Foreign Exchange Fluctuation: Capitalisation and Taxation under the Income-tax Act, 2025

The Income-tax Act, 2025 deals with exchange-rate gains and losses in two sections. Section 42 covers an asset bought for business or profession from outside India: the rupee change in what you owe is added to, or deducted from, the cost of that asset, not claimed as a loss or taxed as a gain. Section 43 covers every other foreign currency transaction: the gain or loss is income or loss, computed as per the income computation and disclosure standards (ICDS) notified under section 276(2).

Section 42 applies "irrespective of anything contained in any other provision of this Act", and section 43 is "subject to" section 42, so you test section 42 first. This guide explains both with worked numbers. Figures and conditions are taken from the Act as amended by the Finance Act, 2026, and the examples use tax year 2026-27.

Which section applies to my foreign exchange gain or loss?

What does section 42 say about capitalising exchange differences?

Section 42(1) applies when, at the time of making a payment during the tax year, your liability expressed in Indian currency changes because the exchange rate moved. The liability must relate to an asset acquired for the purpose of business or profession from a country outside India. The change is then dealt with as set out in section 42(2) and (3).

Section 42(2) gives the formula A = B − C, where:

• A is the variation in liability.
• B is the payment in Indian currency at the time it is made, either (a) towards the whole or part of the cost of the asset, or (b) towards repayment of moneys borrowed (directly or indirectly) in foreign currency, along with interest, specifically for acquiring that asset.
• C is the liability for the same amount, in Indian currency, at the time the asset was acquired.

Any part of the liability met directly or indirectly by another person or authority is excluded. A positive A means you paid more rupees than you originally owed; a negative A means you paid fewer.

Where does the variation go: cost of the asset?

Under section 42(3) the variation is added to, or reduced from, one of three amounts, and the result is treated as the new figure:

Clause	Adjusted amount
42(3)(a)	Actual cost of the asset referred to in section 39
42(3)(b)	Expenditure of capital nature referred to in section 32(i) or 45(1)(a)(i)
42(3)(c)	Cost of acquisition of a capital asset (other than one referred to in section 74) for section 72

Because the adjusted cost is what later feeds depreciation or capital gains, the effect of the exchange movement is spread over the life of the asset instead of hitting one year's profit. For how depreciation works on that cost, see our guide on depreciation rates and block of assets.

Worked example 1: imported machine paid in two instalments (tax year 2026-27)

Assumptions: Meena's manufacturing company buys a machine from a supplier in Germany for USD 100,000 for use in its business. On the date of acquisition the rate is Rs 80 per USD, so the liability is Rs 80,00,000 and the actual cost is Rs 80,00,000. No part of the liability is met by anyone else. The price is paid in two instalments.

Step	Instalment 1	Instalment 2
Amount paid (USD)	40,000	60,000
Rate when paid	Rs 84	Rs 78
B: payment in rupees	40,000 × 84 = Rs 33,60,000	60,000 × 78 = Rs 46,80,000
C: liability at acquisition	40,000 × 80 = Rs 32,00,000	60,000 × 80 = Rs 48,00,000
A = B − C	+ Rs 1,60,000	− Rs 1,20,000
Effect on cost	Added	Reduced

Adjusted cost: Rs 80,00,000 + Rs 1,60,000 − Rs 1,20,000 = Rs 80,40,000. Check: total rupees actually paid are Rs 33,60,000 + Rs 46,80,000 = Rs 80,40,000. The cost equals what the company really paid, and no part of the exchange difference is claimed as a separate loss or taxed as a separate gain.

What if I booked a forward contract with a bank?

Section 42(4) covers a contract with an authorised dealer (as defined in section 2 of the Foreign Exchange Management Act, 1999) to provide a specified sum in foreign currency on or after a stipulated future date at a rate fixed in the contract, to meet the whole or part of the liability. For so much of the contracted sum as is available to discharge the liability, the amount added or deducted is computed with reference to the rate specified in the contract, not the rate on the payment date.

Worked example 2: forward contract fixes the adjustment (tax year 2026-27)

Assumptions: Ravi's firm buys equipment for USD 50,000 for its business from a supplier in Singapore. The rate at acquisition is Rs 80, so C = 50,000 × 80 = Rs 40,00,000. Ravi books a forward contract with an authorised dealer to buy USD 50,000 at Rs 82. On the payment date the market rate is Rs 85.

Step	With the forward contract (section 42(4))	For comparison: without it
Rate used for B	Rs 82 (contract rate)	Rs 85 (rate on payment date)
B	50,000 × 82 = Rs 41,00,000	50,000 × 85 = Rs 42,50,000
C	Rs 40,00,000	Rs 40,00,000
Amount added to cost	Rs 1,00,000	Rs 2,50,000

With the contract, the cost of the equipment goes up by Rs 1,00,000. The comparison column only shows the arithmetic; the contract is what section 42(4) looks to.

How is other foreign exchange gain or loss taxed under section 43?

Section 43(1) says that, subject to section 42, any gain or loss arising on account of change in foreign exchange rates on foreign currency transactions is treated as income or loss, as the case may be. It is computed as per the income computation and disclosure standards notified under section 276(2). Section 276(2) lets the Central Government notify these standards for any class of assessees or income. Section 276(3)(c) lets the Assessing Officer make an assessment under section 271 where income has not been computed as per the notified standards.

Section 43(2) makes this apply to all foreign currency transactions, including those relating to:

• monetary items and non-monetary items;
• translation of financial statements of foreign operations;
• forward exchange contracts; and
• foreign currency translation reserves.

The Act text does not spell out the detailed rules for each item. Those sit in the notified ICDS, so check the standard in force for the year before you finalise a computation.

Worked example 3: an export receivable settled at a higher rate (tax year 2026-27)

Assumptions: Kiran, a trader, books an export sale of USD 10,000 at Rs 82, so the receivable is Rs 8,20,000. The customer pays in the same tax year when the rate is Rs 84, and Kiran receives Rs 8,40,000. The receivable relates to a sale, not to an asset acquired from outside India, so section 42 does not apply. Assume the ICDS in force treats the settlement difference as part of business income.

1. Rupees received: 10,000 × 84 = Rs 8,40,000.
2. Rupees recorded at the time of sale: 10,000 × 82 = Rs 8,20,000.
3. Exchange gain: Rs 8,40,000 − Rs 8,20,000 = Rs 20,000, treated as income under section 43(1).

Had the rate fallen to Rs 80, the same steps would give a loss of Rs 20,000 (Rs 8,00,000 − Rs 8,20,000).

Real-life scenarios

• The importer. Anita, a printing-press owner, imports a press from outside India and pays the last instalment a year later. The rupee has weakened. She asks her CA whether the extra rupees can be claimed as a loss that year. Under section 42 the extra amount is added to the cost of the press, so it comes back through depreciation instead.
• The software exporter. Sunil invoices overseas clients in dollars and holds a balance in a foreign currency account at year end. These are foreign currency transactions that are not asset purchases, so section 43 applies, and the computation follows the notified ICDS.
• The foreign subsidiary. A company with an overseas operation translates that operation's financial statements into rupees. Section 43(2)(b) names this as a foreign currency transaction covered by section 43.

Is a forex loss on a foreign loan for a locally bought asset capitalised?

Section 42(1) is limited to an asset acquired from a country outside India. Where the asset is bought in India and only the funding is in foreign currency, the section 42 text does not cover it, and the general rule in section 43(1) (income or loss, computed per the notified ICDS) is the provision to test. Check how the notified ICDS treats the item before deciding, because the Act text does not itself say.

Common mistakes

• Claiming the whole difference as a revenue loss on an imported asset. If section 42 applies, the variation belongs in the cost of the asset.
• Forgetting the borrowing limb. Section 42(2)(b) covers repayment of foreign-currency loans and interest taken specifically to acquire the asset, not just the supplier invoice.
• Ignoring a forward contract. Where section 42(4) applies, the contract rate drives the adjustment for the covered sum.
• Counting liability met by someone else. Section 42(2) excludes any part met directly or indirectly by another person or authority.
• Treating section 43 as optional accounting. The computation must follow the ICDS notified under section 276(2).

Quick reference

Question	Answer	Provision
Which is tested first?	Section 42	42(1), 43(1)
Formula for variation	A = B − C	42(2)
Where does the variation go?	Cost of the asset or capital expenditure	42(3)
Forward contract with authorised dealer	Contract rate is used for covered sum	42(4)
Other forex gains and losses	Income or loss, per notified ICDS	43(1), 276(2)

Where this is in the Act

• Section 42: Capitalising impact of foreign exchange fluctuation
• Section 43: Taxation of foreign exchange fluctuation
• Section 39: Computation of actual cost
• Section 276: Method of accounting (ICDS under sub-section (2))

For a CA firm, the hard part is tracking which clients have imported assets with payments spread over several years, since each payment triggers a fresh adjustment. Finexo's practice management software helps you keep client-wise task lists and reminders for that follow-up. It does not compute the adjustment for you.

This article is general information on the Act and not tax advice for your case.