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IN THE SUPREME COURT OF INDIA  

CIVIL APPELLATE JURISDICTION

CIVIL APPEAL No.  2206 OF 2009 (arising out of S.L.P.(C) No. 593 of 2008)

Commissioner of Income Tax, Delhi … Appellant (s)

                   versus

M/s Woodward Governor India P. Ltd. … Respondent(s)

with  

CIVIL APPEAL No. 2214  OF 2009 (arising out of S.L.P.(C) No. 7632 of 2008)

Commissioner of Income Tax, Delhi … Appellant (s)

                   versus

M/s Honda Siel Power Products Ltd. … Respondent(s)

with

Civil Appeal No. 2212 /09 @ SLP (C) No. 4708/08   Civil Appeal No. 2207/09 @ SLP (C) No. 18967/08

Civil Appeal No. 2213/09 @ SLP (C) No. 6911/08 Civil Appeal No. 2226 /09 @ SLP (C) No. 6321/09

Civil Appeal No. 2215/09 @ SLP (C) No. 24601/08 Civil Appeal No. 2210/09 @ SLP (C) No. 2159/09

 Civil Appeal No. 2235/09 @ SLP (C) No. 25893/08 Civil Appeal No.  2208/09 @ SLP (C) No. 1300/09 Civil Appeal No.  2209/09 @ SLP (C) No. 1297/09

                               Civil Appeal No. 2211/09 @ SLP (C) No. 850/09 Civil Appeal No. 2216/09 @ SLP (C) No. 4752/09  Civil Appeal No. 2217/09 @ SLP (C) No. 8924/08  Civil Appeal No. 2218/09 @ SLP (C) No. 9819/08

  Civil Appeal No. 2219/09 @ SLP (C) No. 14194/08    Civil Appeal No. 2220/09 @ SLP (C) No. 14199/08    Civil Appeal No. 2221/09 @ SLP (C) No. 16124/08

                                Civil Appeal No. 2222/09 @ SLP (C) No. 2155/09     Civil Appeal No. 2223/09 @ SLP (C) No. 16086/08

                                Civil Appeal No. 2224/09 @ SLP (C) No. 899/09                                  Civil Appeal No. 2225/09 @ SLP (C) No. 5013/09

 Civil Appeal No. 2227/09 @ SLP (C) No. 11516/08

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Civil Appeal No.2228/09 @ SLP (C) No. 11534/08 Civil Appeal No. 2229/09 @ SLP (C) No. 11530/08 Civil Appeal No. 2230/09 @ SLP (C) No. 11517/08 Civil Appeal No. 2231/09 @ SLP (C) No. 11524/08 Civil Appeal No. 2232/09 @ SLP (C) No. 11535/08 Civil Appeal No.2233/09 @ SLP (C) No. 11518/08 Civil Appeal No. 223409 @ SLP (C) No. 11523/08

      Civil Appeal No. 2237/09 @ SLP (C) No. 8718 /09 (CC No. 2868/09)       Civil Appeal No. 2236/09 @ SLP (C) No. 8717/09 (CC No. 3007/09)      Civil Appeal No. 2238/09 @ SLP (C) No. 8719 /09 (CC No. 1999/09)

J U D G M E N T

S.H. KAPADIA, J.

Delay condoned.

2. Leave granted.

3. In  this  batch  of  civil  appeals,  the  following  question  arises  for

determination:

(i) Whether, on the facts and circumstances of the case and in law, the

additional liability arising on account of fluctuation in the rate of

exchange in respect of loans taken for revenue purposes could be

allowed as deduction under Section 37(1) in the year of fluctuation

in the rate of exchange or whether the same could only be allowed

in the year of repayment of such loans?

(ii) Whether  the  assessee  is  entitled  to  adjust  the  actual  cost  of

imported  assets  acquired  in  foreign  currency  on  account  of

fluctuation  in  the  rate  of  exchange  at  each  balance  sheet  date,

pending actual payment of the varied liability?

4. At the outset, for the sake of convenience, we may state that in this batch

of civil appeals broadly we have before us two categories. In the first category, we

are concerned with exchange differences arising in foreign currency transaction on

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revenue items. In such category, we are concerned with the assessee(s) incurring loss

on  revenue  account.  In  that  category,  we  are  concerned  with  the  provisions  of

Sections 28,  29,  37(1) and 145 of the Income-tax Act,  1961 (“1961 Act”).  In the

second category of cases,  we are concerned with exchange differences arising on

repayment of liabilities incurred for the purpose of acquiring fixed assets. In other

words,  in  the  second  category  of  cases,  we  are  concerned  with  the  assessee(s)

incurring liabilities on capital account. In such cases, we are required to consider

the  provisions  of  Section  43(1),  43A  (both,  before  and  after  Amendment  vide

Finance Act, 2002).  

Facts in M/s Woodward Governor India P. Ltd.  [Civil Appeal arising out of SLP(C) No. 593/08]  –   REVENUE ACCOUNT CASE:   

5. The assessee filed its Return of Income on 28.1.1998 for the assessment

year 1998-99 on a total income of Rs.  1,10,28,190.00.  That return was processed

under Section 143(1)(a) on 23.3.1999. On 16.8.1999 a notice under Section 143(2)

was issued to the assessee stating that in the course of assessment proceedings under

Section 143 it was noticed by the Department that the assessee had debited to its

Profit  &  Loss  Account  a  sum  of  Rs.  41,06,746.00  out  of  which  a  sum  of  Rs.

29,49,088.00 was the unrealized loss due to foreign exchange fluctuation on the last

date of the accounting year. The AO held that the liability as on the last date of the

previous  year  under  consideration  was  a  contingent  liability,  it  was  not  an

ascertained liability and consequently it had to be added back to the total income of

the assessee. Accordingly, he added back Rs. 29,49,088.00 being the unrealized loss

due to foreign exchange fluctuation.  In other words, the debit to the P&L account

was disallowed. This order of the AO was upheld by the CIT(A) vide decision dated

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29.11.2001.  Being  aggrieved,  the  assessee  went  in  appeal  to  the  Tribunal.  By

judgment and order dated 1.4.2005 the Tribunal relying on its earlier decision in the

case of M/s Woodward Governor India P. Ltd. for the assessment years 1995-96,

1996-97 and 1997-98 held that the claim of the assessee for deduction of unrealized

loss due to foreign exchange fluctuation as on the last date of the previous year had

to  be allowed.  This decision of the Tribunal has  been upheld by the Delhi  High

Court vide the impugned judgment dated 30.4.2007, hence, this Civil Appeal is filed

by the Department.

6. Shri Parag Tripathi, learned Additional Solicitor General, appearing on

behalf  of  the  Department  submitted  that,  in  this  case,  the  assessee(s)  claims

deduction under Section 37, which is a residuary provision, as there is no specific

provision dealing with adjustment based on foreign exchange fluctuations on the

Revenue account (akin to Section 43A, which deals with such adjustments in the

Capital  account).  According  to  the  learned  counsel,  the  essence  of  deductibility

under Section 37 is that the increase in liability due to foreign exchange fluctuations

must  fulfill  the  twin  requirements  of  “expenditure”  and  the  factum  of  such

expenditure having been “laid out or expended”. According to the learned counsel,

the expression “expenditure” is “what is paid out” and “something which is gone

irretrievably”. In this connection, learned counsel placed reliance on the judgment

of this Court in the case of Indian Molasses Co. (Private) Ltd.  v.  CIT reported in

37 ITR 66. According to the learned counsel, the increase in liability at any point of

time prior to payment cannot fall within the meaning of the word “expenditure” in

Section  37(1).  Therefore,  according  to  the  learned  counsel,  the  requirement  of

expenditure is not met in this case. According to the learned counsel, similarly the

requirement of money being “expended or laid out” is also not satisfied and thus

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additional liability arising on account of fluctuation in foreign exchange rate is not

deductible under Section 37(1).

7. Shri C.S. Aggarwal, learned senior counsel appearing for                  M/s

Woodward  Governor  India  P.  Ltd.  (Civil  Appeal  arising  out  of  S.L.P.(C)  No.

593/08), submitted that the assessee had debited a sum of    Rs. 41,06,748.00 to its

P&L account of which a sum of Rs. 29,49,088.00 stood for the unrealized loss due to

foreign exchange fluctuation. According to the learned counsel, the assessee has been

following mercantile system of accounting. According to the learned counsel, under

mercantile  system  of  accounting,  which  is  also  known  as  accrual  system  of

accounting, whenever the amount is credited to the account of the payee (creditor)

liability stands incurred by the assessee even though the amount is actually not paid.

In this connection,  learned counsel placed reliance on the definition of the word

“paid” in Section 43(2). According to the learned counsel, in the past in some years

when the value of the rupee becomes stronger vis-à-vis US$, the Department had

taxed the  gains  as  income.  Therefore,  according  to  the  learned counsel,  when  it

comes to “income”, the Department says that accrual is enough for taxability and

“payment”  is  irrelevant  but  when  it  comes  to  “loss”,  the  Department  says  that

“payment” alone is relevant for taxability. According to the learned counsel, such

double  standards  cannot  be  countenanced.  Learned  counsel  further  gave  the

following example in support of his contentions:

1.  Where amount is borrowed and used in business:

2. The liability thus was, since by way of loan, the increased liability of

Rs.  500/-  was  towards  business  increased  by  Rs.  500/-  which  resulted  into

business  loss  as  a  result  of  modification  of  existing  liability.  Likewise  if  on

fluctuation, the dollar rate is reduced to Rs. 32/- per dollar, the liability will get

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reduced by Rs. 300/- and there would be a business gain of Rs. 300/-.

8. In the light of the above illustration, learned counsel urged that when the

assessee(s) borrows 100 US$ on 1.4.1999 he incurs a crystallised liability, however,

the value of that liability undergoes a change by 31.3.2000 on account of the fall in

the rupee value. In other words, the rate of exchange fluctuated from Rs. 35 per

dollar as  on  1.4.1999  to  Rs.  40  per dollar as  on  31.3.2000,  thus,  increasing  the

liability of the assessee by       Rs.500. According to the learned counsel, the assessee

was entitled therefore to deduction under Section 37(1) for such enhanced liability.

Similarly, if the dollar rate had reduced from Rs. 35 to Rs. 32 per dollar, then the

assessee’s liability would stand reduced by Rs. 300 and there would be a gain of Rs.

300 which would become taxable. From this hypothetical example, learned counsel

urged that the liability stood incurred on the date on which the assessee borrows 100

$ which in the above example is 1.4.1999, however, on account of fluctuation in the

dollar rate, the liability may enhance or may reduce by 31.3.2000. This has to be

taken  into  account  by  the  Department.  The  learned  counsel  submitted  that

whenever the dollar rate stood reduced, the Department has taxed in the past the

business gains, therefore, as a corollary, the Department has to allow deduction in

the year in which the assessee incurs business loss on account of the increase in the

dollar rate.  Therefore,  according to  the  learned counsel,  there is no warrant for

interfering in the impugned judgment of the High Court.

9. Shri S. Ganesh, learned senior counsel appearing for M/s Maruti Udyog

Ltd.  (Civil  Appeal  arising  out  of  SLP (C)  No.  18967/08),  adopted  the  argument

advanced by Shri C.S. Aggarwal. In addition, he pointed out that the assessee had

maintained  its  accounts  right  from  1985  on  accrual  system  of  accounting.  He

submitted that  during the assessment years 1985-86 to 1989-90 loss claimed was

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allowed. It was pointed out on facts that the assessee borrowed loans in dollar and

yen. It was pointed out that in the assessment year 1990-91, the dollar rate stood

increased but the yen rate stood reduced resulting in gain,  which was offered as

income and which was accordingly taxed. But when it came to the year in question,

namely,  assessment  year 1991-92,  in  which  year there was  a  loss on  account  of

fluctuation in the foreign exchange rate, the Department has taken a contradictory

stand that accrual of liability is irrelevant and that the year of payment/repayment

is relevant. The point which the learned counsel made was that having accepted the

system of accounting undertaken by the assessee, it was not open to the Department

to  introduce  a  new system of  accounting.  According to  the  learned counsel,  the

liability  to  repay the  loan in  US$ or in yen accrues the moment  the  contract  is

entered into. It has nothing to do with the time of payment/repayment. According to

the  learned counsel,  the  date  of payment  has  nothing  to do  with  the  accrual  of

liability.  According  to  the  learned  counsel,  at  the  end  of  the  accounting  year,

namely,  31.3.1991  the  assessee  had  to  value  the  liability  which  it  had  incurred

during the accounting year in question. He urged that Section 145 of the Income-tax

Act, 1961 ties down the AO to the Accounting System followed by the assessee in the

past which accounting system has been accepted by the Department over the years

and if the AO seeks to introduce a new system of accounting he has to give reasons

in his order pointing out defects in the existing accounting system. Learned counsel

pointed out that,  in this case, there is no such finding.  According to the learned

counsel, valuation of asset and liability is a matter of accounting system. The AO

cannot depart from the existing accounting system without giving reasons for such

departure.  According  to  the  learned  counsel,  the  existence  of  liability  stands

crystallized on the  date  of the  contract.  It  has  nothing to  do with  payment  and

valuation of liability at a later date. According to the learned counsel, the income of

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the  assessee  is  decided  only  in  terms  of  the  system  of  accounting.  Therefore,

according to the learned counsel, in the facts of the case in M/s Maruti Udyog Ltd.,

the overall loss suffered by the assessee cannot be disallowed on the ground that

such  loss  has  occurred  on  account  of  fluctuation  in  the  foreign  exchange  rate.

According to the learned counsel, for the above reasons, there is no need to interfere

in the impugned judgment.  

10. As stated above, on facts in the case of M/s Woodward Governor India P.

Ltd., the Department has disallowed the deduction/debit to the P&L account made

by the assessee in the sum of Rs. 29,49,088.00 being  unrealized loss due to foreign

exchange fluctuation. At the very outset, it may be stated that there is no dispute

that in the previous years whenever the dollar rate stood reduced, the Department

had taxed the gains which accrued to the assessee on the basis of accrual and it is

only in the year in question when the dollar rate stood increased, resulting in loss

that the Department has disallowed the deduction/debit. This fact is important. It

indicates the double standards adopted by the Department.

11. The dispute in this batch of civil appeals centers around the year(s) in

which deduction would be admissible for the increased liability under Section 37(1).

12. We quote hereinbelow Section 28(i), Section 29 Section 37(1) and Section

145 of the 1961 Act,  which read as follows:

Profits and gains of business or profession:

Section 28 :

“The following income shall be chargeable to income-tax under the head "Profits and gains of business or profession", -

(i) the  profits  and  gains  of  any  business  or  profession

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which  was  carried  on  by  the  assessee  at  any  time  during  the previous year.”   Income  from profits  and  gains  of  business  or  profession,  how computed:

Section 29:  

“The  income  referred  to  in  section  28  shall  be  computed  in accordance with the provisions contained in sections 30 to 43D.”

General:

Section 37 :

“(1) Any  expenditure (not being expenditure of the nature described  in  sections  30  to  36  and  not  being  in  the  nature  of capital expenditure or personal expenses of the assessee), laid out or  expended  wholly  and  exclusively for  the  purposes  of  the business or profession shall be allowed in computing the income chargeable  under  the  head  "Profits  and  gains  of  business  or profession".  

Explanation.- For the removal of doubts, it is hereby declared that any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no  deduction  or  allowance  shall  be  made  in  respect  of  such expenditure.”  

(emphasis supplied) Method of Accounting:

Section 145:  

“(1) Income chargeable under the head "Profits and gains of business or profession" or "Income from other sources" shall, subject  to  the  provisions  of  sub-section  (2),  be  computed  in accordance with either cash or mercantile system of accounting regularly employed by the assessee.  

(2) The  Central  Government  may  notify  in  the  Official Gazette from time to time accounting standards to be followed by any class of assessees or in respect of any class of income.  

(3)  Where the Assessing Officer is not satisfied about the correctness or completeness of  the  accounts  of  the  assessee,  or where the method of accounting provided in sub-section (1)  or accounting standards as notified under sub-section (2), have not been regularly followed by the assessee, the Assessing Officer may make an assessment in the manner provided in section 144.”

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13. As stated  above,  one  of  the  main arguments  advanced by  the  learned

Additional Solicitor General on behalf of the Department before us was that  the

word “expenditure” in Section 37(1) connotes “what is paid out” and that which has

gone irretrievably. In this connection, heavy reliance was placed on the judgment of

this  Court in the case of Indian Molasses Company (supra).  Relying on the said

judgment, it was sought to be argued that the increase in liability at any point of

time prior to the date of payment cannot be said to have gone irretrievably as it can

always  come back.  According  to  the  learned counsel,  in  the  case  of  increase  in

liability due to foreign exchange fluctuations, if there is a revaluation of the rupee

vis-à-vis foreign exchange at or prior to the point of payment, then there would be

no question of money having gone irretrievably and consequently, the requirement

of “expenditure” is not met. Consequently, the additional liability arising on account

of  fluctuation  in  the  rate  of  foreign  exchange  was  merely  a  contingent/notional

liability which does not crystallize till payment. In that case, the Supreme Court was

considering  the  meaning  of  the  expression “expenditure  incurred” while  dealing

with the question as to whether there was a distinction between the actual liability in

presenti and a liability de futuro. The word “expenditure” is not defined in the 1961

Act. The word “expenditure” is, therefore, required to be understood in the context

in which it is used. Section 37 enjoins that any expenditure not being expenditure of

the  nature  described  in  Sections  30  to  36  laid  out  or  expended   wholly  and

exclusively for the  purposes of the business  should be allowed in  computing  the

income chargeable under the head “profits and gains of business”. In Sections 30 to

36, the expressions “expenses incurred” as well as “allowances and depreciation” has

also been used. For example, depreciation and allowances are dealt with in Section

32. Therefore,  Parliament has used the expression “any expenditure” in Section 37

to cover both. Therefore, the expression “expenditure” as used in Section 37 may, in

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the circumstances of a particular case, cover an amount which is really a “loss” even

though the said amount has not gone out from the pocket of the assessee.

14. In the case of M.P. Financial Corporation v. CIT reported in 165 ITR 765

the Madhya Pradesh High Court has held that the expression “expenditure” as used

in Section 37 may, in the circumstances of a particular case, cover an amount which

is a “loss” even though the said amount has not gone out from the pocket of the

assessee. This view of the Madhya Pradesh High Court has been approved by this

Court  in  the  case  of  Madras  Industrial  Investment  Corporation  Ltd.   v.   CIT

reported in  225 ITR 802.  According to the  Law and Practice  of  Income  Tax  by

Kanga and Palkhivala, Section 37(1) is a residuary section extending the allowance

to  items of business expenditure not  covered by  Sections 30 to  36.  This Section,

according to the learned Author, covers cases of business expenditure only, and not

of  business  losses which  are,  however,  deductible  on  ordinary  principles  of

commercial accounting. (see page 617 of the eighth edition). It is this principle which

attracts the provisions of Section 145. That section recognizes the rights of a trader

to  adopt  either  the  cash  system  or  the  mercantile  system  of  accounting.  The

quantum  of  allowances  permitted  to  be  deducted  under  diverse  heads  under

Sections 30 to 43C from the income, profits and gains of a business would differ

according to the system adopted.  This is made clear by defining the word “paid” in

Section 43(2), which is used in several Sections 30 to 43C, as meaning actually paid

or incurred according to the method of accounting upon the basis on which profits

or gains are computed under Section 28/29.  That is why in deciding the question as

to whether the word “expenditure” in Section 37(1) includes the word “loss” one has

to  read Section 37(1)  with Section  28,  Section  29 and Section 145(1).  One more

principle needs to be kept in mind. Accounts regularly maintained in the course of

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business are to be taken as correct unless there are strong and sufficient reasons to

indicate that they are unreliable. One more aspect needs to be highlighted. Under

Section 28(i),  one needs to decide the profits and gains of any business which is

carried on by the assessee during the previous year. Therefore, one has to take into

account  stock-in-trade  for  determination  of  profits.  The  1961  Act  makes  no

provision  with  regard  to  valuation  of  stock.  But  the  ordinary  principle  of

commercial accounting requires that in the P&L account the value of the stock-in-

trade at the beginning and at the end of the year should be entered at cost or market

price, whichever is the lower. This is how business profits arising during the year

needs  to  be  computed.  This  is  one  more reason  for reading  Section  37(1)  with

Section 145. For valuing the closing stock at the end of a particular year, the value

prevailing on the last date is relevant. This is because profits/loss is embedded in the

closing stock. While anticipated loss is taken into account, anticipated profit in the

shape of appreciated value of the closing stock is not brought into account,  as no

prudent trader would care to show increase profits before actual realization. This is

the theory underlying the Rule that closing stock is to be valued at cost or market

price, whichever is the lower. As profits for income-tax purposes are to be computed

in  accordance  with  ordinary  principles  of  commercial  accounting,  unless,  such

principles stand superseded or modified by legislative enactments, unrealized profits

in  the  shape  of  appreciated  value  of  goods  remaining  unsold  at  the  end  of  the

accounting year and carried over to the following years account  in a continuing

business are not brought to the charge as a matter of practice, though,  as stated

above, loss due to fall in the price below cost is allowed even though such loss has not

been realized actually. At this stage, we need to emphasise once again that the above

system  of  commercial  accounting  can  be  superseded  or  modified  by  legislative

enactment.  This is where Section 145(2) comes into play.  Under that  section, the

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Central  Government  is  empowered  to  notify  from time  to  time  the  Accounting

Standards to  be followed by any class of  assessees or in  respect  of  any  class of

income. Accordingly, under Section 209 of the Companies Act, mercantile system of

accounting is made mandatory for companies. In other words, accounting standard

which  is  continuously adopted by an assessee can be superseded or modified by

Legislative intervention. However, but for such intervention or in cases falling under

Section 145(3), the method of accounting undertaken by the assessee continuously is

supreme. In the present batch of cases, there is no finding given by the AO on the

correctness or completeness of  the  accounts  of  the  assessee.  Equally,  there is  no

finding  given  by  the  AO  stating  that  the  assessee  has  not  complied  with  the

accounting standards.

15. For the reasons given hereinabove, we hold that, in the present case, the

“loss” suffered by the assessee on account of the exchange difference as on the date

of the balance sheet is an item of expenditure under Section 37(1) of the 1961 Act.

16. In the light of what is stated hereinabove, it is clear that profits and gains

of the previous year are required to be computed in accordance with the relevant

accounting standard. It is important to bear in mind that the basis on which stock-

in-trade is valued is part of the method of accounting. It is well established, that, on

general principles of commercial accounting, in the P&L account, the values of the

stock-in-trade at  the beginning and at the end of the accounting year should be

entered  at  cost  or  market  value,  whichever  is  lower  –  the  market  value  being

ascertained as on the last date of the accounting year and not as on any intermediate

date between the commencement and the closing of the year, failing which it would

not be possible to ascertain the true and correct state of affairs. No gain or profit can

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arise until a balance is struck between the cost of acquisition and the proceeds of

sale. The word “profit” implies a comparison between the state of business at two

specific dates, usually separated by an interval of twelve months. Stock-in-trade is

an asset. It is a trading asset. Therefore, the concept of profit and gains made by

business during the year can only materialize when a comparison of the assets of the

business at two different dates is taken into account. Section 145(1) enacts that for

the purpose of Section 28 and Section 56 alone, income, profits and gains must be

computed in accordance with the method of accounting regularly employed by the

assessee. In this case, we are concerned with Section 28. Therefore, Section 145(1) is

attracted to the facts of the present case. Under the mercantile system of accounting,

what is due is brought into credit before it is actually received; it brings into debit

an expenditure for which a legal liability  has  been incurred before it  is  actually

disbursed. (see judgment of this Court in the case of United Commercial Bank v.

CIT reported in 240 ITR 355).  Therefore, the accounting method followed by an

assessee continuously for a given period of time needs to be presumed to be correct

till the AO comes to the conclusion for reasons to be given that the system does not

reflect true and correct profits. As stated, there is no finding given by the AO on the

correctness of the accounting standard followed by the assessee(s) in this batch of

Civil Appeals.

17. Having come to the conclusion that valuation is a part of the accounting

system and having come to the conclusion that business losses are deductible under

Section  37(1)  on  the  basis  of  ordinary principles  of  commercial  accounting  and

having come to the conclusion that the Central Government has made Accounting

Standard-11  mandatory,  we  are  now  required  to  examine  the  said  Accounting

Standard (“AS”).

15

18. AS-11 deals with giving of accounting treatment for the effects of changes

in foreign exchange rates. AS-11 deals with effects of Exchange Differences. Under

para 2, reporting currency is defined to mean the currency used in presenting the

financial statements.  Similarly, the words “monetary items” are defined to mean

money held and assets and liabilities to be received or paid in fixed amounts, e.g.,

cash, receivables and payables. The word “paid” is defined under Section 43(2). This

has been discussed earlier. Similarly, it is important to note that foreign currency

notes,  balance  in  bank  accounts  denominated  in  a  foreign  currency,  and

receivables/payables and loans denominated in a foreign currency as well as sundry

creditors are all monetary items which have to be valued at the closing rate under

AS-11. Under para 5, a transaction in a foreign currency has to be recorded in the

reporting currency by applying to the foreign currency amount the exchange rate

between  the  reporting  currency  and  the  foreign  currency  at  the  date  of  the

transaction. This is known as recording of transaction on Initial Recognition. Para 7

of AS-11 deals with reporting of the effects of changes in exchange rates subsequent

to  initial  recognition.  Para 7(a)  inter  alia states that  on each balance sheet  date

monetary items, enumerated above, denominated in a foreign currency should be

reported using the closing rate. In case of revenue items falling under Section 37(1),

para 9 of AS-11 which deals with recognition of exchange differences, needs to be

considered.  Under  that  para,  exchange  differences  arising  on  foreign  currency

transactions have to be recognized as income or as  expense in the period in which

they  arise,  except  as  stated  in  para 10  and  para 11  which  deals  with  exchange

differences arising on repayment of liabilities incurred for the purpose of acquiring

fixed assets, which topic falls under Section 43A of the 1961 Act. At this stage, we

are concerned only with para 9 which deals with revenue items. Para 9 of AS-11

16

recognises exchange differences as income or expense. In cases where, e.g., the rate

of dollar rises vis-à-vis the Indian rupee, there is an expense during that period. The

important point to be noted is that AS-11 stipulates effect of changes in exchange

rate vis-à-vis monetary items denominated in a foreign currency to be taken into

account for giving accounting treatment on the balance sheet date.  Therefore, an

enterprise has to report the outstanding liability relating to import of raw materials

using closing rate of exchange. Any difference, loss or gain, arising on conversion of

the said liability at the closing rate, should be recognized in the P&L account for the

reporting period.

19. A company imports raw material worth US $ 250000 on 15.1.2002 when

the exchange rate was Rs. 46 per US $. The company records the transaction at that

rate. The payment for the imports is made on 15.4.2002 when the exchange rate is

Rs. 49 per US $. However, on the balance sheet date, 31.3.2002, the rate of exchange

is Rs. 50 per US $. In such a case, in terms of AS-11, the  effect of the exchange

difference has to be taken into P&L account.  Sundry creditors is a monetary item

and hence such item has to be valued at the closing rate, i.e. Rs. 50 at 31.3.2002,

irrespective of the payment for the sale subsequently at a lower rate. The difference

of Rs. 4 (50-46) per US $ is to be shown as an exchange loss in the P&L account and

is not to be adjusted against the cost of raw materials.

20. In the case of Sutlej Cotton Mills Ltd.  v.  CIT reported in 116 ITR 1 this

Court has observed as under:

“The law may,  therefore,  now be  taken to be  well  settled that  where profit  or  loss  arises  to  an  assessee  on  account  of  appreciation  or depreciation in the value of foreign currency held by it,  on conversion into another currency, such profit or loss would ordinarily be a trading profit or loss if the foreign currency is held by the assessee on revenue

17

account or as a trading asset or as a part of circulating capital embarked in the business. But, if on the other hand, the foreign currency is held as a capital asset or as fixed capital, such profit or loss would be of capital nature.”

                                                                      (emphasis supplied)

21. In conclusion, we may state that in order to find out if an expenditure is

deductible the following have to be taken into account (i)  whether the system of

accounting followed by the assessee is mercantile system, which brings into debit the

expenditure amount for which a legal liability has been incurred before it is actually

disbursed and brings into credit what is due, immediately it becomes due and before

it is actually received; (ii) whether the same system is followed by the assessee from

the very beginning and if there was a change in the system, whether the change was

bona fide; (iii) whether the assessee has given the same treatment to losses claimed

to have accrued and to the gains that may accrue to it; (iv) whether the assessee has

been consistent and definite in making entries in the  account books in respect of

losses and gains; (v) whether the method adopted by the assessee for making entries

in  the  books  both  in  respect  of  losses  and  gains  is  as  per  nationally  accepted

accounting standards; (vi) whether the system adopted by the assessee is fair and

reasonable or is adopted only with a view to reducing the incidence of taxation.

Facts in M/s Honda Siel Power Products Ltd.  [Civil Appeal arising out of SLP(C) No. 7632/08]  –   CAPITAL ACCOUNT CASE:   

22. The  main  issue  which  arises  for  determination  in  this  batch  of  civil

appeals is: whether the assessee was entitled to adjust the actual cost of imported

assets acquired in foreign currency on account of fluctuation in the rate of exchange

at each balance sheet date pending actual payment of the varied liability. In this

batch of civil appeals, we are concerned with increase in the existing liability on

18

account of foreign exchange fluctuations on “capital account”.

23. Before coming to the arguments, we quote hereinbelow Section 43A, as it

stood prior to 1.4.2003:

“43A. Special provisions consequential to changes in rate of exchange of  currency—(1)  Notwithstanding  anything  contained  in  any  other provision of this Act, where an assessee has acquired any asset from a country outside India for the purposes of his business or profession and, in consequence of a change in the rate of exchange at any time after the acquisition of such asset, there is an increase or reduction in the liability of  the  assessee  as  expressed in  Indian  currency  for making  payment towards the whole or a part of the cost of the asset or for repayment of the 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  (being  in  either  case  the  liability  existing immediately before the date on which the change in the rate of exchange takes effect), the amount by which the liability aforesaid is so increased or reduced during the previous year shall be added to,  or, as the case may be, deducted from, the actual cost of the asset as defined in clause (1)  of  section  43  or  the  amount  of  expenditure  of  a  capital  nature referred to in clause (iv) of sub-section (1) of section 35 or in section 35A or in clause (ix) of sub-section (1) of section 36, or, in the case of a capital asset  (not  being  a  capital  asset  referred to  in  section 50),  the  cost  of acquisition  thereof  for  the  purposes  of  section  48,  and  the  amount arrived at after such addition or deduction shall be taken to be the actual cost of the asset or the amount of expenditure of a capital nature or, as the case may be, the cost of acquisition of the capital asset as aforesaid.”

24. We also quote hereinbelow Section 43A, as it stands in the Statute book

after substitution by the Finance Act 2002 w.e.f. 1.4.2003:

“43A. Notwithstanding anything contained in any other provision of the Act, where an assessee has acquired any asset in any previous year from  a  country  outside  India  for  the  purposes  of  his  business  or profession  and,  in  consequence  of  a  change  in  the  rate  of  exchange during any previous year after the acquisition of such asset, 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.”                                                         (emphasis supplied)

25. We also quote hereinbelow provisions of Section 43(1):

“43. In sections 28 to 41 and in this  section,  unless the context otherwise requires –

19

(1) “actual cost” means the actual cost of the assets to the assessee, reduced by that portion of the cost thereof, if any, as has been met directly or indirectly by any other person or authority.”

26. Shri Parag Tripathi,  learned Additional Solicitor General appearing on

behalf of the Department, submitted that in Section 43A (as it stood prior to Finance

Act,  2002)  the expression “for making payment”  is  in  the  context  of increase or

decrease of liability and the same hinges on “making the payment towards the whole

or a part  of  …”.  According to  the  learned counsel,  the  expression “towards the

whole or a part of” makes it clear that Section 43A as it stood referred to whole or a

part of the payment and therefore to the point of payment.  According to the learned

counsel, under the pre-amended Section 43A, the effect of increase or decrease of

liability arose only at the point of payment because the point of accrual shifted to the

point  of  payment.  In  this  connection,  learned  counsel  urged  that  the  difference

between accrual and payment of a liability is that normally the point of accrual and

the point of payment represent two different time milestones. However, according to

the learned counsel, in the case of a contingent liability, like that of foreign exchange

fluctuations,  the  point  of  accrual  and  the  point  of  payment  become  the  same.

According to the learned counsel, under the pre-amended dispensation of Section

43A, the effect of increase or decrease of liability could only arise at the point of

payment, as the point of accrual shifts to the point of payment.

27. Learned counsel next contended that on a proper and true interpretation

of the amendment to Section 43A, introduced by Finance Act, 2002, Section 43A is

clarificatory.  According to  the  learned counsel,  the  occasion  for the  clarificatory

amendment  arose  in  view  of  the  judgments  of  the  various  High  Courts,  which

interpreted the unamended provision as laying down the proposition that in case of

20

increase or decrease of liability due to foreign exchange fluctuations, the same is to

be  recognized  at  the  end  of  each  financial  year,  irrespective  of  whether  such

“incremental  liability”  had accrued and had been paid  or not.  According to  the

learned counsel, Section 43A, as amended, recognizes the fact that in case of foreign

exchange fluctuations,  the accrual of liability is co-terminus with the payment of

liability  and  therefore  the  amendment  to  Section  43A  is  clarificatory  and  not

amendatory, notwithstanding the fact that the amendment operates w.e.f. 1.4.2003.

28. In reply,  Shri  Ajay Vohra, learned counsel appearing on behalf of the

assessee, submitted that Section 43A (even prior to the amendment) was inserted to

provide for adjustment in the actual cost of assets pursuant to change in foreign

currency exchange rates. As a consequence of Section 43A (unamended), it became

possible to adjust to increase/decrease in liability relating to acquisition of capital

assets  on  account  of  exchange  rate  fluctuation,  in  the  actual  cost  of  the  assets

acquired in foreign currency and for depreciation to be allowed with reference to

such increased/decreased cost.  According to the learned counsel, the provisions of

Section 43A (unamended) are  pari materia  with para 10 of AS-11 which  inter alia

provides  for adjustment  in  the  carrying  cost  of  fixed assets  acquired  in  foreign

currency, due to foreign exchange fluctuation at  each balance sheet  date.  In this

connection, learned counsel has placed reliance on the judgment of this Court in the

case of CIT  v.  Arvind Mills Ltd. reported in 193 ITR 255.

29. To answer the controversy, we need to analyse Section 43A (unamended).

The period in question in the batch of Civil Appeals is prior to Finance Act, 2002,

therefore, we are required to consider the scope of Section 43A (unamended).

21

30. Section 43A starts with a non obstante clause. Section 43A(1) overrides the

other provisions only as regards cases falling under that sub-section. For instance, in

a case where the asset is acquired, or the liability to pay in foreign exchange arises,

after the change in the rate of exchange, the said sub-section has no application and

the general principles of law must be applied in deciding whether the actual cost is

increased or reduced as a  result of such change.  In other words,  Section 43A(1)

applies only where as a result of change in the rate of exchange there is an increase

or reduction in the liability of the assessee in terms of the Indian rupee to pay the

price of any asset  payable in  foreign exchange  or to  repay moneys borrowed in

foreign currency specifically for the purpose of acquiring the asset. Section 43A(1),

therefore, has no application unless the asset is acquired and the liability existed,

before the change in the rate of exchange takes effect. In such a case, Section 43A

contemplates recomputation of the cost of the assets for the purposes of depreciation

[Sections  32 and 43(1)],  and  also as  regards capital  assets for scientific  research

[Section 35(1)(iv)] and also regarding patent rights or copyrights [Section 35A].

31. As held in Arvind Mills case (supra) increase or decrease in liability in the

repayment  of foreign loan should be taken into  account  to  modify the  figure of

actual cost in the year in which the increase or decrease in liability arises on account

of the fluctuation in the rate of exchange. Thus, the adjustments in the actual cost

are to be made irrespective of the date of actual payment in foreign currency made

by  the  assessee.  This  position  also  finds  place  in  the  clarification  issued  by  the

Ministry of Finance dated 4.1.1967 which inter alia reads as under:

“2. The  Government  agrees  that  for  the  purposes  of  the calculation of depreciation allowance, the cost of capital assets imported before the date of devaluation should be written off to the extent of the full  amount  of  the  additional  rupee  liability  incurred  on  account  of devaluation  and  not  what  is  actually  paid  from year  to  year.  The

22

proposed legal provision in the matter is intended to be framed on this basis.”                                                              (emphasis supplied)

32. One more aspect needs to be mentioned. Section 43(1) defines actual cost

for the purpose of grant of depreciation etc. to mean “the actual cost of the assets to

the  assessee”.  Till  the  insertion  of  the  unamended  Section  43A  there  was  no

provision in the Income-tax Act for adjustment of the actual cost which was fixed

once and for all, at the time of acquisition of the asset. Accordingly, no adjustment

could be made in the actual cost of the assets for purposes of grant of depreciation

for  any  increase/decrease  of  liability  subsequently  arising  due  to  exchange

fluctuation. Consequently, Section 43A was introduced in the Act by Finance Act,

1967 w.e.f. 1.4.1967 in the above terms to provide for adjustment in the actual cost

of  assets  pursuant  to  change  in  the  foreign  currency  exchange  rates.  As  a

consequence of the insertion of the said section,  it  became possible to  adjust  the

increase/decrease in liability relating to acquisition of capital assets on account of

exchange  rate  fluctuation,  in  the  actual  cost  of  the  assets  acquired  in  foreign

currency  and  for,  inter  alia,  depreciation  to  be  allowed  with  reference  to  such

increased/decreased cost. This position is also made clear by Circular No. 5-P dated

9.10.1967 issued by CBDT. One more point  needs to be mentioned.  Section 43A

(unamended) corresponds to para 10 of AS-11 similarly providing for adjustment in

the  carrying  cost  of  fixed  assets  acquired  in  foreign  currency,  due  to  foreign

exchange fluctuation at each balance sheet date. The relevant para reads as follows:

“10. Exchange  differences  arising  on  repayment  of  liabilities incurred for the purpose of acquiring fixed assets, which carried in terms of  historical  cost,  should  be  adjusted in  the  carrying  amount  of  the respective fixed assets.  The carrying amount of such fixed assets should, to the extent not already so adjusted or otherwise accounted for, also be adjusted to account for any increase or decrease in the liability of the enterprise, as expressed in the reporting currency by applying the closing rate, for making payment towards the whole or a part of the cost of the

23

assets or for repayment of the whole or a part of the monies borrowed by the enterprise from any person, directly or indirectly, in foreign currency specifically for the purpose of acquiring those assets.”

33. As stated above, what triggers the adjustment in the actual cost of the

assets, in terms of unamended Section 43A of the 1961 Act is the change in the rate

of exchange subsequent to the acquisition of asset in foreign currency. The section

mandates that at any time there is change in the rate of exchange, the same may be

given effect to by way of adjustment of the carrying cost of the fixed assets acquired

in foreign currency. But for Section 43A which corresponds to para 10 of AS-11

such  adjustment  in  the  carrying  amount  of  the  fixed  assets  was  not  possible,

particularly in  the  light  of  Section  43(1).  The  unamended  Section  43A nowhere

required as condition precedent for making necessary adjustment in the carrying

amount  of  the  fixed  asset  that  there  should  be  actual  payment  of  the

increased/decreased liability as a consequence of the exchange variation. The words

used  in  the  unamended  Section  43A  were  “for  making  payment”  and  not  “on

payment” which is now brought in by amendment to Section 43A vide Finance Act,

2002.

34. Lastly, we are of the view that amendment of Section 43A by the Finance

Act, 2002 w.e.f. 1.4.2003 is amendatory and not clarificatory. The amendment is in

complete substitution of the section as it existed prior thereto. Under the unamended

Section 43A adjustment to the actual cost took place on the happening of change in

the rate of exchange whereas under the amended Section 43A the adjustment in the

actual cost is made on cash basis. This is indicated by the words “at the time of

making  payment”.  In  other  words,  under  the  unamended  Section  43A,  “actual

payment” was not a condition precedent for making necessary adjustment in the

carrying  cost  of  the  fixed  asset  acquired  in  foreign  currency,  however,  under

24

amended Section 43A w.e.f. 1.4.2003 such actual payment of the decreased/enhanced

liability  is  made  a  condition  precedent  for  making  adjustment  in  the  carrying

amount of the fixed asset. This indicates a complete structural change brought about

in  Section  43A  vide Finance  Act,  2002.  Therefore,  the  amended  section  is

amendatory and not clarificatory in nature.

Conclusion:

35. For reasons  given  hereinabove,  we  find  no  infirmity  in  the  impugned

judgments of the Delhi High Court and accordingly the Civil Appeals filed by the

Department stand dismissed with no order as to costs.

………………………..J.   (S. H. Kapadia)

………………………..J.   (Aftab Alam)

New Delhi;  April 8, 2009.   

1.4.1999 - “X” borrows  $ 100/- -  debits the loan A/c by Rs. 3500/-     (at Rs. 35/- per dollar)     on the basis of prevailing market rate. -  Amount borrowed is utilized in business.

31.3.2000 - Rate of exchange fluctuated and it became    Rs. 40/- per Dollar. - Liability increased by Rs. 500/-.

25

ITEM NO. 1-A           ( For Judgment )

           COURT No.3     SECTION  IIIA

              S U P R E M E   C O U R T   O F   I N D I A                            RECORD OF PROCEEDINGS

Civil Appeal No.2206 of 2008 @ SLP(C)No. 593 of 2008

Commissioner of Income Tax, Delhi ..   Appellant(s)     Versus

M/s Woodward Governor India P. Ltd. ..   Respondent(s)                                                                                           WITH

                               Civil Appeal No. 2214/09 @ SLP (C) No. 7632/08     Civil Appeal No. 2212/09 @ SLP (C) No. 4708/08

   Civil Appeal No. 2207 /09 @ SLP (C) No. 18967/08   Civil Appeal No. 2213/09 @ SLP (C) No. 6911/08   Civil Appeal No. 2226/09 @ SLP (C) No. 6321/09   Civil Appeal No. 221509 @ SLP (C) No. 24601/08   Civil Appeal No. 2210/09 @ SLP (C) No. 2159/09

  Civil Appeal No. 2235/09 @ SLP (C) No. 25893/08   Civil Appeal No. 2208/09 @ SLP (C) No. 1300/09   Civil Appeal No. 2209/09 @ SLP (C) No. 1297/09

             Civil Appeal No. 2211/09 @ SLP (C) No. 850/09   Civil Appeal No. 2216/09 @ SLP (C) No. 4752/09   Civil Appeal No. 2217/09 @ SLP (C) No. 8924/08   Civil Appeal No. 2218/09 @ SLP (C) No. 9819/08

  Civil Appeal No. 2219/09 @ SLP (C) No. 14194/08    Civil Appeal No. 2220/09 @ SLP (C) No. 14199/08    Civil Appeal No. 2221/09 @ SLP (C) No. 16124/08

             Civil Appeal No. 2222/09 @ SLP (C) No. 2155/09    Civil Appeal No. 2223/09 @ SLP (C) No. 16086/08

             Civil Appeal No. 2224/09 @ SLP (C) No. 899/09               Civil Appeal No. 2225/09 @ SLP (C) No. 5013/09

  Civil Appeal No. 2227/09 @ SLP (C) No. 11516/08    Civil Appeal No. 2228/09 @ SLP (C) No. 11534/08    Civil Appeal No. 2229/09 @ SLP (C) No. 11530/08    Civil Appeal No. 2230/09 @ SLP (C) No. 11517/08    Civil Appeal No. 2231/09 @ SLP (C) No. 11524/08    Civil Appeal No. 2232/09 @ SLP (C) No. 11535/08    Civil Appeal No.  2233/09 @ SLP (C) No. 11518/08   Civil Appeal No. 2234/09 @ SLP (C) No. 11523/08

     Civil Appeal No. 2237/09 @ SLP (C) No. 8718/09 (CC No. 2868/09)        Civil Appeal No. 2236/09 @ SLP (C) No. 8717 /09 (CC No. 3007/09)

   Civil Appeal No.2238/09 @ SLP (C) No.8719/09 (CC No. 1999/09)

26

DATE : 08/04/2009      These matters were called on for pronouncement of                        judgment today.                                                                                   For Petitioner(s) Ms. Arti Gupta, Adv.

Mr. Kunal Bahri, Adv. Ms. Anubha Agrawal, Adv. Mr. Arijit Prasad, Adv. Mr. H.R. Rao, Adv. Ms. Shweta Garg, Adv. Ms. Ashish Gopal Garg, Adv.

                    Mr. B.V. Balaram Das,Adv.

in 20900/2007:        Mr. Ajay Vohra, Adv. Ms. Kavita Jha, Adv. Mr. Sandeep S. Karhail, Adv.

For Respondent(s) Mr. Bhargava V. Desai,Adv. Mr. Rahul Gupta, Adv. Ms. Reema Sharma, Adv. Mr. Ravi Pratap Mall, Adv.

in 18967/2008:        Mr. S. Sukumaran, Adv.                      Ms. Meera Mathur

Mr. Anand Sukumar, Adv.

in 14199/2008:        Mr. Ajay Vohra, Adv. Ms. Kavita Jha, Adv. Mr. Sandeep S. Karhail, Adv.

              ---

Hon'ble Mr. Justice S.H. Kapadia pronounced the judgment of the Bench

comprising his Lordship and Hon'ble Mr. Justice Aftab Alam.

Delay condoned.

Leave granted.

The Civil Appeals filed by the Department stand dismissed in terms of the

signed judgment which is placed on the file.  There shall be no order as to costs.

[ S. Thapar ]     PS to Registrar

 [ Madhu Saxena ]    Court Master  

[ Signed reportable judgment is placed on the file ]