2009 (4) TMI 4 - SC - Income Tax

Foreign exchange loss on loans deductible under s.37(1); s.43A amendment held amendatory, pre-1.4.03 cost adjustment allowed

SC held that foreign exchange loss on loans, measured as at the balance-sheet date, is an allowable revenue deduction under s.37(1). An increase in ... Deductibility of exchange differences as business expenditure under Section 37(1) - Mercantile (accrual) system of accounting and recognition of exchange differences under Section 145 - Accounting Standard AS-11 - recognition of exchange differences on monetary items (para 9) and adjustment of carrying amount of fixed assets (para 10) - Adjustment of actual cost of imported capital assets for exchange fluctuations under Section 43A (unamended) - Amendment to Section 43A (Finance Act, 2002) making payment a condition precedent - Interaction between commercial accounting principles and tax computationDeductibility of exchange differences as business expenditure under Section 37(1) - Mercantile (accrual) system of accounting and recognition of exchange differences under Section 145 - Accounting Standard AS-11 - recognition of exchange differences on monetary items (para 9) - Whether additional liability arising from foreign exchange fluctuation on loans/transactions of revenue nature is deductible in the year of fluctuation under Section 37(1) or only in the year of repayment. - HELD THAT: - The Court held that where an assessee regularly follows the mercantile (accrual) system of accounting, exchange differences on monetary items denominated in foreign currency must be accounted for at the balance sheet/closing rate in accordance with AS-11 and Section 145(1). Section 37(1) is a residuary provision and, read with Sections 28, 29 and 145, can cover business losses which have been accounted for in accordance with ordinary principles of commercial accounting even though no cash payment has been made. AS-11 (para 9) requires recognition of exchange differences as income or expense in the period in which they arise for revenue items. Absent any finding by the Assessing Officer displacing the assessee's regular accounting method, unrealized losses arising from exchange fluctuations on revenue transactions as on the balance sheet date are deductible as expenditure under Section 37(1). The Court noted that the Department had previously taxed corresponding gains on accrual basis and that accounts regularly maintained are to be accepted unless shown to be incorrect. [Paras 15, 16, 18, 21]Unrealized loss due to foreign exchange fluctuation on revenue (monetary) items, valued and accounted for under the mercantile system and AS-11 at the balance sheet date, is an expenditure allowable under Section 37(1) in the year of fluctuation.Adjustment of actual cost of imported capital assets for exchange fluctuations under Section 43A (unamended) - Accounting Standard AS-11 - adjustment of carrying amount of fixed assets (para 10) - Amendment to Section 43A (Finance Act, 2002) making payment a condition precedent - Whether the actual cost of imported fixed assets acquired in foreign currency can be adjusted at each balance sheet date for exchange rate fluctuations pending actual payment of the varied liability, under Section 43A as it stood prior to 1.4.2003, and the effect of the 2002 amendment. - HELD THAT: - The Court analysed Section 43A as inserted in 1967 and observed that the unamended provision (corresponding to para 10 of AS-11) contemplates adjustment of the carrying cost of fixed assets on account of changes in exchange rates occurring after acquisition, without making actual payment a condition precedent. Section 43A(1) operates notwithstanding other provisions and applies where the liability existed before the change in rate took effect; the unamended text uses the phrase 'for making payment' and does not require 'on payment'. The Court held that under the unamended Section 43A, increase or decrease in liability due to exchange fluctuation must be reflected in the actual cost in the year the change in rate occurs, irrespective of the date of actual payment, and this position is supported by earlier decisions and contemporaneous governmental circulars. Further, the Court held that the Finance Act, 2002 amendment (substituting Section 43A w.e.f. 1.4.2003) is amendatory and not merely clarificatory: it introduces 'at the time of making payment' and thus makes actual payment a condition precedent, effecting a structural change in the provision. [Paras 31, 33, 34]Under the unamended Section 43A (prior to 1.4.2003) the actual cost of imported capital assets could be adjusted for exchange fluctuations at each balance sheet date irrespective of actual payment; the 2002 amendment, effective 1.4.2003, is amendatory and makes actual payment the trigger for adjustment.Final Conclusion: The judgments of the Delhi High Court were upheld: (i) unrealized exchange losses on revenue (monetary) items accounted for under the mercantile system and AS-11 are deductible under Section 37(1) in the year of fluctuation; (ii) under the unamended Section 43A (pre-1.4.2003) exchange differences affecting the cost of imported fixed assets are to be adjusted in actual cost in the year the rate changes, irrespective of payment, and the Finance Act, 2002 amendment thereafter made actual payment a condition precedent. Issues: (i) Whether additional liability arising from foreign exchange fluctuations on loans/transactions of a revenue nature is deductible under Section 37(1) in the year of fluctuation or only in the year of repayment; (ii) Whether the assessee can adjust the actual cost of imported fixed assets acquired in foreign currency for exchange fluctuations at each balance sheet date pending actual payment of the varied liability (scope of Section 43A as in force prior to Finance Act, 2002 and effect of the 2002 amendment).Issue (i): Whether exchange loss on revenue account due to fluctuation in rate of exchange is allowable as deduction under Section 37(1) in the year of fluctuation.Analysis: Deductibility under Section 37(1) must be read with Sections 28, 29 and Section 145(1) concerning the method of accounting. Under the mercantile (accrual) system regularly followed, monetary items denominated in foreign currency are to be reported at the closing rate and exchange differences are recognised in the period in which they arise, in accordance with Accounting Standard-11 (AS-11). Commercial accounting principles admit unrealized losses on revenue/monetary items in the profit & loss account at the balance sheet date while similarly treating realized or unrealized gains consistently. In the absence of any finding that the assessee's accounting system is incorrect or not regularly followed, valuation and recognition dictated by the adopted accounting method govern computation of income and deductible expenditure.Conclusion: The unrealized loss on account of foreign exchange fluctuation on revenue/monetary items recognised at the balance sheet date is an item of expenditure allowable under Section 37(1). This conclusion is in favour of the assessee.Issue (ii): Whether, for fixed assets acquired in foreign currency, the actual cost may be adjusted for exchange differences at each balance sheet date under Section 43A (unamended), and the effect of the Finance Act, 2002 amendment.Analysis: The unamended Section 43A (as inserted in 1967) corresponds to para 10 of AS-11 and contemplated adjustment of the carrying cost of fixed assets for exchange differences arising after acquisition without making actual payment a condition precedent. Historical legislative materials and administrative circulars supported adjustment of depreciation base to reflect increased rupee liability due to devaluation. The Finance Act, 2002 substituted Section 43A with wording that conditions adjustment on the time of making payment, effecting a structural change from an accrual/balance-sheet-date approach to a payment (cash) basis.Conclusion: Under the unamended Section 43A, adjustment of the actual cost of imported fixed assets for exchange fluctuations at each balance sheet date was permissible; the 2002 amendment changed the law to require adjustment at the time of making payment. The pre-2003 position is favourable to the assessee for the period before the amendment.Final Conclusion: On the facts and accounting methods before the authorities and for periods prior to the Finance Act, 2002 amendment, exchange differences on revenue items are deductible under Section 37(1) when recognised under the mercantile system and AS-11, and exchange differences relating to the cost of imported fixed assets could be adjusted in actual cost under the unamended Section 43A; the 2002 amendment altered the rule prospectively to require adjustment at the time of payment.Ratio Decidendi: Where an assessee regularly follows the mercantile system and accounts for foreign-currency monetary items at the closing rate in accordance with AS-11, unrealized exchange losses recognised at the balance sheet date constitute allowable expenditure under Section 37(1); unamended Section 43A allowed adjustment of the carrying cost of fixed assets for exchange differences on balance sheet recognition, whereas the Finance Act, 2002 amendment requires such adjustment only at the time of payment.