The Hindu Business Line : Finality eludes forex accounting

ACCOUNTING for fluctuations in the rate of foreign exchange has always been a tricky issue. This is proved by the fact that the Institute of Chartered Accountants of India (ICAI) has revised twice its Accounting Standard on Accounting for the effects of Foreign Exchange Rates. A Special Bench of the Income-Tax Appellate Tribunal (ITAT) was saddled with this problem in Apollo Tyres vs Assistant CIT (2004 89 ITD 235 Delhi SB).

In this case, the company, after purchasing machinery abroad, entered into 13 forward contracts in pounds and dollars as a de-risking strategy against fluctuations in exchange rates. Six of these were related to repayment of interest liabilities and the rest were towards repayment of principal amounts of foreign loans.

Till 1992, the Reserve Bank of India kept a tight leash on forex contracts. Then, during the initial aura of liberalisation, it removed the floodgates by permitting annulling/cancelling contracts. The company wasted no time is doing this.

Sensing a goldmine as well as an excellent protective tool, the company entered into six more contracts relating to repayment of dollar loans. The company cancelled two of these contracts and for two-fold gains — those relating to interest were dealt in the profit and loss account while that relating to principal were retained in the balance-sheet. The issues referred to the Special Bench for resolution were:

Whether gains earned on cancellation of forex contracts are capital or revenue;

In case they are capital, should they go to reduce the cost of the plant and machinery.

The company's main defence was that it entered into the forex contracts in the course of business. At that point in time, it was not possible to cancel the contracts. It was only later that the RBI relaxed the norm which the company took benefit of. This occurred due to the benevolence granted by the RBI and the company could not be said to have entered into it for a commercial consideration.

The main business of the company, manufacture of tyres and tubes, and the forex market are poles apart.

They took legal support from, inter alia, G. Venkataswami Naidu & Co vs CIT (1959 35 ITR 594 SC), Saroj Kumar Majumdar vs CIT (1959 37 ITR 242 SC) and Triveni Engg Works Ltd vs CIT (1985 156 ITR 202 Delhi).

To convince the Bench that Section 43A would not apply, the company quoted from CIT vs Elgi Rubber Products Ltd (1996 219 ITR 109 Madras) and Beco Engg Co Ltd vs CIT (1999 236 ITR 344 Punjab and Haryana).

The Department was very convinced that the company had embarked upon an adventure in the nature of trade. It claimed that the company had made remittances not out of the spoils of these rate contracts. In the first tranche, the company made payments in mid-April and mid-October but opted for a cancellation of these contracts in end-April. The second tranche of rate contracts entered into in May and June were not utilised for the repayment in mid-October.

It was thus clear that the intent of the company was to share the spoils of the rate fluctuations and not the de-risking tale that it claimed.

The Department felt that the ratio of the decisions in CIT vs Rai Bahadur Jairam Valji (1959 35 ITR 148 SC) and Estate Investment Co. Ltd vs CIT (1980 121 ITR 580 Bombay) would support their view. In addition, CIT vs Sutlej Cotton Mills Supply Agency Ltd (1975 100 ITR 706) has made it clear than even a single foray into an alien world by a company with a commercial intent would constitute an adventure in the nature of trade. Section 43(5) would also apply to this case, the Department opined.

The Special Bench utilising the words of wisdom enunciated in Thew vs South West Africa Co. Ltd (1924 9 TC 41 CA), California Copper Syndicate vs Harris, G. Venkataswami Naidu & Co vs CIT (supra), CIT vs P. K. N. Co Ltd (1966 60 ITR 65 SC) and Sutlej Cotton Mills Ltd vs CIT (1979) ruled that there could be no doubt in anybody's mind that even a single transaction beyond the Lakshmana Rekha would be tagged as a speculative operation.

Emphasis was also placed on the tenet "A capital investment and resale do not lose their capital nature merely because the resale was foreseen and contemplated when the investment was made and the possibility of enhanced values motivated the investment," which was quoted in Leeming vs Jones (1930 15 TC 333 HL). This was sufficient for the Bench to rule that these gains were capital in nature.

Turning to the accounting of these gains/losses, the Bench noted that if the foreign currency is held as a capital or a fixed asset, profits/losses would also be capital in nature — CIT vs Tata Locomotive and Engg Co Ltd (1966 60 ITR 405 SC), CIT vs Canara Bank (1967 63 ITR 328 SC) and CIT vs South India Viscose Ltd (1979 120 ITR 451) were relied on.

The views of the Supreme Court in CIT vs Arvind Mills Ltd (1992 193 ITR 255) were sufficient for the Bench to conclude that Explanation 3 to Section 43A would come into play here.

The Bench also extracted the relevant portion of AS-11 issued by the ICAI dealing with forward contracts, which clearly spelt out that forex differences regarding fixed assets need to be adjusted in the carrying amount of the fixed assets.

The judgement was made on March 23, 2004. The ICAI revised its AS on forex on February 21, 2003. In its latest avatar, the Standard talks only of recognising all gains or losses in the profit and loss account. It is only in a non-speculative forex contract that the premium or discount is permitted to be amortised over the life of the contract.

Even in a forex contract that is intended for trading or speculation, the premium or discount is ignored and at each balance-sheet date, the value of the contract is marked to its current market value and the gain or loss is recognised. Internationally, too, the norm generally is to treat any forex gains/losses in the profit and loss account.

If the decision of the Bench becomes law, we have a straight conflict between AS-11 and the Department. The CBDT can consider amending the law to remove this disparity. In case it continues, we will probably have one more inclusion to the deferred tax list.

(The author is a Hyderabad-based chartered accountant.)