Supreme Court Clarifies Deduction Under Section 80HHC of Income Tax Act: Shah Originals vs. Commissioner of Income Tax (2023) INSC 1014

Date of the Judgment: November 21, 2023
Citation: 2023 INSC 1014
Judges: B.V. Nagarathna, J. and S.V.N. Bhatti, J.

Can gains from foreign exchange fluctuations in an Exchange Earners Foreign Currency (EEFC) account be considered as profits derived from export business, thus qualifying for a deduction under Section 80HHC of the Income Tax Act, 1961? The Supreme Court of India recently addressed this question in a case involving Shah Originals, a 100% Export-Oriented Unit (EOU). The court clarified that such gains do not qualify for deduction under Section 80HHC, as they are not directly derived from export activities.

Case Background

Shah Originals, the appellant, is a 100% Export-Oriented Unit (EOU). For the assessment years 2000-01 and 2001-02, the company declared taxable income, including export turnover. This turnover included gains from foreign currency fluctuations amounting to Rs. 26,62,927 for the assessment year 2000-01. Shah Originals claimed this as income earned from exports and sought a deduction under Section 80HHC of the Income Tax Act, 1961. The Assessing Officer (AO) disallowed this deduction, arguing that gains from foreign currency fluctuations in an EEFC account are not directly related to export activities.

The Commissioner of Income Tax (Appeals) upheld the AO’s decision. However, the Income Tax Appellate Tribunal, Mumbai, set aside the disallowance. The High Court of Judicature at Bombay, in an appeal by the Revenue, reversed the Tribunal’s decision, leading to the present appeal before the Supreme Court.

Timeline

Course of Proceedings

The Assessing Officer (AO) disallowed the deduction claimed by Shah Originals under Section 80HHC of the Income Tax Act, 1961, adding the amount to the taxable income. The Commissioner of Income Tax (Appeals) upheld this decision. Shah Originals then appealed to the Income Tax Appellate Tribunal, which ruled in favor of the assessee, setting aside the disallowance. The Revenue appealed to the High Court of Judicature at Bombay, which reversed the Tribunal’s order and restored the disallowance. This led to Shah Originals appealing to the Supreme Court.

Legal Framework

The core legal issue revolves around Section 80HHC of the Income Tax Act, 1961, which provides a deduction for profits derived from the export of goods or merchandise. The relevant part of Section 80HHC is:

“S.80HHC. Deduction in respect of profits retained for export business. – Where an assessee, being an Indian company or a person (other than a company) resident in India, is engaged in the business of export out of India of any goods or merchandise to which this section applies, there shall, in accordance with and subject to the provisions of this section, be allowed, in computing the total income of the assessee, a deduction to the extent of profits, referred to in sub -section (1B), derived by the assessee from the export of such goods or merchandise.”

The court also considered the Reserve Bank of India (RBI) Notification No. FERA.159/94-RB dated 01.03.1994, which allows 100% EOUs to open and operate an EEFC account. This notification permits a percentage of foreign exchange remittances to be credited to this account.

The key point of contention is the interpretation of the phrase “derived from” in Section 80HHC, specifically whether gains from foreign exchange fluctuations in an EEFC account can be considered as profits “derived from” the export business.

Arguments

Appellant (Shah Originals) Arguments:

• ✓ The assessee, being a 100% EOU, earned foreign currency from garment exports and credited a portion to its EEFC account as permitted by the notification dated 01.03.1994.
• ✓ The funds in the EEFC account were used for business needs.
• ✓ Section 80HHC allows deduction of profits from export business. The foreign exchange gain is chargeable under “profits and gains of business or profession.”
• ✓ Sub-sections (1) and (3) of Section 80HHC, when read together, include gains from foreign exchange within profits from export business.
• ✓ The conversion of foreign currency into Indian Rupees at the end of the financial year is revenue in nature and incidental to the business.
• ✓ The gain from foreign exchange fluctuation is directly linked to the assessee’s business income from exports.
• ✓ The deposit of funds in an EEFC account is a business necessity for exporters.

Respondent (Commissioner of Income Tax) Arguments:

• ✓ The deduction under Section 80HHC requires strict compliance.
• ✓ The case involves profit earned from foreign currency fluctuations in an EEFC account, not directly from export activity.
• ✓ An EEFC account is a facility provided by the RBI, not a mandatory requirement for export business.
• ✓ Crediting foreign exchange to an EEFC account is like a deposit, and the appreciation is not derived from the export business.
• ✓ The expression “derived from” should be interpreted literally and not as “attributable to.”
• ✓ The income claimed as a deduction must have a direct nexus with the main business activity and be a derivative income from that activity.
• ✓ The gain from foreign exchange fluctuation is a passive earning, independent of the export business.

The counsel for the assessee relied on Sutlej Cotton Mills Ltd. v. Commissioner of Income Tax, Calcutta [(1978) 4 SCC 358], Commissioner of Income Tax, Delhi v. Woodward Governor India Pvt. Ltd [(2009) 13 SCC 1], and Commissioner of Income Tax and Anr. v. Motorola India Electronics (P) Ltd. [(2013) SCC OnLine Kar 10731]. The Revenue relied on Pandian Chemicals Ltd. v. Commissioner of Income Tax, Madurai [(2003) 5 SCC 590].

Submissions by Parties

Innovativeness of the Argument: The appellant argued that the foreign exchange fluctuation gains should be considered part of the export business profits by linking the EEFC account to the export business, which is an innovative approach. The respondent’s argument was more conventional, emphasizing the strict interpretation of “derived from” and the nature of the EEFC account as a facilitator rather than a direct part of the export business.

Issues Framed by the Supreme Court

The Supreme Court framed the following issue for consideration:

“Whether the gain on foreign exchange fluctuation in the EEFC account of the assessee partakes the character of profits of the business of the assessee from exports and can the gain be included in the computation of deduction under profits of the business of the assessee under Section 80 HHC of the Act?”

Treatment of the Issue by the Court

Authorities

The Supreme Court considered the following authorities:

The Court also considered Section 80HHC of the Income Tax Act, 1961 and Reserve Bank of India (RBI) Notification No. FERA.159/94-RB dated 01.03.1994.

Judgment

How each submission made by the Parties was treated by the Court?

How each authority was viewed by the Court?

The court distinguished the cases relied upon by the assessee, stating that they did not apply to the facts of the case. The court relied on Pandian Chemicals Ltd. v. Commissioner of Income Tax, Madurai [(2003) 5 SCC 590] for the interpretation of “derived from,” emphasizing the need for a direct nexus. The court also relied on various other cases to reinforce the principle that tax statutes must be interpreted strictly and the expression “derived from” has a narrow meaning.

The court held that the gain from foreign exchange fluctuations in the EEFC account does not qualify for deduction under Section 80HHC of the Income Tax Act. The court reasoned that the phrase “derived from” in Section 80HHC requires a direct and immediate nexus between the profit and the export activity. The EEFC account is merely a facility provided by the RBI, and the gains from currency fluctuations are not directly derived from the export of goods or merchandise.

The court emphasized that the interpretation of tax statutes must be strict, and the words “derived from” cannot be interpreted as “attributable to.” The court also noted that the purpose of Section 80HHC is to incentivize export trade, but this does not extend to gains that are not directly derived from export activities.

The court rejected the argument that the combined reading of sub-sections (1) and (3) of Section 80HHC would include gains from foreign exchange fluctuation. The court stated that the gain from fluctuation is independent of export earnings.

The court upheld the decision of the High Court and dismissed the appeal of Shah Originals.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the strict interpretation of the phrase “derived from” in Section 80HHC of the Income Tax Act, 1961. The court emphasized that the gain from foreign exchange fluctuation in the EEFC account does not have a direct and immediate nexus with the export activity. The court also highlighted that the EEFC account is a facility provided by the RBI and not an integral part of the export business. The court’s reasoning was also influenced by the principle that tax statutes must be interpreted strictly and the words “derived from” cannot be interpreted as “attributable to”.

The court’s emphasis on the strict interpretation of tax laws and the need for a direct nexus between income and the activity for which deduction is claimed indicates a conservative approach to tax benefits.

The court also noted that the purpose of Section 80HHC is to incentivize export trade, but this does not extend to gains that are not directly derived from export activities.

The court’s decision reflects a focus on the literal meaning of the statutory language and a disinclination to expand the scope of tax deductions through interpretation.

Fact:Law Ratio: The ratio of Fact:Law is 30:70. This shows that the court was more influenced by the legal principles and interpretation of the law than the factual aspects of the case.

Logical Reasoning

Key Takeaways

• ✓ Gains from foreign exchange fluctuations in an EEFC account are not considered profits derived from export business under Section 80HHC of the Income Tax Act, 1961.
• ✓ The term “derived from” requires a direct and immediate nexus between the profit and the export activity.
• ✓ Tax statutes are to be interpreted strictly, and the scope of deductions cannot be expanded through interpretation.
• ✓ The EEFC account is a facility provided by the RBI and not an integral part of the export business.
• ✓ This judgment clarifies the scope of Section 80HHC and provides guidance on the tax treatment of foreign exchange gains for exporters.
• ✓ Exporters should not claim deduction under Section 80HHC for gains from foreign exchange fluctuations in EEFC accounts.

This ruling may impact how exporters manage their foreign exchange earnings and plan their tax strategies. It reinforces the need for a direct link between the income and the export activity to claim deductions under Section 80HHC.

Directions

No specific directions were given by the Supreme Court in this judgment.

Development of Law

The ratio decidendi of this case is that the gain from foreign exchange fluctuations in an EEFC account is not “derived from” the export business and therefore, does not qualify for deduction under Section 80HHC of the Income Tax Act, 1961. This judgment reinforces the strict interpretation of the term “derived from” and clarifies that the EEFC account is a facility and not an integral part of the export business. This position is consistent with previous interpretations of the term “derived from” by the Supreme Court. There is no change in the previous position of law, but the judgment clarifies the application of existing legal principles to the specific context of foreign exchange gains in EEFC accounts.

Conclusion

In conclusion, the Supreme Court held that gains from foreign exchange fluctuations in an EEFC account do not qualify for deduction under Section 80HHC of the Income Tax Act, 1961. The court emphasized the need for a direct nexus between the income and the export activity and clarified that the term “derived from” must be interpreted strictly. This judgment provides clarity on the tax treatment of foreign exchange gains for exporters and reinforces the importance of a direct link between income and the activity for which deductions are claimed.