(2009) 312 ITR 254 (SC)
General conditions for revenue expenditure; capitalising exchange rate changes; taxation of foreign exchange fluctuation
Deductible, where the liability is on revenue account. Under the mercantile system a loss arising from restating a revenue liability at the closing rate is an accrued liability, not a contingent one, and realisation is not a precondition.
Is an unrealised loss arising on restating foreign currency liabilities at the year-end rate deductible, or must the loss be realised before it can be claimed?
The assessee had liabilities denominated in foreign currency arising from its trading operations. At the year end, in accordance with the applicable accounting standard, it restated those liabilities at the exchange rate prevailing on the balance sheet date and charged the resulting increase to the profit and loss account, claiming it as a deduction. No payment had yet been made and the loss was therefore unrealised. The Revenue disallowed the claim, characterising it as a notional or contingent loss that could be recognised only on actual payment.
The claim was allowed by the appellate authorities and the High Court. The Revenue appealed to the Supreme Court, which considered both revenue-account liabilities and liabilities incurred for acquiring capital assets.
For the assessee
Under the mercantile system, a liability that has accrued is deductible whether or not it has been discharged. Once the exchange rate has moved, the rupee amount required to settle the liability has increased, and that increase is a present liability rather than a contingency. The accounting treatment follows a mandatory standard and reflects commercial reality.
For the Revenue
Until the liability is actually discharged, the rate may move back and no loss may ever eventuate. What is claimed is a notional figure based on a hypothetical settlement at the balance sheet date, and a deduction cannot be founded on an event that has not occurred.
The Court held that the mercantile system requires expenditure and losses to be recognised when the liability arises, not when it is discharged. Where a trading liability is denominated in foreign currency and the rupee has depreciated by the balance sheet date, the amount the assessee must find in order to settle has increased; that increase is an accrued liability, and the fact that the rate might subsequently move the other way does not make it contingent. The Court examined the accounting framework, noted that restatement at the closing rate was mandated by the applicable standard, and held that where accounts are maintained on the mercantile basis in accordance with recognised standards and are not shown to present a distorted picture, the loss so recognised is allowable. It drew a firm distinction, however, between liabilities on revenue account and liabilities incurred for acquiring capital assets: for the latter, the statutory provision dealing with capitalisation of exchange differences governs and the difference adjusts the cost of the asset rather than being deducted.
The IT Act 2025 addresses this expressly: Section 43 governs the taxation of foreign exchange fluctuation gains and losses, and Section 42 the capitalisation of exchange differences on liabilities for acquiring assets, with the general deduction in Section 34. The revenue–capital distinction the Court drew remains the organising principle, and the case should be read with Tata Iron & Steel on the capital side.