As you all know, the Indian rupee has been playing snakes and ladders for the past two months. It has been steadily on a downward spiral which has set off alarm bells ringing for the economy. While the economic impact has been dissected and analysed, we thought it would be relevant at the same time to recapitulate some of the tax provisions which deal with fluctuation of foreign exchange rates.
1. Rule 115 of the Income-tax Rules, 1962 (“the Rules”) for conversion of foreign income
Rule 115 provides for rate of foreign exchange for conversion of income accruing or arising or deemed to be accruing or arising or received or deemed to be received in foreign currency. According to Rule 115, the rate of conversion for such income would be the telegraphic transfer (“TT”) buying rate of such currency as on the “specified date”.
TT buying rate means the rate of exchange adopted by State Bank of India (“SBI”) for buying such currency through telegraphic transfer.
*However, where the income is payable in foreign currency and from which tax has been deducted at source under Rule 26 as given below, the specified date shall be the date on which the tax was required to be deducted (i.e. the date on which income is paid or credited whichever is earlier, except in case of salaries where it is the date of payment).
2. Rule 26 of the Rules and deduction of tax at source (“TDS”)
In respect of transactions with non-residents, where payments attracting tax withholding are made in foreign currency, Rule 26 of the Rules prescribes the rate of exchange to be used for conversion of foreign currency into INR for the purpose of making TDS. The rate of exchange is the TT buying rate of the respective foreign currency on the date on which tax is required to be deducted at source i.e. date of payment or credit, whichever is earlier (except in case of TDS on salaries under section 192 where deduction is to be made on payment basis). The TT buying rate in relation to foreign currency in this case has the same meaning as given above under Rule 115.
There may be a variation between the prevailing exchange rate as on the date of credit and as on the date of actual payment. A higher exchange rate as on the date of deduction may result in a lesser amount of remittance to the non-resident and vice versa.
For example, let’s suppose Mr A concludes a transaction with a non-resident vendor at $1,000. On the date of credit in the books of accounts of Mr A, the exchange rate is 1$=INR 60 and on the date of actual payment (a subsequent date) it is 1$=INR 50. As per Rule 26, the date on which tax is required to be deducted is relevant for exchange conversion which in this case is the date of credit. Assuming the TDS rate is 10%, the amount of TDS would be (1,000*60)*10%=INR 6,000 or $100. However, while remitting the amount, Mr A will pay $1,000 minus TDS (INR 6,000/50) i.e. $120 and remit $880. This has resulted in an excess cash flow for the non-resident vendor to the extent of $ 20 (120-100) on account of exchange fluctuation on TDS amount. Conversely, say the exchange rate on the date of actual payment was 1$=INR 65. In that case, Mr A would pay $ 1,000 minus TDS (INR 6,000/65) i.e. $ 92 (approx) and remit $ 908 resulting in a gain of $8 (100-92).
This may, however, not have an impact in case the non-resident vendor is not bearing the cost of tax withholding and it is instead borne by the person making the payment to him.
3. Rule 115A of the Rules and computation of capital gains
In case of a non-resident taxpayer, under the first proviso to section 48of the Income-tax Act, 1961 (“Act”), the capital gains arising from the transfer of shares or debentures in an Indian company is computed by converting the cost of acquisition of the asset, expenditure incurred wholly and exclusively in connection with such transfer and the sale consideration received / accruing as a result of transfer into the same foreign currency that was initially used to purchase such shares and debentures. The capital gain so computed in foreign currency is then reconverted into INR.
Rule 115A of the Rules provides for the rate of exchange for conversion of INR into foreign currency and reconversion of foreign currency into INR for the purpose of computing capital gains under the first proviso to section 48 of the Act.
The prescribed rate of exchange shall be as follows:
The TT buying rate in relation to foreign currency in this case has the same meaning as given above under Rule 115. The TT selling rate in relation to foreign currency means the rate of exchange adopted by SBI for selling such currency through telegraphic transfer.
Example:
A non-resident taxpayer purchases 1000 shares of I Co on April 1, 2010 in US $ for INR 600 per share (Average of TT buying and selling rate is 1$ = INR 50). He sells the shares on March 31, 2013 for INR 900 per share (Average of TT buying and selling rate is 1$ = INR 60 and TT buying rate is 1US$ = INR 60.50). Expense incurred in connection with the transfer of the capital asset is INR 12 per share. The capital gains in the instant case would be computed as follows:
Cost of acquisition = (1000*600)/50 = US $ 12,000
Sale consideration = (1000*900)/60 = US $ 15,000
Expenditure incurred in connection with transfer = (1000*12)/60 = US $ 200
Capital gains (in US $) = US $ 2,800 (15,000-12,000-200)
Capital gains (in INR) = 2800*60.50 = INR 169,400
4. Section 43A of the Act and capitalization of expenses
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 moneys 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), section 35A (acquisition of patents or copyrights after February 28, 1966 but before April 1, 1998), section 36(1) (ix) (incurred by a company for promoting family planning amongst its employees);
3. Cost of acquisition of a capital asset for the purpose of section 48.
Typically, settlement / restatement of foreign currency loan raised for acquisition of a capital asset would give rise to exchange gain / loss. Settlement / restatement of foreign currency loan would give rise to the following types of gain / loss:
a. Exchange differences on settlement would be in the nature of realized gain / loss;
b. Exchange differences on restatement of loan would be regarded as unrealized exchange gain / loss.
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.
Example: 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 instalments in FY 2012-13 (1 US $ = INR 45) and FY 2013-14 (1 US $ = INR 58).
Initial cost of the asset = 10,000*50 = INR 500,000
Adjustment in FY 2012-13 = 5,000*(50-45) = INR 25,000 which would be reduced from the cost
Adjustment in FY 2013-14 = 5,000*(58-50) = INR 40,000 which would be added to the cost
5. Allowability of foreign exchange losses as a deduction
As per AS-11, assets and liabilities denominated in foreign currency are converted to rupee values and stated in the financial statements at the end of the year.
Where the loan taken for the purchase of capital assets from outside India is restated at the end of the year, provisions of section 43A of the Act are not applicable since there is no repayment of the loan amount. Since the Act is silent regarding the tax treatment of such item, it has to be determined in accordance with general principles.
Section 37 of the Act provides that any expenditure which is wholly and exclusively laid out for the purposes of business, not being capital expenditure or expenses of a personal nature shall be allowed as a deduction while computing the taxable business income. The same principle can be extended to foreign exchange fluctuation gain / loss as well.
One view based on the instruction[Instruction 3 / 2010 dated March 23, 2010] issued by the Central Board of Direct Taxes (“CBDT”) in the context of tax treatment of forex derivatives which prescribes that ‘mark to market’ losses on forex derivatives should be disallowed, the same being notional in nature. Although the said Instruction deals exclusively with forex derivatives a view could be taken that on the same principles foreign exchange loss on restatement of liability on revenue account should also be disallowed on the basis that it is notional/ contingent in nature.
However, judicial precedents [Oil and Natural Gas Corporation Ltd. vs. Dy. CIT (261 ITR 1) ; CIT vs. Woodward Governor India (P) Limited (162 Taxman 60)] have held that loss/ increase in liability on account of forex fluctuations are not contingent or notional.
If the foreign currency is held by the taxpayer on revenue account or as a trading asset or as part of circulating capital used in the business, the appreciation or depreciation in the value of the currency would result in either a trading profit or trading loss. On the other hand, if the foreign exchange gain / loss arise in relation to acquisition of capital assets, the corresponding gain / loss would be of a capital nature.
The above principles have been enunciated in the case of Sutlej Cotton Mills vs CIT, West Bengal [1]wherein the Supreme Court has 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 or as 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” (Emphasis supplied).
Further, reliance can be placed on the following decisions which have held that foreign exchange gain / loss incurred in connection with purchase of capital assets will result in a capital receipt / expense:
Woodward Governer India (P) Ltd [2]
CIT vs Dempo and Co (P) Ltd [3]
Hero Honda Motors Private Limited [4]
Triveni Engineering Works vs CIT [5]
Sandoz India Limited [6]
CIT vs Tata Locomotive and Engineering Co Ltd [7]
Based on the provisions of the Act and principles upheld in various judicial precedents, it can be concluded that:
Unrealized foreign exchange gain / loss of capital nature earned / incurred in relation to any capital asset shall be treated as gain / loss on capital account and shall not be chargeable to tax / deductible while computing the taxable income of the taxpayer. Unrealized foreign exchange loss on revenue account should qualify as a deduction under section 37 of the Act while computing the taxable income of a taxpayer.
[1]116 ITR 1 [2]162 Taxman 60 (Delhi High Court) [3]206 ITR 291 (Bombay High Court) [4]192 Taxation 1 (Delhi Tribunal) [5]156 ITR 202 [6]206 ITR 599(Bombay High Court) [7]60 ITR 405
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