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 liability attributable to exchange fluctuation on imported capital assets falls within capital account; however, under unamended s.43A prior to 1.4.03 the assessee was entitled to adjust the actual cost of imported assets at each balance-sheet date to reflect exchange variations. The subsequent amendment to s.43A was held to be amendatory, not merely clarificatory.

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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.

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