Weak currency and the taxation of foreign exchange gains

• Pages: 13-20
• Author: Michael Rudnick
• Published date: 01 March 2016
• DOI: 10.10520/EJC186499
• Date: 01 March 2016

13

© SIBER INK

Weak Currency and the

Taxation of Foreign Exchange

Gains

MICHAEL RUDNICKI

ABSTRACT

Foreign exchange gains and losses in respect of debt, units of currency,

forward exchange contracts (‘FECs’) and foreign currency option contracts

(‘FCOCs’) denominated in foreign currency (def‌ined as ‘exchange items’) are

taxed within the provisions of section 24I of the Income Tax Act 58 of 1962.

The depreciating rand against other international currencies has shed light

on the tax consequences of exchange items, in particular where exchange

items in the form of debt is due to a taxpayer but because of liquidity

constraints, the debtor is unable to pay. This aspect was highlighted in the

recent 2016 Budget Proposals.

For foreign loans and claims receivable that are irrecoverable, the spot rate

at year-end is applied to determine the foreign exchange gain or loss. With

the depreciating rand, a taxable gain will arise if the foreign loans and claims

are denominated in a foreign currency. On the face of it the irrecoverable

nature of the claim is ignored for tax purposes, and it is only upon waiver

or write-off of the loan (‘realisation’) that the spot rate at the time is applied

to the foreign currency amount resulting in a taxable gain. The legislative

change foreshadowed in the Budget Proposals are to be welcomed and will

likely deal with matters such as debtor irrecoverability and the taxation of

attendant foreign exchange gains.

The depreciating rand will diminish the market value of the FEC contracts

which will result in foreign exchange losses at year-end and upon settlement

of the FEC. These losses are likely to offset taxable foreign exchange gains on

foreign claims that are hedged.

The tax treatment of FCOCs at year-end and upon realisation (i e exercise

or expiration) is determined with reference to the market value of the option

at that point in time. Market value is deemed to have regard to the value

applied for accounting purposes or the ‘intrinsic value’, being the differ-

ence between the strike price of the option and spot rate at the time of the

exercise of the option. The depreciating rand will reduce the value of an

option contract. This means that options completely out-of-the-money will

result in a zero gain/loss for the option holder at year-end or upon close out

of the option.

It seems apparent that the tax treatment in a depreciating rand environ-

ment has been favourably legislated for exchange items other than foreign

debt. Legislative change is required to govern the latter, however, caution is

suggested in dealing with the respective tax consequences.