FOREIGN EXCHANGE DAVID WARNEKE JULY 2012

FOREIGN EXCHANGE DAVID WARNEKE JULY 2012

Overview Important sections and paragraphs Section 25D Receipts / accruals and expenditure in foreign currency Section 24I Realised and unrealised gains and losses on foreign exchange items 8 th Schedule para 43 Disposal of assets where proceeds and /or expenditure were denominated in a foreign currency 2

Section 25D This section deals with foreign currency receipts and expenditure (i.e. taxable income in a foreign currency), for- Individuals & non-trading trusts Companies & trading trusts It also deals with the rules for- A permanent establishment If no permanent establishment exists A headquarter company 3

Individuals and non-trading trusts Income and expenses can be converted to South African Rands in one of two ways Apply the spot rate on the day the foreign amount was received or accrued or the expenditure or loss was incurred; or Apply the average exchange rate for the relevant year of assessment 4

Companies & trading trusts Income and expenses can be converted to South African Rands in only one way Apply the spot rate on the day the foreign amount was received or accrued or the expenditure or loss was incurred 5

Permanent establishment If an individual, trust, or company carries on business through a permanent establishment situated outside South Africa, then Determine the taxable income of the permanent establishment in the functional currency (defin S1: The currency of the primary economic environment in which business operations are conducted); and Convert the taxable income to S A Rands at the average rate for the year of assessment (section 25D(2)). The currency cannot be that used in the CMA (common monetary area). The rule does not apply in certain cases where the functional currency is of a country with an official inflation rate of 100% or more throughout the year of assessment (section 25D(2A)). Example: SA company has a branch in the USA ($). If the branch earns income or incurs expenditure, then the income and expenditure must be converted to $. Calculate SA taxable income of the branch in $ and convert to ZAR using the average rate. 6

Section 24I Section 24I subjects realised and unrealised gains or losses on exchange items to normal income tax. An exchange item is: A unit of foreign currency A loan, advance or debt in a foreign currency A foreign currency FEC (forward exchange contract) A foreign currency option contract 7

Who is subject to section 24I Individuals and non-trading trusts are subject to section 24I in respect of FEC s and FCOC s. Individuals holding units of foreign currency, loans, advances or debts as trading stock are subject to section 24I. Note: individuals and non-trading trusts are only subject to S24I in limited circumstances. Companies and trading trusts are always subject to section 24I. Non-residents are not subject to section 24I except for CFC s and RSA PE s 8

Calculation of gain or loss A gain or loss has to be calculated when an exchange item is realised. An unrealised gain or loss has to be calculated at each year end that the taxpayer holds exchange items. The gain or loss is referred to as an exchange difference. Three dates are important in calculating exchange differences, i.e. - Transaction date - Translation date (year end) - Realisation date 9

Exchange differences unrealised loss Assume that ABC Ltd (a South African company) imported a machine which cost it $10 000 and that the exchange rate was $1 = R10 at the transaction date. At the year end the supplier had still not been paid, and the exchange rate was $1 = R12,50. Calculation of exchange difference (commercially) Item translated at ruling exchange rate at transaction date $10 000 x 10 R100 000 Item translated at ruling exchange rate at year end (if not paid) $10 000 x 12,50 (125 000) Foreign exchange loss R25 000 Calculation of exchange difference per s24i(1) definition Ruling exchange rate at transaction date R10,00 Ruling exchange rate at translation date (12,50) Difference is a loss R2,50 Apply to amount: $10 000 x 2,50 = loss = R25 000 10

Exchange differences unrealised profit/gain Assume that ABC Ltd (a South African company) sells a machine to an overseas customer for $10 000 and that the exchange rate was $1 = R10 at the transaction date. At the year end the customer had still not paid ABC, and the exchange rate was $1 = R12,50. Calculation of exchange difference (commercially) Item translated at ruling exchange rate at transaction date $10 000 x 10 R100 000 Item translated at ruling exchange rate at year end (if not paid) $10 000 x 12,50 (125 000) Foreign exchange gain R25 000 Calculation of exchange difference per s24i(1) definition Ruling exchange rate at transaction date R10,00 Ruling exchange rate at translation date (12,50) Difference is a profit because seller will get more Rands R2,50 Apply to amount: $10 000 x 2,50 = gain = R25 000 11

Important points to remember A gain or loss has to be calculated separately for each exchange item. It has to be calculated for all exchange items realised during the year and all exchange items still outstanding or existing at year end. The year end is colloquially known as the translation date. 12

Process is as follows: Transaction Date Translation Date Translation Date Realisation Date 13

Transaction dates Loan or advance owing by a person (borrower) When the amount was received by the borrower Debt owing by a person (debtor) When the debt was incurred by the debtor Loan or advance owing to a person (lender) When the amount was paid to the borrower by the lender Debt owing to a person (creditor) The date the debt accrued to the person 14

Transaction dates Forward Exchange Contract Date on which the contract was entered into Foreign currency option contract Date the contract was entered into or acquired Unit of currency Date on which the amount was acquired 15

Realised (Realisation dates) Loan or advance owing by a person (borrower) When and to the extent payment is made Debt owing by a person (debtor) When and to the extent that the debt is paid Loan or advance owing to a person (lender) When and to the extent the amount is received or the debt disposed of Debt owing to a person (creditor) When and to the extent the debt is paid or disposed of 16

Realisation dates Forward Exchange Contract Date on which the payment is received or made Foreign currency option contract Date payment is made or the contract expires or is disposed of Unit of currency Date on which the amount is spent or disposed of 17

A forward exchange contract is usually taken with a bank in terms of which the client is obliged to buy or sell a certain amount of foreign currency at a future date at an agreed exchange rate. The premium is built into the rate. A foreign currency option contract is a contract in which the client has an option to acquire or sell an amount of foreign currency on or before a future date. A separate premium is charged for this. Forward Exchange Contracts & Foreign Currency Option Contracts An affected FEC or FCOC is a contract which is entered into as a hedge in respect of a loan, advance or debt which has not yet arisen by year end. In addition, the loan, advance or debt must be intended to be used to buy / sell assets or services in the ordinary course of trade in terms of an agreement entered into before year end. 18

Ruling exchange rates Unit of Foreign Currency Transaction date: Spot rate Translation date: Spot rate Realisation date: Spot rate Loan, advance or debt Transaction date: Spot rate Translation date: Spot rate Realisation date: Spot rate Forward exchange contract Transaction date: Forward rate Translation date: Market Related Forward rate for rest of contract (MRFR) Realisation date: Spot rate 19

Ruling exchange rates Affected FEC Transaction date: Forward rate Translation date: Forward rate Realisation date: Spot rate Foreign Currency Option Contract Transaction date: Nil Translation date: Market value Realisation date: Market value Affected FCOC Transaction date: Nil Translation date: Premium or consideration paid (this means it is written off in year one when paid) Realisation date: Market value 20

Section 24I(7) Where an exchange difference arises from a loan, advance or debt used to acquire tangible property/assets or create intellectual property/assets, the exchange difference cannot be accounted for in the year before the asset is brought into use in the taxpayer s trade. If Commissioner is satisfied during a year subsequent to that in which the gain or loss arose that the trade will not commence or the asset will not be used, the difference is accounted for in such subsequent year. The same principle applies to an FEC and FCOC entered into as a hedge for the loan, advance or debt above. 21

Section 24I(7A) Loans or advances between connected companies (to the extent not hedged by an FEC) granted during years of assessment ending before 8 November 2005 give rise to 10 % spreading rules per annum. One spreads the gain or loss on such items and recognises 10 % of the rolled up balance of gains or losses per annum. On settlement the entire balance is recognised. 22

Section 24I(10) Offshore company Connected South African resident Section 24I (10) is subject to S24I(7A) and provides that an exchange difference between an offshore company and a South African resident (if they are connected persons) can only be accounted for when realised. The same rule applies to S A residents holding shares in CFC s (between the resident and the CFC or between connected CFC s). The rules extend to FEC s and FCOC s taken out as a hedge against the above exchange items. 23

S24I(10) Example Facts: A foreign holding company makes a foreign denominated loan to its SA subsidiary of $2 million. $1 million of the loan is repaid during the year of assessment. On this portion of the loan an exchange gain of R550 000 results. A R340 000 exchange gain arises on the translation of the remainder of the loan. Result: Only the R550 000 exchange gain is accounted for under S24I in the current year of assessment. 24

Section 24I(11) This section makes it clear that section 24I can only be applied in respect of loans, advances or debts (including FEC s and FCOC s to hedge these) incurred in a foreign currency to acquire assets under the following circumstances : (a)(i)a loan, advance, or debt incurred to acquire an exchange item asset (as defined). (a)(ii)a loan, advance, or debt incurred to acquire an asset if the currency of the expenditure is denominated in the local currency of the taxpayer. (a)(iii)a loan, advance, or debt incurred to acquire a para 43(4) foreign equity instrument. (a)(iii)a loan, advance, or debt incurred to acquire an asset, the disposal of which would give rise to proceeds from a SA source (see especially S9). These are: - Immovable property in SA; assets not attributable to a non-sa pe (and which gain is not subject to non- SA tax); pe assets of a non-sa resident. Examples: 1. A non-sa branch in the USA buys an asset in euros. S24I will not apply to the resulting debt / loan / hedge. 2. A SA branch of a foreign company buys an asset in US $. S24I will apply to the resulting US $ denominated debt / loan / hedge. 3. A SA company with no non-sa branches buys an asset in euros. S24I will apply to the resulting euros denominated debt / loan / hedge. 4. A SA company acquires shares of an unlisted foreign subsidiary in US $, using US $ loan finance. S24I will apply to the resulting US $ loan. If an interest of > 20 % is held after that acquisition, then S24I will not apply to a FEC / FCOC to hedge such loan (S24I(11A)). 25

Examples: Ruling Exchange Rate FACTS: Assume that X Ltd had the following exchange items. The relevant year end of X Ltd is 31 December 2011. 1. A loan of $1 million owing to a supplier. The amount was received on 1 September 2011 and was settled on 15 March 2012. 2. An FEC to purchase $100 000 on 15 March 2012. The contract was taken out on 1 September 2011. 3. An affected FEC (to hedge the debt expected to arise from the sale of an asset) to sell $250 000 on the dates and per details as in 1. 4. The option to purchase $150 000 at a rate of $1 = R6.50 on 15 March 2012 was acquired on 1 September 2011. A premium of R25 000 was paid at acquisition. The option was exercised on realisation date. 26

Class examples: Ruling Exchange Rate (cont) DATE SPOT RATE FORWARD RATE to 15 March 2012 1 September 2011 31 December 2011 $1 = R7 $1 = R8 $1 = R7.50 $1 = R9 15 March 2012 $1 = R8.50 N/a REQUIRED: Calculate the inclusions / deductions in taxable income arising from exchange items 27

Solution SOLUTION: 1 2 3 4 5 6 7 ruling @ ruling @ 2-1 gain / loss 2011 ruling @ 5-2 gain / loss 2012 t'action t'lation realisation 1. R 7 R 7.50 R -0.50 $1 million x R(0.50) = R 8.50 R -1 $1 million x R(1) = R -500 000 R -1 000 000 2. R 8 R 9 R 1 $100 000 x R1 = R 8.50 R -0.50 $100 000 x R(0.50) = R 100 000 R -50 000 3. R 8 R 8 R 0 $250 000 x R0 = R 8.50 R -0.50 $250 000 x R(0.50) = R 0 R -125 000 4. R 0 R 1 R 1 $150 000 x R1 = R 2 R 1 $150 000 x R1 = R 150 000 R 150 000 Note: in 4, R25 000 premium is also deductible in terms of S24I(3) in 2011 year 28

CGT effects of Assets acquired or disposed of in a foreign currency P43 P43(4): Disposal of foreign equity instruments, or assets for which the capital gain or loss is from a SA source. N/A for disposal of S24I exchange items or foreign loans, advances or debts. Translate proceeds to ZAR at average or spot (per S25D rules) in year of disposal AND Translate expenditure to ZAR at average or spot (per S25D rules) in year of incurral. Examples of where this would apply: Foreign equity instruments = listed foreign shares; foreign unit trusts; rights or obligations arising from foreign indices; Kruger rands; options or futures in respect of above. Assets for which the capital gain or loss is from a SA source: Immovable property in SA; assets not attributable to a non-sa pe (and which gain is not subject to non-sa tax); pe assets of a non-sa resident. 29

CGT effects of Assets acquired or disposed of in a foreign currency P43 (cont) P43(1): Disposal of assets in a foreign currency after having incurred expenditure in the same currency. N/A where p43(4) applies. Translate capital gain or loss into ZAR at average or spot (per S25D rules) at date of disposal. Para 43(1) can only apply where the currency of disposal is the same as the currency of expenditure. Examples of assets to which p43(1) can apply: Immovable property outside SA; unlisted foreign shares; foreign loans, advances, debts, FEC s and FCOC s. Assets connected to a non-sa pe. Movables subject to non-sa taxation. 30

Example 1 Disposal of asset in respect of which proceeds are derived and expenditure is incurred in same foreign currency [para 43(1)] Facts: In 1998 Neil purchased a flat in Sydney for AU$135 000 in order to derive rental income. The market value of the property on 1 October 2001 was AU$220 000. In 2008 the property is sold for AU$270 000 when the average AU$/R exchange rate is AU$1 : R6,0663. Neil adopted the market value of the property as the valuation date value and elected to use the average exchange rate for the purpose of translating the capital gain to rands. Result: The capital gain on disposal of the asset is determined as follows: Step 1: Determine capital gain in foreign currency AU$ Proceeds 270 000 Less: Base cost (220 000) Capital gain in foreign currency 50 000 Step 2: Translate capital gain in foreign currency to rands Capital gain in foreign currency as above AU$50 000 Average exchange rate AU$1 : R6,0663 Capital gain in rands R303 315 31

Example 2 Foreign bank accounts Facts: In 2000 Carolyn invested $100 in the Caribbean Islands Shady Bank Inc. All went well until the 2012 year of assessment when the bank manager began speculating in the futures market. As a result, the bank was placed in liquidation, and on 29 February 2012 Carolyn received $40 in full and final settlement of her claim against the bank. The market value of her investment was $100 on valuation date. Carolyn elected to use the spot rate on 29 February 2012 which was $1 = R7,49225. Result: Under para 43(1) Carolyn must determine her capital loss in foreign currency [$40 (proceeds) $100 (base cost) = $60 (capital loss)], and translate that capital loss into rands at the spot rate on 29 February 2012 (date of incurral of the loss), that is, $60 x R7,49225 = R450. Prior to 1 March 2011 she would also have had to determine a capital gain or loss under Part XIII in respect of the bank account. Note: Usually foreign bank accounts will not give rise to a capital gain or loss under para 43(1), since the amount invested will simply be repaid in the same foreign currency. 32

222 Example 3 Loss on disposal of foreign loan involving s 24I and para 43(1) Facts: Greg holds sterling-denominated bonds as trading stock. On 1 March 2011 he lent 100 000 to Chelsea PLC, a United Kingdom-based investment company, when 1 = R14,22343. The loan was of a capital nature and unrelated to his bond-trading activities. Chelsea PLC was placed in liquidation on 29 February 2012 when the exchange rate was 1 = R14,86807. At that time it was established that there was no hope of recovery. The average exchange rate for the year ending 29 February 2012 was 1 = R14,1675 and Greg wishes to use that rate. Result: Since Greg holds exchange items (sterling-denominated bonds) as trading stock, he must, under s 24I(2)(c) determine his exchange gain or loss under s 24I. R 100 000 x R14,86807 1 486 807 100 000 x R14,22343 (1 422 343) Exchange difference 64 464 The exchange difference will be included in Greg s income under s 24I(3)(a). Had an exchange loss arisen it would have been deductible under the same provision read with s11(x). Greg will have a capital loss under para 43(1), determined as follows: Proceeds - Less: Base cost (100 000) Capital loss in sterling (100 000) Average exchange rate for 2008 year of assessment R14,1675 : 1 Capital loss 100 000 x R14,1675 R1 416 750 33

CGT effects of Assets acquired or disposed of in a foreign currency P43 (cont) P43(2): Disposal of assets in one currency after having incurred expenditure in another currency. N/A where p43(4) or (1) applies. Examples of where this would apply: P43(1) categories (see above) where the currency of disposal is not the same as the currency of expenditure. For ease of reference, P43(1) categories are: o Immovable property outside SA; unlisted foreign shares; foreign loans, advances, debts, FEC s and FCOC s. Assets connected to a non-sa pe. Movables subject to non-sa taxation. 34

CGT effects of Assets acquired or disposed of in a foreign currency P43 (cont) (a) where the currency of expenditure is the local currency, translate proceeds into local currency at average for year of disposal and translate capital gain or capital loss into ZAR at average rate for year of disposal. EXAMPLE UK branch of SA resident ( ) buys an asset in and sells it in. - Translate into at the average rate for the year of disposal; - Calculated the capital gain / loss in ; - Translate the capital gain / loss into ZAR at the average rate for the year of disposal. 35

CGT effects of Assets acquired or disposed of in a foreign currency P43 (cont) (b) where the currency of disposal is the local currency, translate expenditure into local currency at average for year of incurral of expenditure and translate the capital gain or capital loss into ZAR at average rate for year of incurral of expenditure; OR EXAMPLE UK branch of SA resident ( ) buys an asset in and sells it in. - Translate into at the average rate for the year of incurral of the expenditure; - Calculated the capital gain / loss in ; - Translate the capital gain / loss into ZAR at the average rate for the year of incurral of expenditure. 36

CGT effects of Assets acquired or disposed of in a foreign currency P43 (cont) (c) where neither the currency of disposal nor the currency of expenditure is local currency, translate expenditure to the currency of disposal at average rate for year of incurral of expenditure and translate the capital gain or loss to local currency at average rate for year of disposal and translate the capital gain or loss to ZAR at average rate for year of disposal. EXAMPLE UK branch of SA resident ( ) buys an asset in US$ and sells it in. 37 - Translate $ into at the average rate for the year of incurral of the expenditure; - Calculated the capital gain / loss in ; - Translated the into at the average rate for the year of disposal; - Translate the into ZAR at the average rate for the year of disposal.