AustLII Home | Databases | WorldLII | Search | Feedback

Journal of the Australasian Tax Teachers Association

ATTA
You are here:  AustLII >> Databases >> Journal of the Australasian Tax Teachers Association >> 2005 >> [2005] JlATaxTA 7

Database Search | Name Search | Recent Articles | Noteup | LawCite | Help

Hanlon, Dean; Nethercott, Les --- "Foreign Currency Translation: The Beginning Of A New Era" [2005] JlATaxTA 7; (2005) 1(1) Journal of The Australasian Tax Teachers Association 95



FOREIGN CURRENCY TRANSLATION: THE BEGINNING OF A NEW ERA

DEAN HANLON[∗]AND LES NETHERCOTT[∗∗]

ABSTRACT: In recent times, much consideration has been given to the merits of reducing the divergence between accounting practice and taxation law. To illustrate, the Review of Business Taxation in A Tax System Redesigned (1999) recommended, ‘appropriate regard be had to accounting principles in the development of taxation legislation...’ (Recommendation 4.23). One area that has received particular attention is the taxation of financial arrangements and, more specifically, foreign exchange gains and losses.

At present, the taxation of foreign currency denominated transactions is largely governed by common law and, in particular, the High Court decision in Federal Commissioner of Taxation v Energy Resources of Australia Limited (1996) 96 ATC 4536, whilst from an accounting perspective such transactions are regulated by Statement of Accounting Concepts SAC 4 Definition and Recognition of the Elements of Financial Statements and Australian Accounting Standards Board AASB 1012 Foreign Currency Translation. It is the intention of this article to undertake a comparative analysis of the accounting and taxation treatment of foreign currency denominated transactions and, in doing so, highlight the disparate recognition of any resultant foreign exchange gain or loss. Furthermore, consideration will be given to recent proposals concerning the taxation of foreign exchange gains and losses, in particular those detailed in the Exposure Draft of the New Business Tax System (Taxation of Financial Arrangements) Bill (Cth) 2002, to establish whether the implementation of such recommendations will contribute to reducing the divergence between accounting practice and taxation law.

I INTRODUCTION

The merits of comparability between accounting practice and taxation law have been recognised by academics,[1]courts of law and governments. In particular, history illustrates the relevance of accounting evidence in a court of law, particularly in the resolution of issues concerning the intended operation of Australia’s income tax legislation.[2]The relevance of accounting practice in taxation law has also been recognised by both the Commonwealth Parliament and the Australian government. Public inquiries initiated by Parliament have recommended the alignment of accounting practice and taxation law in an attempt to simplify Australia’s income tax legislation.[3]

Furthermore, governments of the day have recommended a reduction in the divergence between both accounting and taxation practices in order to reform Australia’s taxation system. To illustrate, the 1975 Asprey Committee proposed ‘to narrow, as far as possible, the differences between net income as determined under the revenue legislation and as

determined by commercial standards’.[4]The Howard government, as a result of its tax reform plan, titled Tax Reform: Not a New Tax, A New Tax System - The Howard Government’s Plan for a New Tax System (1998),[5]also advocated that taxation law more accurately reflect commercial reality, which culminated in the recommendation by the Review of Business Taxation in A Tax System Redesigned (1999) (‘Ralph Report’) that ‘appropriate regard be had to accounting principles in the development of taxation legislation...’.[6]

One area that has received particular attention is the taxation of financial arrangements and, more specifically, foreign exchange gains and losses. At present, the taxation of foreign currency denominated transactions is largely governed by common law and, in particular, the High Court decision in Federal Commissioner of Taxation v Energy Resources of Australia Limited (1996) 96 ATC 4536 (‘ER A’), whilst from an accounting perspective these transactions are regulated by Australian Accounting Standards Board AASB 1012 Foreign Currency Translation (‘AASB 1012’).[7]Statement of Accounting Concepts SAC 4 Definition and Recognition of the Elements of Financial Statements (‘SAC 4’),[8]whilst not mandatory, also assists in accounting for foreign exchange gains and losses, as it offers guidance in the definition and recognition of financial statement elements. It is the intention of this article to undertake a comparative analysis of the accounting and taxation treatment of foreign currency denominated transactions and, in doing so, highlight the disparate recognition of any resultant foreign exchange gain or loss.

Furthermore, consideration will be given to recent recommendations concerning the taxation of foreign exchange gains and losses, in particular those detailed in the Exposure Draft of the New Business Tax System (Taxation of Financial Arrangements) Bill 2002,[9]to establish whether the implementation of such recommendations will contribute to reducing the divergence between accounting practice and taxation law.

The structure of the article is as follows. Section II discusses the facts of ERA, and the decision reached by the High Court. Section III examines whether the ERA decision is consistent with SAC 4, while Section IV analyses the decision of the High Court in relation to AASB 1012 stipulations. Section V determines whether recent recommendations regarding the taxation of foreign exchange gains and losses will reduce the divergence between taxation law and accounting practice. Finally, conclusions are drawn in Section VI.

II FCT V ENERGY RESOURCES OF AUSTRALIA LTD (1996) 96 ATC 4536

This case was originally considered by the Federal Court,[10]which decided in favour of the taxpayer and ordered the Commissioner to pay the costs of the proceedings. The Commissioner appealed to the Full Federal Court,[11]which partially allowed the appeal by a minor change to the order of costs. The Commissioner, however, was dissatisfied with this outcome and sought special leave to appeal to the High Court. Leave was granted by the High Court, and it is the judgement of the High Court that will now be considered.

A Description of the Case

In January 1986, the taxpayer, Energy Resources of Australia Ltd (‘ERA’), issued a series of 90-day promissory notes at a discount pursuant to an agreement made between the taxpayer, the Commonwealth Bank and a number of foreign banks. That agreement allowed the taxpayer to instruct one of the foreign banks to issue promissory notes in the taxpayer’s name. A panel of banks would then tender for the notes at a price less than the face value of the notes. The proceeds received from the issue of the promissory notes were in US dollars. Under the agreement the taxpayer agreed to pay the face value of the notes to the holders when the notes matured. This amount was paid in US dollars.[12]

Prior to entering into the agreement, the taxpayer had the use of a finance facility under which certain banks raised money and on-lent to the taxpayer. The taxpayer used the funds raised to finance the development and operation of a uranium mine in the Northern Territory. Proceeds received from the issue of the first series of promissory notes were used to discharge the liabilities under the finance agreement. Such liabilities were in US dollars. Funds from the subsequent issues of the promissory notes were used to discharge the liabilities of the taxpayer under each preceding issue of the notes. As mentioned above, these were also in US dollars.

In its income tax returns for the 1987 and 1988 years of income, ERA claimed the discount on the notes as an allowable deduction under s 51(1) of the Income Tax Assessment Act 1936 (Cth) (‘ITAA 1936’)[13]; that is, ERA claimed the difference between the proceeds received upon issue and the payment of the face value of the promissory notes as an allowable deduction.

Furthermore, ERA argued that as the obligation to pay the face value of the promissory notes did not arise until payment, the allowable deduction was incurred at the maturity date of the notes. As a consequence, the amount of the allowable deduction was the value of the discount, converted from US dollars (‘USD’) to Australian dollars (‘AUD’), at the time the notes matured.

To illustrate, consider the following hypothetical example. Assume that ERA issued a promissory note at a face value of USD 1 000 000 repayable in 90 days’ time. At the time of issue ERA received USD 900 000, being the proceeds of the issue. Expressed in US dollars the amount of the discount is USD 100 000. However, to determine the amount of the allowable deduction for Australian tax purposes it is necessary to express this discount in Australian dollars.[14]The argument advanced by ERA is that the discount constituted an allowable deduction under s 51(1) as soon as it became obliged to pay the face value of the notes, and ERA argued that this obligation arose when the notes matured.[15]As a result, it is necessary to convert the discount to Australian dollars at that point in time — that is, upon payment of the USD 1 000 000 face value after 90 days. Thus, if one Australian dollar is worth USD 0.80 at that date, the value of the discount in Australian dollars, and consequently the amount of the allowable deduction as per s 51(1) is AUD 125 000 (USD 100 000 / 0.80).

The Commissioner allowed the discount under s 51(1) but assessed the taxpayer on the basis that, as a result of currency fluctuations within the 90-day period, ERA had made a foreign exchange gain upon payment of the face value of the promissory notes, and this constituted assessable income under s 25(1) of the ITAA 1936.[16]The Commissioner argued that due to the frequency and regularity of the transactions, the issue of promissory notes represented an integral part of the taxpayer’s operations and therefore any foreign exchange gains derived in respect of these transactions constitute income derived in the ordinary course of the taxpayer’s business. As a result, the foreign exchange gain derived was on revenue account and therefore assessable under s 25(1).[17]

Thus, the Commissioner did not dispute that the discount, converted to Australian dollars, was an allowable deduction, but rather disputed the way in which ERA determined the amount of the allowable deduction. The Commissioner contended that the obligation or liability to pay the face value of the promissory notes arose when the promissory notes were issued and not when the face value is repaid at maturity. An allowable deduction, therefore, was incurred when the notes were issued. As a result, the Commissioner argued that the discount incurred when the notes were issued must be offset against any foreign exchange gains derived when the notes were repaid to determine a net allowable deduction. As a consequence, the amount of the allowable deduction was to take into account any exchange rate movements that occurred between the time of the obligation arising and the time of settlement.[18]

Specifically, the value of the discount in Australian dollars was to be calculated by deducting from the proceeds of the notes (converted into Australian dollars at the issue date of the notes), the cost of discharging the notes (converted into Australian dollars at the maturity date of the notes).[19]Such a method of calculation takes into account any exchange rate movements within this 90-day period.

To illustrate, continuing with our above example, the Commissioner argued that the value of the discount in Australian dollars was to be calculated by first converting the proceeds on issue of the note into Australian dollars at the issue date. If one Australian dollar is worth USD 0.75 at that date, this equates to AUD 1 200 000 (USD 900 000 / 0.75). It was then necessary to convert the face value of the note into Australian dollars at the time of ERA paying this amount, being the date of maturity. This equates to AUD 1 250 000 (USD 1 000 000 / 0.80). The value of the allowable deduction as per s 51(1) is then determined by deducting the Australian dollar equivalent, calculated at maturity, of the face value of the note from the proceeds upon issuing the note, converted into Australian dollars at the issue date. This equals AUD 50 000 (AUD 1 250 000 – AUD 1 200 000).[20]

In light of the above arguments forwarded by the parties to the action, two issues required resolution: 1. When did the obligation or liability to pay the face value of the promissory notes arise? It is at this point in time that an allowable deduction for the purpose of s 51(1) also arises; and 2. Did ERA make any foreign exchange gains as a consequence of the issue of the promissory notes, and if so when did they arise?

B Decision of the High Court

The High Court, comprising Dawson, Toohey, Gaudron, McHugh and Kirby JJ, held that ERA incurred a liability in respect of the promissory notes when they were issued rather than when they were repaid. At the time of issue, ERA received or was entitled to receive the proceeds of the sale of the notes in US dollars and incurred a present obligation to pay the face value of the notes in US dollars in 90 days’ time.[21]

Furthermore, it was held that an allowable deduction for the purpose of s 51(1) arose at the same time as the creation of the obligation. In terms of calculating the amount of the allowable deduction, the High Court determined that this was equal to the difference between the proceeds ERA received or was entitled to receive and the face value of the notes expressed in Australian dollars at the date of issue. Thus, as the allowable deduction arose when ERA incurred the obligation to pay the face value of the notes, the expression of the discount in Australian dollars is to take place at the time of issuing the notes.[22]Continuing with our example above, the High Court advocated expressing the discount (being USD 100 000) in Australian dollars at the time of issuing the promissory notes. At this point in time one Australian dollar is worth USD 0.75. The allowable deduction is, therefore, AUD 133 333 (USD 100 000 / 0.75).

It was also held ERA did not derive a foreign exchange gain as a consequence of the issue of the promissory notes because it did not convert any of the proceeds received into Australian dollars. ERA dealt only in US dollars. The proceeds received and the payments made by ERA were all in US dollars. As conversion did not occur, no exchange gains or losses could have resulted.[23]

The proceeds received from the promissory notes issued were not converted to Australian dollars at the time of issue, but rather used directly to discharge liabilities expressed in US dollars. Furthermore, the repayment of the promissory notes did not require conversion of the funds to US dollars to satisfy the liability outstanding, as such funds were already expressed in US dollars. As conversion was not necessary, any exchange rate movement between the time of issue and the time of repayment was irrelevant to ERA.[24]

The ERA decision warrants comparison with the recording and reporting of foreign currency denominated transactions for accounting purposes so as to highlight any incompatibility which exists between the two. In particular, four questions require consideration from an accounting perspective:
1. When did the liability to repay the face value of the promissory notes arise under SAC 4?
2. Was revenue derived due to the issue of promissory notes under AASB 1012?
3. If so, what amount is revenue under AASB 1012?
4. When was the discount/loss incurred under AASB 1012?

III COMPARABILITY OF ERA CASE WITH SAC 4 DEFINITION AND RECOGNITION OF THE ELEMENTS OF FINANCIAL STATEMENTS

The High Court in the ERA case held that when the obligation to repay the face value of the promissory notes was established, an allowable deduction for the purposes of s 51(1) was incurred. The creation of such a liability was taken to be when the notes were issued and not when they matured. It is necessary to consider whether this decision is consistent with the creation of a liability in accounting practice.

Whilst not mandatory, SAC 4 provides guidance as to the characteristics which are to be present for a liability to be recognised for accounting purposes. More specifically, SAC 4 defines liabilities as ‘the future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events’.[25]This definition identifies three features of a liability that must be present. These are now considered in the context of the ERA case.

A Existence of a Present Obligation

An essential characteristic of a liability is the existence of a present obligation, which represents ‘a duty or responsibility of the entity to act or perform in a certain way’.[26]Such an obligation ‘implies the involvement of two separate parties, namely the entity and a party external to the entity’[27]and most commonly ‘stems from legally binding contracts’.[28]

When the promissory notes were issued, ERA entered into an agreement with an external entity to repay the face value of the notes after 90 days had expired. The commitment to fulfil this duty arose when the agreement was entered into, which was at the time of issue — that is, the obligation itself arose when the commitment was made to repay the sums of money. Whilst this obligation was not satisfied until 90 days had passed, we are not concerned with when the liability was settled. Rather we are concerned with when the liability was created — that is, at the time of issue. At that point in time ERA was bound to fulfil its obligation, irrespective of such an obligation not being satisfied until 90 days had elapsed. Furthermore, failure to meet this commitment would ultimately represent a breach of the agreement and, as specified in SAC 4, ‘there is no doubt that legally enforceable obligations of an entity are liabilities’.[29]

B Future Sacrifice of Economic Benefits

Another essential characteristic of a liability is that it has adverse financial consequences for the entity — that is, the entity is obliged to sacrifice economic benefits to another entity. Thus:

the existence of a liability depends on the present obligation being such that the ... consequences of failing to honour the obligation leave the entity little, if any, discretion to avoid the future sacrifice of economic benefits to another entity.[30]

ERA issued promissory notes under the condition that the face value of the notes would be repaid in 90 days’ time. Such an agreement had adverse consequences for ERA as it represented an obligation to disburse, or sacrifice, economic benefits in the form of cash at a future point in time. Furthermore, external parties to the agreement had the capacity to enforce repayment by ERA upon the commitment being created, as discussed above, thereby removing any discretion for ERA to avoid the future sacrifice.

Settlement of an obligation on a specified date does not prevent the existence of a liability.[31]Thus, the requirement of ERA to repay the face value of the notes in 90 days’ time does not prevent a liability from being recognised until such payment occurs. For a liability to exist there must be an obligation imposed on an entity to sacrifice future benefits that the entity has little or no discretion to avoid. As illustrated above, such discretion does not exist.

C Past Transactions or Other Past Events

The third essential characteristic of a liability for accounting purposes is that the transaction or event creating the present obligation to sacrifice economic benefits must have occurred. As detailed above, the transactions giving rise to the commitment or obligation for ERA to repay the face value of the promissory notes was at the time of their issue. This constitutes the past transaction or past event for SAC 4 purposes and is consistent with the point in time at which the High Court held a liability was created.[32]

Based on the above analysis, it is concluded the definition of a liability under SAC 4 is satisfied at the point in time at which the High Court determined a liability to exist. However, additional criteria must be satisfied for a liability to be recognised under SAC 4. A liability shall be recognised only when ‘it is probable that the future sacrifice of economic benefits will be required; and the amount of the liability can be measured reliably’.[33]These are now considered in the context of the ERA case.

D Probability of Future Sacrifice of Economic Benefits

One of the essential characteristics of a liability is that a future sacrifice of economic benefits will be required. However, such a sacrifice must be probable. In the present case, the obligation imposed upon ERA is termed ‘unconditional’ — that is, ‘only the passage of time is required to make their performance due’.[34]As a consequence, such an obligation ‘clearly satisf[ies] any criterion regarding the probability of the future sacrifice of economic benefits being required...’.[35]

E Reliable Measurement

For a liability to satisfy the recognition criteria it is necessary that the amount of the liability can be measured reliably. The amount recorded as a liability represents the ‘monetary expression of the obligation to sacrifice economic benefits’.[36]In the present case, the amount of the obligation facing ERA is equal to the face value of the notes issued. Whilst the face value is expressed in US dollars, such an amount may be reliably converted to Australian dollars by examining the exchange rate at the date the obligation arose.[37]

In light of the above analysis, the High Court’s decision that a liability for taxation purposes is created when the promissory notes are issued is consistent with the definition and recognition criteria of SAC 4 and, as a consequence, also constitutes a liability for accounting purposes.

IV COMPARABILITY OF ERA CASE WITH AASB 1012 FOREIGN CURRENCY TRANSLATION

AASB 1012[38]specifically governs foreign exchange gains and losses on both foreign currency denominated transactions and the translation of the accounts of foreign subsidiaries.[39]For the purposes of this article, emphasis is placed on foreign currency denominated transactions. It is perhaps easiest to illustrate the inconsistencies of the decision reached in ERA and accounting practice as per AASB 1012 by outlining the journal entries necessary to comply with both the ERA judgement and accounting practice: (a) when the promissory note is issued; and (b) when the face value of the promissory note is repaid.

A Operation of AASB 1012 Foreign Currency Translation

Continuing with the example outlined previously, according to the High Court, ERA is entitled to an allowable deduction of AUD 133 333, that being the discount determined when the promissory note was issued. The discount is recognised at the time of issue because the taxpayer is deemed to have incurred a liability to repay the face value of the promissory note when it is issued.[40]Based on this, the journal entry at the time of issue would be as follows:



AUD
AUD
DR
Cash
1 200 000

DR
Discount expense
133 333

CR
Liability

1 333 333 (1)

(Cash: USD 900 000 / 0.75)
(Discount expense: AUD 1 333 333 – AUD 1 200 000)
(Liability: USD 1 000 000 / 0.75)

As the above entry illustrates, the proceeds from the note issue (AUD 1 200 000) are less than the obligation to repay the face value of the promissory note (AUD 1 333 333). The difference between the proceeds and the obligation at the time of issue (AUD 133 333) represents a discount, which is an allowable deduction at that point in time under s 51(1).

Furthermore, in complying with the ERA decision, no foreign exchange gains or losses exist as there was no conversion into Australian dollars — that is, any movement in the exchange rate between the time the obligation to repay the face value of the promissory note arises and the time of repayment is not recognised. Given this, the liability, as expressed in Australian dollars, will remain constant over the 90-day period. The appropriate journal entry when repayment takes place, therefore, would be:



AUD
AUD
DR
Liability
1 333 333

CR
Cash

1 333 333 (2)

(Liability: USD 1 000 000 / 0.75)
(Cash: USD 1 000 000 / 0.75)

As this entry illustrates, there is no recognition of the exchange rate movement over the 90-day period. Thus, despite the movement in the exchange rate from USD 0.75 at the time of issue to USD 0.80 at the time of repayment, the liability and the cash outlay to satisfy this obligation are based on the exchange rate at the time of issue.

In terms of accounting practice, AASB 1012 states:

Subject to paragraph 5.2, each asset, liability, item of equity, revenue or expense arising from entering into a foreign currency transaction[41]must be recognised and translated using the spot rate at the date of the transaction.[42]

In light of the above, when the proceeds of the promissory note issue (USD 900 000) are received ERA is to measure this in Australian dollars at an exchange rate of 0.75. This equates to AUD 1 200 000. Furthermore, as a liability also arises at this point in time (USD 1 000 000) ERA is to measure the obligation to repay the face value of the note in Australian dollars at an exchange rate of 0.75. This gives rise to a liability of AUD 1 333 333. As a consequence, a discount expense arises, equal to AUD 133 333 (AUD 1 200 000 – AUD 1 333 333). The journal entry at the time of issue to recognise this is as follows:



AUD
AUD
DR
Cash
1 200 000

DR
Discount expense
133 333

CR
Liability

1 333 333 (1)

(Cash: USD 900 000 / 0.75)
(Discount expense: AUD 1 333 333 – AUD 1 200 000)
(Liability: USD 1 000 000 / 0.75)

This entry is consistent with the journal entry necessary to comply with the ERA decision. AASB 1012, however, allows for the retranslation of outstanding foreign currency monetary items, as it states:

Subject to paragraph 5.4, foreign currency monetary items[43]outstanding at the reporting date must be translated at the spot rate at reporting date. Other items outstanding at the reporting date must not be retranslated subsequent to the initial recognition of the transaction.[44]

Upon a monetary item existing, AASB 1012 states:

Subject to paragraphs 5.6 and 6.5,[45]exchange differences must be recognised as revenues or expenses in the net profit or loss/result in the reporting period in which the exchange rates change.[46]

It is necessary, therefore, to recognise separately from the discount expense any revenue or expense due to exchange rate movements. To illustrate, the liability to repay the face value of the promissory note arose when it was issued. At that time one Australian dollar was worth USD 0.75. However, it was not until 90 days later that this liability was settled — that is, when ERA repaid the USD 1 000 000. At that point in time one Australian dollar was worth USD 0.80. Based on the new exchange rate value, USD 1 000 000 is equivalent to AUD 1 250 000 (USD 1 000 000 / 0.80). Recall, however, that at the time the liability was incurred, the liability was equivalent to AUD 1 333 333. Thus, due to an upward exchange rate movement, the cash outlay necessary to settle the liability is reduced by AUD 83 333 (AUD 1 333 333 – AUD 1 250 000). This represents a foreign exchange gain as it is a reduction in the amount payable, expressed in Australian dollars, as a consequence of an upward movement in the exchange rate. The journal entry to recognise this at the time of repayment is thus:



AUD
AUD
DR
Liability
1 333 333

CR
Foreign exchange gain
83 333

CR
Cash

1 250 000 (2)

(Liability: USD 1 000 000 / 0.75)
(Foreign exchange gain: AUD 1 333 333 – AUD 1 250 000)
(Cash: USD 1 000 000 / 0.80)

The above entry illustrates the effect an upward movement in the exchange rate has on the obligation to repay the face value of the promissory note issued. The obligation, as determined at the time the obligation arises, is equal to AUD 1 333 333. However, due to a movement in the exchange rate the amount payable to settle the obligation at the time of repayment is AUD 1 250 000. The reduction in the amount payable represents a foreign exchange gain as per AASB 1012.[47]

Accordingly, in accounting practice, the taxpayer incurred an overall cost of AUD 50 000 — this being a combination of the discount expense and a reduction in the value of the amount payable due to a favourable movement in the exchange rate. Ultimately, this is consistent with the argument advanced by the Commissioner in the ERA case.

Thus, based on the above analysis, disparity exists in the decision of the High Court in ERA, and accounting practice, as per AASB 1012, concerning foreign currency denominated transactions. This is best illustrated by summarising the journal entries from both an accounting and taxation perspective, when the promissory note is both issued and repaid, in table format, as shown in Table 4.1:

Table 4.1

A SUMMARY OF THE JOURNAL ENTRIES CONCERNING THE ISSUE AND REPAYMENT OF PROMISSORY NOTES FROM AN ACCOUNTING AND TAXATION PERSPECTIVE

ERA High Court decision
AASB 1012/AASB 121
Upon Issue

AUD
AUD

AUD
AUD
DR Cash
1 200 000

DR Cash
1 200 000

DR Discount expense
133 333

DR Discount expense
133 333

CR Liability

1 333 333
CR Liability

1 333 333
Upon Repayment

AUD
AUD
AUD
AUD

DR Liability
1 333 333

DR Liability
1 333 333




CR Exchange gain

83 333
CR Cash
1 333 333

CR Cash

1 250 000

It is important to recognise that from an accounting perspective there is:

1. A discount expense of AUD 133 333 upon issue of the promissory notes; and

2. A foreign exchange gain of AUD 83 333 upon maturity of the promissory notes.

From a taxation point of view, however, there is:

1. A discount expense of AUD 133 333; and

2. A non-taxable gain of AUD 83 333

It seems, therefore, that while there is an alignment of accounting and taxable concepts in measuring the discount expense of AUD 133 333 upon issuing the promissory notes, there is a different outcome in assessing the gain of AUD 83 333 upon maturity of the notes. This is because, while AASB 1012 stipulates the gain is to be treated as revenue, from a tax perspective this amount is non-taxable. As indicated earlier, such disparity arises due to the fact that ERA dealt only in US dollars. As conversion did not occur, no exchange gains or losses could have resulted.

In light of the above, the implication of the High Court is that the ERA decision would have been decided differently if ERA had converted the proceeds received into Australian dollars and, subsequently, reverted back to US dollars to discharge the outstanding liability. Continuing with our example, it may be argued that if an amount of Australian currency had been converted to US dollars to repay the liability upon maturity, a foreign exchange gain of AUD 83 333 would have been realised.[48]

B Different Income Years

In determining the foreign exchange gain or loss arising upon discharge of the outstanding liability, the analysis has been based upon a comparison in time when a promissory note issue, and subsequent discharge, has taken place in one income year. It is worthwhile extending this analysis to consider the situation in which the period between issuing and discharging the promissory notes straddles two income years.

Continuing with the above example, assume that, in between the note issue and repayment, the income year comes to an end on 30 June 20X2 and one Australian dollar is worth USD 0.77. In accordance with para 5.5 of AASB 1012 / para 28 of AASB 121, there is a need to:

1. Recognise a discount expense of AUD 133 333 upon issue of the notes;[49]

2. Recognise a foreign exchange gain of AUD 34 632 at the end of the reporting period, despite it being unrealised (USD 1 000 000 / 0.75 – USD 1 000 000 / 0.77);[50]and

3. Recognise a foreign exchange gain of AUD 48 701 upon maturity of the notes (USD 1 000 000 / 0.77 – USD 1 000 000 / 0.80). Across both reporting periods, this gives rise to a foreign exchange gain totalling AUD 83 333 (AUD 1 333 333 – AUD 1 250 000).

Based on the above, the journal entries in accordance with AASB 1012/AASB 121 are as follows:

(1) Upon Issue



AUD
AUD
DR
Cash
1 200 000

DR
Discount expense
133 333

CR
Liability

1 333 333

(Cash: USD 900 000 / 0.75)
(Discount expense: AUD 1 333 333 – AUD 1 200 000)
(Liability: USD 1 000 000 / 0.75)

(2) 30 June 20X2



AUD
AUD
DR
Liability
34 632

CR
Foreign exchange gain

34 632

(Liability: USD 1 000 000 / 0.75 – USD 1 000 000 / 0.77)
(Foreign exchange gain: USD 1 000 000 / 0.75 – USD 1 000 000 / 0.77)

(3) Upon Maturity



AUD
AUD
DR
Liability
1 298 701

CR
Foreign exchange gain
48 701

CR
Cash

1 250 000

(Liability: USD 1 000 000 / 0.75 – AUD 34 632)
(Foreign exchange gain: USD 1 000 000 / 0.77 – USD 1 000 000 / 0.80)
(Cash: USD 1 000 000 / 0.80)

By way of comparison, the tax consequences as at 30 June 20X2 would be to recognise the discount expense of AUD 133 333 as a deduction under s 8-1 of the ITAA 1997, while the unrealised gain of AUD 34 632 would not be recognised. Thus, the accounting and taxation measures of income vary significantly when a promissory note issue straddles two income years.

V PROPOSALS FOR CHANGE

In recent times, considerable debate has surrounded the appropriate taxation of financial arrangements, a component of which is the tax treatment of foreign exchange gains and losses. In 1993, Taxation of Financial Arrangements: A Consultative Document (‘TOFA CD’)[51]was released and recommended a retranslation basis of recognising foreign exchange gains or losses. This was subsequently endorsed in Taxation of Financial Arrangements: An Issues Paper (‘TOFA IP’),[52]which was issued in December 1996. While consistent with AASB 1012, the tax consequences of the retranslation approach would be to tax unrealised gains at the end of an income year arising from exchange rate movements.

In July 1999, the Ralph Report recommended the adoption of a mark to market basis of valuing financial assets and liabilities.[53]Also consistent with AASB 1012, the mark to market approach involves the conversion of a foreign currency denominated financial asset or liability to Australian dollars at the exchange rate prevailing at the end of the relevant income year. However, like the retranslation approach endorsed in TOFA CD and TOFA IP, the mark to market approach recognises and taxes unrealised foreign exchange gains or losses where the holding of the asset or liability straddles more than one income year.

On 17 December 2002, an Exposure Draft of the New Business Tax System (Taxation of Financial Arrangements) Bill 2002 was released, which considers the taxation of foreign exchange gains and losses. Later enacted as the New Business Tax System (Taxation of Financial Arrangements) Act (No. 1) 2003 (Cth) (‘NBTS FA 2003’), two principles are of particular interest.

First, sub-div 775-B of the ITAA 1997 identifies points in time at which foreign exchange gains or losses are to be realised for taxation purposes. In particular, foreign exchange gains or losses will be treated as assessable or deductible upon the occurrence of a ‘realisation event’. One such realisation event is when the taxpayer ceases to have a liability to pay an amount of foreign currency.[54]This will arise where the taxpayer repays the liability.[55]Upon satisfying the liability, the taxpayer has made a foreign exchange gain if the amount paid is less than the amount outstanding when the liability was created due to exchange rate movements.[56]

Second, a general conversion rule exists that converts foreign currency denominated amounts into Australian dollars irrespective of whether actual conversion took place.[57]It is, therefore, a departure from the ERA decision, which held actual conversion must occur to recognise a foreign exchange gain.[58]A liability to pay an amount of foreign currency must be converted to Australian dollars under the general conversion rule when the liability is created.[59]A foreign exchange gain will arise if the amount paid, in Australian dollars, which triggers the realisation event is less than the amount originally owing as determined under the general conversion rule.

With respect to the ERA case, upon payment of the face value of the promissory notes at maturity ERA ceased to be obliged to pay US dollars to the promissory note holders. Furthermore, the amount paid to satisfy the liability was less than the amount outstanding upon issue of the notes when expressed in Australian dollars.[60]Continuing with the example outlined previously, NBTS FA 2003 would treat as assessable income the foreign exchange gain of AUD 83 333 derived by ERA. This, as illustrated above, is equal to the amount of revenue recognised under AASB 1012/AASB 121.

VI CONCLUSION

The High Court decision in ERA is a hallmark decision concerning the tax consequences of holding foreign currency denominated debt where there is a variation in the exchange rate. The decision establishes that a discount on debt, which is in the form of promissory notes, is a deduction to be determined at the time of issue using the prevailing exchange rate. Furthermore, where there is a favourable movement in the exchange rate between the time of issue and maturity this does not give rise to a foreign exchange gain if the taxpayer deals only in foreign currency. That is, if actual conversion to Australian dollars does not occur.

From an accounting perspective, however, it is apparent that, in accordance with the retranslation of foreign currency monetary items that are outstanding at reporting date, a foreign currency denominated transaction under AASB 1012/AASB 121 may give rise to a foreign exchange gain. Thus, even if a firm deals only in foreign currency and does not convert to Australian dollars, a favourable exchange rate movement will generate revenue for the firm. Moreover, AASB 1012/AASB 121 also recognises a foreign exchange gain at the end of a reporting period when the outstanding liability extends to more than one reporting period.

In the context of recent tax reform initiatives, with particular respect to NBTS FA 2003, a departure from the ERA decision is apparent. It is argued there is a recognised need to assess as income favourable exchange rate movements on foreign currency denominated transactions. In particular, NBTS FA 2003 states that a taxpayer convert foreign currency denominated amounts to Australian dollars, irrespective of whether actual conversion occurs, and assess the taxpayer on any foreign exchange gain arising from such conversion. This is consistent with AASB 1012/AASB 121, and represents a shift to reduce the divergence between accounting practice and taxation law.


[∗] BEc, MComm(Hons) (Monash), Lecturer, Department of Accounting and Finance, Monash University, Caulfield. Note: Dean Hanlon is the corresponding author and can be reached at the Department of Accounting and Finance, Monash University, 900 Dandenong Road, Caulfield East, Victoria, Australia, 3145.

[∗∗] BEc(Hons), MEc (Monash), Associate Professor, Department of Accounting and Management, La Trobe University, Bundoora.

[1] See, eg, A W Blaikie, ‘The Relevance of Accounting Principles to the Income Tax Assessment Act(1981) 15 Taxation in Australia 690; Trevor Boucher, ‘The Simplification Debate - Too Simplistic?’ (1991) 26 Taxation In Australia 277; Graeme S Cooper, ‘Some Observations on Tax Accounting’ (1986) 15(3) Australian Tax Review 221; C F Farleigh, ‘The Accountant as Expert’ (1979) 8 Australian Tax Review 64; Richard Fayle, ‘Accounting Standards and Their Relevance to Taxation Law’ (Paper presented at the Ninth National Convention of the Taxation Institute of Australia, Adelaide, 1–4 May 1990); G L Herring, ‘The Impact of Accounting Principles Upon the Determination of Taxable Income’ (Paper presented at the Seventh National Convention of the Taxation Institute of Australia, Hobart, April 1986); Justice G Hill, ‘Tax and Accounting - Whether the Twain Will Meet?’ (Paper presented at the Fourth National Retreat of the Taxation Institute of Australia, Noosa, 1–3 August 1996); Ross W Parsons, ‘Legal Recoverability and Accruals Accounting’ (1972) 1(4) Australian Tax Review 219; Ross W Parsons, ‘Income Taxation – An Institution in Decay?’ (1986) 3 Australian Tax Forum 233; Chris N Westworth, ‘Accounting Standards – A Framework for Tax Assessment’ (1985) 2(3) Australian Tax Forum 243.

[2] See, eg, Sun Insurance Office v Clark [1912] AC 443; C of T v The Executor Trustee and Agency Company Of South Australia Ltd [1938] HCA 69; (1938) 63 CLR 108; FCT v James Flood Pty Ltd [1953] HCA 65; (1953) 88 CLR 492; Arthur Murray (NSW) Pty Ltd v FCT [1965] HCA 58; (1965) 114 CLR 314; J Rowe & Son Pty Ltd v FCT (1971) 71 ATC 4157; FCT v Australian Guarantee Corp Ltd (1984) 84 ATC 4642; Hooker Rex Pty Ltd v FCT (1988) 88 ATC 4392; Woolcombers (WA) Pty Ltd v FCT (1993) 93 ATC 4342; Coles Myer Finance Ltd v FCT (1993) 93 ATC 4214; FCT v Citibank Ltd (1993) 93 ATC 4691; Australia and New Zealand Banking Group Ltd v FCT (1994) 94 ATC 4026; FCT v Unilever Australia Securities Ltd (1995) 95 ATC 4117.

[3] To illustrate, in 1993 the Joint Committee of Public Accounts suggested that ‘the possible alignment of the taxation law with accounting concepts and standards would be a fundamental change to be considered’ in achieving more simplified income tax legislation: Joint Committee of Public Accounts, Commonwealth Parliament of Australia, ‘An Assessment of Tax - A Report on an Inquiry into the Australian Taxation Office’, Report No.326 (1993) para 5.30; while in 1997 the Joint Committee of Public Accounts (1997) specified that the Tax Law Improvement Project (‘TLIP’) sought to not only clarify Australia’s income tax legislation, but also ‘bring the operation of the law more in line with commercial or actual practice’: Joint Committee of Public Accounts, Commonwealth Parliament of Australia, ‘An Advisory Report on the Tax Law Improvement Bill 1996’, Report No.348 (1997) para 3.5.

[4] Commonwealth Taxation Review Committee (K W Asprey, chair), Full Report (1975) para 8.8.

[5] Commonwealth Government of Australia, Tax Reform: Not a New Tax, A New Tax System - The Howard Government’s Plan for a New Tax System (1998).

[6] Review of Business Taxation (John Ralph, chair), A Tax System Redesigned: more certain, equitable and durable (Final Report, 1999) (‘Ralph Report’), Recommendation 4.23.

[7] Australian Accounting Standards Board, AASB 1012 Foreign Currency Translation (2001) (‘AASB 1012’).

[8] Public Sector Accounting Standards Board and Australian Accounting Standards Board, Statement of Accounting Concepts SAC 4 Definition and Recognition Criteria of the Elements of Financial Statements (1995) (‘SAC 4’).

[9] Since the time of writing this has been enacted as the New Business Tax System (Taxation of Financial Arrangements) Act (No. 1) 2003 (Cth).

[10] Energy Resources of Australia Ltd v FCT (1994) 94 ATC 4225.

[11] FCT v Energy Resources of Australia Ltd (1994) 94 ATC 4923.

[12] FCT v Energy Resources of Australia Limited (1996) 96 ATC 4536, 4538.

[13] Such an amount would now be considered under s 8-1 of the Income Tax Assessment Act 1997 (Cth).

[14] Section 20(1) of the Income Tax Assessment Act 1936 (Cth) states: ‘For all purposes of this Act, income wherever derived and any expenses wherever incurred shall be expressed in terms of Australian currency’.

[15] FCT v Energy Resources of Australia Limited (1996) 96 ATC 4536, 4538.

[16] Ibid 4537. Note: such an amount would now be considered under s 6-5 of the Income Tax Assessment Act 1997 (Cth).

[17] Australian Taxation Office, Taxation of Financial Arrangements: An Issues Paper (1996) (‘TOFA IP’) para 11.9 reiterates that it is the view of the ATO that this is the appropriate way to deal with foreign currency denominated debt.

[18] FCT v Energy Resources of Australia Limited (1996) 96 ATC 4536, 4540–1.

[19] Ibid 4538.

[20] The Commissioner also submitted an alternative argument whereby the allowable deduction may be calculated by converting the discount into Australian dollars at the maturity date of the notes and deducting from it the reduced value of the proceeds received as at the date of maturity: at 4538. To illustrate, continuing with the above example, converting the discount of USD 100 000 to Australian dollars at the maturity date would give rise to a discount, in Australian dollars, of AUD 125 000 (USD 100 000 / 0.80). At the date of maturity the value of the proceeds received, expressed in Australian dollars, is AUD 1 125 000 (USD 900 000 / 0.80). At the date of issue the value of the proceeds received, expressed in Australian dollars, is AUD 1 200 000 (USD 900 000 / 0.75). The difference between these two amounts is AUD 75 000 and represents the reduced value of the proceeds received as at the maturity date of the note (AUD 1 200 000 – AUD 1 125 000). The Commissioner argued this amount must be deducted from the discount converted into Australian dollars at the date of maturity (AUD 125 000) to give the amount allowable as a deduction under s 51(1). This is AUD 50 000 (AUD 125 000 – AUD 75 000). The High Court, however, did not consider this method of determination.

[21] FCT v Energy Resources of Australia Limited (1996) 96 ATC 4536, 4540.

[22] Ibid. In contrast, consider the High Court decision in Coles Myer Finance Ltd v FCT (1993) 93 ATC 4214, which held that an allowable deduction, being the difference between the selling price and face value of the notes issued, was to be apportioned over the life of the notes. Thus, unlike ERA, Coles Myer Finance was not entitled to an immediate allowable deduction, but rather was required to spread the deduction over the life of the notes issued. It is argued that this is because the High Court, in the ERA decision, held that as the proceeds from the note issue were used in the current income year, an immediate allowable deduction within that year was appropriate. It appears, therefore, that the High Court in the ERA decision interpreted the need for apportionment as being dependent upon the use of the proceeds received from the notes issued, as opposed to the life of the notes themselves.

[23] FCT v Energy Resources of Australia Limited (1996) 96 ATC 4536, 4540. See also D Hanlon, ‘Foreign Currency Translation: The Beginning of a New ERA’ (Paper presented at the AAANZ Conference, Adelaide, 3–6 July 1998).

[24] Ibid 4540. In contrast, consider the High Court decision in International Nickel Australia Ltd v FCT (1977) 77 ATC 4383, which held that as the repayment of the outstanding liability was less, when expressed in Australian dollars, than the value of the liability when the obligation arose, due to a favourable exchange rate movement, the foreign exchange gain was assessable income under s 25(1). It is argued this is because the liability was on revenue account and, unlike ERA, International Nickel converted Australian dollars, at the current exchange rate at the time, into pounds sterling to discharge the outstanding liability. As a result, any exchange rate fluctuation had an impact on the amount of Australian dollars required to discharge the liability.

[25] SAC 4 para 48. As of 1 January 2005, Australian Accounting Standards Board AASB Framework for the Preparation and Presentation of Financial Statements (‘AASB Framework’) superseded SAC 4 in defining financial statement elements. In particular, a liability is now defined as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits (AASB Framework para 49). Despite the change in terminology, the essential characteristics of a liability remain. As such, the following analysis remains relevant.

[26] SAC 4 para 51.

[27] Ibid.

[28] SAC 4 para 54.

[29] SAC 4 para 57.

[30] SAC 4 para 61.

[31] SAC 4 para 63.

[32] Hanlon (1998), Foreign Currency Translation: The Beginning of New Era, above n 23, 21.

[33] SAC 4 para 65. This is restated in AASB Framework, as a financial statement element ‘should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or other value that can be measured with reliability’ (AASB Framework para 83).

[34] SAC 4 para 66.

[35] Ibid.

[36] SAC 4 para 69.

[37] It is questionable whether this value remains a reliable measure of the amount of the outstanding liability. The face value of the notes issued, converted to Australian dollars using the exchange rate at the date the obligation arose, is no longer accurate if exchange rate fluctuations subsequently occur. It is unfeasible, however, to adjust the value of the liability subsequent to each exchange rate movement in order to provide a reliable measure of the amount outstanding.

[38] Effective 1 January 2005, Australian Accounting Standards Board AASB 121 The Effects of Changes in Foreign Exchange Rates (‘AASB 121’) supersedes AASB 1012. As illustrated by the following analysis, the accounting treatment of foreign currency denominated transactions does not alter.

[39] It must be noted that, in accordance with s 296(1) of the Corporations Law 1991 (Cth), accounting standards have the force of law.

[40] D Hanlon, ‘Foreign Currency Translation: Accounting and Tax Practices’, CPA Communiqué, September 1998, 1.

[41] Encompassing the issue of promissory notes by ERA, a foreign currency transaction means ‘a transaction that is denominated in or requires settlement in a foreign currency’ (AASB 1012, para 10.1).

[42] AASB 1012 para 5.1. AASB 121 is consistent with this, stating a ‘foreign currency transaction shall be recorded, on initial recognition in the functional currency, by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction’ (AASB 121 para 21). Note: Paragraph 5.2 of AASB 1012 stipulates that where a foreign currency contract fixes an exchange rate for translation purposes, such a rate must be used. As the promissory note issue by ERA did not specify a fixed exchange rate, it does not impact on our analysis.

[43] A foreign currency monetary item is defined as ‘money held and assets and liabilities to be received or paid in fixed or determinable amounts of money’ (AASB 1012, para 10.1). In the present case, the outstanding promissory notes repayable by ERA at face value represent a liability repayable at a fixed or determinable amount.

[44] AASB 1012 para 5.3. AASB 121 para 23 reiterates this, stating ‘[a]t each reporting date: (a) foreign currency monetary items shall be translated using the closing rate’, which is defined as ‘the spot exchange rate at the reporting date’ (AASB 121 para 8). Note: Paragraph 5.4 of AASB 1012 stipulates that monetary items arising under a foreign currency contract, which fixes an exchange rate for translation purposes, must be retranslated at the exchange rate fixed in the contract. As the promissory note issue by ERA did not specify a fixed exchange rate, it does not impact on our analysis.

[45] As paragraph 5.6 of AASB 1012 is concerned with a foreign currency monetary item attributable to the acquisition of a non-current asset, and paragraph 6.5 of AASB 1012 relates to hedging commitments, neither affects the foreign currency contract entered into by ERA.

[46] AASB 1012 para 5.5. This is consistent with AASB 121, which states ‘[e]xchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in a previous financial report, shall be recognised in profit or loss in the period in which they arise’ (AASB 121 para 28).

[47] Hanlon (1998), Foreign Currency Translation: Accounting and Tax Practices, above n 40, 3.

[48] On 17 December 2002, an Exposure Draft of the New Business Tax System (Taxation of Financial Arrangements) Bill 2002 was released, which proposed removing the need for actual conversion for a foreign exchange gain to arise. This will be discussed further in Section V of this article.

[49] In accordance with the matching principle, it is arguable that the discount expense is to be spread over the life of the promissory notes. If the life of these notes straddles more than one income year, this may require the discount expense to be apportioned across these income years. Continuing with the above example, and assuming the life of the promissory notes is evenly spread across both income years, a discount expense of AUD 66 667 would be recognised in the income year ending 30 June 20X2 and AUD 66 666 in the following period.

[50] This is consistent with SAC 4, as ‘[t]he inflows or other enhancements of future economic benefits or savings in outflows of future economic benefits that constitute revenues may be of various kinds. For example, revenues in the form of savings in outflows of future economic benefits can arise ... where liabilities are forgiven and where exchange gains arise on translation of loans denominated in a foreign currency’ (SAC 4 para 113).

[51] Australian Taxation Office, Taxation of Financial Arrangements: A Consultative Document (1993) (‘TOFA CD’).

[52] TOFA IP, above n 17.

[53] Ralph Report, above n 6, Recommendation 9.1(a).

[54] Income Tax Assessment Act 1997 (Cth) s 775-55(1).

[55] John Morgan and John Riley, ‘Taxation of Financial Arrangements Bill – Exposure Draft’ (2003) 37(8) Taxation in Australia 417.

[56] Income Tax Assessment Act 1997 (Cth) s 775-55(3). It is only when a realisation event has occurred that a taxpayer may be assessed on a foreign exchange gain. As the end of an income year is not included as a realisation event, it prevents a taxpayer being assessed on unrealised foreign exchange gains because a financial asset or liability straddles more than one income year. This overcomes the deficiencies of the retranslation approach proposed in TOFA CD and TOFA IP, and the mark to market approach recommended in the Ralph Report.

[57] Income Tax Assessment Act 1997 (Cth) s 960-50(6) Item 1.

[58] FCT v Energy Resources of Australia Limited (1996) 96 ATC 4536, 4540. The Explanatory Memorandum, New Business Tax System (Taxation of Financial Arrangements) Bill (Cth) 2002 recognises the departure, stating that without realising gains and losses on foreign currency denominated transactions, irrespective of whether actual conversion to AUD occurs, ‘foreign currency gains and losses arising out of “business” transactions may fall outside the income tax net. This possibility is illustrated by FCT v Energy Resources of Australia Ltd [1996] HCA 10; (1996) 185 CLR 66 (‘the ERA case’)’ (ch 2, para 2.7).

[59] Income Tax Assessment Act 1997 (Cth) s 775-55(7).

[60] FCT v Energy Resources of Australia Limited (1996) 96 ATC 4536, 4540.


AustLII: Copyright Policy | Disclaimers | Privacy Policy | Feedback
URL: http://www.austlii.edu.au/au/journals/JlATaxTA/2005/7.html