Capital Account and Current Account Transactions

In one line

The distinction between a current and a capital account transaction decides whether a dealing is free or managed: the current account is free under section 5, the capital account is permissible only to the extent specified or prescribed under section 6. The two are exhaustive and complementary, because section 2(j) defines a current account transaction as a transaction other than a capital account transaction.

Why the distinction carries the Act

Because the two kinds of transaction pose different risks. A payment for goods, for a service, for interest or for a child's education abroad is the settlement of an obligation already incurred, and refusing it damages trade without protecting anything. A transaction that creates or extinguishes an asset or liability across the frontier is different: capital can move in very large amounts, very quickly, and in the same direction as everybody else's, and a sudden outflow can break a currency and a banking system.

India's policy since 1994 has therefore been convertibility on the current account and management on the capital account, and section 5 and section 6 are that policy in statutory form. India accepted the obligations of Article VIII of the Articles of Agreement of the International Monetary Fund in August 1994, undertaking not to impose restrictions on payments and transfers for current international transactions, and has never accepted full capital account convertibility.

The classification is therefore the first question in any FEMA problem after residence, because it determines which of two entirely different regimes applies.

The definitions

"Capital account transaction" is section 2(e): a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India, and includes transactions referred to in sub-section (3) of section 6.

The cross-reference is broken. Section 6(3) was omitted with effect from 15 October 2019, so the definition points at a provision which no longer exists. The substance is not lost, having moved to sections 6(2), 6(2A) and 6(7), but a candidate should state the position rather than reciting the definition as though it were intact.

The operative words are "alters the assets or liabilities". A capital account transaction changes a balance sheet across the frontier: it creates an asset abroad for a resident, or extinguishes one; or creates a liability in India for a non-resident, or extinguishes one. Contingent liabilities are expressly included, which catches a guarantee given by a resident in favour of a non-resident, an arrangement that alters nothing until it is called but changes the exposure immediately.

"Current account transaction" is section 2(j): a transaction other than a capital account transaction and, without prejudice to the generality of the foregoing, such transaction includes: