Assessee allowed deduction for foreign-exchange losses on loans on accrual (mercantile) basis; ICAI AS-2 cited

ITAT allowed the assessee's claim for deduction of foreign-exchange losses on loans on an accrual basis under the mercantile system, rejecting the AO's view that such losses were contingent or notional. The tribunal noted consistent accounting treatment since AY 1982-83, acceptance of corresponding gains in other years, and conformity with ICAI AS-2 requiring restatement of long-term liabilities when conversion yields a net loss. Absent any evidence of tax-avoidance, the assessee's method was held valid and the appeal was allowed.

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Issues Involved:
1. Deductibility of foreign exchange loss on foreign loans attributable to revenue account.
2. Consistency and validity of the mercantile system of accounting adopted by the assessee.

Summary:

Issue 1: Deductibility of Foreign Exchange Loss
The primary issue was whether the additional liability arising from fluctuations in the exchange rate for loans taken for revenue purposes could be allowed as a deduction in the year of fluctuation or only in the year of repayment. The assessee, ONGC, claimed a loss of Rs. 5,78,25,83,451 on an accrual basis due to foreign exchange rate fluctuations, which the Assessing Officer disallowed, considering it a notional loss. However, the Tribunal noted that ONGC had consistently followed the mercantile system of accounting, where such losses were accounted for annually based on the prevailing exchange rate at the end of the financial year. The Tribunal referenced several judicial decisions, including Sutlej Cotton Mills Ltd. v. CIT [1979] 116 ITR 1 (SC), which supported the treatment of such losses as trading losses if the foreign currency was held on revenue account. The Tribunal concluded that the loss due to exchange rate fluctuation was real and allowable as a deduction in the year it occurred, not merely in the year of repayment.

Issue 2: Consistency and Validity of Mercantile System of Accounting
The Tribunal examined whether ONGC's method of accounting, which included recognizing foreign exchange losses on an accrual basis, was consistent and in line with accepted accounting standards. The Tribunal formulated several test questions to determine the appropriateness of the accounting method, including whether the method was consistently followed, whether it treated gains and losses similarly, and whether it adhered to nationally accepted accounting standards. The Tribunal found that ONGC had consistently followed the mercantile system since the assessment year 1982-83, and the method was bona fide and aligned with Accounting Standard-II (AS-II) issued by the Institute of Chartered Accountants of India. The Tribunal also noted that the Department had accepted gains from exchange rate fluctuations in other years, reinforcing the consistency of ONGC's accounting method. Consequently, the Tribunal upheld the mercantile system of accounting adopted by ONGC and allowed the deduction of the foreign exchange loss.

Conclusion:
The Tribunal allowed the appeal of ONGC, affirming that the foreign exchange loss due to fluctuations in the exchange rate for loans taken for revenue purposes was deductible in the year of fluctuation. The Tribunal also confirmed the validity and consistency of the mercantile system of accounting followed by ONGC. The appeal of Maruti Udyog Ltd. was to be decided by the regular Bench in accordance with the decision of this Special Bench on the issue of foreign exchange loss.

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