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Tax Treatment of Exchange Gains and Losses
181
Economic Analysis and Policy
Vol. 15 No. 02, September 1985
TAX TREATHElfT OF BICBANGE GAINS AND LOSSKS
Charles Gibbons Gene r al Manager - Group Taxation Services CRA Ser vices Limited
1.
INTRODUCTION
In the past two decades, the Western world has witnessoC:l lIIajor changes in the financial system . The post_war period was dominated by the Bretton-Woods arrangements which set rules for world financial conduct. These arrangements, which included the establishment of the International Monetary Fund and World Bank, were set up in a period when the OS dollar dominated the world ' s financial system. One feature of this period was the relative stability of exchange rates - an arrangement designed to limit the damaging practices developed in the thirties which i ncluded competitive devaluations, exchange contrOls and other barriers to world trade. Floating exchange rates have now largely replaced the fixed rates of the Bretton-Woods era. In addition, deregulation of financial markets and the evolution of electronic transfer of funds have transformed the nature of the world ' s finsncial markets . A twenty-four hour round the globe set Of integrated markets has emerged. New financial products or packagee have become an everyday event. Huge SIllllS of capital now move into and out of markcts with increasing speed snd this has lead to a notable increase in volatility. During this period , there have been insufficient funds in the Australian market to meet all the borrowing needs of Australian COlllpanies . This has caused many Australian companies to raise !'Iubstantial bor rowings from overseas lenders. As such, these companies have not had the simple chOice of altel"ing their currency exposure by tapping the local capita l market resources . The mining industry is one of the many industriea which has sl,Ibstantinl oumo from overseas. The 19011 Hlm:l'sl Im.lul:ltry Survey by Coopers .5. Lybrand showed that the total borrowings of that (which does not include 011 and gas) were around $10.4 billion a nd amount foreign borrowings amounted to some $1.1 billion.
borrowed prepareo industry of this
The taxation treatment of exchange gains and losses haa provoked considerable argument and debate for many years. Also , this question has been the subject of a number of cases which have been litiga ted by both taxpayers and the Taxation Authorities. 1 But the judgements in these cases have clarified only some areae of this subject. Unfortunatel y these judgements have also tended to add even further complexities to t his a lready complex area of law. A list of reference cases is given at the end of the paper.
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Although exchange losses have been incurred over the last decade, the recent floating of the Australian dollar and the substantial decline in its value has greatly exacerbated the situation. As such , substantial actual exchange losses now could be incurred on most, if not all, foreign borrowings. But, if the exchange rate of the Austra11an dollar has nO'ol bottomed, future borrowers of foreign runds could derive exchange gains thus reversing the current experience. This paper will consider : (a)
the current generally accepted tax treatment for exchange gains or losses on loan transactions in respect of a non-finance company and a finance cOlllpanYi
(b)
when a currency gain is derived or a loss incurred.
(o)
the distinction between a revenue gain or loss as o pposed to a capital gain or loss; and
(d)
other .atters r elating to this complex area .
It 1a also proposed to consider what tax reforlllB might be considered in relation to the question of the tax treatlllent of currency gains or losses . This seotlon will also briefly look at the assessabi1ity or deductibility for tax purposes o f exchange Variations in countries with whom Austra11a cOlllpetes in international trade.
However, it is not proposed in this paper to adopt the usual approach of quoting cases , seotions of the Income Tax Assessment Aet and extensi ve passages frolll judgementa in various legal cases. Instead it is proposed to give only a general and hopefully informative out11ne of the current tax position together with some of the major problems in this area of taxation.
2.
CURRENT TAX POSITION
In order to provide a more meaningful summary of the eu rrent tax position, the question of the tax treabrlent of exchange gains or losses will be expanded to cover not only borrowings but also other associated areas. These are areas whieh relate to foreign curreney payments for pur chases of goods and serVices , the sale in a foreign currency of goods and serviees, transaotions involving eurrency hedges , and the treatment of exchange gains or losses arising from the holding of fUnds in a foreign currency usually in an off_shore bank account . The Taxation Act provides that income wherever derived and any expenses wherever incurred shall be expressed in terms of Austra11an currency. Two key questions relate to when income is derived and when expenses are inourred. In relation to the purchase or sale of goods in a foreign currency the transaction is initially recorded in Au"tral1an dollars at the t1llle the transaotion takes place (which, for example, 16 often at the time property in goods passe,,).
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If subsequentl y, when payment is lIIade, the Australian dollar equiva lent ill more o r less than t hat wh ich was recorded at the time the goods were either purchased or sold , the difference should be a dju sted t o the co st of purchases or the sales value of the goods sold. For taxation purposes, the se adjustments are t o r evenue account. Ae such , the va riation will be either asses sable or deductible . It is also desirable that these va riatio ns be re flec ted in the Accounts of the company by either adding to o r subtracting from the or iginal purchase or sales f'igure as o ppos ed to showing this adjus tment as an exchange variation. In the case of a c urrency hedge which is taken out by a non-finance company , the gain or lo ss will usually follow the character of the underlying t r ansaction t o which the hedge re lates. For exampl e, 1r the hedge relate8 to the payment of , say , i ntere8t or the purcha8e o f operating supplies such as fuel oil, the gain or loss for tax purposes will be to revenue account. However, i f the hedge relates to a capital transaction, the gain or loss from the hedge for t ax pur poses wil l be to capital account. If there is no underlying tr~nsaction it is mos t likely that the hedge would be re garded a s part of a profit making scheme or undertaking or, depending upon the frequency of the hedge, could be regarded as a business activity in !.ts own right o r part o f the overall business activities of the company conc erned. In either case, for tax purposes, the gain or loss resulting fr om the hedge would be to revenue account. Often a non-finance company will reta in foreign currency funds 1n an off -shore bank account . These funds, which would normally be derived from sales made i n a for eign currency , are used to meet short term foreign obligations. It is usual to record the Australian dollar equivalent of the f oreign funds in this o ff _sho re bank account at the t ime the runds are deposited to the account. In t heor y, t hese rund9 should then be continually re-valued , probably on a daily basis, to r e flect the movement in the Australian dollar. This would then en.,ure that as the funds are used, the cost of the particular use of the fund9 is recorded at the Australian do llar cost when the obligation is met . But from a practical as pect, it is usual to only adjust this bank account on a monthly basis unless there ie a major move~ent 1n the exchange rate of the Australian dol lar during the month. The Question whlch has to be considered is what is the tax treatment of t he realised gain o r loss which arises from the continuous re-valuation of this o ff-sh o re bank account . There ap pears to be no judicial guidance 1n thie area. Nor do es there appear to be any ruling issued by the Taxation Au thorities . one argument is t hat the e xc ha nge VAria tion is to capital account in that 1t r ... la tes to the appre ciation or depreciation of an asset of the company. A con trary argument is that the activity i s so intertwined with the trading activities o f the company, the exchange variation is to r evenue account. The argument wh ich could prevail ls that t he exchange variation i.!!l to capital account although this conclusion l.!!l not reached witho ut .!!lome conside ra ble doub t.
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The Question of the tax treatment of loan repayments by a non-finance company has, as mentioned earlier, been the subject of a number of tax cases considered by our Courts. The present tax position of this type of company is that exchange variations are assessable or deductible when the liability repaid is to revenue account. But the exchange variations are not assessable or deductible if the liability repaid is to capital account. Generally, the onus is on the company to prove that the borrowings are to revenue account. In general, the Taxat ion Authorities take the view that borrowings are prima facie part of the company ' s capital structure or base and are the refore to oapital account. As such, most exchange variations are held by theso Authorities to be to capital account. One main exception whi ch has judiCial support is where the funds are specifically borrowed for the purpose of acquiring trading stock. In relation to this main exception, it is perhaps interesting to speculate what would be the tax position if a company, which manufactures and sells a product and has borrowed foreign funda to finance its trade d~btors, restructures ih activities. Would the tax position be different if the selling activity is carried out by a separate group company and that company then specifically borrows the foreign funds to acquire trading stock, with payment being made on delivery, frolll the first cOlllpany (i.e., the loan is now used to finance trading stock and not trade debtors)? The tax position in relation to a finan ce company which carries on a business of lending and borrowing money is different to that of a non_finance company. TIle reason being that the borrowing and lending of money is their trading activity and aa such these transactions are to revenue account ( whereas in the cas e of a non_finance company these activities would usually be to capital account). In general
terms, for tax purposes, all exchange variations derived or incurred by a finance company would be either assessable or deductible. The main exception to this general rule appears to be exchange variationa relating to borrowings used to strengthen the finan cial baae or structure o f the finance company. In this case, exchange gaina or losses tor tax purposes are to capital account.
3.
WHEN A CURRENCY GAIN IS DERI VED OR A LOSS INCURRED
There appears to be judiCial support that the translation of a foreign loan at the end of an accounting period. is a bookkeeping exercise and as such this exer Cis e its elf does not create a taxable gain or loss. It is considered that, fcr tax purposes, any gain or loss i n relation to a f oreign borrowing would not be assessable or deductible on an accrued basis but would only be assessable or deductible (if at all) on a realised basia. The IDain Question Which then has to be considered 1s when the currency gain or loss is realised . Where a company reduces 1ts overall foreign indebtedness by repaying either in whole or in part a foreign borrOWing, any currency variation arising from that repayment would be realised at the t1me of repayment.
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However, this Ques ti o n of realisation is not as clear when foreign indebtedness is r epa id by fund .!J obta ined from a further f oreign loan. That is , the firl'lt foreign loan is in who le or in part repaid by proceeds rece i ved frOID a second foreign loan . Sometimes, the second f or eign loan could even be in a different foreign currenc y. It would a ppear that the Taxation Authorit:.ies in this case tend to take the view that a 10.!Js has no t been realised until the f oreign borrowings of the company cease to exist (or are reduced ). They argue that support for this view c an be obtained fr om the decision in the 19&0 Caltex case . This case i nvolved the tra nsfer by an Australian company of a US dollar loan from one US company t o another US company . Reference wa s made in the judgement to the fact that f1rstly , no Australian money figured in any way in either loan, and secondly , that the transaction appea red tc leave the Australian company owing the same number o f dollars (i . e . , foreign dollars) and that not h i n g had happened but the novation o r something akin to a novation o f a dollar indebtedness . Howeve r , it is also interesti ng to note that a comment was made in this case that the position could ha ve been differe nt if the Australian company had first augmented its funds by borr owi ng from a bank or had dh charged the ir.debtedness out o f its own resources, either by buying foreign dollars with hustra lian currency , or utilising foreign do llars of its own . Again, it 1s interesti ng to specu l ate on the situation where , for instance, there is a. time gap between the repayment of the f ore i gn indebtedness and the draw down o f a subsequent foreign indebtedness, or if the loan is repaid from proceeds received from a loan i n a different foreign curre nc y. Alternatively it may be worthwhile (even though there would be a cost) to remi t the funds obtained from the 3econd foreign inde btedness to AUstralia and then use t hose funds to repay the first indebtedness. In other words, a cash exchange 109S i 9 created i n Australian dOllars in re lation to the repayment o f the first f oreign indebtedness . Hnally . i n cons idering the merits of the Caltex case , it must be appreciated that this case was heard o ver 20 years ago and considerable changes have occ urred in the world of. finance since thi.!l C33e was heard. For example, in many cases the old style of loan, whic h involve lending an amoun t fo r a fixed period and at a fixed inte rest rate with repayments eit her over the life of the loan o r at the end of the loan, has been replaced with loans in the form of cOlllllercial paper or bankers aooeptances which are continua lly rolled over (e .g., every 45 days), floating interest rates, interest swap arrangements, and the ability to swap o urren c ies thoughout the term of the loan f acility. It is considered that a currency ga in or l oss is realised when t he loan is repaid ev en though this repayment may be finan ced direc tly by a subsequent foreign bor r owi ng either in the same or a different currency.
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4.
Vol. 15 No. 02, September 1985
REVENUE _v_ CAPITAL
The question of deterlll1ning whether an exchange variation is to revenue 01'" to capital account is complex and has, over the years, been the subject of a number of court cases . There are possibly two main questions which wil l, in many cases, largely deterlll1ne the issue . The first question is whether the exchange variations relate to a cost for the use of the funds (such as interest ) as opposed to exchange variations which relate to a cost o f borrowing the fUnds (such as stamp duty). The second QUestion is whether the loss incurred relates to the car rying on of a bUsiness by the company (i.e. , it is so intertwined with their business activities and as such becomes part of those activities). or whether it relates to an activity involving the strengthening of the capital hase or structure of the bUsiness framework of the company. As mentioned, where the business o f the company involves the borrowing and lending of llIoney. it has been successfully argued that the cost is so intertwined with the business activities of the company 01'" is even a business activity in its own right that exchange gains or losses 1'01'" tax purposes are to revenue account. However, it would appeal'" from various Judicial comments that the financing of trade debtors (even though this is a harrowing for working capital purposes) i8 regarded more as an activity designed to s trengthen the bUsiness framework 01'" base of the company and as such the exchange variations for tax pu rposes are to capital account. This treatment shOuld be C!Qntrast.d with the rinanoins or the puroh30e of tr3din.!!i otock which is to revenue account . It ia alao interesting to consider the tax position of currency variations which arise 1n relation to finance provided by a supplier of plant or equipment (i .e., there is a direct nexus between the supplier o f plant and the exchange variations). Where the seller of the plant or equipment is being paid by, say, a series of foreign currency bills payable over a period, should the cost of the plant be adjusted each time a bill is paid in o rder to reflect the variations in the Australian dollar exchange rate? It is considered that these adjustments do vary the cost of plant and as such should be r eflected 1n the amount or tax depreciation claimed over the lire of the plant .
5.
OTHER HATTERS
From the various comments made, it can be appreciated that the correct distinction between currency variations to revenue account as opposed to cap1 tal a ocount 1s not clear and in sOllie cases there appears to be some elements of inconsistency. However, a new factual si tuation has been established as a result o r GoverlllDent deregulaticn of the financial market , the availabi11ty of new types of international borrowings together with the way these borrowings are marketed. A major deregulation initiative was the floating of the Australian dollar in December 1983.
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under the previous managed exchange rate system, changing perceptions of Australian economic performance (e .g . , international competitiveness) we re reflected in areas such as interest rates and foreign reserves, which could ha v e eventually led to a formal chan ge to the exchange rate of the Australian dollar. The movement to a floating exchange rate system has allowed these changes in perception to be 1lIImediately reflected in the exchange rate. In recent months this has resulted in high voletility in the exchange rate. The Question of deciding the currency of the loan is often as vital as the Question of the interest rate . The reason being that far greater losses now can be incurred as a result of exchange variations than as a result of any difference between the interest rate applying to borrowings in different cu rrencies. Also, many loans now allow the borrower to change or swap currencies continuously during the period of the facility. In other words, the use of currencies is a tool now used by financial or treasury experts i n considering the overall cost of the funds. As such, currency variations, in many c8ses, are derived or incurred as part of the overall cost relating to the use of the borrowed fUnds . This is especially so when currencies are swapped during the life of the loan faoility. The last two deoades or so have seen a movement ( and this has been accelerated during the last few years ) towards Quite volatile currency rate fluctuations. For many years the eXChange rate movement of currencies of major world trading countries was reasonably stable . But in the last few years, and especially as a result of Government de regulation , the exchange rates have become quite volatile and this has led to a major re-thinking by finance and treasury experts. As such, the traditional approach to the question that exchange variations in relation to l oan repayments of a non-finance company are largely to capi tal account must be re-thought. This loss can no longer be regarded as relating to the borrowing of the funds but in a majority of cases now relates to the use of the funds.
6.
TAX REFORM
A number of countries with whom AU3traiia competes for international trade do allow a tax deduction for foreign exchange 10:lses. Likewise, foreign exchange gains would be subject to income tax . These countries include the USA, Japan and New Zea land . Perhaps when exchange losses were n ot great, the added cost res ulting from the non-deductibility of these losses could , in many cases, be borne by the company without greatly affecting its international competitiveness. However, with the recent volatile movement in exchange rates , this situation has Changed. The addi tional coat as a result of t.he non_deductibility of exchange losses is now affecting the international competitiveness of Australian companies with substantial fore ign bOl'rowings which trade Oil international markets. For example, since the beginning of 1985, the additional exchange loss which
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could be realised by one large Australian international group has increased by some $500 m1ll10n. Whether this massive exchange loss will be eventually realised does of course depend on the exchange rate at the date or repayment. A number of comments have been made that companies which trade on the international markets and have, for example, contracts in US dollars , can use these dollars to cover their US loan repayments. This, to a degree, is true. However, it must be appreciated that first, the additional Australian dollars rece ived rrom salea proceeds are subject to tax and as such all that is left is 54 cents in the dollar to possibly pay 100 cents in the dollar exchange losa . Secondly, it. should also be appreciated that many or the costs incurred in earning the sales revenue are roreign currency obligations. As such, higher Australian dollar costs must be taken into account in determining the net addi tiona 1 Australian dollars received rrom sales proceeds. "It is con:ddered that the Federal Government should urgently review the question of exchange losses, especially having regard to the massive devaluation which has occurred in the Australian dollar over the last rew months . The objective of this review should he to amend the taxation law so as to ensure that all exchange gains and losses are assessable or deductible.
An amendment of this nature would specifically recognise the changed factual Situation of e xchange varolations. The old rules are no longer applicable due to the high volatility of exchange rates which has reaulted in the exchange risks becom1ng a cost or the use of the fUnds (as opposed to the cost of borrowing the fUnds when exchange roates were roelatively stable) . Howevero, this new legislation would only apply to loans which have been borrowed on or after a cerotain date . The pu rpose of this would be to roeflect the point at which the nature of exchange varolations ohanged to that of a roe venue nature. It is suggested that this point be the date when the Australian dollar was floated. Therefore, curorency losses in respect or loans borrowed on or after that date would be deductible and profits would be assessable. Also, it may he necessary to amend the taxation law in order to clariry when a loss is realised. Again it is conSidered that the taxation law shOUld provide that the method ot re-financing a loan should not be taken into account in determining this question. Urgent action is needed to be taken by the Federal Government in this area
at exchange v8roiBtions and it is suggested that this action should be along the lines outlined above.
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REfERE NCES 1.
Cases : Caltex Ltd v foC . of T (1960) 106 CLR 205 Texas Co . (Aus tralasia) Ltd v f . C. of T ( 1940) 63 CLR 382 Armco (Aus t ralia) P/L v f.C. of T (1947 - 48) 76 CLR 584 International Nickel Australia Ltd v f . C. of T (1977) 7 ATR 739 Corrune rcial and Genera l Acceptance Ltd v F . C. of T 77 ATC 11375 Thies!'! Toyota Pty Ltd v f.C . o f T (1978) 9 ATR 14 Avec FinanCial Services Ltd v f.C. of T (1982) 13 ATR 63 f.C. o f T v Hunter Douglas Ltd 83 ATC 4562 f . C. of T v Cadbury
2.
Fry PascalI (Austra lia) Ltd 79 ATC 11346
Income Tax Rulings: IT2005 : fi NANCE SECURITIES .
CO MPA NIES
_
GAI NS ANO LOSSES
IT2050 : " INTEREST - SWAPPI NG" TR ANSACTIONS .
ON REDE MPTIO N OF
Economic Analysis and Policy
Vol. 15 No. 02, September 1985
TAX TREATHElfT OF BICBANGE GAINS AND LOSSKS
Charles Gibbons Gene r al Manager - Group Taxation Services CRA Ser vices Limited
1.
INTRODUCTION
In the past two decades, the Western world has witnessoC:l lIIajor changes in the financial system . The post_war period was dominated by the Bretton-Woods arrangements which set rules for world financial conduct. These arrangements, which included the establishment of the International Monetary Fund and World Bank, were set up in a period when the OS dollar dominated the world ' s financial system. One feature of this period was the relative stability of exchange rates - an arrangement designed to limit the damaging practices developed in the thirties which i ncluded competitive devaluations, exchange contrOls and other barriers to world trade. Floating exchange rates have now largely replaced the fixed rates of the Bretton-Woods era. In addition, deregulation of financial markets and the evolution of electronic transfer of funds have transformed the nature of the world ' s finsncial markets . A twenty-four hour round the globe set Of integrated markets has emerged. New financial products or packagee have become an everyday event. Huge SIllllS of capital now move into and out of markcts with increasing speed snd this has lead to a notable increase in volatility. During this period , there have been insufficient funds in the Australian market to meet all the borrowing needs of Australian COlllpanies . This has caused many Australian companies to raise !'Iubstantial bor rowings from overseas lenders. As such, these companies have not had the simple chOice of altel"ing their currency exposure by tapping the local capita l market resources . The mining industry is one of the many industriea which has sl,Ibstantinl oumo from overseas. The 19011 Hlm:l'sl Im.lul:ltry Survey by Coopers .5. Lybrand showed that the total borrowings of that (which does not include 011 and gas) were around $10.4 billion a nd amount foreign borrowings amounted to some $1.1 billion.
borrowed prepareo industry of this
The taxation treatment of exchange gains and losses haa provoked considerable argument and debate for many years. Also , this question has been the subject of a number of cases which have been litiga ted by both taxpayers and the Taxation Authorities. 1 But the judgements in these cases have clarified only some areae of this subject. Unfortunatel y these judgements have also tended to add even further complexities to t his a lready complex area of law. A list of reference cases is given at the end of the paper.
182
Economic Analysis and Policy
Vol. 15 No. 02, September 1985
Although exchange losses have been incurred over the last decade, the recent floating of the Australian dollar and the substantial decline in its value has greatly exacerbated the situation. As such , substantial actual exchange losses now could be incurred on most, if not all, foreign borrowings. But, if the exchange rate of the Austra11an dollar has nO'ol bottomed, future borrowers of foreign runds could derive exchange gains thus reversing the current experience. This paper will consider : (a)
the current generally accepted tax treatment for exchange gains or losses on loan transactions in respect of a non-finance company and a finance cOlllpanYi
(b)
when a currency gain is derived or a loss incurred.
(o)
the distinction between a revenue gain or loss as o pposed to a capital gain or loss; and
(d)
other .atters r elating to this complex area .
It 1a also proposed to consider what tax reforlllB might be considered in relation to the question of the tax treatlllent of currency gains or losses . This seotlon will also briefly look at the assessabi1ity or deductibility for tax purposes o f exchange Variations in countries with whom Austra11a cOlllpetes in international trade.
However, it is not proposed in this paper to adopt the usual approach of quoting cases , seotions of the Income Tax Assessment Aet and extensi ve passages frolll judgementa in various legal cases. Instead it is proposed to give only a general and hopefully informative out11ne of the current tax position together with some of the major problems in this area of taxation.
2.
CURRENT TAX POSITION
In order to provide a more meaningful summary of the eu rrent tax position, the question of the tax treabrlent of exchange gains or losses will be expanded to cover not only borrowings but also other associated areas. These are areas whieh relate to foreign curreney payments for pur chases of goods and serVices , the sale in a foreign currency of goods and serviees, transaotions involving eurrency hedges , and the treatment of exchange gains or losses arising from the holding of fUnds in a foreign currency usually in an off_shore bank account . The Taxation Act provides that income wherever derived and any expenses wherever incurred shall be expressed in terms of Austra11an currency. Two key questions relate to when income is derived and when expenses are inourred. In relation to the purchase or sale of goods in a foreign currency the transaction is initially recorded in Au"tral1an dollars at the t1llle the transaotion takes place (which, for example, 16 often at the time property in goods passe,,).
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Economic Analysis and Policy
Vol. 15 No. 02, September 1985
If subsequentl y, when payment is lIIade, the Australian dollar equiva lent ill more o r less than t hat wh ich was recorded at the time the goods were either purchased or sold , the difference should be a dju sted t o the co st of purchases or the sales value of the goods sold. For taxation purposes, the se adjustments are t o r evenue account. Ae such , the va riation will be either asses sable or deductible . It is also desirable that these va riatio ns be re flec ted in the Accounts of the company by either adding to o r subtracting from the or iginal purchase or sales f'igure as o ppos ed to showing this adjus tment as an exchange variation. In the case of a c urrency hedge which is taken out by a non-finance company , the gain or lo ss will usually follow the character of the underlying t r ansaction t o which the hedge re lates. For exampl e, 1r the hedge relate8 to the payment of , say , i ntere8t or the purcha8e o f operating supplies such as fuel oil, the gain or loss for tax purposes will be to revenue account. However, i f the hedge relates to a capital transaction, the gain or loss from the hedge for t ax pur poses wil l be to capital account. If there is no underlying tr~nsaction it is mos t likely that the hedge would be re garded a s part of a profit making scheme or undertaking or, depending upon the frequency of the hedge, could be regarded as a business activity in !.ts own right o r part o f the overall business activities of the company conc erned. In either case, for tax purposes, the gain or loss resulting fr om the hedge would be to revenue account. Often a non-finance company will reta in foreign currency funds 1n an off -shore bank account . These funds, which would normally be derived from sales made i n a for eign currency , are used to meet short term foreign obligations. It is usual to record the Australian dollar equivalent of the f oreign funds in this o ff _sho re bank account at the t ime the runds are deposited to the account. In t heor y, t hese rund9 should then be continually re-valued , probably on a daily basis, to r e flect the movement in the Australian dollar. This would then en.,ure that as the funds are used, the cost of the particular use of the fund9 is recorded at the Australian do llar cost when the obligation is met . But from a practical as pect, it is usual to only adjust this bank account on a monthly basis unless there ie a major move~ent 1n the exchange rate of the Australian dol lar during the month. The Question whlch has to be considered is what is the tax treatment of t he realised gain o r loss which arises from the continuous re-valuation of this o ff-sh o re bank account . There ap pears to be no judicial guidance 1n thie area. Nor do es there appear to be any ruling issued by the Taxation Au thorities . one argument is t hat the e xc ha nge VAria tion is to capital account in that 1t r ... la tes to the appre ciation or depreciation of an asset of the company. A con trary argument is that the activity i s so intertwined with the trading activities o f the company, the exchange variation is to r evenue account. The argument wh ich could prevail ls that t he exchange variation i.!!l to capital account although this conclusion l.!!l not reached witho ut .!!lome conside ra ble doub t.
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The Question of the tax treatment of loan repayments by a non-finance company has, as mentioned earlier, been the subject of a number of tax cases considered by our Courts. The present tax position of this type of company is that exchange variations are assessable or deductible when the liability repaid is to revenue account. But the exchange variations are not assessable or deductible if the liability repaid is to capital account. Generally, the onus is on the company to prove that the borrowings are to revenue account. In general, the Taxat ion Authorities take the view that borrowings are prima facie part of the company ' s capital structure or base and are the refore to oapital account. As such, most exchange variations are held by theso Authorities to be to capital account. One main exception whi ch has judiCial support is where the funds are specifically borrowed for the purpose of acquiring trading stock. In relation to this main exception, it is perhaps interesting to speculate what would be the tax position if a company, which manufactures and sells a product and has borrowed foreign funda to finance its trade d~btors, restructures ih activities. Would the tax position be different if the selling activity is carried out by a separate group company and that company then specifically borrows the foreign funds to acquire trading stock, with payment being made on delivery, frolll the first cOlllpany (i.e., the loan is now used to finance trading stock and not trade debtors)? The tax position in relation to a finan ce company which carries on a business of lending and borrowing money is different to that of a non_finance company. TIle reason being that the borrowing and lending of money is their trading activity and aa such these transactions are to revenue account ( whereas in the cas e of a non_finance company these activities would usually be to capital account). In general
terms, for tax purposes, all exchange variations derived or incurred by a finance company would be either assessable or deductible. The main exception to this general rule appears to be exchange variationa relating to borrowings used to strengthen the finan cial baae or structure o f the finance company. In this case, exchange gaina or losses tor tax purposes are to capital account.
3.
WHEN A CURRENCY GAIN IS DERI VED OR A LOSS INCURRED
There appears to be judiCial support that the translation of a foreign loan at the end of an accounting period. is a bookkeeping exercise and as such this exer Cis e its elf does not create a taxable gain or loss. It is considered that, fcr tax purposes, any gain or loss i n relation to a f oreign borrowing would not be assessable or deductible on an accrued basis but would only be assessable or deductible (if at all) on a realised basia. The IDain Question Which then has to be considered 1s when the currency gain or loss is realised . Where a company reduces 1ts overall foreign indebtedness by repaying either in whole or in part a foreign borrOWing, any currency variation arising from that repayment would be realised at the t1me of repayment.
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However, this Ques ti o n of realisation is not as clear when foreign indebtedness is r epa id by fund .!J obta ined from a further f oreign loan. That is , the firl'lt foreign loan is in who le or in part repaid by proceeds rece i ved frOID a second foreign loan . Sometimes, the second f or eign loan could even be in a different foreign currenc y. It would a ppear that the Taxation Authorit:.ies in this case tend to take the view that a 10.!Js has no t been realised until the f oreign borrowings of the company cease to exist (or are reduced ). They argue that support for this view c an be obtained fr om the decision in the 19&0 Caltex case . This case i nvolved the tra nsfer by an Australian company of a US dollar loan from one US company t o another US company . Reference wa s made in the judgement to the fact that f1rstly , no Australian money figured in any way in either loan, and secondly , that the transaction appea red tc leave the Australian company owing the same number o f dollars (i . e . , foreign dollars) and that not h i n g had happened but the novation o r something akin to a novation o f a dollar indebtedness . Howeve r , it is also interesti ng to note that a comment was made in this case that the position could ha ve been differe nt if the Australian company had first augmented its funds by borr owi ng from a bank or had dh charged the ir.debtedness out o f its own resources, either by buying foreign dollars with hustra lian currency , or utilising foreign do llars of its own . Again, it 1s interesti ng to specu l ate on the situation where , for instance, there is a. time gap between the repayment of the f ore i gn indebtedness and the draw down o f a subsequent foreign indebtedness, or if the loan is repaid from proceeds received from a loan i n a different foreign curre nc y. Alternatively it may be worthwhile (even though there would be a cost) to remi t the funds obtained from the 3econd foreign inde btedness to AUstralia and then use t hose funds to repay the first indebtedness. In other words, a cash exchange 109S i 9 created i n Australian dOllars in re lation to the repayment o f the first f oreign indebtedness . Hnally . i n cons idering the merits of the Caltex case , it must be appreciated that this case was heard o ver 20 years ago and considerable changes have occ urred in the world of. finance since thi.!l C33e was heard. For example, in many cases the old style of loan, whic h involve lending an amoun t fo r a fixed period and at a fixed inte rest rate with repayments eit her over the life of the loan o r at the end of the loan, has been replaced with loans in the form of cOlllllercial paper or bankers aooeptances which are continua lly rolled over (e .g., every 45 days), floating interest rates, interest swap arrangements, and the ability to swap o urren c ies thoughout the term of the loan f acility. It is considered that a currency ga in or l oss is realised when t he loan is repaid ev en though this repayment may be finan ced direc tly by a subsequent foreign bor r owi ng either in the same or a different currency.
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Vol. 15 No. 02, September 1985
REVENUE _v_ CAPITAL
The question of deterlll1ning whether an exchange variation is to revenue 01'" to capital account is complex and has, over the years, been the subject of a number of court cases . There are possibly two main questions which wil l, in many cases, largely deterlll1ne the issue . The first question is whether the exchange variations relate to a cost for the use of the funds (such as interest ) as opposed to exchange variations which relate to a cost o f borrowing the fUnds (such as stamp duty). The second QUestion is whether the loss incurred relates to the car rying on of a bUsiness by the company (i.e. , it is so intertwined with their business activities and as such becomes part of those activities). or whether it relates to an activity involving the strengthening of the capital hase or structure of the bUsiness framework of the company. As mentioned, where the business o f the company involves the borrowing and lending of llIoney. it has been successfully argued that the cost is so intertwined with the business activities of the company 01'" is even a business activity in its own right that exchange gains or losses 1'01'" tax purposes are to revenue account. However, it would appeal'" from various Judicial comments that the financing of trade debtors (even though this is a harrowing for working capital purposes) i8 regarded more as an activity designed to s trengthen the bUsiness framework 01'" base of the company and as such the exchange variations for tax pu rposes are to capital account. This treatment shOuld be C!Qntrast.d with the rinanoins or the puroh30e of tr3din.!!i otock which is to revenue account . It ia alao interesting to consider the tax position of currency variations which arise 1n relation to finance provided by a supplier of plant or equipment (i .e., there is a direct nexus between the supplier o f plant and the exchange variations). Where the seller of the plant or equipment is being paid by, say, a series of foreign currency bills payable over a period, should the cost of the plant be adjusted each time a bill is paid in o rder to reflect the variations in the Australian dollar exchange rate? It is considered that these adjustments do vary the cost of plant and as such should be r eflected 1n the amount or tax depreciation claimed over the lire of the plant .
5.
OTHER HATTERS
From the various comments made, it can be appreciated that the correct distinction between currency variations to revenue account as opposed to cap1 tal a ocount 1s not clear and in sOllie cases there appears to be some elements of inconsistency. However, a new factual si tuation has been established as a result o r GoverlllDent deregulaticn of the financial market , the availabi11ty of new types of international borrowings together with the way these borrowings are marketed. A major deregulation initiative was the floating of the Australian dollar in December 1983.
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under the previous managed exchange rate system, changing perceptions of Australian economic performance (e .g . , international competitiveness) we re reflected in areas such as interest rates and foreign reserves, which could ha v e eventually led to a formal chan ge to the exchange rate of the Australian dollar. The movement to a floating exchange rate system has allowed these changes in perception to be 1lIImediately reflected in the exchange rate. In recent months this has resulted in high voletility in the exchange rate. The Question of deciding the currency of the loan is often as vital as the Question of the interest rate . The reason being that far greater losses now can be incurred as a result of exchange variations than as a result of any difference between the interest rate applying to borrowings in different cu rrencies. Also, many loans now allow the borrower to change or swap currencies continuously during the period of the facility. In other words, the use of currencies is a tool now used by financial or treasury experts i n considering the overall cost of the funds. As such, currency variations, in many c8ses, are derived or incurred as part of the overall cost relating to the use of the borrowed fUnds . This is especially so when currencies are swapped during the life of the loan faoility. The last two deoades or so have seen a movement ( and this has been accelerated during the last few years ) towards Quite volatile currency rate fluctuations. For many years the eXChange rate movement of currencies of major world trading countries was reasonably stable . But in the last few years, and especially as a result of Government de regulation , the exchange rates have become quite volatile and this has led to a major re-thinking by finance and treasury experts. As such, the traditional approach to the question that exchange variations in relation to l oan repayments of a non-finance company are largely to capi tal account must be re-thought. This loss can no longer be regarded as relating to the borrowing of the funds but in a majority of cases now relates to the use of the funds.
6.
TAX REFORM
A number of countries with whom AU3traiia competes for international trade do allow a tax deduction for foreign exchange 10:lses. Likewise, foreign exchange gains would be subject to income tax . These countries include the USA, Japan and New Zea land . Perhaps when exchange losses were n ot great, the added cost res ulting from the non-deductibility of these losses could , in many cases, be borne by the company without greatly affecting its international competitiveness. However, with the recent volatile movement in exchange rates , this situation has Changed. The addi tional coat as a result of t.he non_deductibility of exchange losses is now affecting the international competitiveness of Australian companies with substantial fore ign bOl'rowings which trade Oil international markets. For example, since the beginning of 1985, the additional exchange loss which
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could be realised by one large Australian international group has increased by some $500 m1ll10n. Whether this massive exchange loss will be eventually realised does of course depend on the exchange rate at the date or repayment. A number of comments have been made that companies which trade on the international markets and have, for example, contracts in US dollars , can use these dollars to cover their US loan repayments. This, to a degree, is true. However, it must be appreciated that first, the additional Australian dollars rece ived rrom salea proceeds are subject to tax and as such all that is left is 54 cents in the dollar to possibly pay 100 cents in the dollar exchange losa . Secondly, it. should also be appreciated that many or the costs incurred in earning the sales revenue are roreign currency obligations. As such, higher Australian dollar costs must be taken into account in determining the net addi tiona 1 Australian dollars received rrom sales proceeds. "It is con:ddered that the Federal Government should urgently review the question of exchange losses, especially having regard to the massive devaluation which has occurred in the Australian dollar over the last rew months . The objective of this review should he to amend the taxation law so as to ensure that all exchange gains and losses are assessable or deductible.
An amendment of this nature would specifically recognise the changed factual Situation of e xchange varolations. The old rules are no longer applicable due to the high volatility of exchange rates which has reaulted in the exchange risks becom1ng a cost or the use of the fUnds (as opposed to the cost of borrowing the fUnds when exchange roates were roelatively stable) . Howevero, this new legislation would only apply to loans which have been borrowed on or after a cerotain date . The pu rpose of this would be to roeflect the point at which the nature of exchange varolations ohanged to that of a roe venue nature. It is suggested that this point be the date when the Australian dollar was floated. Therefore, curorency losses in respect or loans borrowed on or after that date would be deductible and profits would be assessable. Also, it may he necessary to amend the taxation law in order to clariry when a loss is realised. Again it is conSidered that the taxation law shOUld provide that the method ot re-financing a loan should not be taken into account in determining this question. Urgent action is needed to be taken by the Federal Government in this area
at exchange v8roiBtions and it is suggested that this action should be along the lines outlined above.
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REfERE NCES 1.
Cases : Caltex Ltd v foC . of T (1960) 106 CLR 205 Texas Co . (Aus tralasia) Ltd v f . C. of T ( 1940) 63 CLR 382 Armco (Aus t ralia) P/L v f.C. of T (1947 - 48) 76 CLR 584 International Nickel Australia Ltd v f . C. of T (1977) 7 ATR 739 Corrune rcial and Genera l Acceptance Ltd v F . C. of T 77 ATC 11375 Thies!'! Toyota Pty Ltd v f.C . o f T (1978) 9 ATR 14 Avec FinanCial Services Ltd v f.C. of T (1982) 13 ATR 63 f.C. o f T v Hunter Douglas Ltd 83 ATC 4562 f . C. of T v Cadbury
2.
Fry PascalI (Austra lia) Ltd 79 ATC 11346
Income Tax Rulings: IT2005 : fi NANCE SECURITIES .
CO MPA NIES
_
GAI NS ANO LOSSES
IT2050 : " INTEREST - SWAPPI NG" TR ANSACTIONS .
ON REDE MPTIO N OF