Treatment of Foreign Exchange Fluctuations

Introduction

Foreign exchange fluctuations arising due to change in foreign exchange rates can be either on capital account or revenue account. Foreign exchange fluctuation on capital account shall be adjusted in accordance with Section 42 when the liability is actually paid. The foreign exchange loss on revenue account is deductible under Section 34(1) and gain is taxable under Section 26, as the case may be, in accordance with the provisions of ICDS – VI (The Effects of Changes in Foreign Exchange Rates).

1. About

1.1. Meaning of ‘Foreign Exchange Fluctuation’

When an assessee acquires an asset, whether depreciable or non-depreciable, or undertakes any business transaction with a foreign country, he needs to recognize the value of such asset or transaction, in his books of account, which shall be translated in local currency (INR) on the date of transaction. Subsequently, at the year-end or when the liability is paid, there can be a difference in the liability initially recognized in the books of assessee and the liability reinstated at year-end or amount re-paid, as the case may be, due to change in exchange rate of foreign currency. Such differences are called foreign exchange fluctuations. These fluctuations can be either negative (loss) or positive (gain).

1.2. Types of Foreign Exchange Fluctuation

Foreign exchange fluctuation gain or loss can be on two accounts - capital account fluctuations or revenue account fluctuations. Capital account fluctuations arise where transactions entered into are linked with the assets purchased outside India. All foreign exchange fluctuations other than those on capital account are treated as revenue account fluctuations.

2. Capital Account Fluctuations [Section 42]

2.1. What is capital account fluctuation?

When an assessee buys a capital asset from a foreign country for the purpose of business or profession, it incurs a liability for the payment of purchase price and other costs of the asset to the seller. If the assessee discharges the liability immediately at the time of purchase, no exchange difference arises. However, if the payment is deferred by the assessee, then the exchange difference arising at the time of discharging the liability shall be treated as capital account fluctuation which shall adjusted with the written down value or cost of the related asset.

2.2. When capital account fluctuation arises?

The foreign exchange fluctuation on capital account shall arise when following conditions are satisfied:

(a) Assessee acquires an asset in any previous year from a country outside India. The asset may be a depreciable asset or otherwise.

(b) The asset is acquired for the purpose of business or profession.

(c) In consequence of a change in rate of exchange, there is an increase or reduction in the liability of the assessee as expressed in Indian currency (as compared to the liability existing at the time of acquisition of the asset) at the time of making payment:

• towards the whole or a part of the cost of the asset; or

• towards repayment of whole or a part of the moneys borrowed by him from any person, directly or indirectly, in any foreign currency specifically for the purpose of acquiring the asset along with interest, if any.

2.3. Treatment of capital account fluctuation

Any increase or decrease in the liability of the assessee due to such foreign exchange fluctuations shall be added to or reduced from the:

(a) Actual cost of the asset

(b) Amount of capital expenditure on scientific research asset

(c) Amount of capital expenditure on patent rights or copyrights

(d) Amount of capital expenditure on family planning expenditure

(e) Cost of acquisition of a capital asset, not being a depreciable asset, for the purposes of computing capital gains.

Such adjustments shall be made in the year of payment, irrespective of the method of accounting adopted by the assessee, and it is not necessary that such adjustment shall be made only if it is adjusted in the books of account. The amount arrived at after such adjustment (addition or deduction) shall be deemed to be the actual cost of the asset, or the amount of capital expenditure, or the cost of acquisition of the capital asset, as the case may be.

2.4. Calculation of capital account fluctuation

2.4-1. In general

The amount to be adjusted from the actual cost or expenditure or WDV of the asset shall be determined in following two steps.

Step 1: Initial recognition of cost and liability

To calculate the foreign exchange fluctuation at the time of actual payment, the first step is to recognize such foreign currency transaction in the books of account by translating it into local currency, i.e., INR. Rule 115 of the Income-tax Rules provides guidance for conversion of foreign currency earning into INR, but it does not provide any guidance for converting the value of a capital asset, acquired in foreign currency, into INR.

Example, a machinery, worth 1 million USD, is acquired from USA on credit period of 6 months. Which rate of exchange, from the below table, should be considered to recognize the value of machinery in the books of account?

The Income-tax Act does not provide any guidance in respect of the rate and date at which such transaction should be recognised. Furthermore, Accounting Standards (AS) and Indian Accounting Standards (Ind AS) also do not provide any specific guidance on this aspect. The guidance in this regard is available in the opinion given by the Expert Advisory Committee (EAC), which provides for recognition of such transaction on the date on which all significant risk and rewards associated with the ownership is passed on to the entity provided the consideration for such transaction is ascertained on the date of recognition. Thus, the terms and conditions of a contract should be considered while determining the date on which all significant risks and rewards of ownership are transferred.

In the above example, if the machinery is purchased on FOB basis, the risk and reward associated with the transaction shall be deemed to be passed on to the entity on the date on which goods are dispatched from the USA. Thus, the machinery shall be recognized in the books of account at the exchange rate prevailing on 01-07-2025, i.e., Rs. 86/$.

If the machinery is purchased on CIF basis, the risk and reward associated with the transaction shall be deemed to be passed on to the entity on the date on which goods are delivered at the premise of the entity. Thus, the machinery shall be recognized in the books of account at the exchange rate prevailing on 01-09-2025, i.e., Rs. 88/$.

Step 2: Comparison of initial liability with actual payment

While making payment of liability by the assessee in foreign currency, the INR amount spent for the purpose of buying foreign currency at current exchange rate is compared with the liability initially determined at the time of purchase of asset (as per Step 1). If the INR amount is more than the initially determined liability, then the difference is considered as exchange loss, otherwise difference shall be the exchange gain.

Example, on April 1, Year 00, A Ltd. purchased a machinery from USA for $ 10,000. The asset has been recognized in the books of account by translating the purchase price into at the exchange rate of Rs. 80/$. The recorded value of asset and the corresponding liability is Rs. 800,000. The amount is payable on February 28, Year 00. If the exchange rate on the date of payment is Rs. 81/$, then the written down value of the machinery shall be increased by Rs. 10,000 on account of exchange loss arising due to increase in liability. If the exchange rate comes down to Rs. 79/$, the written down value shall be decreased by Rs. 10,000 on account of exchange gain.

2.4-2. When cost is met by other person

Where any part of the liability, towards acquisition of asset, is met by any person other than the assessee, directly or indirectly, it shall not be considered while determining the foreign exchange fluctuations.

2.4-3. In case of forward contract

Sometimes an assessee enters into a forward contract for purchase of foreign currency on or after a stipulated future date at an agreed rate. These agreements are generally entered into to cover the risk of the foreign exchange fluctuations. Where such agreement has been entered into, the adjustment to the cost (or expenditure) shall be made with reference settlement price of such agreement.

2.4-4. If underlying asset is transferred

As the adjustment of foreign exchange fluctuations are made at the time of payment only, there may be cases when such differences arise after the relevant asset is transferred. In such case, the exchange gain or shall be adjusted from the written down value of the respective block.

2.4-5. If relevant block of asset is transferred

If exchange fluctuation gain or loss arises after the relevant asset is transferred and the block of asset ceases to exist, then the foreign exchange gain or loss shall be treated as capital receipt/expenditure which will have no tax treatment.

Example, Mr X acquired an asset on April 15, Year 00 from USA by taking a loan from Mr Z (USA resident). On June 30, Year 00 Mr X transferred such asset, whereas loan is repaid on August 10, Year 01.

If the respective block of asset exists at the time of repayment, foreign exchange fluctuations, if any, will be adjusted with the written down value of the block. Whereas if the respective block ceases to exist, foreign exchange fluctuation, if any, will be deemed as capital receipt or expenditure which will have no tax treatment.

3. Revenue Account Fluctuations [Section 43]

Any foreign exchange fluctuation which is not regarded as capital account fluctuation are regarded as revenue account fluctuation. The gain or loss as a result of such fluctuations shall be computed in accordance with ICDS-VI (The Effects of Changes in Foreign Exchange Rates). The resultant foreign exchange gain shall be taxable under section 28 and the foreign exchange loss shall be allowed as deduction under Section 37(1).

ICDS-VI covers all gain or losses in respect of all foreign currency transactions including those relating to:

(a) Monetary items and non-monetary items.

(b) Translation of financial statements of foreign operations.

(c) Forward exchange contracts.

(d) Foreign currency translation reserves.

This article is general information and not tax advice. Provisions change. Confirm your position with a qualified professional before acting.