Business Expenditure — S. 42(1) — Special provisions for prospecting for mineral oil — Production sharing contract accounts is an independent accounting regime — Foreign exchange losses on account of foreign currency transaction is allowable as a deduction.
CIT v. Enron Oil and Gas India Ltd (2008) 305 ITR 75 (SC)
The respondent-Enron Oil and Gas India Ltd. (‘the EOGIL’), a company incorporated in Cayman Islands was engaged in the business of oil exploration. In 1993, the Government of India through the Petroleum Ministry invited bids for development of concessional blocks. EOGIL offered its bid for the development of concessional blocks. A consortium of EOGIL with RIL was given the contract. Later on, ONGC joined. EOGIL with RIL and ONGC executed a production sharing contract (PSC) with the Government of India. EOGIL was entitled to a participating interest of 30% in the rights and obligations arising under the PSC. RIL was also entitled to participating interest of 30%. ONGC was entitled to a participating interest of 40%. EOGIL was designated as the operator under the said PSC.
Vide Notification No. 1997, dated March 8, 1996, u/s.293A of the Income-tax Act, 1961 (‘the 1961 Act’), each co-venturer was liable to be assessed for his own share of income. They were not to be treated as an association of persons.
EOGIL filed its return of income for the assessment year 1999-2000 declaring its taxable income of Rs. 71,19,50,013 u/s.115JA.
During the year, EOGIL debited its profit and loss account by exchange loss of Rs.38,63,38,980. The Assessing Officer disallowed this loss on the ground that it was a mere book entry and actually no loss stood incurred by the assessee.
The decision of the Assessing Officer was challenged in appeal by EOGIL before the Commissioner of Income-tax (Appeals), who after analysing PSC held that each co-venturer in this case had made contribution at a certain rate, whereas the expenditure incurred out of the said contribution stood converted on the basis of the previous month’s average daily means for the buying and selling rates of exchange which exercise resulted in loss/profit on conversion. Under the circumstances, according to the Commissioner of Income-tax (Appeals), it could not be said that the assessee had incurred notional loss. In fact, during the course of proceedings, the Commissioner of Income-tax (Appeals) found that during the A.Ys. 1995-96 and 1996-97 the assessee had earned profits which stood taxed by the Department. He further found that one co-venturer (ONGC) had gained Rs.293.73 crores during the A.Y. 1997-98 because the Indian rupee had appreciated as compared to foreign currency and the Department had taxed the same, but when during the assessment year in question there is a loss on account of such conversion, the Department has refused to allow the deduction for such conversion losses. According to the Commissioner of Incometax (Appeals), the Department cannot blow hot and cold. Consequently, it was held that just as the foreign exchange gain was taxable, loss was allowable u/s.42(1) of the Income-tax Act in terms of the PSC. Therefore, the Commissioner of Income-tax (Appeals) allowed as deduction, the loss of Rs. 38,63,38,980.
Aggrieved by the order passed by the Commissioner of Income-tax (Appeals), the Department carried the matter in appeal to the Income-tax Appellate Tribunal objecting to the deletion made by the Commissioner of Income-tax (Appeals) on the ground that the loss was only a book entry. Before the Tribunal the matter pertained to the A.Ys. 1999-2000, 1998- 99, 2000-01 and 1996-97. However, for the sake of convenience, the Tribunal focussed its attention on the facts and figures given for the A.Y. 1999-2000. Before the Tribunal, the Department contended that the assessee borrows in USD and repays in the same currency for the preparation of the balance sheet. The loans, according to the Department, were stated at prevalent exchange rates and the loss arrived at was charged to the profit and loss account. Therefore, according to the Department, the said loss was a book entry and it was not an actual loss in foreign exchange caused to the assessee. This argument of the Department was rejected by the Tribunal. It was held that the assessee was a foreign company. It carried out business activity in India. It had to maintain its accounts in rupees for the purpose of income-tax, that the PSC had to be read with S. 42(1) of the Income-tax Act, which entitled the assessee to claim conversion loss as deduction, particularly when the said PSC provided for realised and unrealised gains/losses from the exchange currency. According to the Tribunal, the assessee was maintaining its accounts in rupees and such accounts had to reflect the loan liability under consideration as the loan had been taken for the Indian activity. Therefore, according to the Tribunal, the liability arising as a consequence of depreciation of the rupee had to be considered both for accounting and tax purposes. Accordingly, the Tribunal refused to interfere with the findings returned by the Commissioner of Income-tax (Appeals).
The above concurrent finding stood confirmed by the judgment delivered by the Uttarakhand High Court.
On further appeal, the Supreme Court observed that the only question which needed consideration was whether the assessee was entitled to claim deduction for foreign exchange losses on account of foreign currency translation. In other words, whether loss arising on account of foreign currency translation is allowable deduction or not and conversely whether the gains on account of foreign currency translation is to be treated as a receipt liable to tax. Analysing the provisions of S. 42(1), the Supreme Court held that it was clear that the said Section was a special provision for deductions in the case of business of prospecting, extraction/production of mineral oils. S. 42(1) provides for admissibility in respect of three types of allowances provided they are specified in the PSC. They relate to expenditure incurred on account of abortive exploration, expenditure incurred before or after the commencement of commercial production in respect of drilling or exploration activities and expenses incurred in relation to depletion of mineral oil in the mining area. If one reads S. 42(1) carefully, it becomes clear that the above three allowances are admissible only if they are so specified in the PSC.
Accordingly, the Supreme Court noted that the PSC in question provided for both capital and revenue expenditures. It also provided for a method in which the said expenses had to be accounted for. The Supreme Court held that the said PSC was an independent accounting regime which included tax treatment of costs, expenses, incomes, profits, etc. It prescribed a separate rule of accounting. In normal accounting, in the case of fixed assets, generally when currency fluctuation results in an exchange loss, addition is made to the value of the asset for depreciation. However, under the PSC, instead of increasing the value of expenditure incurred on account of currency variation in the expenses itself, EOGIL was required to book losses separately. The said PSC prescribed a special manner of accounting which was at variance with the normal accounting standards. The said ‘PSC accounting’ obliterated the difference between capital and revenue expenditure. It made all kinds of expenditure chargeable to the profit and loss account without reference to their capital or revenue nature. But for the PSC accounting there would have been disputes as to whether the expenses were of revenue or capital nature. In view of the special accounting procedure prescribed by the PSC, Accounting Standard 11 had to be ruled out.
The Supreme Court observed that Appendix C prescribed the manner in which a contractor is required to maintain his accounts. It stipulated that each of the co-venturers had to follow the computation of Income-tax under the 1961 Act. Clause 1.6.1. of appendix C referred to currency exchange rates. It stated that for translation purposes between USD and INR, the previous month’s average of the daily means of buying and selling rates of exchange as quoted by SBI shall be used for the month in which revenue, costs, expenditure, receipts or incomes are recorded. The Supreme Court therefore, held that clause 1.6.1 of appendix C provided for translation. The Supreme Court noted that subsequent to the award of the concession, EOGIL along with RIL and ONGC executed the PSC with the Government of India. Under the said PSC, each co-venturer remitted money, known as cash call to the bank account of the operator in the USA. The expenditure for the joint venture was made out of the said account. The trial balance was required to be prepared at the end of the month in USD, which was then required to be translated on the basis of accounting procedure mentioned in Appendix C to the PSC. The Supreme Court held that the cash call in other words was not a loan. Cash call was a contribution. It was made by each co-venturer at a certain rate, whereas the expenditure against it had to be converted on the basis of the exchange rates as provided for in the PSC, which stated that the same had to be converted on the basis of the previous month’s average of the daily means of buying and selling rates of exchange. The above analysis showed that the capital contribution had to be converted under the PSC at one rate, whereas the expenditure had to be converted at a different rate. This exercise resulted in loss/ profit on conversion. Under the PSC, the respondent had to convert revenue, costs, receipts and incomes. If EOGIL had a choice to prepare its accounts only in USD, there would have been no loss/profit on account of currency translation. It is because of the specific provision in the PSC for currency translation that loss/profit accrued to EOGIL. The Supreme Court further held that in the PSC, the foreign company provides the capital investment and cost and the first proportion of oil extracted is generally allocated to the company which uses oil sales to recoup its costs and capital investment. The oil used for that purpose is termed ‘cost oil’. Often a company obtains profit not just from the ‘profit oil’, but also from the ‘cost oil’. Such profits cannot be ascertained without taking into account translation losses. Moreover, taxes are embedded in the profit oil. If these concepts are kept in mind, then it cannot be said that ‘translation losses’ under the PSC are illusory losses.