, is required to be understood in the context in which it is used. S. 37 provides that any expenditure not being an expenditure of the nature described in S. 30. to S. 36 laid out or expended wholly and exclusively for the purpose of business should be allowed in computing the Business Income. In S. 30 to S. 36, the expressions, ‘expenses incurred’ as well as ‘allowances and depreciation’ have also been used. However, in S. 37, the expression used is ‘any expenditure’, which covers both. Therefore, the expression ‘expenditure: as used in S. 37, in the circumstances of particular case, covers an amount which is really a ‘loss’, even though the said amount has not gone out of the pocket of the assessee. For this, the Court also referred to the judgment of the M.P. High Court in the case of M.P. Financial Corporation (165 ITR 765), in which similar view has been taken with regard to the expression ‘expenditure’ and stated that this view has been approved by the Apex Court in the case of Madras Industrial Investment Corpn. Ltd. (225 ITR 802). It seems that the Court, in the context of the issue on hand, was not impressed by the reliance placed on the judgment of the Apex Court in the case of In-dian Molasses Company (37 ITR 66) by the counsel of the Department in support of his above argument for non-applicability of S. 37 in the present case.
2.8 Further explaining the effect of S. 37, the Court stated as under (Page 263) :
“… According to the Law and Practice of Income Tax by Kanga and Palkhivala, S. 37(1) is a residuary Section extending the allowance to items of business expenditure not covered by S. 30 to S. 36. This Section, according to the learned author, covers cases of business expenditure only, and not of business losses which are, however, deductible on ordinary principles of commercial accounting. (see page 617 of the eighth edition). It is this principle which attracts the provisions of S. 145. That Section recognises the rights of a trader to adopt either the cash system or the mercantile system of accounting. The quantum of allowances permitted to be deducted under diverse heads u/s.30 to u/s.43C from the income, profits and gains of a business would differ according to the system adopted. This is made clear by defining the word ‘paid’ in S. 43(2), which is used in several S. 30 to S. 43C, as meaning actually paid or incurred according to the method of accounting upon the basis on which profits or gains are computed u/s.28/29. That is why in deciding the question as to whether the word “expenditure” in S. 37(1) includes the word “loss” one has to read S. 37(1) with S. 28, S. 29 and S. 145(1) …. “,
2.9 Dealing with the effect of accounts regularly maintained by the assessee in the course of business and effect of provision of S. 145 on S. 37, the Court further stated as under (Page 263) :
“…. One more principle needs to be kept in mind. Accounts regularly maintained in the course of business are to be taken as correct unless there are strong and sufficient reasons to indicate that they are unreliable. One more aspect needs to be highlighted. U /s.28(i), one needs to decide the profits and gains of any business which is carried on by the assessee during the previous year. Therefore, one has to take into account stock-in-trade for determination of profits. The 1961 Act makes no provision with regard to valuation of stock. But the ordinary principle of commercial accounting requires that in the profit and loss account the value of the stock-in-trade at the beginning and at the end of the year should be entered at cost or market price, which-ever is the lower. This is how business profits arising during the year need to be computed. This is one more reason for reading S. 37(1) with S. 145 …. “,
2.10 The Court then reiterated the settled general principle that the profit for income tax purposes should be determined in accordance with the ordinary principles of commercial accounting subject to specific provisions contained in the Act. The Court then also noted that the unrealised profit in the shape of appreciated value of the goods remaining unsold at the year end is not subject to tax as a matter of practice, though loss due to fall in the price below the cost is allowed as deduction even though such a loss has not been realised actually. The Court also explained the philosophy behind this practice and stated that while anticipated loss is taken into account, anticipated profit is not considered as no prudent trader would care to show increased profit before the actual realisation. The Court also noted the provisions of S. 145(2) under which, the Central Government is empowered to notify from time to time the accounting standard to be followed and also noted the provisions of S. 209 of the Companies Act, which makes Mercantile System of Accounting mandatory for the companies. According to the Court, but for the specific provision or applicability of S. 145(3), the method of accounting undertaken by the assessee continuously is supreme unless the AO gives a finding otherwise for the reasons to be stated.
2.11 With the above and earlier referred observations and discussion, on the major issue raised on behalf of the Department, the Court concluded as under (Page 264) :
“For the reasons given hereinabove, we hold that, in the present case, the ‘loss’ suffered by the assessee on account of the exchange difference as on the date of the balance-sheet is an item of expenditure u/s.37(1) of the 1961 Act”.
2.12 Further, after considering the general principles with regard to method of valuation of closing stock (i.e. cost or market value, whichever is less) and the general principles of commercial accounting for determining the profits, the Court stated that S. 145(1) is enacted for the purpose of S. 28 and S. 56. In the present case, S. 28 is relevant and hence, S. 145(1) is attracted. Accepting the relevance of method of accounting for computing business income as provided in S. 145(1), the Court explained the effect of Mercantile System of Accounting, under which the expenditure is debited when a legal liability has been incurred before it is actually disbursed. The Court then expressed the view that the accounting method consistently followed by the assessee needs to be presumed as correct till the AO comes to the conclusion for the reasons to be given that the system does not reflect true and correct profits.
2.13 The Court then stated that having come to the conclusion that valuation is part of accounting system and the business losses are deductible u/s. 37(1) on the basis of ordinary principles of commer-cial accounting and having come to the conclusion that the Central Government has made Accounting Standard 11 (AS 11) mandatory, one needs to examine the said Accounting Standard. The Court then noted various requirements of AS11 including the requirement of recording the transaction at the exchange rate of that date and re-statement of outstanding liability on the closing rate of exchange (referred to in Para 1.2 above). The Court also noted the requirements that any difference, loss or gain, arising on conversion of the said liability at the closing rate should be recognised in the profit and loss account of the reporting period. The Court, then, explained the fact of this requirement by the following hypothetical example (Page 266) :
“A company imports raw material worth US $ 250000 in January 15, 2002, when the exchange rate was Rs.46 per US $. The company records the transaction at that rate. The payment for the imports is made on April 15, 2002, when the exchange rate is Rs.49 per US $. However, on the balance-sheet date, March 31, 2002, the rate of exchange is Rs.50 per US $. In such a case, in terms of AS-II, the effect of the exchange difference has to be taken into the profit and loss account. Sundry creditors is a monetary item and hence such item has to be valued at the closing rate, i.e. Rs.50 at March 31, 2002, irrespective of the payment for the sale subsequently at a lower rate. The difference of Rs.4 (50-46) per US $ is to be shown as an exchange loss in the profit and loss account and is not to be adjusted against the cost of raw materials”.
2.14 Finally, the Court reiterated the settled principles to determine the nature of the exchange difference (referred to in Para 1.3 above) and concluded on the issue as under (Page 267) :
“In conclusion, we may state that in order to find out if an expenditure is deductible the following have to be taken into account (i) whether the system of accounting followed by the assessee is the mercantile system, which brings into debit the expenditure amount for which a legal liability has been incurred before it is actually disbursed and brings into credit what is due, immediately it be-comes due and before it is actually received; (ii) whether the same system is followed by the assessee from the very beginning and if there was a change in the system, whether the change was bonafide; (iii) whether the assessee has given the same treatment to losses claimed to have accrued and to the gains that may accrue to it; (iv) whether the assessee has been consistent and definite in making entries in the account books in respect of losses and gains; (v) whether the method adopted by the assessee for making entries in the books both in respect of losses and gains is as per nationally accepted accounting standards; (vi) whether the system adopted by the assessee is fair and reasonable or is adopted only with a view to reducing the incidence of taxation”.
Conclusion:
3.1 In view of the above judgment of the Apex Court, it is now clear that such loss on account of exchange difference arising due to restatement of liability at the year end exchange rate is not to be regarded as notional/contingent loss, when the assessee follows Mercantile System of Accounting.
3.2 In view of the above judgment of the Apex Court, it is now clear that for income tax purpose, in the case of assessee following the Mercantile System of Accounting, such loss arising on account of fluctuation in the foreign exchange rate at the year end is deductible while computing the business income in all bonafide cases.
3.3 While taking the above view, it seems that the Court was also largely guided by the fact that in the earlier years profit on similar account has been offered for tax by the assessee and the same has also been taxed as income by the Department. As such, it seems that the Court has, though impliedly, accepted the contention raised on behalf of the assessee that such double standards cannot be permitted.
3.4 In particular circumstances, in the context of S. 37, the expression, ‘expenditure’ includes ‘loss’. It seems that this conclusion should be read in the context of the question raised and the arguments advanced on behalf of the Department. Otherwise, in general, the difference between the ‘loss’ and the ‘expenditure’ still survives.
3.5 It seems that the requirement of adopting method for making entries in the books in respect of losses and gains as per nationally accepted accounting standard mentioned by the Court also should be read and considered in the context of the issue involved in the cases before the Court.
3.6 The Court has also reiterated the settled position that the method of accounting consistently followed by the assessee should be presumed to be correct unless the AO comes to the conclusion for the reasons to be given that the system does not reflect the true and correct profits. Accordingly, such method can be disregarded only by justifiable reasons to be recorded in the order.
3.7 Though in the above write-up we have not considered the effect of exchange difference in Capital Account Cases, we may mention that the above judgment is also an authority to hold that amendment made by the Finance Act, 2002 (w.e.f. A.Y. 2003-4) is prospective.
