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

Commissioner of Income Tax, Delhi  Versus  M/s Woodward Governor India P. Ltd.,  M/s Honda Siel Power Products Ltd.

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 ... Fluctuation in rate of exchange - Increased liability in respect of loans taken - in which year, loss incurred on “revenue account” should be deducted u/s 37(1) - held that loss suffered as on the date of balance sheet is an item of expenditure u/s 37(1) - increase in liability on “capital account” - scope of S. 43A (unamended) prior to 1.4.03 – assessee entitled to adjust the actual cost of imported assets at each balance sheet date - held that amended section is amendatory, not clarificatory ISSUES PRESENTED AND CONSIDERED 1. Whether additional liability arising from fluctuation in the rate of exchange in respect of loans taken for revenue purposes is deductible under Section 37(1) in the year of fluctuation (accrual/mercantile recognition) or only in the year of repayment. 2. Whether an assessee may adjust the actual cost/carrying amount of imported fixed assets denominated in foreign currency for exchange-rate fluctuation at each balance-sheet date pending actual payment of the varied liability, i.e., whether unamended Section 43A permits balance-sheet recognition of such exchange differences prior to payment. ISSUE-WISE DETAILED ANALYSIS - I. Revenue-account exchange differences (Deductibility under Section 37(1)) Legal framework: Sections 28 and 29 (profits of business to be computed), Section 37(1) (residuary deduction: expenditure 'laid out or expended' wholly and exclusively for business), Section 145(1) (cash or mercantile system of accounting), and Accounting Standard (AS)-11 dealing with effects of changes in foreign exchange rates; relevant principles of commercial accounting (closing stock valued at cost or market, accrual/mercantile treatment). Precedent treatment: Indian Molasses Co. was relied upon by Revenue for the proposition that 'expenditure' means money 'paid out' or 'gone irretrievably'. M.P. Financial Corporation (Madhya Pradesh HC) and Madras Industrial Investment Corporation Ltd. (approved) support that 'expenditure' under Section 37 may, in appropriate circumstances, include losses not actually paid out. Sutlej Cotton Mills recognized classification of foreign exchange gains/losses as revenue or capital depending on nature of holding. Interpretation and reasoning: The Court reads Section 37(1) in the context of Sections 28, 29 and 145 and commercial accounting principles. Section 37's reference to 'any expenditure' is wide enough to cover losses recognized by mercantile accounting though not actually paid. Section 145(1) gives primacy to the regularly employed accounting method (mercantile or cash) unless AO is satisfied as to incorrectness under Section 145(3). AS-11 requires monetary items denominated in foreign currency to be reported at closing rate and exchange differences on revenue items to be recognized in the period in which they arise (para 9). Principles of commercial accounting (valuation of stock-in-trade and recognition of unrealized losses) support allowing unrealized exchange losses recognized in P&L under accrual system. The Revenue's contention that 'expenditure' necessarily implies payment is rejected as too literal and inconsistent with statutory scheme and established accounting practice. The fact that the Department had earlier taxed unrealized gains on accrual further supports the need for consistent treatment. Ratio vs. Obiter: Ratio - Where an assessee regularly follows the mercantile (accrual) system and accounts comply with AS-11 / accepted accounting principles, exchange losses on revenue/monetary items arising on the balance-sheet date are deductible under Section 37(1) in the year of fluctuation; AO must point to defects in accounting to deny such treatment. Obiter - observations on policy and double standards by Revenue and illustrative examples serve explanatory purposes. Conclusions: Under the mercantile system regularly followed and absent AO findings under Section 145(3), unrealized exchange losses on revenue (monetary) items recognized as expenses in the P&L on the balance-sheet date qualify as 'expenditure' allowable under Section 37(1). The accounting standard AS-11 obliges recognition of exchange differences on monetary items at closing rate; therefore such losses are deductible in the year they arise. ISSUE-WISE DETAILED ANALYSIS - II. Capital-account exchange differences (Adjustment of actual cost under Section 43A and Section 43(1)) Legal framework: Section 43(1) (definition of 'actual cost'), unamended Section 43A (as originally enacted w.e.f. 1.4.1967) which authorized addition/deduction to actual cost where change in exchange rate after acquisition increases/reduces liability 'for making payment' towards cost or repayment of monies borrowed specifically for acquiring the asset; amended Section 43A (Finance Act, 2002) which altered language to refer to change 'at the time of making payment'. AS-11 para 10 deals with adjustment of carrying amount of fixed assets for exchange differences on liabilities incurred to acquire them. Precedent treatment: Arvind Mills (Supreme Court) held increase/decrease in liability due to exchange fluctuation should modify actual cost in the year the fluctuation arises irrespective of date of payment. Ministry of Finance circular (1967) and CBDT Circular support giving effect to additional rupee liability for depreciation calculation in the year of devaluation. Several High Court decisions had interpreted unamended Section 43A as permitting year-end recognition; this prompted later statutory amendment. Interpretation and reasoning: The Court analyses the unamended Section 43A's language and purpose. The non obstante clause makes Section 43A a special code overriding other enactments for cases falling within it. The unamended provision contemplates adjustment on occurrence of a change in exchange rate after acquisition where liability existed before the change; it uses 'for making payment' rather than 'on payment'. AS-11 para 10 is pari materia with unamended Section 43A, mandating adjustment in carrying amount of fixed assets for exchange differences at each balance-sheet date. Historical legislative intent, the 1967 clarification and contemporaneous AS-11 treatment demonstrate that unamended Section 43A allowed adjustment of actual cost when the liability changed in rupee terms due to exchange-rate movement, without a condition precedent of actual payment. The 2002 substitution, introducing 'at the time of making payment', effects a structural change converting recognition to a cash/payment basis. Ratio vs. Obiter: Ratio - Under the unamended Section 43A, an assessee was entitled to adjust the actual cost/carrying amount of fixed assets for exchange-rate variations in the year the exchange-rate change occurred (i.e., recognition on accrual/balance-sheet basis) even if actual payment had not been made. Obiter - observations on legislative history and concluding characterisation of the 2002 amendment as amendatory (not merely clarificatory) are treated as integral to the Court's conclusion about temporal effect of recognition. Conclusions: Prior to the Finance Act 2002 amendment, Section 43A permitted adjustment of actual cost of imported fixed assets for exchange-rate fluctuations at the balance-sheet date without requiring actual payment; such recognition corresponded to AS-11 para 10 and Arvind Mills. The 2002 amendment replacing the provision introduced a payment-based trigger ('at the time of making payment'), effecting an amending (not clarificatory) change that shifts recognition to the time of payment for periods on or after its effective date. OVERALL CONCLUSION OF THE COURT The impugned judgments upholding accrual/mercantile recognition of exchange losses on revenue items under Section 37(1) and recognition of exchange differences for capital assets under unamended Section 43A are correct; departmental appeals are dismissed. The 2002 amendment to Section 43A is an amendatory change that alters recognition to a payment-time basis going forward.