Capitalising the impact of foreign exchange fluctuation.

42(1)

Irrespective of anything contained in any other provision of this Act, where at the time of making payment during the tax year, there is a variation in liability of an assessee as expressed in Indian currency due to change in rate of exchange in relation to an asset acquired for the purpose of business or profession in foreign currency from a country outside India, it shall be dealt with in the manner specified in sub-sections (2) and (3).

42(2)

For this section, “variation in liability” shall be computed as—

A = B-C

where,—

A = variation in the liability;

B = amount paid in Indian currency (excluding any part met, directly or indirectly, by any other person or authority) during the tax year for acquisition of the asset for—

• (a) the whole or part of the cost of asset; or
• (b) repayment of money borrowed along with interest in foreign currency, specifically for acquiring such asset;

C = liability, corresponding to the amount referred in B, in Indian currency at the time of acquisition of such asset.

42(3)

The variation in liability shall be added or reduced from the—

• (a) actual cost of the asset as referred in section 39; or
• (b) expenditure of capital nature referred to in section 45(1)(a) or (c) or 32(i); or
• (c) cost of acquisition of a capital asset (not being capital asset referred to in section 74) for the purpose of section 72,

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.

42(4)

Where the assessee has entered into a contract with an authorised dealer as defined in section 2 of the Foreign Exchange Management Act, 1999, for providing him with a specified sum in a foreign currency on or after a stipulated future date at the rate of exchange specified in the contract to enable him to meet the whole or any part of the said liability, the amount, if any, to be added to, or deducted from, 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 under this section shall, in respect of so much of the sum specified in the contract as is available for discharging the said liability, be computed with reference to the rate of exchange specified therein

Explanation

Section Summary:

Section 42 of the new income tax law addresses how foreign exchange fluctuations impact the liability of an assessee when acquiring assets for business or profession purposes in foreign currency. It provides a framework for calculating and adjusting the variation in liability due to exchange rate changes and specifies how this variation affects the cost of the asset or capital expenditure.

Key Changes:

1. Explicit Treatment of Foreign Exchange Fluctuations: The section introduces a clear method to account for variations in liability due to exchange rate changes, which was not explicitly detailed in the prior income tax act.
2. Adjustment to Asset Cost: The variation in liability is now directly added to or deducted from the actual cost of the asset, capital expenditure, or cost of acquisition, depending on the context.
3. Inclusion of Forward Contracts: The section specifically addresses scenarios where the assessee has entered into forward contracts with authorized dealers to hedge against exchange rate fluctuations.

Practical Implications:

1. Impact on Taxable Income: The adjustment to the cost of assets or capital expenditure due to exchange rate fluctuations will affect the depreciation claimed or capital gains computed, thereby impacting taxable income.
2. Businesses with Foreign Currency Liabilities: Businesses acquiring assets or borrowing in foreign currency will need to account for exchange rate variations in their tax calculations, ensuring compliance with the new provisions.
3. Hedging Contracts: Assessees using forward contracts to manage foreign exchange risk must compute the variation in liability based on the contracted exchange rate, not the prevailing rate at the time of payment.

Critical Concepts:

1. Variation in Liability (A): Calculated as the difference between the amount paid in Indian currency (B) and the liability in Indian currency at the time of asset acquisition (C). Formula: A = B - C.
2. Adjustment to Asset Cost: The variation (A) is added to or deducted from:
   • The actual cost of the asset (as per Section 39),
   • Capital expenditure (as per Section 45(1)(a) or (c) or Section 32(i)), or
   • The cost of acquisition of a capital asset (as per Section 72).
3. Forward Contracts: If the assessee has a forward contract with an authorized dealer, the variation is computed using the contracted exchange rate, not the actual rate at the time of payment.

Compliance Steps:

1. Track Exchange Rates: Maintain records of exchange rates at the time of asset acquisition and payment.
2. Compute Variation in Liability: Use the formula A = B - C to calculate the variation.
3. Adjust Asset Cost or Expenditure: Add or deduct the variation from the relevant cost (actual cost, capital expenditure, or cost of acquisition).
4. Document Forward Contracts: If applicable, ensure forward contracts with authorized dealers are documented and used for computation.

Examples:

Scenario 1: Simple Foreign Currency Liability Adjustment

• An Indian business acquires machinery worth $100,000 when the exchange rate is ₹75/$.
• At the time of payment, the exchange rate is ₹80/$, and the business pays ₹8,000,000.
• Variation in liability (A) = ₹8,000,000 (B) - ₹7,500,000 (C) = ₹500,000.
• The ₹500,000 is added to the actual cost of the machinery for depreciation purposes.

Scenario 2: Forward Contract Adjustment

• The same business enters a forward contract at ₹78/$ to pay $100,000.
• At payment, the exchange rate is ₹80/$, but the business pays ₹7,800,000 as per the contract.
• Variation in liability (A) = ₹7,800,000 (B) - ₹7,500,000 (C) = ₹300,000.
• The ₹300,000 is added to the actual cost of the machinery, not ₹500,000, as the forward contract rate is used.

This section ensures that foreign exchange fluctuations are systematically accounted for, providing clarity and consistency in tax calculations.