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.

Royalty as per DTAA vs definition of “Process” in Explanation 6 to section 9(1)(vi) of Income Tax Act

Royalty as per DTAA vs definition of “Process” in Explanation 6 to section 9(1)(vi) of Income Tax Act

Facts

·         Income Tax Act, 1961

a)      The royalty is being defined in exhaustive manner under Explanation 2 to section 9(1)(vi), which among other thing cover royalty as consideration (excluding consideration which would be income of the recipient chargeable under the head “Capital gains”) for following transaction:-

S.No	Property involved	Transaction
1.	Patent, Invention, Model, Design, Secret Formula or Process or Trade Mark or Similar Property	a)      Transfer of all or any right in property. b)      Imparting any information concerning the working of property. c)       Use of Property. d)      Rendering of any service in connection with above-mentioned transactions.

b)      Explanation 6 to section 9(1)(vi) (hereinafter referred to Explanation 6), which was inserted by Finance Act 2012 with retrospective effect from 01-06-1976, provide as under:-

For removal of doubts, it is clarified that expression “process includes and shall be deemed to  have always included transmission by satellite (including up-linking, amplification, conversion for down-linking of any signal), cable, optic fibre or by any other similar technology, whether or not process is secret.

·         Double Taxation Avoidance Agreement (DTAA)

a)      Both OCED and UN Model convention on DTAA, defined Royalty under Article 12 as under:-

Payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, or films or tapes used for radio or television broadcasting(not in OECD model)) any patent, trademark, design or model, plan, secret formula or process,……….

b)      The word “Process” has not been defined in the DTAA.

c)       Article 3(2) of DTAA (Both OECD and UN Model) provides that as regard the application of the convention at any time by a contracting state, any term not defined therein shall, unless the context otherwise requires, have the meaning that it has at that time under the laws of that state for the purpose of the taxes to which the convention applies, any meaning under the applicable tax laws of that state prevailing over a meaning given to term under other laws of that state (not in UN model)

Issue Involved

The question for consideration is whether the meaning of the word “Process” as used in Royalty definition under DTAA, has to import from the Explanation 6, in view of provision Article 3(2) of DTAA.

a)      Before analyzing the issue, let us considered following:

i)                    Suppose a person has purchased patented product, will it mean that he is using the patent. The obvious answer will be NO, since he is using the product, which has been patented.

ii)                   Similarly, if a person is availing the transmission services backed by some process, does it mean that person is using the process? The person is using the transmission services analogous to above example of use of product.

In both of above examples, the consideration paid for product or services should not be considered as Royalty in common parlance, as person is not using the subjected intellectual property in his own right rather he is using the product/services supported by intellectual property.

However under Income Tax Act, the definition of Royalty is being extended to cover the consideration paid for use of transmission services

In this artifact, honest attempt is made to understand whether definition of Royalty under DTAA can also be equated with concept of Royalty under Income Tax Act, to cover within its realm consideration for transmission services.

b)      One may ask what different will happen, if meaning of the term process under DTAA is  treated at par with Explanation 6, in the sense that upon tax paid being  in India on consideration for transmission service (treating as Royalty), the resident of other contracting state will get credit of the same in his state under DTAA.

But this is not the case, explained as under:-

DTAA is an international agreement entered into between two Nations, where by one Nation agree to waive its sovereign power of taxation in favour of other state (i.e. Taxation power under DTAA is restricted to either of one state or where both states have taxation power, residence state gives credit for tax paid in source state either through credit method or exemption method).

Nation agree to compromise its taxation power under DTAA only when taxes involved are worked out strictly in terms of provision of DTAA, as commonly contemplated by both the states. If one state does not cover the transmission services within the ambit of Royalty, then upon tax paid by its resident in India, he will not get the credit of same in his state i.e state will not cede its taxation right on such income under DTAA. Thus there will be juridical double taxation, which is against the vowed objective of two nations at the time of entering into DTAA.

Analysis

The solution to controversy regarding the extension of extended meaning of Royalty in domestic legislation to DTAA, has been attempted in two spheres:-

1.       To understand and analyze the way the concept of Royalty is used in DTAA.

2.       Under what circumstances, the reference can be made to term “Process” under domestic legislation for application of DTAA, in view of trade-off between ‘Context” and “meaning defined in domestic legislation”

·         Understanding the concept of Royalty in DTAA

1.       DTAA is a written international agreement between two states and to apprehend the issue involved, reference is made to  Vienna Convention on law of treaties (VCLT)

2.       VCLT is considered as Treaty of Treaties and was an attempt to codify the several aspects of customary International law.

3.       VCLT is applicable to written agreement between two states.

4.       Among other things, Article 31 of VCLT provides principles of Interpretation of the Treaty between States.

5.       Since DTAA is a written agreement between two Nations, the guidance can be drawn from said Article 31 for interpretation of DTAA.

6.       Article 31 provides that “Treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of Treaty in their context and in the light of its objective”

7.       As per Commentary on double taxation convention by Professor Klaus Vogel, the ordinary meaning for article 31 shall be taken as under:-

The “ordinary meaning” of the term is not necessarily that of everyday usage. To the extent that an internationally uniform legal usage or legal usage consistent between the contracting states has developed, or to the extent that a specific technical language has developed in certain specialized area, such as tax laws, is this “ordinary” usage within the meaning of Article 31. This is particularly true for those terms which, under the influence of OECD Model convention and its commentary have since developed into an international language.

8.       The OECD commentary  on Article 12, which can be used to comprehend the concept of Royalty in common parlance, clearly provides that Royalty is for the use of Asset and not for services, on account of following reasoning:-

a)      Para 8 provide that definition of Royalty relates to payment for the use of, entitlement to use, right or property …….

b)      Para 8.2 provides that if payment is in consideration for transfer of full ownership of property or rights, payment is not royalty. This Para provide that only use of asset is covered under royalty and not sale of asset.

c)       Para 11.2 provides that knowhow contract ( contract where one of the parties agrees to impart to other, so that he use them for his own account, his special knowledge and experience which remain unrevealed to the public) differs from contracts for provision of services, in which one of the parties undertakes to use the customary skills of his calling to execute work himself for other party and such service contract do fall under Article 12, thus highlighting the point that Royalty does not consideration for services.

d)      Para 9.1 provides that payments made by customers under typical “transponder leasing” agreement are payments made for the use of transponder transmitting capacity and will not constitute royalties. These payments are not made in consideration for use of, or right to use property.

9.       Thus in view of interpretative rule of Article 31, the ordinary meaning of royalty is payment for use of asset and not for services.

10.   The other point for consideration is that India, till date, has yet not ratified the Vienna Convention on law of Treaties, implying that for Interpretation of DTAA, whether India is required to apply Article 31 of VCLT.

11.   India has entered into DTAA with 85 countries and out of those, 63 countries has ratified VCLT. Thus, at this point, the moot question is: how to interpret the India’s standpoint in the absence of application of Article 31.

12.   Among different principles of customary International Law, one of them is “silence as consent”. Generally, sovereign nations must consent in order to be bound by a particular treaty or legal norm. However, international customary laws are norms that have become pervasive enough internationally that countries need not consent in order to be bound. In these cases, all that is needed is that the state has not objected to the law.

13.   Now if one state is applying the Article 31 of VCLT to interpret the term Royalty as payment for use of asset and India has not objected to the same through express provision in DTAA, it amounts to India’s consent on the same.

14.   The other part of drawing conclusion on “ordinary meaning” under Article 31 of VCLT is based on legal usage consistent between the contracting states.

15.   If under the legislation of both the states, the royalty definition is being extended to cover services also, and then by entering into DTAA, it means they want to have similar connotation of royalty in DTAA also.

Thus based on afore-said analysis, the following conclusion can be drawn on concept of Royalty under DTAA

i)                    If states have different interpretation of Royalty in their domestic legislation, then common meaning of Royalty, being payment for use of asset, will prevail

ii)                   If states have common purport intending to covering services under Royalty, then same meaning will in flow in DTAA.

·         Reference to domestic meaning in view of Context of Treaty

For application of Article 3(2) of DTAA, one needs to look into two aspects:-

                                I.            Whether meaning of term used in DTAA is defined under Domestic legislation of contracting state applying the treaty?

                              II.            Whether using the meaning of term under domestic law, is in consonance with Context of treaty?

Ø  Meaning of term used in domestic legislation

Whether the  term “Process” as explained by Explanation 6, can be taken as meaning of term “Process” as contemplated under Article 3(2), is also not free from doubt on account of following:-

        I.            The Explanation 6 was inserted by Finance Act 2012 with retrospective effect from 01-06-1976

      II.            In CAgIT vs. Planation Corporation of Kerala Ltd (2001) 247 ITR 155, 161-62 (SC), it was held that an Explanation is intended to either explain the meaning of certain phrases and expression contained in statutory provision or depending upon its language it might supply to take away something from contents of provision and at times even, by way of abundant caution, to clear any mental cobweb surrounding the meaning of a statutory provision spun by interpretative process to make the position beyond controversy or doubt.

    III.            The Memorandum explaining the provision of Finance Bill 2012 provide the following rationale for introduction of Explanation 6 – “… doubts have been raised regarding the meaning of the term process. Considering the conflicting decisions of various courts in respect of income in the nature of royalty and to restate the legislative intent, it is further propose to amend the Income tax Act

    IV.            In view of afore-said, one would appreciate that Explanation 6 was introduced on the statue to clarify the implied meaning of the term process (which was disputed at judicial forum)  since time, definition of Royalty in explanation 2 was bought in statue i.e 01-06-1976

      V.            Thus whether implied meaning of term process under Income Tax Act can be considered as meaning of term under domestic legislation from perspective of Article 3(2) is questionable.

    VI.            However for our analysis purpose, the said explanation 6 is taken as meaning of term process for the purpose of Article 3(2)

Ø  Context of Treaty

        I.            What exactly should be taken as context of treaty has not been codified in express terms in either domestic statutes or legislation of foreign countries.

      II.            To apprehend the same, one has to refer the commentaries on Double taxation Convention and one of them is by learned Professor Klaus Vogel.

    III.            According to this commentary, the context of treaty should be arrived at after considering the following:-

a)      Objective of Treaty – to prevent/avoid double taxation

b)      Text of the treaty – any special meaning of term/concept apparent from treaty.

c)       Any supplementary instrument attached to treaty –any special meaning of term/concept assigned in supplementary instrument executed by contracting states.

d)      The relevant provision of two national legal systems.

Article 3(2) which is interpretative clause for other Articles of DTAA, should in itself be interpreted according to Article 31 of VCLT i.e. in good faith and accordingly the reference to domestic meaning in view of context of treaty, should be referred in following cases:

a)      The other contracting state also convey similar meaning to term as assigned by one contracting state.

b)      If above case does not hold true, the reference to domestic meaning will not lead to double taxation.

Conclusion

In my opinion, the meaning of word “Process” as used in definition of Royalty in Article 12, should be carry from Explanation 6 in following cases:-

a)      We should need to ascertain whether other contracting state also intend to cover the transmission services under the definition of Royalty in their domestic legislation. If yes, then meaning of term “Process” in definition of Royalty in Article 12 should be interpreted accordingly. This approach will in consonance with article 31 of VCLT (ordinary meaning as per legal usage consistent between the contracting states) and Article 3(2) of DTAA (Context is taken in harmony with provisions of two national legal system).

b)      If other contracting state considered Royalty as payment for use of asset, then meaning of words “Process” in definition of Royalty in article 12 should not treated at par with the definition of term process. This approach will be in synch with Article 31 of VCLT (ordinary meaning  of Royalty is per specific technical language that has developed in certain specialized area, such as tax laws (OECD commentary)) and Article 3(2) of DTAA (Context is taken in terms of objective of prevention of double taxation)