Chapter 5 - Alternative treatments for the FX component
5.1 Pragmatic alternative tax treatments of the FX component are discussed in this chapter as follows:
- For IFRS taxpayers the IFRS GAAP treatment as described earlier would be the tax treatment. This would include relevant FX amounts for designated FEC hedges which are included in the IFRS GAAP values of goods or services. However, the IFRS GAAP treatment would not be available for FX amounts for designated FEC hedges included in the IFRS GAAP amounts recognised for capital goods or services, except to the extent the assets are depreciable. In these cases the FEC hedges would continue to be taxed as separate financial arrangements.
- For non-IFRS taxpayers the general rule to value the property or services would be the spot rates at the payment dates. There would be two exceptions, the first being for trading stock which would allow FX amounts from hedges to be included in the value of stock when these are included in the stock values in the taxpayer’s stock system. The second is for depreciable property where FX amounts from qualifying hedges would be included in the value of the property.
Discussing the alternatives
5.2 The IFRS GAAP treatment as described above would be compulsory for tax for IFRS taxpayers. This treatment would include FX amounts for designated FEC hedges in the values of goods or services. This treatment of the hedging FEC coincides with the current Determination G29 (methods A and B) treatment of the FX component at the forward rate and is compliance-friendly. This treatment is appropriate for a hedged agreement.
5.3 Compared with the status quo, the inclusion of FEC hedging amounts in the value of goods or services in agreements is a compliance concessionary treatment. These amounts would otherwise be taxable at maturity of a FEC and including them in the value of goods or services per IFRS GAAP is a timing issue which merely re-spreads these amounts for tax. The re-spreading is considered acceptable as over time the gains and losses being spread should even out. It is also noted that it is hard to forecast at any time whether there will be FX gains or losses on FECs. This treatment will also apply to amounts included in the cashflow hedge reserve and subsequently the value of the underlying item for designated hedges which are rolled. Undesignated rolled hedges would continue to have a base price adjustment (BPA) applied to them for tax at that point.
5.4 Hedging FEC gains/losses included in the value of goods and services will need to be excluded from consideration for the purposes of the BPA, and possibly for spreading purposes as well.
5.5 We consider that this option should not be available for a FEC hedging non-taxable/capital goods or services, except for assets which are tax depreciable. The hedging FECs in these cases would continue to be taxed as stand-alone financial arrangements. It may also be necessary to include recapture rules for hedging amounts included in the cost of depreciable items which are subsequently disposed of at an amount in excess of cost (discussed in “potential permanent differences” below).
5.6 We suggest that it be mandatory for IFRS taxpayers to follow the IFRS GAAP treatment in all cases where the IFRS GAAP is the basis for financial reporting. This is effectively the modified fair value method. There are two main reasons for this suggestion. The first is that it is the most compliance-friendly approach for these taxpayers because it follows the profit and loss account result of the agreements and any designated hedges. Secondly, there is a concern that allowing IFRS taxpayers to use an alternative expected value approach for these agreements may provide a significant fiscal risk, where they can result in leaseback transactions (as discussed below).
Tax rules and GAAP
5.7 Previous working groups have reported on various aspects of the alignment of the accounting and tax treatments of financial arrangements. The 1990 tax simplification report made the following comment:
Wherever possible, the accruals determinations should be aligned to the New Zealand Society of Accountants’ statements of standard accounting practice (SSAPs).
5.8 Including hedging foreign exchange gains/losses with income/expenditure on the underlying hedged item for tax purposes has been considered by various working groups in the past, especially the Valabh Committee in its 1991 report. One aspect considered by that committee was the treatment of hedging foreign exchange instruments, primarily financial arrangements. It concluded that the two arrangements should continue to be taxed separately. The conclusion was influenced by the difficulties of identifying which hedges were for particular underlying transactions and policy concerns about FX hedging gains/losses for non-taxable hedged items.
5.9 We note that the IFRS GAAP rules for designated hedging mean it is easier to identify which financial arrangements are being used to hedge particular FX exposures. However, there are situations when taxpayers choose not to adopt designated hedging for accounting when they are economically hedged. In these situations it will be difficult for tax purposes to consider allowing hedging gains/losses to be included in the taxation of underlying items such as fixed assets and trading stock. As discussed in the 1991 report, there is no ability to allow hedging gains/losses on financial arrangements to be included in items that are not taxable, such as non-depreciable capital account items, for example.
5.10 We acknowledge that the tax rules do follow the accounting treatment in some areas. These include financial arrangements where the financial accounting treatment is an alternative spreading method available to many taxpayers. It also applies generally to the valuation of trading stock.
5.11 Further, IFRS tax spreading methods follow IFRS GAAP hedging to an extent. The modified fair value method excludes some amounts recognised in equity reserves in years prior to the BPA. The amounts in equity reserves mostly arise from cashflow hedge accounting.
5.12 Many agreements are for trading stock and the tax treatment of trading stock is generally based on GAAP costs/valuations. This is acceptable tax policy.
Summary of any IFRS GAAP tax treatment of foreign currency agreements for the sale and purchase of property or services and associated FEC hedges
5.13 The following table summarises how the suggested IFRS GAAP (GAAP in the table) tax treatment would apply:
|GAAP Treatment||FX agreement||FEC|
|No FEC||Capitalise at spot rate = GAAP, with any GAAP loan interest & FX gains/losses taxed in profit and loss account.||N/A
|FEC not designated as a hedge||Capitalise at spot rate = GAAP, with any GAAP loan interest & FX gains/losses taxed in profit and loss account.||
GAAP profit and loss account includes all fair value gains/losses on FEC.
Use IFRS financial reporting method (fair value).
OR G14B (expected value).
|FEC designated as cashflow hedge||Capitalise at FEC hedged amount = GAAP, with any GAAP loan interest & FX gains/losses taxed in profit and loss account.||
Fair value gains/losses on FEC in cash flow hedge reserve.
Use modified fair value (mandatory) as the hedge is locked into the agreement for tax accounting.
|FEC designated as fair value hedge (unlikely)||
Capitalise at hedged amount per fair value hedging = GAAP * with any GAAP loan interest & FX gains/losses taxed in profit and loss account.
* Capitalisation includes any FX amounts attributable to the hedged risk on firm commitments recognised in the balance sheet as DRs/CRs under fair value hedging prior to recognition of the underlying item.
Those same amounts (in reverse) have been included in the profit and loss account under fair value hedging.
GAAP profit and loss account includes all fair value gains/losses on FEC.
Use modified fair value (mandatory) as the hedge is locked in to the agreement for tax accounting.
5.14 It is suggested that non-IFRS taxpayers aggregate the NZ$ amounts of the payments made at the spot rates at the various payment dates for valuing the goods and services under the agreements. This would be the general rule for non-IFRS taxpayers, with two exceptions:
- Trading stock – Where a taxpayer’s trading stock system includes FX amounts from FEC hedges in its cost and value for trading stock, that treatment would be followed for tax.
- Depreciable assets – A taxpayer would include FX amounts from qualifying FEC hedges in the cost of the assets for tax purposes and those amounts would be excluded from being taxed for the FEC.
5.15 Qualifying FEC hedges – The criteria for qualifying FEC hedges would be strict to prevent inappropriate risks to the tax base. Only over-the-counter FECs with recognised or approved financial institutions in New Zealand would be qualifying hedges. There will probably be other necessary requirements regarding documentation and perhaps elections to evidence the hedges. It is assumed that most non-IFRS taxpayers with these agreements are only using FECs to hedge them and do not have FECs for other purposes. Otherwise, it may be difficult to allow this treatment where the use of FECs is not restricted to hedging. We are not yet convinced that this suggestion can be legislated and complied with in an appropriate manner. Submissions are specifically requested on this.
5.16 Transitional matters – See the comments at the end of this chapter for the suggested general transitional measures that would apply to both IFRS and non-IFRS taxpayers.
Other matters related to the suggested alternatives
5.17 The consistency/anti-arbitrage rules will not need to be amended if the IFRS GAAP treatment is compulsory for these agreements for IFRS taxpayers.
5.18 There may be concern that the IFRS GAAP hedging rules may provide opportunities for taxpayers to declare or not declare FEC hedges of agreements to get the best tax result. The IFRS hedging criteria are quite strict about what can be designated as a hedge and when hedging starts and stops. For FECs, any unrealised FX gains/losses prior to a FEC being designated as a hedge are taken to the profit and loss account and will not be included in amounts subsequently recognised for the hedged item. If a hedge (say FEC) is de-designated as a hedge before it matures, unrealised gains/losses on the hedge up to the point it is de-designated are subsequently included in the value of the hedged item. Gains/losses on the hedge subsequent to de-designation are included in the profit and loss account and do not affect the value of the hedged item.
5.19 These hedging rules should mean that the risk of manipulation of hedging for tax purposes is small. For FEC hedges, FX gains/losses on the FEC prior to designation and after de-designation are taken to the profit and loss account and will be taxable at that point. They are not included in the values of the goods/services on a retrospective basis so that there is no ability for taxpayers to retrospectively decide to include/not include amounts related to FEC hedges in the values for goods or services. It is only the FEC gains/losses during the period of hedge designation which are included in the IFRS GAAP values of the goods or services.
5.20 For non-IFRS taxpayers, the suggested changes outlined above are a significant departure from the current tax treatments of both the hedged item and the FEC hedges, and therefore may carry significant risk for the revenue base. Consequently, it will be necessary to have robust criteria for the qualifying hedges and for the consistent use of the tax treatment for all FEC hedges of trading stock and depreciable assets during an income year and from year-to-year.
IFRS recognition date and the tax rights date
5.21 The IFRS GAAP recognition rules would generally coincide with the rights dates for possession and dates for provision of services which are used for tax. At the very least they will be reasonably approximate to those dates and there is only a small risk of significant timing mismatches between the two. We consider that using the GAAP recognition concepts for goods and services included in these agreements is acceptable for tax purposes.
Potential permanent differences
5.22 Including FX gains/losses on these agreements in the value of assets by using IFRS GAAP rather than taxing them separately under the current rules has the potential to create significant permanent differences. These will occur when depreciable assets are sold in excess of their cost and the resulting (net) gains are not subject to tax. It is noted that the FX amounts included in the cost of the assets could be either gains or losses and that a taxpayer will have to apply the same treatment to all these agreements.
5.23 These factors will tend to negate the impact of the non-taxation of FEC gains/losses over time and make it less of a concern. However, we are considering if it is necessary to include recapture provisions for any FEC gains/losses included in the cost of these items. Submissions are specifically requested on this.
5.24 We are aware that some assets subject to these agreements become sale/leaseback transactions at the point of delivery of the goods/assets. Under the current tax treatment, the ability to make some agreements sale/leaseback transactions while making others direct purchases (without a sale/leaseback) can result in risks to the tax base.
5.25 The Determination G29 treatment of an unhedged foreign currency agreement for the sale and purchase of property or services which is assigned to a financier just prior to the delivery of the goods would give a net nil tax result for the assignor (the original purchase party to the agreement). The current Determination G29 treatment (without an expected value alternative) would create unrealised FX gains/losses in the years prior to the BPA. When the agreement is assigned to a third party lessor under a sale/leaseback transaction, a BPA is required for the agreement.
5.26 The consideration received for the assignment of the agreement will be the value of removal of the assignor’s obligation to purchase the goods. This will be the value of the goods at the spot rate at that time. The consideration paid for the assignment will be the loss of the right to receive the goods which will also be valued at the spot rate at that time. These two amounts will net to zero in the BPA. Any income/expenditure in prior years will be reversed by the BPA to give an overall net nil result for tax for all years.
5.27 The overall result on assignment of the agreement for the assignor is no taxable income/deductions. If the goods were depreciable assets it would capitalise them at the spot rate on delivery under the leaseback transaction (a finance lease for tax).
5.28 This situation could be managed to produce the most advantageous result for the taxpayer. Where the maturity of an agreement was to produce taxable income as a result of the final “a – b” calculations of methods A and B, the agreement could be assigned. A sale/leaseback transaction would be put in its place and this would give the net nil result outlined above. Where the agreement “a – b” calculations produced an overall net loss, the agreement would not be assigned. The asset would be capitalised at the forward rate and the FX loss taken for tax.
5.29 The unrealised gains/losses under the “a – b” calculations would be taxable in the years before the BPA but the choice to assign and enter into a sale/leaseback may still be advantageous. If an expected value alternative was provided for and used by a taxpayer, there would be no “a – b” FX gains/losses in the years before the BPA. In this case the choice to assign would be even more appealing in many cases, where there is an overall gain on the agreement.
5.30 The IFRS GAAP treatment may not provide the same opportunity for these agreements. It would probably deal with both the sale/leaseback transaction and the outright purchase at the spot rates on delivery. For a hedged agreement it would probably deal with both transactions at the hedged rate. We are continuing our analysis of the IFRS GAAP treatment of this matter to confirm there are no revenue base concerns.
5.31 Because of the widespread compliance difficulties with the existing rules referred to earlier, it will be necessary to provide appropriate transitional provisions for existing agreements and any new alternatives provided.
5.32 We suggest that agreements in place at the time of any amending legislation using methods which are either existing or suggested new alternatives provided in amended legislation be retrospectively validated to prevent any disputes over past returns. There will be no ability to change the methods used for agreements and any FEC hedges in past returns when the returns have been filed under the conditions outlined above.
5.33 New alternative methods provided in any amending legislation would only be applied to new agreements entered into from the date of amending legislation.
5.34 We specifically request submissions on this suggestion.