Chapter 4 - Policy discussion of FX component
4.1 Current law requires foreign currency agreements for the sale and purchase of property or services to be effectively taxed as two separate components.
4.2 The first component is taxed as a FEC from the date the agreement is entered into until the date the first rights in the goods pass, or the services are performed (the rights date), or the final payment is made. However there is no expected value approach available for these agreements as there is for FECs (as outlined in Determination G14B). As a consequence, the FX component is taxed under Methods A and B of Determination G29 on unrealised gains/losses each year. This can result in volatile taxable income over the term of the agreement.
4.3 Another effect of the FX component tax treatment is that the property or services included in agreements are also taxed, based on values using forward rates. For example, a fixed asset being purchased with an agreement is capitalised and depreciated based on the forward rate, irrespective of whether the agreement is hedged with a separate FEC.
Policy rationale and history of current rules
4.4 The background to the current rules is summarised in the statement in the Tax Information Bulletin, Vol 7, No 9 (February 1996).
A deferred settlement FX ASAP is the economic equivalent of an ASAP denominated in New Zealand dollars plus two separate financial arrangements:
• A FEC, in which one party agrees to exchange a foreign currency for New Zealand dollars at a future time. This is for the period between the date of entering into the FX ASAP and date of delivery of the property.
• A foreign currency denominated loan for the period between the date of delivery of the property and payment.Therefore, the tax treatment of a FX ASAP should, as far as practical, be consistent with the tax treatment of these other financial arrangements.
FX component
4.5 The policy outcome described above was influenced by the court decision in the Dewavrin[2] case. One of its findings was that the changing New Zealand currency value of the property in an agreement should be spread over the term of the contract.
4.6 Following this case, the policy for the FX component focussed on the appropriate method to value the property or services in an agreement and how to tax the FX component under the accrual rules. 4.7 It was considered that the spot rate at the rights date accorded with legal precedence, economic theory and commercial practice. At the start of the contract the spot rate on the (future) rights date is not known so the forward rate from the contract date to the rights date was used as the best estimate. The forward rate is consequently used to establish the tax cost/value of the property/services included in the agreement and the amount of any notional loan from the rights date to the settlement date. 4.8 It was also concluded that the FX component was the same in principle as a usual FEC and should be taxed the same way. At that time the taxation of FECs under the accrual rules was essentially on a market/fair value approach and there was no expected value approach available. 4.9 We have considered two aspects of this approach. The first is that there is no expected value method available for spreading the FX gains/losses on the agreements. An expected value method would allow volatility to be removed until any FX gain/loss is realised. FECs have an expected value method applied to them (according to Determination G14B). 4.10 The second aspect is treating the FX component of these agreements as a usual FEC. 4.11 The Determination G29 tax treatment under methods A and B can be demonstrated by the following simplified examples: 4.12 The asset is then depreciated based on the NZ$143 with a one-off taxable gain of NZ$18 on the agreement at maturity per the base price adjustment (BPA) = all consideration received/paid = consideration received being the value of the asset at the forward rate (NZ$143) and consideration paid being the cash at the spot rate (NZ$125). The BPA result could go either way based on the spot rate at delivery compared with the forward rate at the beginning. 4.13 Any separate hedging FEC will be dealt with in its own right and does not affect the taxation of the agreement under Determination G29 (see further comments below about hedging). 4.14 A usual FEC is taxed as follows, assuming the same facts as above, except that the item being purchased is US$100 cash at the forward rate of 0.70: 4.15 The recognition of the one-off loss for the FEC is based on the value of the US$100 being only NZ$125 at the spot rate at maturity compared with the purchase price of NZ$143. In this case the asset is correctly recognised at the spot rate at delivery (NZ$125 DR to bank account) and if it continued to be held in the form of a US$ deposit it will be revalued periodically at the relevant spot rate. This is an appropriate tax treatment for the purchase of the foreign currency asset. 4.16 For the purchase of an unhedged item the concerns are the use of the forward rate and the compulsory recognition of an FX gain or loss. This is especially the case when IFRS accounting uses the spot rate and accordingly does not recognise any FX component. 4.17 The original policy approach may have been recognising that in many cases taxpayers were hedging these agreements with matching FECs. In such cases the taxpayer would be effectively paying for the asset at the forward rate and it would be appropriate to capitalise and depreciate the asset at that value. However, the agreement is a separate financial arrangement from any hedging FEC and, in principle, its tax treatment should stand alone. (See the discussion below of alternative options to deal with the FX component of these agreements.) 4.18 One aspect of the development of the financial arrangements rules is the reluctance to amalgamate the taxation of hedging instruments with the underlying hedged items. However, if a separate FEC is used to fully hedge a foreign currency agreement for the sale and purchase of property or services, the tax position is that the one-off FX gain/loss at maturity of the agreement will be offset by a corresponding one-off FX loss/gain on the FEC. Also, the asset will be capitalised at the forward rate according to Determination G29 which is the amount of cash paid under the hedging FEC to purchase the overseas currency. The overall tax result in this case is an appropriate policy outcome and we note it is the IFRS GAAP designated hedging result. 4.19 While the FX component of these agreements may not be economically equivalent to a usual FEC we consider that they do contain an FX element which has to be dealt with under the financial arrangements tax rules. 4.20 However, chapter 5 discusses some alternative tax treatments of the FX component in certain situations. These alternative treatments are suggested as pragmatic ways of dealing with the difficulties faced by many taxpayers. 4.21 The current rules tax these types of agreements where applicable through including them in the definitions of “forward contract” and “future contract”. This is appropriate and in accordance with the original policy intent. There are no changes suggested to the current treatment of these financial arrangements. 2CIR v Dewavrin Segard (NZ) Ltd (1994) 16NZTC 11,048; (1994) 18 TRNZ509 (CA).Discussion of the tax approach of the FX component
Capitalise asset at the forward rate
(US$100 @ 0.70) = DR Asset NZ$143
Pay cash at spot rate = US$100 @ 0.80 = CR Cash NZ$125
Recognise a one-off FX gain = CR Income NZ$18Pay cash at the forward rate = US$100 @ 0.70 = CR Cash NZ$143
Bank US$ at spot rate = USD @ 0.80 = DR Cash NZ$125
Recognise one-off FX loss on FX contract = DR Income NZ$18Agreements for commodities or assets substituted for money