2011 (9) TMI 1264 - AT - Income Tax

Summary

1. ISSUES PRESENTED and CONSIDERED

The core legal question considered in both appeals was whether the gain arising from foreign exchange fluctuations on cancellation of foreign exchange contracts, entered into in relation to foreign currency loans taken for acquisition of capital assets, should be treated as income from other sources (revenue receipt) or as a capital receipt. Specifically, the issue was whether such gain is taxable as income or exempt as capital receipt when the business of the assessee had not yet commenced.

2. ISSUE-WISE DETAILED ANALYSIS

Issue: Taxability of gain on foreign exchange fluctuations arising from cancellation of foreign exchange contracts related to foreign currency loans taken for acquisition of capital assets, particularly when business has not commenced.

Relevant Legal Framework and Precedents: The primary statutory provision involved was Section 143(3) of the Income Tax Act, 1961, under which the Assessing Officer made additions treating the gain as income from other sources. The appellate authorities considered judicial precedents, including:

• The Special Bench decision in Apollo Tyres Ltd. vs. ACIT, which held that gains on foreign exchange contracts related to capital assets are capital receipts.
• The Third Member decision in Essar Steel Ltd., supporting the above principle.
• The Hon'ble Apex Court decision in Tuticorin Alkali Chemicals & Fertilizers Ltd. vs. ACIT, which held that interest income earned from investment of surplus funds before commencement of business is revenue in nature and taxable accordingly.
• The jurisdictional High Court decision in DCIT vs. Garden Silk Mills Ltd., which clarified that foreign exchange gains arising from contracts entered into for repayment of foreign currency loans taken for acquisition of capital assets are capital receipts.

Court's Interpretation and Reasoning: The Court noted that the Assessing Officer and the learned Departmental Representative heavily relied on the Apex Court's decision in Tuticorin Alkali Chemicals, which dealt with interest income earned from investment of surplus funds before business commencement. The Apex Court held that such interest income was revenue in nature and taxable, and that expenditure incurred for setting up business could not be set off against such income.

However, the Court distinguished the present facts from Tuticorin Alkali Chemicals. In the present case, the assessee had taken foreign currency loans specifically for financing the development of port projects, and the foreign exchange contracts were entered into for repayment of these loans, i.e., for capital liabilities. The Court emphasized that the gain or loss on cancellation of such contracts would bear the character of the underlying transaction, which was capital in nature.

The Court relied extensively on the jurisdictional High Court's ruling in Garden Silk Mills Ltd., which held that foreign exchange contracts entered into to hedge foreign currency loans taken for acquisition of capital assets are capital transactions, and gains arising therefrom are capital receipts. The Court quoted the High Court's reasoning that the character of foreign exchange gains depends on whether the underlying transaction is a trading transaction or related to capital assets, and that in the case of capital assets, such gains are capital receipts.

The Court further observed that the fact that the assessee had not commenced business was not determinative against the assessee's claim. On the contrary, it supported the characterization of the gain as capital receipt because the foreign currency loan and related contracts were for acquisition of capital assets, not for trading or revenue purposes. The Court rejected the Department's argument that the absence of business commencement distinguished the precedents.

Key Evidence and Findings: The audit report and assessment order confirmed that the assessee had not commenced business during the relevant year. The gain on cancellation of foreign exchange contracts was quantified and related to foreign currency loans taken for capital asset acquisition. The Court found the facts identical to those in Garden Silk Mills Ltd. and consistent with Apollo Tyres Ltd. and Essar Steel Ltd.

Application of Law to Facts: Applying the settled legal principles, the Court held that the gain on cancellation of foreign exchange contracts linked to foreign currency loans for capital assets is a capital receipt. The Court distinguished the Apex Court decision in Tuticorin Alkali Chemicals as it concerned revenue income from investment of surplus funds, not gains on capital liabilities.

Treatment of Competing Arguments: The Department argued for taxation of the gain as income from other sources, relying on the Tuticorin Alkali Chemicals decision and the fact that business had not commenced. The Court rejected this, holding that the relevant test is the nature of the underlying transaction (capital vs. revenue), not commencement of business. The assessee's reliance on Garden Silk Mills Ltd. and ITAT decisions was accepted as correctly stating the law.

Conclusions: The Court upheld the order of the Commissioner of Income-tax (Appeals) deleting the addition made by the Assessing Officer treating the gain as income. The gain on foreign exchange fluctuations on cancellation of contracts related to foreign currency loans for capital assets was held to be a capital receipt and not taxable as income from other sources.

3. SIGNIFICANT HOLDINGS

"The principle that is to be applied for determining the character of a receipt, whether results in any profit or loss on account of appreciation or depreciation in the value of foreign currency held by the assessee, upon conversion into another currency, would depend on whether the transaction is relatable to a trading transaction or is in relation to a capital asset or in relation to fixed capital."

"The foreign exchange acquired under the contract is for the purpose of discharging an obligation on capital account, i.e. for borrowing for the purpose of importing capital asset by entering into the foreign exchange forward contract, the assessee-company was merely wishing to freeze its capital liability to discharge debts/borrowing in foreign exchange."

"It is not relevant whether the assessee has commenced the business or not. The relevant fact would be whether the contract in the foreign exchange is relatable to the trading transaction or in relation to the capital assets. In fact, if the assessee has not commenced its business, this will support the case of the assessee because then obviously, the transaction was made in relation to a capital asset."

The Court conclusively determined that gains arising from foreign exchange fluctuations on cancellation of contracts related to foreign currency loans taken for acquisition of capital assets are capital receipts and not taxable as income from other sources, irrespective of whether the business has commenced.

Accordingly, the appeals filed by the Revenue were dismissed, and the order of the Commissioner of Income-tax (Appeals) was upheld in both cases.