Court : SUPREME COURT OF INDIA
Brief : Income Tax Act, 1961 — section 293 A — vide Notification No. 9997 dated 8.3.1996 under Section 293A of the Income Tax Act, 1961, each co-venturer was liable to be assessed for his own share of income. They were not to be treated as an AOP — 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 as deduction or not and conversely whether the gains on account of foreign currency translation is to be treated as a receipt liable to tax.
Citation : Yet to Report.
IN THE SUPREME COURT OF INDIA
CIVIL APPELLATE JURISDICTION
CIVIL APPEAL NO. 5433 OF 2008
(Arising out of S.L.P. (C) No.16886 of 2008)
Commissioner of Income Tax,
Dehradun & Anr. ... Appellants
v.
Enron Oil & Gas India Ltd. ....
Respondent
JUDGMENT
S.H. KAPADIA, J.
Leave granted.
2. Respondent-Enron Oil & Gas India Ltd. ("EOGIL") is a company
incorporated in Cayman Islands engaged in the business of oil exploration.
In 1993, Government of India through 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 Production Sharing Contract (PSC) with Government of India.
EOGIL was entitled to a participating interest of 30% in the rights and
2
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.
3. Vide Notification No. 9997 dated 8.3.1996 under Section 293A of the
Income Tax Act, 1961 ("1961 Act"), each co-venturer was liable to be
assessed for his own share of income. They were not to be treated as an
AOP.
4. EOGIL filed his return of income for Assessment Year 1999-00
declaring its taxable income of Rs. 71,19,50,013 under Section 115JA.
5. During the year, EOGIL debited its P&L account by exchange loss of
Rs. 38,63,38,980. The A.O. disallowed this loss on the ground that it was a
mere book entry and actually no loss stood incurred by the assessee.
6. The decision of the A.O. was challenged in appeal by EOGIL before
CIT(A), who after analyzing the 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
3
month's average daily means of the buying and selling rates of exchange
which exercise resulted into loss/profit on conversion. Under the
circumstances, according to CIT(A), it cannot be said that the assessee had
incurred notional loss. In fact, during the course of proceedings, CIT(A)
found that during Assessment Years 1995-96 and 1996-97 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 Assessment
year 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 CIT(A), the Department cannot blow hot
and cold. Consequently, it was held that just as foreign exchange gain was
taxable, loss was allowable under Section 42(1) of Income Tax Act in terms
of the PSC. Therefore, CIT(A) allowed as deduction the loss of Rs.
38,63,38,980.
7. Aggrieved by the order passed by CIT(A) the Department carried the
matter in appeal to ITAT objecting to the deletion made by CIT(A) on the
ground that the loss was only a book entry. It may be noted that before the
4
Tribunal the matter pertained to Assessment Years 1999-00, 1998-99, 2000-
01 and 1996-97. However, for the sake of convenience, the Tribunal
focused its attention on the facts and figures given for Assessment Year
1999-00. 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 so arrived at was charged to the P&L
account. Therefore, according to the Department, the said loss was a book
entry and it was not an actual loss in the 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 Section 42(1) of the Income
Tax Act, which entitled the assessee to claim conversion loss as deduction,
particularly when the said PSC provided for realized and unrealised
gains/losses from the exchange of 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
5
accounting and tax purposes. Accordingly, the Tribunal refused to interfere
with the findings returned by CIT(A).
8. The above concurrent finding stood confirmed by the impugned
judgment delivered by the Uttrakhand High Court in ITA No. 74/07 along
with ITA No. 76/07 and ITA No. 77/07 decided on 17.1.2008. Hence, this
civil appeal.
9. The only question which needs to be considered in this civil appeal is
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 as
deduction or not and conversely whether the gains on account of foreign
currency translation is to be treated as a receipt liable to tax.
10. At the outset, we quote hereinbelow Section 42(1) of the Income Tax
Act, 1961, which reads as follows:
"Special provision for deductions in the case of
business for prospecting, etc., for mineral oil.
42. (1) For the purpose of computing the profits or gains
of any business consisting of the prospecting for or
extraction or production of mineral oils in relation to
which the Central Government has entered into an
agreement with any person for the association or
6
participation of the Central Government or any person
authorised by it in such business (which agreement has
been laid on the Table of each House of Parliament),
there shall be made in lieu of, or in addition to, the
allowances admissible under this Act, such allowances
as are specified in the agreement in relation -
(a) to expenditure by way of infructuous or
abortive exploration expenses in respect of
any area surrendered prior to the beginning
of commercial production by the assessee;
(b) after the beginning of commercial production,
to expenditure incurred by the assessee,
whether before or after such commercial
production, in respect of drilling or
exploration activities or services or in
respect of physical assets used in that
connection, except assets on which
allowance for depreciation is admissible
under section 32 :
Provided that in relation to any agreement
entered into after 31st day of March, 1981,
this clause shall have effect subject to the
modification that the words and figures
"except assets on which allowance for
depreciation is admissible under section 32"
had been omitted; and
(c) to the depletion of mineral oil in the mining
area in respect of the assessment year
relevant to the previous year in which
commercial production is begun and for
such succeeding year or years as may be
specified in the agreement;
and such allowances shall be computed and made
in the manner specified in the agreement, the other
provisions of this Act being deemed for this
7
purpose to have been modified to the extent
necessary to give effect to the terms of the
agreement.
(2) ...
Explanation.- For the purposes of this section,
"mineral oil" includes petroleum and natural gas."
11. Section 42 is a special provision applicable to oil contracts. It has to
be construed in the background of the PSC. There is a difference between
Production Sharing Contracts and Revenue Sharing Contracts. PSCs were
put in place in order to enable Sovereign Governments to maximize their
gains from oil exploration by private corporations. PSC is a regime.
12. Prior to the PSC regime, Governments recovered royalty and imposed
tax on revenues from oil exploration. However, in countries like India,
where there is a great demand for oil, PSC was devised to give the
Governments a stake in oil exploration and development- virtually making
it a partner in the process. Under the PSC, Government or its nominee
becomes a party. The private parties either single company or a consortium
are the other parties to the contract. The consortium consists of an Indian
partner and a foreign company. The private parties are generally called as
Contractors. These contractors have a defined share which is called as
8
"Participating Interest". One of the Contractors would be designated as an
"Operator", who would have a control over day to day operations. Upfront
investments are made generally by the Contractors. For this purpose, the
Operator "in this case being M/s EOGIL" would make "cash calls". The
operating expenses are also similarly funded. In these Contracts, generally
there are three types of costs, namely, exploration costs, which is a capital
expenditure, development cost which is also capital expenditure and
production cost which is operational expenditure. Under the PSC, costs are
recovered from the oil produced until such time as they are fully absorbed.
Oil so recovered is called "Cost Oil". Oil in excess of "Cost Oil" is called
"Profit Oil". In Profit Oil there is the sharing percentage. The share of each
constituent is equal to their participating interest. Similarly, between the
Contractors and the Government, the oil produce is shared on the basis of
pre-determined shares. In the initial years, generally the Contractors who
have made upfront investment in the Project have a lion's share of
production as they have to recover their investments made upfront. The
contractors in the initial years recover their investments as cost oil, and in
the later years most of the oil produced is profit oil and, therefore, the more
profit oil is recovered the higher is the Return on Investment (ROI) earned
9
by the Contractor. With the increased ROI recovered by the Contractor, the
percentage share of the Government goes on increasing.
13. The above analysis of the PSC indicates that both the Government
and the Contractor are entitled to their "take" in oil and not in money. That
is why the contract is called as Production Sharing Contract and for that
purpose it becomes necessary to translate costs into oil barrels. This is done
by dividing the monetary value of costs by the agreed price of oil. The price
of oil generally is bench-marked - x% above Brent Crude quotation, or it
may depend on oil market price.
14. In India, oil had to be sold during the years in question by the
Contractors to IOC so that it was convenient to have a bench-marked price.
15. If the price of oil increased, the extent of profit oil would also
increase and thereby the share of the Government would automatically
increase. It is for this reason that PSCs were considered to be a better
arrangement for ensuring the Sovereign Governments (owners of the
natural resources) the maximum possible "take". At the same time, such
contracts ensure that the projects remained attractive enough for foreign
10
investors. However, due to this kind of structure of the PSC, inherently
there has to be frequent conversion from one currency to the other. Cash
calls were made in USD; some of the cash calls were required to be
converted to INR for local expenses; some of the expenses stood incurred in
USD whereas some to be incurred in INR; the sale price of oil was in USD
whereas the accounts were drawn up in USD. When some of the expenses
were incurred in USD and some incurred in INR, conversion had to be made
at the prevalent rates of exchange to bring them all to the contract currency,
i.e., USD. Similarly, as stated above, the sale price of oil was in USD. At the
time of sale, the INR - USD rate would change from that on the date of the
cash calls. Similarly, as stated above, the accounts were required to be
drawn up in USD. For that purpose also one had to reconvert the costs from
barrels to monetary terms. For the said reasons, clauses 1.6.1 and 1.6.2 of
appendix `C' to the PSC envisaged booking of all currency gains and losses
irrespective of whether such gains/losses stood realized or remained
unrealized. In case of gains, a part of the credit would go to the
Government, and taxes would be payable on the income to the extent of
such gains credited. Therefore, in our view, currency gains and losses
constituted an inextricable part of the accounting mechanism for expenses
incurred on the development and production of oil.
11
16. Section 42 of the 1961 Act was enacted to ensure that where the
structure of the PSC was at variance with the accounting principles
generally used for ascertaining taxable income, the provisions of the PSC
would prevail. Section 42 provides for deduction on expenditure incurred
on prospecting for or extraction or production of mineral oil whereas
Section 44 BB contains special provision for computing profits and gains in
connection with the business of exploration or extraction or production of
mineral oils. The Head Note itself indicates that Section 42 is a special
provision for deduction on expenditure incurred on prospecting, extraction
or production of mineral oils.
17. PSC is a contract in which the Central Government is not only a
party, it is a partner in the process. Such contracts are required to be placed
before each House of Parliament under Section 42.
18. Analysing Section 42(1), it becomes clear that the said section is a
special provision for deductions in the case of business of prospecting,
extraction or production of mineral oils. As stated above, Section 42(1) inter
alia provides for deduction of certain expenses.
12
19. Broadly speaking, Section 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 Section 42(1) carefully it becomes clear that the above three
allowances are admissible only if they are so specified in the PSC. For
example, in the PSC in question expenses incurred on account of depletion
of mineral oil is not provided for. Therefore, to that extent, respondent
would not be entitled to claim deduction under Section 42(1)(c). Under
section 42(1) it is made clear that for the purpose of computing the profits
or gains of any business consisting of prospecting, extraction or production
of mineral oil, an assessee would be entitled to claim deduction in respect of
abovementioned three items of expenditure in lieu of or in addition to the
allowances admissible under the 1961 Act. Further, such allowances shall
be computed and made in the manner specified in the agreement. In short,
an assessee is entitled to allowances which are mentioned in the PSC.
According to the Department, translation losses claimed by EOGIL are not
13
specified in the PSC, hence they cannot be claimed as deduction under
Section 42(1).
20. The question which this Court needs to answer is - are the translation
losses within the scope of Section 42?
21. In order to answer the above question, we are required to analyse
certain provisions of the PSC in question. Article 1 deals with definitions.
Under Article 1.21 "Contract Costs" means exploration costs, development
costs, production costs and all other costs related to petroleum operations.
Similarly, "Cost Petroleum" is defined to mean the portion of the total
volume of petroleum produced which the contractor is entitled to take for
the recovery of Contract Costs as specified in Article 13. Under Article 13
the Contractor is entitled to recover Contract Costs out of the total volume
of petroleum produced. That costs include development and exploration
costs. Similarly, Article 1.69 defines "Profit Petroleum" to mean all
petroleum produced and saved from the Contract Area in a particular period
as reduced by Cost Petroleum and calculated in terms of Article 14.
Continuing the analysis of PSC, Article 7 inter alia provides that the
contractor shall provide for all funds necessary for the conduct of petroleum
14
operations. Article 13 deals with recovery of costs, as stated above. Article
15 deals with taxes, royalties, rentals etc. It indicates that Government of
India is entitled to get taxes apart from profit petroleum. Article 15.2.1 inter
alia provides that in order to compute profits of the business consisting of
prospecting, extraction or petroleum production there shall be made
allowances in lieu of the allowances admissible under the 1961 Act, such
allowances as are specified in the PSC pursuant to Section 42 in relation to
three items of expenditure specified under Section 42(1)(a), (b) and (c).
Under Article 15.2.1, two allowances are provided for. They are for abortive
exploration expenses and expenses incurred after the commencement of
commercial production in respect of drilling or exploration activities. In
other words, two out of three allowances mentioned in Section 42(1) are
provided for in Article 15.2.1.
22. The above analysis shows that Section 42 provides for deduction for
expenses provided such expenses/allowances are provided for in the PSC.
The PSC in question provides for both capital and revenue expenditures. It
also provides for a method in which the said expenses had to be accounted
for. The said PSC is an independent accounting regime which includes tax
treatment of costs, expenses, incomes, profits etc. It prescribes a separate
15
rule of accounting. In normal accounting, in the case of fixed assets,
generally when the 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. Therefore, PSC represented an independent regime. The
shares of the Government and the contractors were also determined on that
basis. Section 42 is inoperative by itself. It becomes operative only when it
is read with the PSC. Expenses deductible under Section 42 had to be
determined as per the PSC. This implied that expenses had to be accounted
for only as contemplated by the PSC. If so read, it is clear that the primary
object of the PSC is to ensure a fair "take" to the Government. The said
"take" comprised of profit oil, royalty, cesses and taxes. 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 P&L 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
16
special accounting procedure prescribed by the PSC, Accounting Standard
11 had to be ruled out.
23. The question before us still remains as to whether the PSC talks of
translation, and if so, whether translation losses could be claimed by
EOGIL. In this connection, we need to consider Article 20.2 which inter alia
states that the rates of exchange for the purchase and sale of currency by the
Contractor shall be the prevailing rates as determined by the State Bank of
India and for accounting purposes under the PSC such rates shall apply as
provided for in clause 1.6 of Appendix `C' to the PSC. Appendix is a part
of PSC. The purpose of Appendix `C' inter alia is to prescribe the
Accounting Procedure. Clause 1.1 of appendix `C' provides for
classification of costs and expenditures. That classification is warranted as
PSC contemplates costs recovery by the contractor(s), who has made initial
contribution/investment of funds in foreign currency. The said classification
of costs and expenditures is also indicated in appendix `C' for profit sharing
purposes and for participation purposes. Appendix `C' prescribes the
manner in which a contractor is required to maintain his accounts. It
stipulates that each of the co-venturer has to follow the computation of
income tax under the 1961 Act. Clause 1.6.1 of appendix `C' refers to
currency exchange rates. It states that for translation purposes between USD
17
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 revenues, costs, expenditures, receipts or incomes are recorded.
Therefore, in our view, clause 1.6.1 of Appendix `C' provides for
translation.
24. On reading the said PSC, one finds that it not only deals with
ascertainment of profits of individual stakeholders including Government of
India but it also refers to taxes on individual shares, calculation of costs
against revenues from sale of petroleum, allowances admissible for
deduction, taxability, valuation, recovery, conversion etc. In other words, it
is a complete Code by itself.
25. The question to be asked is why does the PSC warrant translation?
26. To understand this aspect, we need to reiterate some important facts
of this case. In 1993, Government of India, through Petroleum Ministry
invited bids for the development of concessional blocks. The respondent-
assessee offered its bid for the concession. Accordingly, a consortium of
M/s EOGIL and RIL was awarded the contract for development of Panna,
Mukta and Mid & South Tapti fields. Respondent was designated as an
18
Operator. Subsequent to the award of the concession, EOGIL along with
RIL and ONGC executed PSC with Government of India. Under the said
PSC, each co-venturer remitted money, known as cash call to the bank
account of the Operator in USA. The expenditure for the joint venture is
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. Cash call in other words was not a loan. A wrong illustration
has been given in the impugned judgment. 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, as stated above, 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 (see clause 1.6.1 of Appendix `C' to
PSC).
27. The above analysis shows 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 into loss/profit on
conversion. Under the PSC, the respondent had to convert revenues, 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
19
translation. It is because of the specific provision in the PSC for currency
translation that loss/profit accrued to EOGIL. Moreover, under clause 1.6.2
of Appendix `C' to PSC it was inter alia provided that any realized or
unrealized gains or losses from the exchange of currency in respect of
Petroleum Operations shall be credited or charged to the Accounts.
Therefore, it would be wrong to say, as stated by the A.O., that the currency
translation losses incurred by EOGIL, during the years in question, was only
a notional loss/ book entry.
28. To sum up, the simple question which arises for determination in this
civil appeal is whether translation losses are illusory or real losses?
According to the Department, they are illusory losses.
29. To answer this question we were required to understand the subject of
a Production Sharing Contract (PSC). The State hires the investor(s) as a
contractor(s) for the conduct of work connected with the extraction of
minerals. The subsoil belongs to the State. It has a monopoly over the use of
the subsoil and the removal from it all natural resources. Under the PSC the
State grants to the contractor (investor) exclusive rights to conduct activity
of exploration envisaged by the contract. A PSC is a civil-law contract. The
contractor (investor) carries out the activities envisaged in the contract
20
(prospecting, search, exploration, extraction etc.) at his own expense and
risk. The State does not bear any expenses or risks. If the investor invests in
the prospecting and exploration but does not discover any oil, the expended
funds is not refundable unless the contract provides otherwise. The State
hires the investor as a contractor to perform work for it, but at the expense
and risk of the investor. The said work is carried out on a compensated
basis, with the State paying the investor not in money, but in terms of a
portion of the produced product (oil). This is called as Production Sharing.
30. There are two main systems around the world: royalty/tax systems or
production sharing systems. PSCs have become the fiscal system of choice
for most countries. Taxes are embedded in the Government share of profit
oil. PSC is a complex system. In it, the foreign company provides the capital
investment in exploration, drilling and construction of infrastructure. The
first proportion of oil extracted is allocated to the company, which uses oil
sales to recoup its costs and capital investment. The oil used for this
purpose, namely, to recoup capital investment and cost is termed as "cost
oil". Once costs have been recovered, the remaining "profit oil" is divided
between the State and the company in agreed proportions. The company is
taxed on its profit oil. Sometimes, the State participates either itself or
21
through its nominee as a commercial partner in the contract, operating in
joint venture with foreign oil companies. In such cases, the State provides
its percentage share of capital investment, and directly receives the
percentage share of cost oil and profit oil.
31. As stated above, in 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 as "cost oil". Often a
company obtains profit not just from the "profit oil", but also from "cost
oil". Such profits cannot be ascertained without taking into account
translation losses. Moreover, as stated above, 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.
32. Before concluding, we may point out that on behalf of the
Department, great emphasis was placed on clause 3.2 of Appendix `C'
annexed to the PSC which inter alia referred to costs not recoverable and
not allowable under the Contract (PSC). In the said clause it was stated that
exchange losses on loans or other financing would not be admissible for
deduction. We find no merit in this argument advanced on behalf of the
22
Department. As stated above, "Cash Call" is not a loan. It is a contribution
made into the Account of the Operator by each co-venturer in USD. Clause
3.2 of Appendix `C' refers to loans borrowed by an assessee or loans which
are financed on which the assessee has to pay interest. Interest costs
incurred by the assessee on such loans is not allowable under clause 3.2 of
Appendix `C' to the PSC. That clause is not applicable for cash
call/contribution. It may be noted that PSC is a special regime. It does not
come under Accounting Standard 11. Note 12 annexed to the Accounts for
the year ending 31.3.1999 refers to carrying costs of fixed assets financed
through loans. This Note refers to the P&L account of EOGIL. It is a
comment regarding the 2nd tier whereas clause 1.6.1 of Appendix `C' to the
PSC refers to tier 1. If one keeps in mind the concept of PSC being a
separate regime and if one keeps in mind the concept of cash call being an
investment and not a loan then the entire controversy stands resolved. In
this case, we are concerned with foreign currency transaction under which
all monetary balances were required to be translated at the exchange rates
prevailing as on the last date of the accounting year (balance sheet date) and
accordingly the resultant translation gains/losses were required to be
recognized which is referred to in Note 1(d) to Schedule R, annexed to the
Accounts for the year ending 31.3.1999.
23
33. For the aforestated reasons, we find no merit in this civil appeal and
the same is dismissed with no order as to costs.
.................................J.
(S.H. Kapadia)
.................................J.
(B. Sudershan Reddy)
New Delhi;
September 2, 2008.
