Section 42: capitalising the impact of foreign exchange fluctuation

Introduction

A foreign-currency liability used to acquire an asset from outside India can alter the asset's tax cost when exchange rates change. Section 42 directs capital treatment for its covered liability rather than immediate business income or loss treatment.

Key takeaways

When this section applies

Section 42(1) applies where, at the time an assessee makes a payment during the tax year, there is a variation in liability (expressed in Indian currency) due to a change in the exchange rate, in relation to an asset acquired for business or profession from a country outside India.

How the variation is computed

Section 42(2) excludes any part of the liability met directly or indirectly by another person, and computes the "variation in liability" as A = B minus C, where B is the payment in Indian currency at the time it is made (towards the asset's cost, or towards repayment of foreign-currency borrowings taken specifically to acquire the asset, including interest), and C is the corresponding liability in Indian currency at the time the asset was acquired.

Where the variation gets added or reduced

Section 42(3) requires the variation in liability to be added to, or reduced from: the actual cost of the asset (as computed under Section 39); the capital expenditure referred to in Section 32(i) or 45(1)(a)(i); or the cost of acquisition of a capital asset (other than one covered by Section 74) for the purposes of Section 72. The resulting figure becomes the revised actual cost, capital expenditure, or cost of acquisition.

Forward contracts

Section 42(4) covers the case where the assessee has a forward contract with an authorised dealer (as defined under FEMA, 1999) to receive a specified sum in foreign currency at a stipulated future date at a contracted exchange rate, to meet the liability. To the extent the contracted sum is available for discharging the liability, the amount to be added or deducted is computed with reference to the rate specified in that forward contract.

Step-by-step flow for applying Section 42

1. 1

   Is a payment made in the tax year for an asset acquired from outside India for business or profession, or for repaying foreign-currency borrowing taken specifically to acquire it?

   • No: Section 42 does not apply.
   • Yes: Go to the next step.
2. 2

   Exclude any part of the liability met by another person or authority

3. 3

   Is there a forward contract with an authorised dealer covering the payment?

   • Yes: Use the contract rate for the amount covered (Section 42(4)).
   • No: Use the rate at the time of payment.
4. 4

   Compute A = B - C

   B = payment in Indian currency when made; C = corresponding liability in Indian currency at the time of acquisition.

5. 5

   Adjust the cost

   Add (if positive) or reduce (if negative) A to the actual cost under Section 39, the capital expenditure under Section 32(i) or 45(1)(a)(i), or the cost of acquisition of a capital asset (not being a capital asset referred to in Section 74) for the purpose of Section 72.

Practical checklist

Glossary

Exchange variation

Change in rupee liability caused by a foreign-exchange rate movement.

Capitalisation

Including a qualifying exchange difference in an asset's tax cost instead of current income or loss.

Frequently asked questions