Is Foreign exchange fluctuation loss allowable as an expenditure under Income Tax?
A foreign exchange gain/loss occurs when a company buys and/or sells goods and services in a foreign currency, and that currency fluctuates relative to their home currency. It can create differences in value in the monetary assets and liabilities, which must be recognized periodically until they are ultimately settled.
Section 37 of the Income Tax Act pertains to general allowability of business expenditure while computing Profits or Gains from Business or Profession. According to Section 37(1), any expenditure, not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee, laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”.
Let us refer to the case of CIT v. Woodward Governor India (P.) Ltd. (2009), where the issue under consideration was whether the fluctuation loss suffered by assessee on account of foreign exchange difference as on date of balance sheet is an item of expenditure under section 37(1) or not.
Facts of the Case:
- The assessee-company had debited to its profit and loss account certain unrealized loss due to foreign exchange fluctuation in foreign currency transaction on revenue items, on the last date of the accounting year.
- The Assessing Officer (AO) held that the liability as on the last date of the previous year under consideration was not an ascertained liability, but a contingent liability and, consequently, it had to be added back to the total income of the assessee.
- The Commissioner upheld the assessment order. The Tribunal allowed the claim, which was affirmed by the High Court.
Observations of the Supreme Court (SC) on provisions of law
- The term ‘expenditure’ in section 37 was not defined in the Act and therefore, had to understood contextually.
- It covered an amount which was a ‘loss’ even though the said amount had not gone out from the pocket of the assessee.
- The ‘loss’ suffered by the assessee on account of the exchange difference as on the date of the balance sheet was an item of expenditure under section 37(1).
- Further, profits and gains were required to be computed in accordance with commercial principles and accounting standards (AS-11).
- Accounts and the accounting method followed by an assessee continuously for a given period of time needed to be presumed to be correct till the AO came to the conclusion for reasons to be given that the system did not reflect true and correct profits
- Accounting Standards, which were continuously adopted by an assessee, can be superseded or modified by legislative intervention.
- However, but for such intervention or in cases falling under section 145(3), the method of accounting undertaken by the assessee continuously was supreme.
- In the instant case, there was no finding given by the Assessing Officer on the correctness or completeness of the accounts of the assessee.
- Equally, there was no finding given by the Assessing Officer stating that the assessee had not complied with the Accounting Standards.
- As per AS 11, any difference, loss or gain arising on conversion of the said liability at the closing rate, should be recognized in the profit and loss account for the reporting period
Observations of the Supreme Court (SC) on factors to be taken into account in order to find out if an expenditure is deductible
The following factors have to be taken into account in order to find out if an expenditure is deductible:
- whether the system of accounting followed by the assessee is mercantile system, which brings into debit the expenditure amount for which a legal liability has been incurred before it is actually disbursed and brings into credit what is due, immediately it becomes due and before it is actually received
- whether the same system is followed by the assessee from the very beginning and if there was a change in the system, whether the change was bona fide
- whether the assessee has given the same treatment to losses claimed to have accrued and to the gains that may accrue to it
- whether the assessee has been consistent and definite in making entries in the account books in respect of losses and gains
- whether the method adopted by the assessee for making entries in the books both in respect of losses and gains as per accepted Accounting Standards
- whether the system adopted by the assessee is fair and reasonable or is adopted only with a view to reduce the incidence of taxation.
Thus, SC concluded that the loss suffered by the assessee on account of fluctuation in the rate of foreign exchange as on the date of the balance sheet was an item of expenditure under section 37(1) of the Act and will be allowed as an expenditure under Income Tax Provisions.