TAX TREATMENT OF FOREIGN EXCHANGE TRANSACTIONS

Would you like to know how foreign exchange transactions are treated for tax purposes?

This article outlines the key concepts and tax implications discussed in the recent FIRS publication.

International Financial Reporting Standard (IFRS) guidelines often differ from tax treatments when recognizing certain transactions in financial statements, a good example is foreign currency transactions. The tax authority acknowledges that IFRS guidelines are good for accounting purposes. However, they may not be consistent with tax regulations.

Understanding the concept of Exchange Difference

A foreign exchange difference occurs when the exchange rate used for booking a foreign-currency transaction is different from the rate used on reporting or settlement date.

Let's say a Nigerian company exported goods to the United States for $10,000. At the time of the transaction, the exchange rate is $1 = ?400. It implies that the sale value of the goods in naira is ?4,000,000.

However, when the foreign company was about to pay for this transaction, the exchange rate had changed to $1 = ?600. Now, the sales value in naira would be calculated as $10,000 * ?600 = ?6,000,000.

The difference between the initial sales in naira (?4,000,000) and the updated sales (?6,000,000) is the foreign exchange gain of (?2,000,000). This difference can affect the company's financial statements and tax calculations.

On second notes, if the exchange rate changes from $1 = ?300 when the foreign company paid, there would be a foreign exchange loss of N1,000,000.

How to determine realized and unrealize exchange differences Using the above scenario.

At the time of invoicing, the Nigeria company would initially Debit Receivables with N4,000,000 and Cr Revenue with the same amount because the payment has not yet been received.

After confirmation of increased in exchange rate, you will agree with me that Receivable would change from N4,000,000 to N6,000,000. Whereas the expected revenue is still N4,000,000. At this point, IFRS standard (specifically IAS 21) require the reporting entities to recognize other income of N2,000,000 even when the payment has not been received.

This income is what we call unrealized exchange gain. The concept behind the word’’ Unrealized’’ is because exchange gain can either increase or decrease any time before payment is actually made. Hence, it will be wrong to form a judgement or make decision on uncertain figure.

Now, a tax authorities will disregard this income because payment has not been received. This item will be treated as non-taxable income and is not subject to tax.

On the other hand, if payment was received, the recognition would shift to realised exchange gain of N2,000,000 which would then be subject to tax appropriately. Likewise, if the exchange difference resulted to unrealised exchange loss. The item will be added to back to profit because loss has not crystallized as the fund is still sitting as receivables. Apparently, realised exchange loss will be allowable expenses if payment was received after exchange rate reduce below the invoice rate. It is pertinent to note that exchange differences can occur in other business transactions such as foreign loan, importation of capital expenditure etc.

After elucidating the above points, the FIRS publication aims to differentiate and prescribe treatment of foreign exchange transactions based on the following classification:

a. Capital Exchange difference: Realized capital exchange loss arises from purchased of fixed asset should not be deducted for tax purposes. Instead, the loss amount should be added to the fixed asset's cost and compute capital allowances. On the contrary, any capital exchange gains will be subject to Capital Gains Tax at the applicable rate when the gain is realized.

b. Monetary and non-monetary items: For both monetary and non-monetary items, exchange differences will be handled as follows:

i. Exchange differences when settling or receiving payment for a monetary item are considered realized exchange differences.

ii. Exchange differences on foreign currency cash balances are unrealized when converting to another currency or another type of monetary or non-monetary item.

iii. Exchange differences on any monetary item are treated as taxable income or deductible expenses for income tax purposes, unless the transaction involves the main component of a capital item.

For example, exchange differences on the sale of land in a foreign currency by a non-property dealing company are considered capital expenditure. However, if a property dealing company conducts the same transaction, it's treated as a revenue item.

c. Hedging Transactions: When companies use strategies to protect themselves from losses due to changes in currency exchange rates (hedging), any foreign exchange differences are not counted as taxable income or deductible expenses until the protected item is sold or settled. At that point, how these differences are treated whether as regular income or as capital gains or losses depends on how the original item being protected is classified.

d. Company income tax: Unrealised exchange differences do not increase or decrease the tax liability and they must be ignored in the computation of the assessable profits. Where unrealised exchange loss is charged to statement of comprehensive income account (i.e., Profit and Loss Account), such unrealised losses are not tax deductible, while unrealised gain are equally not taxable income.

However, realised exchange differences would either increase (in the case of a gain) or decrease (in the event of a loss) tax due as they are included in the computation of the assessable profits.

e. Tertiary Education Tax: The tax treatment of exchange currency transactions and translations also apply to TET. This means that exchange differences which are taxable income or deductible expenses for Companies Income Tax (CIT) purposes shall be similarly treated in arriving at assessable profits for TET purposes.

f. Other taxes: Unrealised exchange differences recognised for accounting purposes shall not be adjusted in computing the following taxes:

i. National Agency for Science and Engineering Infrastructure (NASENI) levy at 0.25% of the Profit Before Tax for eligible companies.

ii. National Information Technology Development Agency (NITDA) Levy at 1% of Profit Before Tax payable by companies specified in the NITDA Act.

iii. Minimum tax payable under section 33(2) of CITA at the rate of 0.5% of gross turnover as defined under section 105 of CITA (less franked investment income) where applicable.

g. Tax exempt items: Exchange differences from items that are exempt from tax won't be taxed if there's a gain or deducted if there's a loss. For example, any exchange gain or loss from the sale of Federal Government of Nigeria (FGN) Eurobonds isn't counted as taxable income or a deductible expense for income tax purposes, regardless of the taxpayer's business type.

Overview and insight:

The Federal Inland Revenue Service (FIRS) demonstrates a commendable understanding of International Financial Reporting Standards (IFRS) and the importance of aligning accounting principles with tax regulations. The publication provides a clear and structured explanation of how foreign exchange transactions should be treated for tax purposes. The breakdown of different categories (capital, monetary/non-monetary, hedging) is helpful for businesses in understanding their tax obligations and ensuring compliance.

However, treatments of stamp duties arising from foreign business transactions, such as those on foreign loans, share capital, leases, etc., are not addressed. There remains a need for further simplification and clarity in these areas to reduce complexity and ensure consistent application of tax rules.