Common forex transactions

Common forex transactions include those made through foreign currency denominated accounts, shares and hedging transactions.

Foreign currency denominated accounts

This foreign exchange (forex) information relates to certain foreign currency denominated accounts. It describes the general application of foreign currency tax laws to those accounts, and answers some frequently asked questions.

A foreign currency denominated account (forex account) can be a forex deposit account or a forex loan account (including a forex credit card account).

The foreign currency tax laws (forex measures) relevant to this information are contained in Division 775 and Subdivision 960-C of the Income Tax Assessment Act 1997 (ITAA 1997). The forex measures have broad application to transactions denominated in foreign currency.

The forex measures set out rules for expressing the Australian currency values of amounts that are denominated in foreign currency, and explain how to calculate gains and losses that are attributable to currency exchange rate fluctuations. The measures treat many of those gains and losses as assessable income or allowable deductions.

Under the forex measures:

• assessable gains are referred to as 'forex realisation gains'
• deductible losses are referred to as 'forex realisation losses'
• forex realisation gains and losses only arise when 'forex realisation events' happen.

The forex measures apply generally to the realisation of assets, rights, and parts of rights acquired, and obligations and parts of obligations assumed, on or after the 'applicable commencement date'. Accounts are rights or obligations. For example, if you have a deposit account, such as a bank savings account, you have a right (a 'chose in action') that relates to the money deposited in the account. If you have a loan account, you have an obligation to repay.

The forex measures apply to all taxpayers except for, broadly speaking, taxpayers that are banks or similar financial institutions. However, if you hold a forex account with a bank (such as a savings or loan account in foreign currency) you will usually have to consider the application of these laws in calculating your assessable income and allowable deductions.

The '$250,000 balance election' is an important choice that may be helpful to taxpayers who do not have large forex account balances. If you satisfy all requirements for making this election, and remain eligible to rely on it, you can disregard certain gains and losses that you would otherwise have to return.

Which forex accounts do the forex measures affect?

Unless you made a 'transitional election', forex measures do not apply to transactions on your forex account if you opened that account:

• after 19 February 1986, and
• before your 'applicable commencement date'.

In general, for transactions on forex accounts opened between 19 February 1986 and your applicable commencement date, any taxation consequences attributable to the effect of currency exchange rate fluctuations are determined by application of laws that were in place before the forex measures applied.

For most taxpayers, the 'applicable commencement date' was the first day of their 2003-04 income year (which in most cases was 1 July 2003).

Taxpayers on a substituted accounting period (SAP) for taxation purposes, and whose first day of their 2003-04 income year was before 1 July 2003, will have an 'applicable commencement date' of the first day of their 2004-05 income year.

Forex accounts with a low balance

The '$250,000 balance election' may be an attractive option for taxpayers who do not have large forex accounts. If you qualify for this election, you should consider whether you would like to choose to have it apply. After you make the $250,000 balance election, and continue to be eligible to rely on it, you will not realise any more assessable forex gains or deductible forex losses on withdrawals from relevant forex deposit accounts or repayments on relevant loan accounts.

How do I make a gain or loss on my forex accounts?

Transactions on a forex account often result in forex realisation gains or losses being made. Examples of this include withdrawing money from a foreign currency deposit account, or paying all, or part, of the balance of a foreign currency loan account.

Forex accounts with a credit balance (that is, deposit or savings account)

A forex realisation gain or loss may arise on a forex account that has a credit balance at the time a withdrawal is made. This is due to fluctuations in exchange rates which may result in the Australian dollar value of amounts deposited into a forex account with a credit balance - measured at the time of the deposit - being more than or less than the Australian dollar value of that amount measured at the time of withdrawal.

The difference is usually brought to account under the forex measures as assessable income if it is a gain, or an allowable deduction if it is a loss, to the extent that the gain or loss is due to currency exchange rate movements between the Australian dollar and the foreign currency. The forex realisation gain or loss represents the gain or loss in Australian dollar terms made in respect of the right that was acquired against the banker, measured between the time the right was acquired (which was at the time of deposit) and the time that right ceased (which was at the time of withdrawal).

Forex accounts with a debit balance (that is, loan account)

A forex realisation gain or loss may arise on a forex account that has a debit balance at the time a repayment on that account is made. A common example of such an account is a forex loan account. Due to fluctuations in exchange rates, a forex realisation gain or loss would arise if the Australian dollar value of an amount - measured at the time you received the funds - is different from the Australian dollar value of that amount measured at the time you deposited (repaid) that amount into the loan account.

The difference is usually brought to account under the forex measures as income, or an allowable deduction, to the extent that it is due to currency exchange rate movements between the Australian dollar and the foreign currency. The forex realisation gain or loss represents the gain or loss in Australian dollar terms made in respect of the obligation owed to the banker, measured between the time that obligation was incurred (which was the time the funds were received) and the time that obligation ceases (which is at the time of deposit).

How do I work out when I deposited the actual amounts that I am withdrawing?

Under the ordinary operations of the forex measures, when a withdrawal is made from a forex deposit account, it is essential to identify the Australian dollar value of the foreign currency amount initially deposited to the account, and its Australian dollar value on withdrawal. Similarly, when an amount on a forex loan account is repaid, it is essential to know the value of the amount initially borrowed and the value when it is repaid.

Due to one unit of foreign exchange being identical to and interchangeable with another unit (a quality referred to as 'fungibility'), a first-in first-out rule usually applies. This rule identifies the time the foreign currency amount(s) that are withdrawn from a forex deposit account were originally deposited, and the time that the amount of a repayment on a forex loan account was originally borrowed. The first-in first-out rule applies under the ordinary operation of the forex measures. However, in certain circumstances, you can choose to have the forex measures apply differently to transactions on your forex accounts.

The forex measures allow you to choose certain alternative methods that may make it easier to calculate any gains and losses on your forex account.

Alternative methods of calculation are available by making the 'retranslation election' or the weighted average election.

Are my ordinary accounting calculations relevant to the calculation of forex realisation gains or losses for tax purposes?

If you are in business, you may have to apply generally accepted accounting principles to work out the notional foreign exchange gain or loss on your forex account at the end of each income year for other purposes (that is, for purposes other than taxation). This accounting exercise is generally irrelevant for the purposes of applying the forex rules.

The forex rules will generally only bring to account a forex realisation gain or loss on your forex account when you have either:

• withdrawn money from your forex savings account, or
• repaid some, or all, of the balance on your forex loan account.

However, the 'retranslation election' operates in a way that may be similar to the practices you adopt for ordinary accounting purposes.

All my foreign currency income and expenses go through my forex account. Do I have to separately convert the income and expenses for tax purposes?

Yes. The rules governing the translation (often called the 'conversion') of foreign currency denominated income and expenses are different from the rules relating to the calculation of forex gains and losses resulting from the effect of exchange rate fluctuations (such as those on forex accounts).

In very general terms, the translation rules in Subdivision 960-C of the ITAA 1997 specify how and when you should translate (convert) foreign currency denominated amounts that are relevant to taxation (including income and expenses) into equivalent Australian dollar amounts. The forex measures in Division 775 of the ITAA 1997 apply to calculate gains and losses that occur as a result of the effects of currency exchange rate fluctuations. They apply to a broad range of foreign currency denominated assets and liabilities (foreign currency; and rights, parts of rights, obligations and parts of obligations that are denominated in foreign currency such as a forex account).

You will need to apply these translation rules to properly bring those amounts to account in your income tax return. The general translation rules will apply whether or not the income is paid into, or expenses paid out of, a forex account.

Foreign currency denominated shares

This document contains information on the application of the foreign exchange gain and loss Income Tax Assessment Act 1997 (the forex measures) to the acquisition and/or disposal of ordinary shares denominated in a foreign currency under Division 775 of the Income Tax Assessment Act 1997 (ITAA 1997).

Generally, the forex measures apply prospectively to the realisation of assets, rights and obligations acquired or assumed on, or after, the commencement date. The commencement date is usually the first day of the 2003-04 income year, which for most taxpayers will be 1 July 2003.

Shares acquired or sold under contracts entered into before 1 July 2003

As a general rule, former Division 3B of the Income Tax Assessment Act 1936 (ITAA 1936) continues to apply to currency exchange gains and losses of a capital nature arising from 'eligible contracts' entered into on, or after, 18 February 1986, and before 1 July 2003. Although Division 3B of the ITAA 1936 has been repealed, Taxation Determination TD 94/88 considers its application to ordinary shares denominated in a foreign currency in the limited situations where it still has application. Therefore, we recommend you read this information in conjunction with TD 94/88.

Shares acquired or sold under contracts entered into from 1 July 2003

What gains or losses do the forex measures apply to?

The forex measures do not deal with the effect of any change in the exchange rate for the period of the ownership of foreign currency denominated ordinary shares (that is, between the time of purchase and the sale of the shares). Rather, as an example, if the shares are held on capital account, the capital gains tax (CGT) rules in Parts 3-1 and 3-3 of the ITAA 1997 will incorporate any foreign currency gain or loss which occurs between the time of acquisition and the time of disposal as part of the overall capital gain or loss made on the shares.

The forex measures will apply in respect of the acquisition or disposal of foreign currency denominated shares for an amount of foreign currency where there is a 'currency exchange rate effect' between:

• the date or time on which the contract for the acquisition or disposal is made
• (respectively) the date or time payment is made or disposal proceeds are received.

The forex measures will not give rise to a foreign exchange realisation (forex realisation) gain or loss where the payment for the acquisition of the shares, or receipt on disposal of the shares, occurs at the same time as the contract. After 26 April 2005, where under the purchase or disposal contract there is a requirement for settlement within two business days, the payment for the acquisition or receipt of the disposal proceeds will generally be translated at the exchange rate applicable on the date of the contract, so no forex realisation gain or loss will arise - refer to item 8C of the table in subsection 960-50(6) of the ITAA 1997.

Acquisition of foreign currency denominated shares

A taxpayer has an obligation to pay foreign currency on entering into a contract to acquire shares where the consideration is payable in foreign currency. When payment is made, the obligation ceases, and a forex realisation event 4 (FRE 4) occurs.

Disposal of foreign currency denominated shares

Similarly, a taxpayer will have a right to receive foreign currency on entering into a contract to dispose of shares where the amount is receivable in a foreign currency. When the amount is received, the right ceases, and a forex realisation event 2 (FRE 2) occurs.

Currency exchange rate effect

A forex realisation gain or loss arises under such a FRE 4 or FRE 2 when there is a currency exchange rate effect between entering into the purchase or sale contract, and settling that contract. In the context of the purchase or sale of shares denominated in a foreign currency, a currency exchange rate effect will commonly occur where a taxpayer either:

• incurs an obligation to pay foreign currency under a contract for the acquisition of the shares, and there is a difference in the exchange rate at the time of the contract and the time of payment, or
• acquires a right to receive foreign currency under a contract for the disposal of the shares, and there is a difference in the exchange rate at the time of the contract and the time of the receipt - refer to section 775-105 of the ITAA 1997.

Short-term transactions – the 12 month rule

The 12 month rule (also known as the short-term rule) generally provides that the forex measures do not apply to forex realisation gains and losses on the acquisition or disposal of capital assets where the time between that acquisition or disposal, and the due time for payment, is not more than 12 months. Such gains and losses are effectively folded into the CGT treatment of the assets.

However, where a taxpayer has made a valid election out of the 12 month rule within the required timeframe, the 12 month rule will not apply.

Foreign currency hedging transactions

All legislative references made in this document are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise specified.

Entities may be exposed to foreign currency fluctuation risk, particularly when a transaction is denominated in a foreign currency.

To mitigate this risk, entities often enter into foreign currency hedging transactions. The purpose of a foreign currency hedge is to offset all, or part, of any currency fluctuation on an underlying transaction. This is generally achieved through the use of derivatives such as forwards, futures, options and swaps.

For the purposes of the foreign currency gains and losses rules contained in Division 775, any forex realisation gain or loss on the underlying transaction is calculated separately to any forex realisation gain or loss arising on the hedge contract.

Common forex transactions are those made through foreign currency denominated accounts, shares and hedging transactions.