Foreign Exchange Gains and Losses
A taxpayer may make a windfall gain or loss due to fluctuations in exchange rates between the time the tax law recognises an amount and the time of realisation or receipt or payment of an amount. The amount of the gain or loss (referred to as a forex realisation gain or forex realisation loss) may be assessable or deductible to the taxpayer, at least to the extent such gain or loss is not private in nature.
The rules addressing the tax treatment of foreign exchange gains and losses are contained in Division 775 of the Income Tax Assessment Act 1997. There are also translation rules contained in Subdivision 960-C and 960-D of the ITAA 1997.
A word of warning: the forex rules can be complex.
Division 775 of the ITAA 1997
Division 775 provides that a taxpayer must include in assessable income any forex realisation gain resulting from a forex realisation event. Conversely, any forex realisation losses may be an allowable deduction. A forex gain is included in assessable income in the income year realised and a forex loss is deductible in the income year it is made. Any forex realisation gain is not included in assessable income to the extent it is private in nature. Any forex realisation loss is not an allowable deduction to the extent it is private in nature. Any private nature to a gain or loss can be determined by considering the character of the relevant transaction or the character of the underlying asset relevant to the forex realisation event.
Note that certain forex realisation gains and losses may not be considered private despite those gains or losses flowing from an underlying asset that is private. This includes forex realisation gains and losses flowing from land which is used for private purposes, collectables and personal use assets.
The trigger for recognising a forex realisation gain or loss is the occurrence of a forex realisation event.
There are eight possible forex realisation events, but five main events which are listed below:
FRE 1 where the taxpayer disposes of a foreign currency or a right to receive foreign currency to another entity.
FRE 2 where the taxpayer ceases to have a right to receive foreign currency (e.g. when the right expires or when the amount of foreign currency is paid out to the taxpayer thereby discharging the right) and the right is a right to either: ordinary or statutory income, a right in return for ceasing to hold a depreciating asset, a right in return for agreeing to pay an amount of Australian or foreign currency, or a right in return for the occurrence of a realisation event to a CGT asset.
FRE 3 where the taxpayer ceases to have an obligation to receive foreign currency and that obligation was for a right to pay foreign currency or Australian currency.
FRE 4 where the taxpayer ceases to have an obligation to pay foreign currency and the obligation is an outgoing that is deductible or included in the cost of an asset for taxation purposes.
FRE 5 where the taxpayer ceases to have a right to pay foreign currency that was acquired for assuming an obligation to pay foreign currency or Australian currency. This includes a right to pay an amount that is calculated by reference to a currency exchange rate effect, but which is not an amount of foreign currency.
The below provides a more detailed address of each event and includes examples:
FRE 1
As provided in section 775-40 of the ITAA 1997, a taxpayer makes a forex realisation gain if:
- They make a capital gain from CGT event A1; and
- Some or all of the capital gain is attributable to a ‘currency exchange rate effect’.
The amount of the forex realisation gain is so much of the capital gain as is attributable to the currency exchange rate effect. It would be commonly expected that a forex realisation gain is entirely attributable to the currency exchange rate effect.
There are similar rules for calculating a forex realisation loss.
Remember that a capital gain is calculated as capital proceeds less cost base. A capital loss is calculated as capital proceeds less reduced cost base.
A ‘currency exchange rate effect’ is essentially any currency exchange rate fluctuation or the difference between:
- An agreed currency exchange rate for a future date or time; and
- The actual currency exchange rate at that date or time.
The translation rules in section 960-50 or section 960-80 (which is applicable) should be consulted to calculate the currency exchange rate effect (if any).
FRE 1 will be triggered either when the foreign currency is disposed or when the relevant right is disposed.
The forex realisation gain, unlike the relevant capital gain, is on revenue account and assessable to the taxpayer as income.
As an example of FRE 1, take Buddy Pty Ltd which is an Australian resident company. The company purchases shares in a NZ company for NZ$200,000. At the time of purchase / disposal of the foreign currency, according to the prevailing exchange rate, NZ$200,000 equates to A$180,000.
The company makes the purchase from existing holdings of NZ$. At the time the NZ$200,000 was acquired, NZ$200,000 equated to A$160,000. Therefore, the NZ$200,000 had a cost base of A$160,000.
CGT event A1 happens to the NZ$200,000 when Buddy Pty Ltd purchases the shares as the foreign currency is disposed (that is, there is a change of ownership over the NZ$ used to purchase the shares). The happening of CGT event A1 triggers FRE 1 (when the A$200,000 is paid to acquire the shares). The result is a A$20,000 forex realisation gain. This is the capital proceeds of $180,000 (the A$ cost of the shares acquired at the time FRE 1 occurs) less the cost base of $160,000 (the A$ cost of acquiring the NZ$ utilised to acquire the shares).
To further illustrate what triggers FRE 1, take the example of a taxpayer using foreign banknotes to pay for goods or services. The change of ownership of the foreign currency (i.e. the handing over of the banknotes) triggers CGT event A1 which thereby triggers FRE 1. That is, FRE 1 occurs at the time of hand over (when ownership of the banknotes changes).
Alternatively, take the example of a taxpayer depositing foreign banknotes into a bank account denominated in that foreign currency. In this instance, the taxpayer has disposed of the banknotes to the bank for a right to receive an equivalent amount of that foreign currency. Ownership over the banknotes has been transferred which triggers CGT event A1 which thereby triggers FRE 1. Therefore, FRE 1 occurs at the time of deposit.
FRE 1 applies to foreign currency (or a right to foreign currency) using a first-in first-out method or a weighted average method if the taxpayer makes an election to use that method.
FRE 2
As provided in section 775-45 of the ITAA 1997, a taxpayer makes a forex realisation gain if:
- The amount they receive in respect of the event happening exceeds the forex cost base of the right or part of a right (the forex cost base is worked out as at the ‘tax recognition time’); and
- Some or all of the excess is attributable to a currency exchange rate effect.
The amount of the forex realisation gain is so much of the excess as is attributable to the currency exchange rate effect.
There are similar rules for calculating a forex realisation loss.
FRE 2 occurs at the time when the taxpayer’s right ceases. Generally, this is when an amount is received to discharge a right.
The ‘tax recognition time’ varies depending on the nature of the right as set-out below:
- For a right to receive ordinary income, the tax recognition time is when the ordinary income is derived.
- For a right to receive statutory income, the tax recognition time is when the statutory income is included in assessable income.
- For a right created in return for ceasing to hold a depreciating asset, the tax recognition time is when the taxpayer stops holding the asset.
- For a right involving payment an amount of Australian or foreign currency, the tax recognition time is when the amount is paid.
- See section 775-45 for further examples.
You can see that the ‘tax recognition time’ is the time the relevant right (as listed above and in s 775-45) is recognised for tax purposes.
Therefore, the forex realisation gain or loss is essentially picking up the difference between the amount received (at the time FRE 2 occurs) and the amount recognised by the tax law (at the tax recognition time). Put another way, the forex realisation event is designed to capture a gain made between the time the tax law recognises an amount and the time the amount is received. A favourable fluctuation in the exchange rate during this period would otherwise be tax-free.
As an example, take Buddy Pty Ltd which on 1 January 2023, acquires a depreciating asset to be used in the business. On 1 January 2024, the company sells the asset to a foreign purchaser and stops holding it. The asset sells for NZ$100,000 which, at the time, equates to A$80,000. On 1 February 2024, the payment for the asset is made and received. At this time, NZ$100,000 is equated to A$90,000. Here, FRE 2 occurs when the company receives the payment which discharges the right created in return for ceasing to hold a depreciating asset. The cost base of the right to receive the NZ$100,000 is A$80,000. This the value of the right at tax recognition time. There is therefore a $10,000 forex realisation gain, being: A$90,000 (the A$ equivalent amount received in respect of the event) less A$80,000 (the A$ equivalent of the forex cost base). In this example, it is assumed that the forex realisation gain is 100% attributable to a ‘currency exchange rate effect’.
FRE 3
As provided in section 775-50 of the ITAA 1997, a taxpayer makes a forex realisation gain if:
- The amount they receive in respect of the event happening exceeds the net costs of assuming the obligation (the net costs are worked out as at the tax recognition time); and
- Some or all of the excess is attributable to a ‘currency exchange rate effect’.
The amount of the forex realisation gain is so much of the excess as is attributable to the currency exchange rate effect. There are similar rules for calculating a forex realisation loss.
FRE 3 occurs at the time when the taxpayer’s obligation ceases.
The tax recognition time is when the taxpayer receives an amount in respect of the event happening.
The ‘net costs’ of assuming the obligation is essentially the total consideration (including the value non-cash benefits) the taxpayer must pay to fulfil their assumed obligation.
As an example, take Buddy Pty Ltd which enters into a contract to buy an asset from a US company for US$1,000,000 with payment due in 12 months. Buddy Pty Ltd enters into a forward contract to acquire US$1,000,000 for A$1,200,000 to mitigate the risk of currency movements during the 12-month period leading into payment. At the time of contract, US$1,000,000 equates to A$1,200,000. However, after 12 months, when the currency exchange occurs to make payment for the asset, the Australian dollar has become weaker against the US dollar. That is, US$1,000,000 now equates to A$1,300,000. In this instance, Buddy Pty Ltd makes a forex gain of $100,000, being A$1,300,000 (A$ equivalent of amount received) less $1,200,000 (A$ equivalent of net costs of assuming the obligation at the tax recognition time).
You can see that FRE 3 is applicable in the above example as Buddy Pty Ltd ceases to have an obligation to receive foreign currency when receipt occurs.
FRE 4
As provided in section 775-55 of the ITAA 1997, a taxpayer makes a forex realisation gain if:
- The amount they paid in respect of the event happening falls short of the proceeds of assuming the obligation. The proceeds are worked out as at the tax recognition time; and
- Some or all of the shortfall is attributable to a currency exchange rate effect.
The amount of the forex realisation gain is so much of the shortfall as is attributable to a currency exchange rate effect. There are similar rules for calculating a forex realisation loss.
FRE 4 occurs at the time when the taxpayer’s obligation ceases.
The tax recognition time varies depending on the relevant obligation as can be seen in section 775-55.
The ‘proceeds of assuming the obligation’ is defined in section 775-95. Essentially, this refers to the total consideration (including the value of non-cash benefits) the taxpayer receives or is entitled to receive in return for incurring the obligation, less any amounts that are otherwise assessable.
As an example, take Buddy Pty Ltd which engages a USA based contractor to provide services on that day for US$50,000. The contract cannot be escaped and the taxpayer is definitely committed to payment. The exchange rate at the time of the contract is A$70,000. As agreed, the services under the contract are immediately carried out. However, the contract provides that payment is due within 90 days. Buddy Pty Ltd waits the full 90 days before making payment. At the time the payment is made and received, the exchange rate for US$50,000 is A$60,000.
In this instance, there is a forex gain of $10,000, being the shortfall created from A$60,000 (the A$ equivalent amount actually paid) less A$70,000 (the A$ equivalent of the proceeds of assuming the obligation at tax recognition time).
You can see that FRE 4 is applicable in the above example as the obligation of the Buddy Pty Ltd to pay the foreign currency to the contractor ceases once that payment is made.
Note the relevant tax recognition time here is the date of contract, as this is when the expense becomes deductible. By way of reminder, an expense becomes deductible when it is incurred. That is, at the point in time when there is a money debt that cannot be escaped and where the taxpayer is definitively committed to payment.
FRE 5
As provided in section 775-60 of the ITAA 1997, a taxpayer makes a forex realisation gain if:
- The amount they pay in respect of the event happening falls short of the ‘forex entitlement base’ of the right. The forex entitlement base is worked out as at the tax recognition time; and
- Some or all of the shortfall is attributable to a currency exchange rate effect.
The amount of the forex realisation gain is so much of the shortfall as is attributable to a currency exchange rate effect.
FRE 5 occurs at the time when the taxpayer’s right ceases.
The ‘forex entitlement base’ is defined in section 775-90. Essentially, this refers to the total consideration (including the value of non-cash benefits) the taxpayer receives or is entitled to receive in respect of the discharge or satisfaction of the right.
The ‘tax recognition time’ occurs when the taxpayer pays an amount in respect of the event happening.
FRE 6 – FRE 8
These are less common forex realisation events. Refer to Division 775 of the ITAA 1997 for further details.
Alterations to above rules
There are several alterations to the forex realisation rules in terms of the need for calculating the relevant gain or loss and then having that amount assessed or available as an allowable deduction. Some of these alterations are designed to reduce the significant compliance burdens that might otherwise be imposed on taxpayers in requiring the calculation of forex realisation gains or losses on every occasion there is a FRE.
- Alteration 1: Short term forex realisation gains and losses
- Alteration 2: Roll over relief for facility agreements
- Alteration 3: Qualifying forex accounts and the limited balance test
- Alteration 4: Retranslation for qualifying forex accounts.
Below provides further explanation and examples of each alteration.
Alteration 1: short term forex realisation gains and losses
The taxation consequences of short term forex realisation gains are set out in section 775-70. These consequences vary as set out below:
- If there is a forex gain from FRE 2 and the right to receive foreign currency was created in return for the occurrence of a realisation event in relation to a CGT asset the taxpayer owns and item 6 of the table in section 775 45 applies and the foreign currency became due for payment within 12 months after the occurrence of the realisation event then, the forex realisation gain is not included in assessable income and CGT event K10 occurs instead.
- If there is a forex gain from FRE 4 and the obligation to pay foreign currency was incurred in return for the acquisition of a CGT asset or as an element of the cost base of a CGT asset (but not the first element of the cost base) and item 9 of the table in section 775 55 applies and the foreign currency became due for payment within 12 months after the time the asset is acquired or the relevant expenditure is incurred (whichever is relevant) then, the forex realisation gain is not included in assessable income and instead the cost base of the CGT asset is reduced by the amount of the forex gain. It appears that any forex realisation gain that exceeds the cost base of the CGT asset is not required to included in assessable income.
- If there is a forex gain from FRE 4 and the obligation to pay foreign currency was incurred in return for starting to hold a depreciating asset or as a second element cost of a depreciating asset and the foreign currency became due for payment within 12 months after or before the time the asset is acquired or due for payment within 12 months after the relevant expenditure is incurred (whichever is relevant) then, the forex gain is not included in assessable income and instead the relevant asset tax value is to be reduced (up to nil) by the amount of the forex gain. Any forex realisation gain that exceeds the tax value of the relevant depreciating asset will need to be included in assessable income.
- See section 775-70 for further scenarios addressing short term realisation gains.
As you can see, the key underlying requirement here is that the foreign currency is due for payment within 12 months after the relevant event occurs (i.e. within 12 months of the occurrence of the realisation event, or the time the asset is acquired, or the time relevant expenditure is incurred).
You will also note that the short term forex realisation gains or losses rather than being assessable or deductible per the standard rules will still need to be brought to account under the tax law. For example, the forex realisation gain or loss may need to be recognised on capital account by reducing the cost base of a CGT asset or reducing the tax cost of a depreciating asset.
Alteration 2: Roll over relief for facility agreements
A facility agreement involves an agreement between at least two entities where the first entity has a right to issue eligible securities and another entity must acquire those securities. The purpose of the agreement must be to enable the first entity to obtain finance in a specific foreign currency.
The taxpayer can choose to apply roll over relief in respect of certain forex realisation gains made from facility agreements.
For example, if a forex realisation gain is made under FRE 4, the forex realisation gain may be disregarded if the event happens because the taxpayer discharges their obligations in relation to the eligible security and satisfies additional conditions.
Alteration 3: Qualifying forex accounts and the limited balance test
The taxpayer can make a written election to disregard a forex realisation gain or forex realisation loss from FRE 2 or FRE 4 (or any capital gain or loss in respect of CGT event C1 or C2 as a result of a currency exchange rate effect) that occurs in relation to a qualifying forex account(s) which pass the limited balance test at the time the relevant forex realisation event occurs.
In essence, this concession is designed to enable taxpayers with a foreign bank account or foreign denominated bank account (a qualifying forex account) with a small balance (under the amount allowed under the limited balance test) to disregard foreign exchange gains and losses that occur in relation to that account. For example, when a taxpayer makes a deposit to an account with a debit balance (FRE 2 possible) or when a taxpayer makes a withdrawal from an account with a credit balance (FRE 4 possible).
A ‘qualifying forex account’ is defined as an account that:
- Is denominated in a particular foreign currency; and
- Is held with an ADI or similar institution; and
- Is an account that has the primary purpose of facilitating transactions (e.g. a bank account used to facilitate foreign transactions); or
- Is a credit card account.
Whether a bank account of the taxpayer has the primary purpose of facilitating transactions will depend on the commercial circumstances of the taxpayer and the intended purpose and use of the account.
Once an election is made in writing, it will subsist until either:
- The taxpayer ceases to hold the account
- The account stops being a ‘qualifying forex account’
- The election is varied to remove the particular account
- The election is withdrawn.
Note that multiple accounts may be included in the election. Accounts may be added to and removed from the election by way of variation.
The qualifying forex account(s) will pass the limited balance test if at the time of the relevant event, an election has effect in relation to the account(s) and the aggregate credit balance of all the qualifying forex accounts covered by the election is less than the exchange rate equivalent of A$250,000. The exchange rate that needs to be used to test the taxpayer under the limited balance test is the average exchange rate with that foreign currency for the third month that preceded the income year. For an entity with a 30 June year end, this means the average exchange rate for April (before the income year in which the relevant forex realisation event occurs) is used to determine the foreign currency equivalent of A$250,000.
Note that the A$250,000 threshold also applies to the aggregate debit balance of all the qualifying forex accounts. That is, if total debits against all the qualifying forex accounts covered by the election exceed A$250,000, the test threshold will be exceeded.
Note also that the $250,000 threshold is extended to $500,000 if there are short periods where the taxpayer exceeds the threshold. The excess must not occur on more than 2 occasions within an income year and, on each occasion, must not subsist for longer than 15 days. This is known as the buffering rule.
Alteration 4: Retranslation for qualifying forex accounts
The taxpayer may make a written election for retranslation for a qualifying forex account (qualifying forex account defined in the above heading).
In essence, the retranslation rule provides an entity with a simplified way of calculating forex realisation gains and losses relating to the flow of funds in and out of a foreign account.
The rule enables forex realisation gains or losses made from FRE 2 or FRE 4 (or capital gains or losses from CGT event C1 or C2 related to a currency exchange rate effect) to be disregarded. Instead, FRE 8 applies to bring to account any forex realisation gains or losses which are calculated on a retranslation basis.
The taxpayer will make a forex realisation gain if there is a positive retranslation amount for the account during the retranslation period. The retranslation amount is calculated according to the formula contained in section 775-285.
The formula essentially looks at the A$ translated change in the balance of the qualifying forex account for the income year (i.e. the ‘retranslation period) and then adjusts for the A$ translated value of deposits and withdrawals during that period. The adjustment is necessary to identify fluctuations in the account balance that are the result of movements in exchange rates.
The written election continues to have effect until the first of the following occurs:
- The taxpayer ceases to hold the account; or
- The account ceases to be a qualifying forex account; or
- A withdrawal of the election (in writing) takes effect.
Subdivision 960-C and 960-D of the ITAA 1997
Subdivision 960-C and Subdivision 960-D contain translation rules aimed at how amounts expressed in a foreign currency are to be translated into Australian currency.
The core translation rule in Subdivision 960-C is that an amount of foreign currency is to be expressed in Australian currency. This rule applies broadly to different amounts. For example, it includes:
- An amount of ordinary income
- An amount of an expense
- An amount of an obligation
- An amount of a liability
- An amount of a receipt
- An amount of a payment
- An amount of consideration.
There are special translation rules that address the timing of the translation. These rules are set out in section 960-50.
For example:
- In the case of the cost of a depreciating asset, the cost of the asset is translated to Australian currency at the exchange rate applicable when the taxpayer begins to hold the asset or when the obligation incurred is satisfied (whichever is relevant depending on the circumstances).
- In the case of an item of trading stock, where the cost method is used, the value of the item is translated to Australian currency at the exchange rate applicable at the time the item became on hand.
- However, in the case of an item of trading stock where the market selling value or replacement value method is used, the value is to be translated to Australian currency at the exchange rate applicable at the end of the income year.
- In the case of an amount that can be deducted (other than under Division 40), the amount is translated at the time the amount is deductible unless paid before it becomes deductible in which case the time of translation is when payment occurs.
Refer to section 960-50 for other specific special translation rules.
Subdivision 960-D provides translation rules for certain entities that keep accounts predominantly in a particular foreign currency. These rules enables the entity to calculate net income entirely in that foreign currency. The net income is then translated into Australian currency.