Commr. of Income Tax,
Dehradun & ANR. Vs. M/S Enron Oil & Gas India Ltd.  INSC 1483 (2
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. ....
S.H. KAPADIA, J.
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.
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.
filed his return of income for Assessment Year 1999-00 declaring its taxable
income of Rs. 71,19,50,013 under Section 115JA.
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.
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.
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).
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.
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.
the outset, we quote hereinbelow Section 42(1) of the Income Tax Act, 1961,
which reads as follows:
provision for deductions in the case of business for prospecting, etc., for mineral
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
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
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.
Explanation.- For the
purposes of this section, "mineral oil" includes petroleum and
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.
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.
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.
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.
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.
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.
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.
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.
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).
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.
Costs" means exploration costs, development costs, production costs and
all other costs related to petroleum operations.
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.
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.
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.
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.
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
question to be asked is why does the PSC warrant translation?
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).
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
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
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.
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.
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.
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.
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.
the aforestated reasons, we find no merit in this civil appeal and the same is
dismissed with no order as to costs.
(B. Sudershan Reddy)
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