Foreign Exchange Fluctuation Treatment under Income Tax

Foreign Exchange Fluctuations- Treatment Under Income Tax

1.       CBDT vide notification dated 31.3.2015 has notified 10 Income Computation and Disclosure (ICDS) Standards u/s 145(2) of Income Tax Act and among them ICDS –VI deals with effects relating to Changes in Foreign Exchange rates

2.       I have tried to summaries the treatment of foreign exchange fluctuations under Income Tax  in view of provision of :-

a)      ICDS-VI

b)      Provisions of Income Tax Act-Section 43A

c)       Past case laws on Supreme Court

ICDS –VI

1.       It is applicable for computation of income chargeable under the head “Profits and gains of business or profession” or “Income from other sources” and not for the purpose of maintenance of books of accounts.

2.       In the case of conflict between the provisions of the Income‐tax Act, 1961and this Income Computation and Disclosure Standard, the provisions of the Act shall prevail to that extent

3.       ICDS-VI among other things deal with :-

a)      Treatment of Transaction in Foreign Currencies

b)      Treatment of foreign Currency transactions in the nature of Forward Exchange Contracts

4.       ICDS-VI defined Exchange difference is the difference resulting from reporting the same number of units of a foreign currency in the reporting currency of a person at different exchange rates.

5.       Recognition of Exchange Difference

a)      In respect of monetary items (Cash, receivables, payables), exchange differences arising on the settlement thereof or on conversion thereof at last day of the previous year shall be recognised as income or as  expense in that previous year.

b)      In respect of non‐monetary items (Inventory, fixed assets, Investments in equity shares etc.), exchange differences arising on conversion thereof at the last day of the previous year shall not be recognised as income or as expense in that previous year.

c)       Recognition of Exchange difference shall be subject to provision of section 43A of Income Act.

6.       Treatment of foreign Currency Transaction in the nature of Forward Exchange contracts

a)      The underlying treatment on forward exchange contract is available when following conditions are satisfied

i)                    Forward Exchange Contract is not intended for trading or speculation purpose

ii)                   Forward Exchange Contract is entered into to establish the amount of INR required at the settlement date of transaction.

b)      Treatment

i)                    Any Premium or discount arising at the inception of forward exchange Contract shall be amortised as expenses or income over the life of Contract

ii)                  Exchange differences on such contract shall be recognised as income or expenses in the previous year in which the exchange rate changes.

iii)                 Any Profit or loss arising on cancellation on renewal shall be recognised as income or expense for the previous year.

7.       At this point, it is worth mentioning, that ICDS-VI provides for transferring the all foreign exchange differences to the Profit & loss account, irrespective of that whether it pertains to capital asset or current asset.  This aspect is more clarified later on.

Section 43A of Income Tax Act

1.       The provision provide as under:-

a)      Override all other provision of Act.

b)      Assessee acquired asset in any previous year from country outside India

c)       On account of change in rate of exchange, there is increase or decrease in liability of assessee in Indian Currency, as compared to liability existing at the time of acquisition of asset, at the time of making payment towards:-

i)                    Whole or part of the cost of asset

ii)                  Repayment of the whole or part of  the moneys borrowed in foreign currency for acquiring the asset along with interest if any

d)      The increase or decrease in liability in Indian currency shall be added or deducted from Actual cost of asset acquired

2.       Section 43A provides for capitalization of Foreign Exchange difference arising at the time of making payment towards cost of assets or repayment of loan to the cost of asset.

3.      Section 43A does not provide  for treatment of foreign exchange difference arising on conversion of outstanding liability at the end of previous year

Supreme Court Judgments

1.       CIT v Woodword Governor India (P) Ltd and others (2009) 312 ITR 254 (SC)

Foreign Exchange losses arising on restatement of foreign exchange current asset and current liabilities in INR at the end of previous year is allowable u/s 37.

2.       Sutlej Cotton Mills Ltd V CIT - 116 ITR 1 (1979) (SC)

The law may, therefore, now be taken to be well settled that where profit or loss arises to an assessee on account of appreciation or depreciation in the value of foreign currency held by it, on conversion into another currency, such profit or loss would ordinarily be a trading profit or loss if the foreign currency is held by the assessee on revenue account or as a trading asset or as a part of circulating capital embarked in the business. But, if on the other hand, the foreign currency is held as a capital asset or as fixed capital, such profit or loss would be of capital nature.”

Thus loss on foreign exchange fluctuation would be capital loss where the foreign exchange loan is taken for purchase of capital asset

3.       CIT V. Tata Iron and Steel Co. Ltd. (1998) 231 ITR 285

It has been held that cost of an asset and cost of raising money for purchase of asset are two different and independent transactions and events subsequent to acquisition of assets cannot change price paid for it.

Thus this ruling does not allow the capitalisation of cost to fixed asset incurred in connection with servicing of loan.

Foreign Exchange fluctuation Treatment in real life scenarios

1.       Exchange difference on Current asset and Current liabilities not related to capital asset in 2 cases:-

a)      Arising on Restatement of foreign exchange in INR at the end of previous year

b)      Arising on actual settlement of foreign exchange asset or liability

Foreign Exchange difference is allowable loss or taxable income in view of Provision of ICDS-VI and ruling in CIT v Woodword Governor India (P) Ltd and others (2009) 312 ITR 254 (SC)

2.       Exchange difference on current or long term liability related to capital asset

a)      Asset is purchase outside India and Borrowing is done in foreign currency

i)                    Exchange difference on restatement of liability at the end of previous year

Exchange difference is neither allowable loss nor a taxable income as per ruling in Sutlej cotton mills 116 ITR 1 (SC)

ii)                  Exchange difference on actual settlement of liability

Exchange difference be added or reduced from actual cost of asset as per provision of section 43A of Income Tax Act.

b)      Asset is Purchase in India and Borrowing is done in foreign Currency

i)                    Exchange difference on restatement of liability at the end of previous year

Exchange difference is neither allowable loss nor a taxable income as per ruling in Sutlej cotton mills 116 ITR 1 (SC)

iii)                 Exchange difference on actual settlement of liability

·         Section 43A is not applicable and in view of ruling CIT V. Tata Iron and Steel Co. Ltd. (1998) 231 ITR 285 exchange difference cannot be added or reduced from actual cost.

·         Exchange difference is neither allowable loss nor a taxable income as per ruling in Sutlej cotton mills 116 ITR 1 (SC)

3.       Exchange difference in forward exchange contracts. It is assumed that forward exchange contract is entered for genuine hedging purpose and not for speculation or trading purpose

a)      Forward exchange contract related to current asset and current liabilities, not related to capital assets

Foreign Exchange difference is allowable loss or taxable income in view of Provision of ICDS-VI and ruling in CIT v Woodword Governor India (P) Ltd and others (2009) 312 ITR 254 (SC)

b)      Foreign exchange contract related to current or long term liability related to capital asset.

Exchange difference is neither allowable loss nor a taxable income as per ruling in Sutlej cotton mills 116 ITR 1 (SC)

Constitutional Validity of Section 43A of Income Tax Act in view of Article 14 of Constitution

1.       Article 14 of the Constitution read as under:-

Equality before law.—The State shall not deny to any person equality before the law or the equal protection of the laws within the territory of India.

2.       Under equal protection of law, the Article 14 forbids class legislation but permits reasonable classification.

3.       The reasonable classification test is satisfied in following conditions:-

a)      The Classification must be founded on the intelligible differentia which distinguishes persons or things that are grouped together from other left out of the group

b)      The differentia must have a rational relation to the object sought to be achieved by the act.

4.       Section 43A creates two classes of Assessee:-

a)      Assessee availing foreign borrowing for purchase of assets outside India – Foreign Exchange fluctuations on repayment of loan is allowed to be capitalized to the cost of asset

b)      Assessee availing foreign borrowing for purchase of assets in India -  Foreign Exchange fluctuations on repayment of loan is NOT allowed to be capitalized to the cost of asset

5.       The point for consideration is that whether this classification by section 43A satisfy the  reasonable classification test in view of following:-

a)      Intelligible differentia - Present Foreign exchange regulations do permit the utilization of External Commercial Borrowings for purchase of assets in India. Thus a transaction (4b) which is permitted under Economic laws of the country but which is treated differently from other transaction (4a) under Income Tax law, the test of intelligible differential seems to be lacking.

b)      Rational Relation to object – The objective of section 43A is to prescribe the treatment for foreign exchange fluctuation on payments relating to fixed assets. However restricting the capitalisation of foreign exchange fluctuation to situation envisaged in clause 4(b), a differentia does not seems to have rational relation with the objective of section 43A.