19 May 2016 EY Tax Alert Pune Tribunal upholds tax deductibility of MTM exchange fluctuation loss on forex loan borrowed to reduce interest cost and hedge export receivables Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. This Tax Alert summarizes a recent ruling of the Pune Income Tax Appellate Tribunal (Tribunal) in the case of Cooper Corporation Pvt. Ltd. [1] (Taxpayer) on the issue of tax deductibility of marked-to-market (MTM) exchange fluctuation loss on foreign currency loan borrowed to repay earlier rupee loans with a view to reduce interest cost and hedge export receivables. The Tribunal noted that, as per the settled law under Indian tax jurisprudence, exchange fluctuation loss on revenue item is deductible for tax purposes, though exchange fluctuation loss on capital item is not deductible. The Tribunal allowed the deduction of MTM loss on the ground that such loss has direct nexus to saving in interest-costs which is a revenue item. The Tribunal further held that MTM loss being recognized in books of account, under the mandate of accounting standard notified under Companies Act as per the mercantile system of accounting, cannot be regarded as notional or contingent loss. [1] [TS-265-ITAT-2016 (PUN)]
Background Accounting Standard 11 (AS-11) issued by Institute of Chartered Accountants of India (ICAI) and notified as one of the mandatory accounting standards under Companies Act requires outstanding foreign currency monetary items at year end to be translated into Indian rupees by applying the foreign exchange rate as on the closing day of reporting period and the net exchange difference resulting on such translation is required to be recognized as income or expense in Profit & Loss account for the respective financial period. However, for tax purposes, as per the law settled by Indian tax jurisprudence, exchange fluctuation loss on revenue item is deductible for tax purposes but loss on capital item is not deductible. As a corollary, exchange fluctuation gain on revenue item is taxable and gain on capital item is not taxable. While the above is the general principle, by way of an exception, Section 43A of the Indian Tax Laws (ITL) requires exchange fluctuation loss/gain on liability relating to or loan borrowed for acquiring capital asset from country outside India to be capitalized to the cost of such asset. But, pursuant to the amendment made with effect from tax year 2002-03, such capitalization is permitted with reference to loss/gain at the time of actual repayment and not on MTM basis. This provision has its origin to the devaluation of Indian rupee made in 1966 which, but for this provision, would have resulted in sunk cost for many Indian taxpayers which had borrowed loans in foreign currency for acquiring imported capital assets. ICDS VI, relating to the effects of changes in foreign exchange rates, on lines of AS-11, requires outstanding foreign currency monetary items to be translated at closing rate at year end and resulting exchange differences to be recognized as income or expense but subject to the provisions of Section 43A. Facts of the case The Taxpayer is a private limited company engaged mainly in foundry and manufacturing business. The Taxpayer had borrowed loans in Indian rupees for the purposes of acquiring capital assets in India. These loans carried interest rates ranging from 12% to 14% per annum. In order to save on interest costs, the Taxpayer converted these loans into forex loans with lower interest rates ranging from 6% to 7% per annum but the forex loans carried risk of exchange fluctuation loss/gain. The forex loan also acted as a hedge against export receivables in foreign currency. For tax year 2007-08, the Taxpayer booked an MTM loss on INR10.20M on restatement of outstanding forex loans at year end as per AS-11 and claimed the same as revenue deduction for tax purposes. The Tax Authority disallowed the loss on two grounds viz. (a) such MTM loss was notional and contingent in nature and (b) the loss was relatable to capital item and, hence, not allowable for tax purposes. The Tax Authority relied on the provisions of Section 43A for this purpose. The ITL permits Central Government to notify income computation and disclosure standards (ICDS) to be followed by taxpayers for the purpose of computing taxable income. Pursuant to this provision, the Central Government notified 10 ICDS on 31 March 2015 effective from tax year 2015-16 onwards which substituted two erstwhile standards which were notified in 1996. The First Appellate Authority upheld the Tax Authority s action. Being aggrieved, the Taxpayer filed further appeal before the Tribunal.
Issue before the Tribunal Whether MTM exchange fluctuation loss on foreign currency loan borrowed to repay earlier rupee loans with a view to reduce interest cost is allowable for tax purposes? Tribunal ruling The Tribunal ruled in favor of the Taxpayer and held that such loss was allowable as revenue deduction for following reasons: It is not disputed that forex loans were borrowed to convert existing rupee loans with a view to reduce interest cost. There is also no dispute that the capital assets acquired from rupee loans were already put to use. Hence, the forex loss is a post facto event subsequent to capital assets having been put to use. Further, the profits/gains from the business have been admittedly computed in accordance with the generally accepted accounting practices and the extant ICDS. The ITL requires the Taxpayer to adopt either cash or mercantile basis of accounting. The Taxpayer having adopted mercantile basis of accounting was obliged to adopt AS-11 under Companies Act and ICDS notified by Central Government under the ITL. Both AS-11 and ICDS VI [2] require MTM restatement difference on foreign currency monetary items to be recognized as income or expense. AS-11 is a mandatory accounting standard notified under Companies Act which the Taxpayer is bound to follow. The Supreme Court (SC) ruling in the case of CIT v. Woodward Governor India (P) Ltd. [3] supports that MTM loss recognized in compliance with the mandatory accounting standard cannot be regarded notional or contingent loss. It represents accrued liability as at year end. Section 43A is not applicable in the present case since forex loan has not been utilized for acquiring imported assets. Section 43A gets triggered only if the capital assets are imported assets. It does not apply to acquisition of indigenous assets. The definition of actual cost for depreciable assets under the ITL also does not require adjustment of forex loss/gain to the cost of the asset. This is supported by the SC ruling in the case of CIT v. Tata Iron and Steel Co Ltd. [4] in which the SC held that cost of asset and cost of raising money for purchase of asset are two different and independent transactions. The manner of repayment of forex loan does not affect the cost of the asset. It is true that the SC in the case of Sutlej Cotton Mills Ltd. v. CIT [5] held that any profit or loss which arises to a taxpayer on account of depreciation in foreign currency would be ordinary trading loss if the foreign currency held by the taxpayer is on revenue account. However, if the foreign currency is held as a capital asset, the loss would be capital in nature. The aforesaid principle is not applicable to the Taxpayer s case since fluctuation loss inflicted upon the Taxpayer bears no nexus or relation to the acquisition of capital assets. The forex loan was borrowed to save interest cost and consequently to augment the profitability or reduce revenue losses of the Taxpayer. The impugned loss, therefore, has a direct nexus to the savings in interest costs without bringing any new capital asset into existence. The fact that the forex loan served as a hedging mechanism against revenue receipts from exports also portrays the commercial expediency. [2] Effective from tax year 2015-16 [3] (2009) 312 ITR 254] [4] [(1998) 231 ITR 285] [5] [(1979) 116 ITR 1]
Comments While the principle of characterization of exchange fluctuation difference based on nature of underlying item is well settled under tax jurisprudence, the application of the principles to facts of a particular case do typically pose challenges. In the present case, the Tribunal leaned in favour of revenue characterization having regard to the fact that forex loans were borrowed to reduce the interest cost on rupee loans and to act as hedge against export receivables. The Tribunal also noted that the forex loan in the present case had a direct nexus with savings in interest cost which augment profitability and the hedge against export receivables also portrayed commercial expediency.
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