Facts of the Case

The assessee was engaged in the business of manufacturing toners and developers. For its project activities, it had initially availed term loans from banks and financial institutions. The interest liability on these borrowings was substantial.

To reduce the burden of interest costs, the assessee resorted to External Commercial Borrowing (ECB) from State Bank of India, Frankfurt, Germany, amounting to approximately USD 21,35,400. The interest rate on domestic term loans ranged between 20% and 26%, whereas the interest rate on the ECB was only 8.1%.

As a result of availing the ECB, the assessee’s interest liability significantly reduced during the relevant assessment year. However, due to fluctuation in foreign exchange rates at the close of the accounting year, the assessee recorded an increase in liability amounting to Rs. 64,06,200 attributable to the foreign currency borrowing.

The dispute arose regarding the correct tax treatment of the increased liability caused by foreign exchange fluctuation. The Revenue contended that the amount should be treated as a capital item, whereas the assessee claimed that it should be treated on revenue account.

Issues Involved

  1. Whether the increase in liability arising from foreign exchange fluctuation in respect of External Commercial Borrowing was capital in nature or revenue in nature?
  2. Whether the assessee was entitled to claim the foreign exchange fluctuation loss as a revenue expenditure for income-tax purposes?
  3. Whether consistency in tax treatment required similar treatment where gains arising from foreign exchange fluctuation had been assessed as business income in other assessment years?

Petitioner’s Arguments (Revenue)

The Revenue contended that:

  • The increased liability resulting from fluctuation in foreign exchange rates related to the borrowing obtained by the assessee.
  • Such increase should be regarded as a capital adjustment and not as a revenue expenditure.
  • Consequently, the amount could not be allowed as a deduction while computing business income.

Respondent’s Arguments (Assessee)

The assessee argued that:

  • The foreign currency borrowing was obtained to reduce interest costs and was integrally connected with the business operations.
  • Whenever gains arose due to foreign exchange fluctuation, the Revenue had assessed those gains as business income.
  • In Assessment Years 2003-04 and 2004-05, foreign exchange gains had already been treated and taxed as business income.
  • Therefore, on the principle of consistency, any increase in liability arising from foreign exchange fluctuation should also be treated on revenue account.
  • The foreign exchange fluctuation loss was thus deductible as a business expenditure.

Court Findings

The Delhi High Court noted that during earlier proceedings it had granted time to the Revenue to verify the assessee’s submission that foreign exchange gains had been assessed as business income in Assessment Years 2003-04 and 2004-05.

Upon verification, counsel for the Revenue confirmed the correctness of the assessee’s statement.

The Court observed that since gains arising from foreign exchange fluctuations had been assessed as business income in earlier years, the assessee was equally entitled to treat the increased liability arising from foreign exchange fluctuation as falling on the revenue account.

The Court agreed with the view taken by the Income Tax Appellate Tribunal and held that the foreign exchange fluctuation liability was revenue in nature.

Court Order

  • The Delhi High Court upheld the decision of the Income Tax Appellate Tribunal.
  • The increase in liability due to foreign exchange fluctuation on the External Commercial Borrowing was held to be on revenue account.
  • The assessee was entitled to claim the amount as a revenue deduction.
  • The Revenue’s appeal was dismissed.

Important Clarification

The Court emphasized the principle of consistency in tax treatment. Where gains arising from foreign exchange fluctuations had been treated and assessed as business income, corresponding losses or increased liabilities arising from the same source could not be treated differently without justification.

The judgment reinforces that the nature of foreign exchange fluctuation gains and losses must be examined consistently with their treatment in earlier years and in the context of the underlying business transaction.

Sections Involved

  • Section 28 of the Income-tax Act, 1961 – Profits and Gains of Business or Profession
  • Section 37(1) of the Income-tax Act, 1961 – General Deduction for Business Expenditure
  • Principles governing treatment of foreign exchange fluctuation gains and losses under Income-tax Law

Link to Download the Order

https://delhihighcourt.nic.in/app/case_number_pdf/2008:DHC:12300-DB/BDA10122008ITA9172008_162417.pdf

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