Foreign Exchange Gains and Losses: Timing and Other Tax Issues
By Robert R. Worthington, Shea Nerland LLP
Any cross-border transaction that involves a currency conversion may involve tax issues from foreign exchange (FX) gains and losses. Taxpayers may be subject to unfavourable double taxation risks – or alternatively, “double non-taxation” planning opportunities. Complex FX tax issues can be triggered by the most commonplace transactions, a few examples of which are provided below.
For accounting purposes, FX gains and losses are often booked on an “unrealized” basis, being the relative value of the home currency to the foreign currency as of the fiscal year end. In many countries, the tax treatment may diverge from the accounting treatment. Generally, FX gains are only taxed at the time they are realized, depending on the local tax rules. That is, there must typically be some transaction or event, such as a disposition of property or a repayment of a debt, for an FX gain or loss to be recognized for tax purposes.
To take an example, suppose a company resident in Canada renders an invoice in pounds sterling to a customer in the UK on February 1. The receivable was outstanding until it is settled on June 24, the day after the Brexit referendum. On February 1, the GBP/CAD exchange rate was 2.01 and on June 24 it was 1.77. The Canadian company will be required to report its tax results in Canadian dollars. But, which exchange rate should be used – the exchange rate on date the invoice was rendered, the date the receivable was paid, or the average exchange rate for the period? In the Canadian example, the answer might depend on whether the underlying transaction was on income or capital account for tax purposes.
Another type of FX tax problem arises where a company lends money to a foreign subsidiary using the foreign currency, and that currency had appreciated against the home currency by the time the debt was settled. In that case, there might be an FX gain in the home country and an FX loss in the foreign subsidiary at the time the debt was repaid. For accounting purposes, the FX gains and losses would disappear on consolidation. But for tax purposes, the FX loss may be trapped in the foreign subsidiary, and not able to be deducted or netted against the parent company’s taxable gain.
Suppose the situation were reversed, and the FX loss landed in the parent and the gain in the subsidiary. Would the gain be subject to tax immediately in the home country under its anti-deferral regime even if the cash is not brought back home? Such an anti-deferral rule may apply to a US taxpayer in certain circumstances, namely, if the FX gain falls into the rules in subpart F of the Internal Revenue Code. Clearly, even for a transaction as benign as an intercompany advance, the currency in which the debt is denominated should be selected carefully, and the tax rules of both countries should be analyzed, including which functional currency is required to be used under the respective tax rules.
In a recent Canadian case (Kruger v. The Queen), a taxpayer attempted to net an FX loss against a gain on a foreign currency derivative by using mark-to-market accounting. The court departed from the “realization principle” somewhat, allowing the taxpayer’s appeal. It remains to be seen whether this decision will be overruled by legislation or otherwise.
Nuances in domestic tax laws can have counter-intuitive results with respect to FX issues. In the example of inter-company accounts, there could be “stop-loss rules” that deny or suspend FX losses. Settlement of debts may trigger phantom income inclusions if a debt is settled for a lower than face value solely because of currency fluctuations, even though the settlement was for the original principal amount based on the historical exchange rate. In the US, a sale of property that is subsequently replaced can be a nonrecognition event for tax purposes under section 1031 of the Internal Revenue Code (known as “1031 exchanges”). But the tax law of the other country where the taxpayer resides may not have a parallel non-recognition rule. This type of mismatch of tax rules can flow through to the FX gains, exacerbating the problem for the foreign taxpayer. Even if the property that is sold has not increased in value, there may be a taxable gain on account of the FX fluctuations.
Tax treaties are notably silent on FX gains and losses. Domestic tax laws will govern. Given the complexity of these types of FX issues, it is always best to engage a tax advisor in the relevant jurisdictions.
Robert WorthingtonShea Nerland LLP, Calgary, Canada
Robert Worthington is a tax partner at Shea Nerland Calnan LLP Business. His practice includes tax planning for trusts, corporations, and shareholders of private companies, as well as for transactions of a broad spectrum of complexity and size, both domestic and international. He is member of the Society of Trust and Estate Practitioners, Canadian Bar Association, Canadian Tax Foundation, and International Fiscal Association.
Shea Nerland Calnan LLP is a premier tax and business law firm in western Canada based in Calgary. The firm’s lawyers are recognized as highly innovative and at the forefront of complex tax planning opportunities, estate planning, and tax litigation, with broad experience in capital markets, securities, real estate, mergers & acquisitions, business litigation and strategic representation.
Published: July 2016 l Photo: Colourbox.de