Backdrop
One of the most apprehensive subjects for India for last couple of years has been the dwindling rupee value which besides triggering inflation and broadening the current account deficit has also augmented certain tax related issues. One such issue stems from the concerns relating to the treatment of foreign exchange loss arising on revaluation of External Commercial Borrowing (ECB) for assets acquired within India. Whether such loss can be capitalised with the cost of assets or can be claimed as revenue loss is a question many taxpayers are grappling with today.
Law on the subject
If the proceeds of ECBs are utilized to acquire capital assets from any place outside India, the provisions of Section 43A of the Income-tax Act, 1961 (“the Act”) would govern the situation. Section 43A provides for capitalisation of the loss with the cost of asset at the time of repayment of the ECB resulting in crystallisation of loss. However, the said section is inapplicable in the context of indigenous assets as its language confines its applicability only to a case “where an assessee has acquired any asset from a country outside India”.
In the absence of any specific provision in law on this facet, coupled with some distinct judicial pronouncements in the past, there is an element of uncertainty surrounding this aspect.
There are no precise rules formulated to distinguish a loss on revenue count vis-à-vis a loss on capital count and there lies a thin line of demarcation between the two, but certain judicial pronouncements are worth noting in the present issue under consideration to understand the nature of such a loss. While revenue loss is allowable, the capital loss on the other hand cannot be allowed as a deduction while computing business income [see end note 1].
Section 43A of the Act, was introduced by the legislature vide Finance (No. 2) Act, 1967 with effect from 1st April, 1967. Supreme Court in Tata Iron & Steel [TISCO - (1998) 231 ITR 285 (SC)] had an occasion to deal with this issue for a period prior to its introduction. The assessee in that case acquired certain depreciable assets using foreign currency loans, and adjusted the foreign exchange fluctuation with the cost of the asset. The apex court, on these set of facts, besides observing that section 43A is inapplicable (as was being introduced later), held that, “the manner of repayment of loan can’t affect the cost of the assets so acquired. What is the actual cost must depend on the amount paid to acquire the asset. The company might have raised the funds to purchase the asset by borrowing but what the company had paid for it was the price of the asset. That price could not change by any event subsequent to the acquisition of the asset. What has to be borne in mind is that the cost of an asset and the cost of raising money for purchase of the asset are two different and independent transactions.”
Given that the provisions of Section 43A requiring foreign exchange gain/loss to be adjusted with the cost of the assets, apply only with respect to imported assets, the case of indigenous assets will continue to be governed by the ratio of the Tata Iron & Steel’s decision (supra). However, the matter becomes complex as there are certain judicial pronouncements analogous to the issue under consideration, which have denied deduction by holding such loss to be on capital count. But before we proceed to discuss those cases, following decisions are relevant for setting the things in perspective.
In the Shell Company of China Ltd. [22 ITR 1 (CA)] the Court of Appeals held that, “gains arising on deposits (in foreign currency) are capital receipt as the deposits were in essence loan/capital and not a trading receipt.”
Further in Sutlej Cotton Mills Ltd., [(1979) 116 ITR 1 (SC)] it was held by Supreme Court that, “the law may, therefore, now be taken to be well settled that where the 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.”
Also in Tata Locomotive & Engineering Co. Ltd. [TELCO - (1966) 60 ITR 405 (SC)] a similar view was again reiterated.
The aforesaid decisions were later consistently followed by some High Courts in Bestobell (India) Ltd. [see end note 2], Union Carbide India [see end note 3], Oil India Limited [see end note 4], Bharat General and Textile Industries Limited [see end note 5], Groz-Beckert Saboo Ltd. [see end note 6], Sandoz (India) [see end note 7], Electric Lamp Manufacturers (India) Limited [see end note 8] and V. S. Dempo & Co. (P) Ltd. [see end note 9] in the context of ECB holding that if the foreign exchange fluctuation loss arises on restatement of ECBs utilized for acquiring capital asset indigenously in India, then such loss will be capital in nature.
As is evident from above analysis, the controversy really finds its foundation when the decision of Court of Appeal in the case of the Shell Company of China was first followed by Calcutta High Court. Later decisions also drew support from the decisions of Sutlej Cotton Mills and TELCO though rendered in the context of foreign currency held as an asset as against a foreign currency loan.
Many corporate taxpayers find it a safe proposition to capitalise the exchange loss and claim depreciation thereon rather than claiming it as revenue loss. One should however bear in mind that if in a subsequent year the tax authorities deny depreciation on the capitalised loss relying on the decision of Supreme Court in TISCO (supra) then in such an eventuality taxpayers may find it difficult to revisit the earlier years’ return and claim it as revenue loss therein. It is therefore important that the decision in this regard shall be taken after a thorough research and analysis of the legal position both from the perspective of technical merits as well as from the perspective of strategy.
Summing up
Many multinationals, small and medium enterprises and corporate houses in India prefer availing foreign currency borrowings with a view to save on interest cost. Very often those funds are utilized to acquire capital assets indigenously in India and hence the issue of dealing with foreign exchange fluctuation calls importance.
This short write-up attempts to highlight that the determination of correct treatment of exchange fluctuation loss is extremely complex since the ratio of the decision in Tata Iron and Steel is apparently in contrast with the ratio of the decision in Sutlej Cotton Mills and various other High Courts. Fundamentally, by raising loan itself no capital asset comes into existence and hence expenses for raising loan should in authors’ view be treated as revenue in nature. Further the variation in the loan amount has no bearing on the cost of the asset as the loan is a distinct and independent transaction. The author believes that the claim of exchange fluctuation loss as revenue on count is founded on strong legal arguments. Nevertheless, given the contrary judicial precedents the matter is undoubtedly prone to litigation.
[The first author is Director, Lakshmikumaran & Sridharan, Chandigarh and the co-author is a Senior Associate, Lakshmikumaran & Sridharan, New Delhi]
End Notes:
- Hasimara Industries vs. CIT (231 ITR 842) (SC)
- (1979) 2 Taxman 62 (Cal.)
- (1981) 130 ITR 351 (Cal.)
- (1982) 137 ITR 156 (Cal.)
- (1986) 157 ITR 158 (Cal.)
- (1981) 127 ITR 608 (P&H)
- (1994) 206 ITR 599 (Bom.)
- (1992) 198 ITR 760 (Cal.)
- (1994) 206 ITR 291 (Bom.)