2008 (9) TMI 3 - SC - Income Tax

Foreign exchange losses on account of foreign currency translation - whether translation losses are illusory or real losses however Interest costs incurred by the assessee on loans is not allowable under PSC (Production Sharing Contract) but Cash Call is not a loan - Cash Call is a investment/contribution made into the Account of the Operator by each co-venturer so loss arising on account of foreign currency translation is allowable as deduction held that impugned loss are real loss

Summary

Issues Involved:
1. Entitlement to claim deduction for foreign exchange losses on account of foreign currency translation.
2. Interpretation and application of Section 42(1) of the Income Tax Act, 1961.
3. Analysis of the Production Sharing Contract (PSC) and its accounting mechanisms.
4. Determination of whether translation losses are real or illusory.

Detailed Analysis:

1. Entitlement to Claim Deduction for Foreign Exchange Losses:
The primary issue was whether the assessee (EOGIL) could claim deductions for foreign exchange losses resulting from currency translation. The assessee argued that these losses were real and should be deductible under the PSC and Section 42(1) of the Income Tax Act, 1961. The Department contended that these losses were merely book entries and not actual losses.

2. Interpretation and Application of Section 42(1) of the Income Tax Act, 1961:
Section 42(1) provides special provisions for deductions related to the business of prospecting, extraction, or production of mineral oils. The court noted that Section 42(1) allows for deductions of specific expenses if they are specified in the PSC. The PSC in question did not explicitly mention translation losses, but it did provide for the deduction of costs related to petroleum operations, which includes currency translation.

3. Analysis of the Production Sharing Contract (PSC) and Its Accounting Mechanisms:
The PSC is a special regime designed to maximize the gains for the Government from oil exploration by private corporations. It involves frequent currency conversions due to the nature of the operations, where expenses and revenues are incurred in different currencies. The PSC mandates that all currency gains and losses, whether realized or unrealized, be accounted for. The court highlighted that the PSC is an independent accounting regime that obliterates the difference between capital and revenue expenditures, making all expenses chargeable to the P&L account.

4. Determination of Whether Translation Losses Are Real or Illusory:
The court examined whether the translation losses were real or merely notional. It concluded that the losses were real because the PSC required conversion of revenues, costs, receipts, and incomes at different exchange rates, leading to actual gains or losses. The court emphasized that under the PSC, EOGIL had to account for these translation losses in its financial statements, making them an inextricable part of the accounting mechanism for oil production expenses.

Conclusion:
The Supreme Court dismissed the civil appeal, affirming that the translation losses incurred by EOGIL were real and deductible under Section 42(1) of the Income Tax Act, 1961, as per the provisions of the PSC. The court emphasized that the PSC represented a unique accounting regime that required the recognition of currency translation gains and losses, thereby validating the assessee's claim for deductions.