Foreign exchange forex the general translation rule
Australia has recently adopted a revolutionary new codified regime for dealing with the taxation treatment of transactions that occur in foreign currency. Leaving aside a limited number of exceptions, the new rules will generally be relevant whenever transactions take place in foreign currency and are, therefore, clearly of great importance to all tax practitioners and tax scholars.
The new forex regime comprises a set of rules for translating foreign currency into Australian currency and a set of rules for dealing with foreign currency exchange gains and losses. This article provides a conceptual and theoretical framework for analysing the new legislation. It examines the operation of the key provisions in the statute and it provides a number of illustrations of how some of the main rules work in a practical context. It also touches on various underlying policy issues relating to the scheme.
The second set of provisions, located in Subdivs C and D of the ITAA97, contain rules for translating foreign currency into Australian currency. Together, these provisions represent a substantial body of new law and are of fundamental importance to the way in which transactions that occur in foreign currency are treated under the Australian income tax law. These reforms were first mooted in the early s. Since that time there has been an on-going consultative process between Treasury and the private sector with a view to developing an appropriate and consistent set of rules for taxing financial arrangements in Australia.
The third and fourth stages of the reforms are now proposed to operate from no earlier than 1 July The third stage foreign exchange forex the general translation rule to the taxation of commodity hedges while the fourth stage relates to various tax timing issues and synthetic arrangements. This article focuses exclusively on the new forex rules. In this regard, the article examines the operation of the key sections within the legislation including the many important and lengthy tables that reside within these sections and it provides a number of practical illustrations of how some of the main rules operate.
The article also considers some of the policy aspects that underpin these rules and concludes with some broad observations about the regime. One of the main roles of the new forex regime is to provide the necessary legislative framework for doing this.
These rules are superimposed upon the general provisions in the legislation and they work in conjunction with the specific foreign currency exchange gain and loss provisions located in Foreign exchange forex the general translation rule of the ITAA97 see 5. The rules in Subdivs C and D replace a range of ad hoc currency translation rules that were previously scattered throughout the tax legislation.
Consequently, these rules will continue to operate in relation to transactions entered into before the commencement date of the forex regime. The general translation rule is contained in s 1. The most important feature of the general translation rule is that it contains a set of foreign exchange forex the general translation rule rules for determining the time at which particular amounts are translated into Australian currency.
These rules are located in the table in s 6. The table sets out eleven specific translation rules, which operate subject to any modifications that may be made by the regulations.
Y Co sells machinery to retailers in Europe and is ordinarily paid in Euro within three months of entering the contracts. As the income is derived prior to payment being received, Y Co is required to translate the foreign currency denominated income into Australian dollars at the exchange rate applicable at the time of derivation.
These events and their consequences are discussed in detail below see 5 and 6. The particular entities that are able to choose to use the functional currency rules and the particular amounts that these rules apply to are set out in the table in s 1.
There are five situations covered by the table:. A choice to use the applicable functional currency must be made by the relevant entity in writing. A choice will continue to have effect until a withdrawal of the choice which must also be made in writing takes effect as determined in accordance with the table in s - The way in which amounts are translated using the applicable functional currency is set out in the table in s foreign exchange forex the general translation rule Different translation rules apply depending on the entity involved and the particular kind of tax calculation undertaken eg calculation of taxable income, tax losses, attributable income etc.
The relevant tax liability is then calculated in the applicable functional currency. Special two-stage translation rules, contained in soperate where:. The same process operates where a previous choice has been made, except the previously applicable functional currency is substituted for Australian currency. The double translation is designed to ensure that any unrealised gain or loss that exists at the time of the choice does not escape taxation simply because the choice is made.
The new currency translation rules discussed above operate in conjunction with the new foreign currency exchange gain and loss rules discussed below see 5. However, before turning to examine these rules, it is appropriate to first discuss the general nature of foreign currency exchange gains and losses 3.
Foreign currency exchange gains and losses typically arise where taxpayers enter into contracts and the price is expressed in a foreign currency. The difference in these amounts is the amount of the respective exchange gain or loss made by the taxpayer.
Fred is a furniture exporter. Under the general translation rule see 2. Under the common law, exchange gains and losses could only arise where amounts in one currency were actually converted into another currency. The High Court held that the taxpayer had not made any exchange gains or losses from the relevant transactions as only one currency was involved.
In effect, this means that the outcome of Energy Resources would be different under the new rules. It is clear that in drafting the forex rules, the legislature specifically sought to address the Energy Resources principle. This policy intent is clearly expressed in the Explanatory Memorandum to the Bill which introduced the forex regime where it is stated:.
Prior to the introduction of the forex regime, foreign currency exchange gains and losses were dealt with under a number of different tax regimes. Initially, the only provisions that dealt with foreign currency exchange gains and losses under the Australian income tax law were the ordinary income and general deduction provisions contained in former s 25 1 and s 51 1 of the ITAA36 now ss 6 - 5 and 8- 1 of the ITAA To fall within these provisions it was necessary that the exchange gains and losses could be characterised as being of an income or revenue nature as opposed to being of a capital nature.
More specifically, the cases dealing with the former ss 25 1 and 51 1 established that exchange gains are assessable and exchange losses are deductible in so far as they are referable to discharging or providing for liabilities on revenue account eg the purchase or sale of trading stock: Division 3B of Foreign exchange forex the general translation rule III of the ITAA36 s 82U to 82ZB was introduced in the mids in order to bring certain exchange gains and losses that were of a capital nature and which therefore did not fall within the ordinary income or general deduction provisions within the tax system.
In other words, the Division was focused on currency exchange gains and losses that were of an income producing or business character, but which did not fall within the ordinary income and general deduction provisions simply because they were of a capital nature. The Division did not apply to currency exchange gains and losses that were of a private character. In practice, however, the CGT regime did not usually bring such gains and losses to account, since the gains and losses were usually already brought to account under either the general taxation rules or the special rules in Div 3B.
The CGT regime ordinarily provided relief against double taxation or double benefit in these circumstances. The rules for dealing with currency exchange gains and losses under the new forex regime are contained in Div of the ITAA97 s 5 to s The following discussion examines the general operation of this Division, which spans almost 50 pages of legislation.
As mentioned previously, the rules in Div work in conjunction with the foreign currency translation rules discussed above. While the forex regime generally applies prospectively ie to gains and losses on transactions entered into from the commencement datea transitional rule allows taxpayers to elect to have the forex rules apply to gains and losses made on transactions entered into before the commencement date, but realised after that date.
The forex regime has been designed to largely replace the former regimes dealing with exchange gains and losses. To the extent that any gains or losses fall within the forex regime, they are not also assessable or deductible under other provisions in the legislation eg they do not fall within the ordinary income or general deduction provisions.
A special transitional rule, however, maintains the operation of the Division ie it is treated as if it had not been repealed in relation to eligible contracts entered into before the commencement date. Accordingly, while the forex regime now contains the principal rules for dealing with foreign exchange forex the general translation rule gains and losses, it does not apply in all cases.
In those circumstances where the forex regime does not foreign exchange forex the general translation rule, the pre-forex regimes see 4 will generally continue to operate. Division has been designed as a comprehensive taxation framework for dealing with currency exchange gains and losses. There are five main kinds of forex realisation events:. In addition, there are three further kinds of forex realization events which operate where certain choices have been made.
To prevent double taxation of gains, s 15 4 provides that to the extent that a forex realisation gain would otherwise be included in assessable income under another provision eg under s 6 - 5the gain is only included in assessable income under s Similarly, to prevent double deductions for losses, s 4 provides that to the extent that a forex realisation loss would otherwise be deductible under another provision eg under s 8- 1the loss is only deductible under s The way in which a forex realisation gain or a forex realisation loss is calculated depends on the kind of forex realisation event involved.
In general, the amount of the gain or loss is calculated according to one of the following two broad methods:. As mentioned above see 5. It is particularly important to realise foreign exchange forex the general translation rule every time foreign currency is paid to another entity eg as consideration under a contractthe foreign currency will be disposed of and it will therefore be necessary to consider the application of FRE 1.
This forex realisation event is therefore extremely common. The circumstances in which an entity makes a forex realisation gain or forex realisation loss under FRE 1 are as follows:. The time of the forex realisation event is when the entity ceases to have the right or part of the right to receive the foreign currency. FRE 2 commonly occurs when a right to receive foreign currency is satisfied by the actual receipt of the foreign currency. The circumstances in which an entity makes a forex realisation gain or forex realisation loss under FRE 2 are as follows:.
Betty is a software exporter. As a consequence of the payment, Betty ceases to have the right to receive foreign exchange forex the general translation rule foreign currency as the debt is satisfied.
This results in FRE 2 happening on 1 October FRE 3 happens under s 50 1 if:. The time of the forex realisation event is when the entity ceases to have the obligation or part of the obligation. The circumstances in which an entity makes a forex realisation gain or forex realisation loss under FRE 3 are as follows:.
FRE 4 happens if an entity ceases to have an obligation, or foreign exchange forex the general translation rule of an obligation, to pay foreign currency and the obligation, or part of the obligation, is one which falls within the list in s 1 b. For instance, it covers: It also covers obligations incurred in return for receiving Australian or foreign currency, or the right to receive such currency.
FRE 4 commonly occurs when a taxpayer actually makes a payment of foreign currency. For example, FRE 4 would occur when a taxpayer pays an amount of foreign currency in relation to a deductible expense that it has incurred or where it pays an amount of foreign currency to acquire a CGT asset. The circumstances in which an entity makes a forex realisation gain or forex realisation loss under FRE 4 are as follows:.
Pamela operates a beauty parlour and imports make-up from overseas which she sells in the ordinary course of her business. As a consequence of the payment, Pamela ceases to have an obligation to pay the foreign currency as she has satisfied the debt. This results in FRE 4 happening on 1 October FRE 5 happens if an entity ceases to have a right, or part of a right, to pay foreign currency  and the right, or part of foreign exchange forex the general translation rule right, is created or acquired in return for foreign exchange forex the general translation rule assumption of an obligation to pay foreign currency or Australian currency.
The circumstances in which an entity makes a forex realisation gain or forex realisation loss under FRE 5 are as follows:. There are cases in which a particular transaction might give rise to more than one forex realisation event. Foreign exchange forex the general translation rule example, a transaction involving the future sale of one foreign currency in exchange for another foreign currency will foreign exchange forex the general translation rule both a right or obligation to receive foreign currency and a right or obligation to pay foreign currency.
In order to prevent the duplication of forex realisation gains and losses in these cases, s 65 contains a table that specifies which forex realisation events are to be ignored.