Holding

Translation losses under the PSC are real losses and are admissible as a deduction under Section 42(1) of the Income Tax Act, 1961.

Summary

Enron Oil & Gas India Ltd (EOGIL), a foreign company and operator under a Production Sharing Contract (PSC) with the Government of India, claimed foreign exchange losses arising from currency translation of cash calls and expenses in its profit and loss account for AY 1999‑2000. The Assessing Officer disallowed the deduction, deeming it a mere book entry, but the CIT(A), ITAT and the Uttarakhand High Court allowed it. The Supreme Court examined whether such translation losses are "actual" losses specified in the PSC and thus deductible under Section 42(1) of the Income Tax Act, 1961. It held that the PSC, via Appendix C, expressly mandates booking of realized and unrealized gains and losses, making them a real part of the accounting mechanism, and therefore permissible as a deduction. Consequently, the appeal was dismissed.

Issues considered

Whether foreign exchange losses arising from currency translation under a Production Sharing Contract are deductible under Section 42(1) of the Income Tax Act, 1961.
Whether such translation losses are "actual" losses specified in the PSC or merely notional book entries.

Legislation cited

Income Tax Act, 1961s. 293A, s. 32, s. 42(1), s. 44BB

Subjects

Production Sharing Contractforeign exchange lossSection 42currency translationPSC accountingcash callincome tax deductionoil and gasforeign company

Judgment

[2008] 12 S.C.R. 1168

,
A COMMISSIONER OF INCOME TAX, DEHRADUN & ANR. '"Y
\/.
ENRON OIL & GAS INDIA LTD.
(Civil Appeal No. 5433 of 2008)
SEPTEMBER 2, 2008
B
[S.H. KAPADIA AND B. SUDERSHAN REDDY, JJ.]
~
Income Tax Act, 1961 - s. 42 (1) - Deduction under -
Product Sharing Contract (PSC) - For depletion of mineral
c oil in th~ mining area - Between Government of India and a
consortium of companies, Operator whereof was a foreign
Company - Return of income filed by foreign Company,
deducting foreign exchange losses on account of foreign
currency translation - Deduction not allowed by Assessing
Officer - Allowed by authorities/Courts below - On appeal,
D
held such deduction is admissible - In view of Appendix C to
the·PSC which provides for translation of currency, such loss -,.
is actual and not merely notional.
Words and Phrases - 'Production Sharing Contract' -
E Meaning of '
'
Government of 'India, through Petroleum Ministry
awarded contract for development of concessional "
blocks to a consortium of Companies i.e. respondent-a
foreign company and two other Indian Companies.
F Respondent was designated as the Operator. The
> ..(,
respondent along with two other companies executed
Production Sharing Contract (PSC) with Government of
India. Under the PSC each co-venturer remitted money,
known as Cash Call to the Operator in USA. The·
G expenditure for the joint venture was made, out of the
said account. The Trial Balance was required to be made ....-..
at the end of the month in USO which was then required
to be translated on the basis of accounting procedure
mentioned in Appendix 'C' to PCS. As per Notification
H 1168
COMM. OF INCOME TAX, DEHRADUN & ANR. 1169
v. ENRON OIL & GAS INDIA LTD .
.. '""' dated 8.3.1996 u/s 293A of Income tax Act, 1961, each co- A
venturer was liable to be assessed for his own share of
income.
Respondent filed its return of income for the
Assessment year 1990-2000. It debited its Profit and Loss
Account by the loss due to exchange of currency. B
.... Assessing Officer disallowed the same on the ground
that it was only a book entry and not actual loss. In appeal
CIT (A) allowed the deduction. The order was further
confirmed by appellate Tribunal as well as High Court.
Hence the present appeal. c
Dismissing the appeal, the Court
HELD: 1.1 The respondent-assessee was entitled to
claim deduction for foreign exchange losses on account
of foreign currency translation. Due to the kind of D
structure of the Product Sharing Contract (PSC),
inherently _there has to be frequent conversion from one
currency to the other. Cash calls were made in USO; some
of the cash calls were required to be converted to INR for
local expenses; some of the expenses stood incurred in E
USO whereas some to be incurred in INR; the sale price
of oil was in USO whereas the accounts were drawn up
in USO. At the time of sale, the INR - USO rate would
change from that on the date of the cash calls. Similarly,
the accounts were required to be drawn up in USO. For F
......
> 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
G
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 ga.ins credited. Therefore,
currency gains and losses constituted an inextricable
part of the accounting mechanism for expenses incurred
H
1170 SUPREME COURT REPORTS [2008] i2 S.C.R.

A on the development and production of oil. [Paras 9 and
15] [1174,H; 1178,B-F]
1.2 Section 42(1) of Income tax Act, 1962 provides
for- admissibility in respect of three types of allowances
provided they are specified in the PSC. They relate to
8 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. The above
C three allowances are admissible only if they cire so
specified in the PSC. [Para 19] [1179,D-F]
1.3 Article 20.2 of PSC 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
0
the State Bank of India and for accounting purposes
under the PSC such rates shall apply as provided for in i
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
E appendix 'C' provides for classification of costs and
expenditures. Clause 1.6.1 of Appendix-·c· provides for
translation. [Para 23] [1182,A-C]
1.4 PSC not only deals with ascertainment of profits
F 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. PSC is a complete Code by
G itself. [Para 24] [1182,F-G]
1.5 The capital contribution had to be converted -<t.

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
H respondent had to convert revenues, costs, receipts and
COMM. OF INCOME TAX, DEHRADUN & ANR. 1171
v. ENRON OIL & GAS INDIA LTD .
, ...;

incomes. If the respondent had a choice to prepare its A
accounts only in USO, there would have been no loss/
profit on account of currency translation. It is because of
the specific provision in the PSC for currency translation
that loss/profit accrued to the respondent. Moreover,
under clause 1.6.2 of Appendix ·c· to PSC it was inter a/ia B
-+:
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, that the currency
translation losses incurred by the respondent during the c
years in question, was only a notional loss/ book entry.
[Para 27] [1183,F-H; 1184,A]
) 1.6 In PSC, the foreign company provides the capital
investment and cost and the first proportion of oil
)r
extracted is generally allocated to the company which D
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 E
losses. Moreover, 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. [Para 31] [1185,C-E]
_.....__
,.. 1.7 It is not correct to say that clause 3.2 of Appendix F
'C' annexed to the PSC which stated .that exchange losses
on loans or other financing would not be admissible for
deduction. Clause 3.2 of Appendix 'C' refers to loans
borrowed by an assessee or loans which are financed
:J· on which the assessee has to pay interest. That clause is G
not applicable for cash call/contribution. "Cash Call" is
not a loan. It is a contribution made into the Account of
the Operator by each co-venturer in USO. PSC is a special
regime. It does not come under Accounting Standard 11.
In this case, the Court is concerned with foreign currency H
1172 SUPREME COURT REPORTS [2008] 12 S.C.R.

)"---

A 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
B 1(d) to Schedule R, annexed to the Accounts for the year r
ending 31.3.1999. [Para 31] [1185,F-H; 1185,A-D] ·t·

CiVILAPPELLATE JURISDICTION: Civil Appeal No. 5433
of 2008

c From the final Juagment and Order dated 17.1.2008 of
the High Court of Uttarakhand at Nainital in Income Tax Appeal
No. 77 of 2007
Parag P. Tripathi, ASG., Arti Gupta, Naresh Kaushik, t
Manish Kaushik and B.V. Balaram Das for the Appellants.
D
Harish N. Salve, Rohan Shah,. Tarun Gulati, Praveen i
Kumar, Tushar Jarwal, Jaiveer Shergill, Ankur Chawla,
Meenakshi Grover, Pallavi Langer and Prithvi Sidhu for the
Respondent.

E The Judgment of the Court was delivered by
S.H; KAPADIA, J. 1. Leave granted.
2. Respondent-Enron Oil & Gas India Ltd. ("EOGIL") is a .,
company incorporated in Cayman Islands engaged in the
.>--
F business of oil exploration. In 1993, Government of India through 'I
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
G
executed Production Sharing Contract (PSC) with Government
of India. EOGIL was entitled to a participating interest of 30%
in the rights and 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.
H
COMM. OF INCOME TAX, DEHRADUN & ANR. 1173
v. ENRON OIL & GAS INDIA LTD. [S.H. KAPADIA, J.]
->;
3. Vide Notification No. 9997 dated 8.3.1996 under A
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
. ·-t 1999-00 declaring its taxable income of Rs. 71, 19,50,013 under B
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 c
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 D
r stood converted on the basis of the previous 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 E
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 F
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.
:f
G
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 H
1174 SUPREME COURT REPORiS [2008] 12 S.C.R.

~ ..
A 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 Tribunal the
matter pertained to Assessment Years 1999-00, 1998-99, 2000-
01 and 1996-97. However, for the sake of convenience, the
B Tribunal focused its attention on the facts and figures given for
Assessment Year 1999-00. Before the Tribunal, the Department t-
contended that the assessee borrows in USO and repays in
the. same currency for the preparation of the Balance Sheet.
The loans, according to the Department, were stated at prevalent
c exchange rates and the loss so arrived at was charged to the
P&L account. Therefore, according to the Department, the said
lbss 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
D
activity in India. It had to maintain its accounts in rupees for the 1
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
E 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. lherefore,
according to the Tribunal, the liability arising as a consequence
F of depreciation of the rupee had to be considered both for _,.
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
G
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
r
(:
H deduction for foreign exchange losses on account of foreign
'.
COMM. OF INCOME TAX, DEHRADUN & ANR. 1175
v. ENRON OIL & GAS INDIA LTD. [S.H. KAPADIA, J.]
:i
currency translation? In other words, whether loss arising on A
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 herein below Section 42(1) of

..
__,
' the lricome Tax Act, 1961, which reads as follows: B
--<(

"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 c
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 participation of the
Central Government or any person authorised by it in such
-( business (which agreement has been laid on the Table of D
'r 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 E
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 F
I > expenditure incurred by the assessee, whether
before or after such commercial production, in
'I respect of drilling or exploration activities or services
1
or in respect of physical assets used in that
connection, except assets on which allowance for
G
::' depreciation is admissible under section 32 :
Provided that in relation to any agreement entered
into after 31st day of March, 1981, this clau~e shall
< have effect subject to the modification that the words
and figures "except assets on which allowance for H
<l
1176 SUPREME COURT REPORTS [2008] 12 S.C.R.

)'.
A 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
B 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
c of this Act being deemed for this 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
D
oil" includes petroleum and natural gas." ·-y
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
E and Reyenue 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.
F 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
G a consortium are the other partie::; 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
"Participating Interest". One of the Contractors would be
H designated as an "Operator", who would have a control over
COMM. OF INCOME TAX, DEHRADUN & ANR. 1177
v. ENRON OIL & GAS INDIA LTD. [S.H. KAPADIA, J.]
:i

day to day operations. Upfront investments are made generally A
by the Contractors. For this purpose, the Operator "in this case
being Mis 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 8
~
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. c
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
D
't 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 by the Contractor. With the
increased ROI recovered by the Contractor, the percentage E
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
I' F
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.
::'- G
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
H
...
1178 SUPREME COURT REPORTS [2008] 12 S.C.R.

).'.

A 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
B ensure that the projects remained attractive enough for foreign
~
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 USO; some of the cash
calls were required to be converted to INR for local expenses;
c some of the expenses stood incurred in USO whereas some
to be incurred in INR; the sale price of oil was in USO whereas
the accounts were drawn up in USO. When some of the
expenses were incurred in USO 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., USO. Similarly, as
0
stated above, the sale price of oil was in USO. At the time of r
sale, the INR - USO 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 USO. For that purpose also one had ~
to reconvert the costs from barrels to monetary terms. For the
E 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 s~ood 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
~
F 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.
16. Section 42 of the 1961 Act was enacted to ensure that
G \
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
H
COMM. OF INCOME TAX, DEHRADUN & ANR. 1179
v. ENRON OIL & GAS INDIA LTD. [S.H. KAPADIA, J.]
~
44 BB contains special provision for computing profits and A
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. B
~ 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
t under Section 42.
I c
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.
D
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 E
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 F
~
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
G
prospecting, extraction or production of mineral oil, an assessee
f
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
H
1180 SUPREME COURT REPORTS [2008] 12 S.C.R.

A 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 specified in the PSC, hence they cannot be
claimed as deduction under Section 42(1 ).
B 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
c 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
0
13. Under Article 13 the Contractor is entitled to recover Contract
Costs out of the total volume of petroleum produced. That costs r
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
E 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 operations. Article 13 deals with recovery
of costs, as stated above. Article 15 deals with taxes, royalties,
F 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
G 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
H after the commencement of commercial production in respect
COMM. OF INCOME TAX, DEHRADUN & ANR. 1181
v. ENRON OIL & GAS INDIA LTD. [S.H. KAPADIA, J.]

~
of drilling or exploration activities. In other words, two out of A
three allowances mentioned in Section 42(1) are provided for
in Article 15.2.1.
22. The above analysis shows th.at Section 42 provides
for deduction for expenses provided such expenses/allowances
are provided for in the PSC. The PSC in question provides for B
_..
I 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 rule of accounting. In normal accounting, c
~
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 D
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 E
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 F
A.
)j 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.
G
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 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 H
1182 SUPREME COURT REPORTS [2008] 12 S.C.R. '
;'

).'._
A 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
B of India and for accounting purposes under the PSC such rates
I
shall apply as provided for in clause 1.6 of Appendix 'C' to the . ....,
I

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
c 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
D
contractor is required to m(3intain his accounts. It stipulates that
each of the co-venturer has to follow the computation of income r
tax under the 1961 Act. Clause 1.6.1 of appendix 'C' refers to
currency exchange rates. It states that for translation purposes
between USO and INR, the previous month's average of the
E 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.

F 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
G
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
H
COMM. OF INCOME TAX, DEHRADUN & ANR. 1183
v. ENRON OIL & GAS !NOIA LTD. [S.H. KAPADIA, J.]
;;(
important facts of this case. In 1993, Government of India, A
through Petroleum Ministry invited bids for the development of
1',.
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 B
designated as an 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 c
out of the said Account. The Trial Balance was required to be
prepared at the end of the month in USO 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
0
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 E
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 F
,..__
)I 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
USO, there would have been no loss/profit on account of
currency translation. It is because of the specific provision in
G
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.
H
1184 SUPREME COURT REPORTS [2008] 12 S.C.R.

A 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
8 are illusory or real losses? According to the Department, they
are illusory losses.
29. To answer this question we were requirep to understand
the subject of a Production Sharing Contract (PSC). The State
c 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
0
is a civil-law contract. The contractor (investor) carries out the
activities envisaged in the contract (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
E 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
F 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
G the fiscal system of choice for most countries. Taxes are
embedded in the Government share of profit oil. PSC is a -'I'
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
H
COMM. OF INCOME TAX, DEHRADUN & ANR. 1185
v. ENRON OIL & GAS INDIA LTD. [S.H. KAPADIA, J.]

investment. The oil used for this purpose, namely, to recoup A
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 through its nominee as a commercial B
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 c
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 D
profits cannot be ascertained without taking into account
t 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. E
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 F
~
)I on loans or other financing would not be admissible for
deduction. We find no merit in this argument advanced on behalf
of the 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 USO. Clause 3.2 of Appendix 'C' refers to G
-,L
loans borrowed by an assessee or loans which are financed on
w~ich 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 H
1186 SUPREME COURT REPORTS [2008] 12 S.C.R.

A 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
B 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
c monetary balances were required to be translated at the
exchange rate$ 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.
0
33. For the aforestated reasons, we find no merit in this
civil appeal and the same is dismissed with no order as to
costs.
K.K.T. Appeal dismissed.
E