Treatment of Exchange Fluctuation from Income Tax point of view

As we know today’s world is dominated by globalization in which geographical boundaries of business houses has spread beyond its countries also. As a consequence of which, exchange fluctuation in currencies is becoming one of the major concern for importers & exporters. Therefore it is vital to know the treatment of these exchange fluctuations from the income tax point of view.

As we all of us aware that in running business there are usually two types of expenditure one is revenue and other is capital. Hence, exchange fluctuation also affects only these two accounts which are discussed one by one below.

1. Revenue Account:
Under Revenue account foreign exchange fluctuations are on an account of debtors for exports, creditors for purchases and expenses payable etc. Gain on Fluctuations of these accounts will be recognized on accrual basis under head profit and gains of business or profession. Similarly, loss on fluctuation is also allowed on accrual basis under section 37(1).
The above principal has been enunciated in case of CIT VS Woodward Governor India (p) ltd wherein Supreme Court has observed as follows:
The word ‘expenditure’ is not defined in the Act. The word ‘expenditure is, therefore, required to be understood in the context in which it is used. Therefore, the expression ‘expenditure’ used in section 37 may include ‘loss’ also even though the said amount has not gone out from pocket of the assessee. Any difference, loss or gain arising on conversion of the said liability at the closing rate, should be recognized in profit and loss account for the reporting period.

2. Capital Account
Under capital account fluctuations are on an account of foreign currency loan taken to acquire fixed capital asset, foreign capital issued abroad. Gain on Fluctuations of these accounts will be capital receipt which has no tax treatment. Similarly, loss on fluctuation will be a capital loss which has no tax treatment i.e. it is neither allowed to set off nor allowed to carry forward. In simple words, it’s a dead loss.
The above principle has been enunciated in case of Sutlej Cotton Mills VS CIT wherein Supreme Court observed as follows:

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 him, 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. But, if on the other hand, the foreign currency held as a capital asset or as fixed capital, such profit or loss would be of capital nature.
Similarly in case of CIT VS Jagatjit Industries Ltd (Delhi.) it was held that Share capital is a capital account and therefore gain/loss on foreign exchange fluctuation on share capital is a capital receipt/capital loss.  

  3. Section 43A Capitalization of Expenses. (An Exception to Capital Account Treatment)
The provisions of section 43A of the Act deal with the treatment of foreign exchange fluctuation in respect of loan borrowed in foreign currency for acquiring assets from outside India for the purpose of business or profession. 

Section 43A is a non-obstante clause which overrides all the other provisions of the Act and the tax treatment prescribed in this section has to be adopted irrespective of the method of accounting followed by the taxpayer.

The conditions required to be satisfied for attracting the provisions of section 43A of the Act are as follows:

  a. The taxpayer should have acquired an asset from outside India;

  b. The increase or reduction in the liability should be in relation to the cost of asset or towards repayment of money borrowed, including interest, specifically for acquiring the asset; and

  c. The increase or reduction in liability is at the time of making the payment. 

The increase or decrease as stated above shall be adjusted towards:

  1. Actual cost of the depreciable asset as defined in section 43(1) of the Act;

  2. Amount of capital expenditure as referred to in section 35(1)(iv) (for scientific research related to business of the taxpayer)

  3. Cost of acquisition of a capital asset for the purpose of section 48. (Non-depreciable assets)  

The provisions of section 43A of the Act provide for making adjustments to the cost of assets / expenditure only in relation to exchange gain / loss arising at the time of making payment. It therefore refers to realized exchange gain / loss. The treatment of unrealized exchange gain / loss is not covered under the scope of section 43A of the Act. 

Further, where the whole or any part of the liability is not met by the taxpayer but directly or indirectly by any other person or authority, the liability so met shall not be taken into account for the purpose of this section. The section also provides that where the taxpayer takes a forward contract for repayment of the loan with an authorized dealer, the rate specified in the contract would be added to or deducted from the cost of the asset. 

A Co. acquires a capital asset in foreign currency for US $ 10,000 in Financial Year FY 2011-12 (1 US $ = INR 50) which is fully financed by a foreign currency loan. Subsequently the loan is repaid in 2 equal installments in FY 2012-13 (1 US $ = INR 45) and FY 2013-14 (1 US $ = INR 58). 

Initial cost of the asset = 10,000X50 = INR 500,000

Adjustment in FY 2012-13 = 5,000X(50-45) = INR 25,000 which would be reduced from the cost**

Adjustment in FY 2013-14 = 5,000X(58-50) = INR 40,000 which would be added to the cost**

**As per Supreme Court in case of Arvind Mills Ltd held that actual cost referred to in section 43A should be read as “Actual Cost minus depreciation allowed till date”