Foreign Exchange Differences

IAS 21 – The Effects of Changes in Foreign Exchange Rates establishes the principles for recognizing and accounting for realized and unrealized foreign exchange gains and losses. Understanding these concepts is crucial before analyzing their tax implications.

Realised Foreign Exchange

Realized foreign exchange differences arise when a foreign currency transaction is settled, resulting in either gains or losses dictated by fluctuations in exchange rates. When a business receives foreign currency and subsequently converts it back into its local currency, it may encounter discrepancies between the original recorded transaction value and the amount received, depending on the current exchange rate. Below is an example for realised foreign exchange differences.

1. Initial Sale Transaction

Journal Entry:

Debit: Accounts Receivable $10,000 (translated to Mur 145,000)

Credit: Sales Revenue Mur 145,000

2. Settlement of Payment

3. Calculating Realized Foreign Exchange Difference

Unrealized Foreign Exchange

Unrealized foreign exchange differences result from fluctuations in exchange rates on outstanding foreign currency transactions that have not yet been settled. Companies must revalue their foreign currency accounts to reflect current market exchange rates at reporting periods to ensure financial statements accurately represent the economic position at that time.

Below an example for unrealised foreign exchange difference

1.       Initial Sale Transaction

2. Exchange Rate Fluctuation

As of December 31, the exchange rate is 1 $ = 43.9 Mur. Therefore, the loan should be revaluated and the true value of the $ 100,000 must be recorded.

3. Calculating Unrealized Foreign Exchange Difference

Although unrealized foreign exchange differences don't directly impact cash flow, they significantly affect reported earnings and financial position, highlighting currency risk in international operations.

Unlike standard accounting practices that often don't distinguish between realized and unrealized gains/losses, the treatment of these differences is distinct. Crucially, tax treatment differs further, often depending on the reason for the exchange difference, rather than a simple accounting realization distinction.

The Tax Treatment

The exchange difference, whether realized or unrealized, should be accounted for in a company's financial statements. However, the taxation of realized and unrealized exchange differences has historically, and potentially currently, been a complex and potentially problematic issue, particularly pre-2013.

Prior to 2013, both realized and unrealized exchange differences were subject to tax in Mauritius, with a distinction made between capital and revenue items. This led to uncertainty and potential tax burdens (or benefits) for companies, especially concerning unrealized differences, due to their inherent uncertainty. This was likely exacerbated by the difficulty of definitively categorizing them as revenue or capital in nature.

Stakeholder representations prompted a review, potentially leading to a change in the Mauritian tax treatment post-2013. Further details regarding the changes would be necessary to understand the current tax implications.

Statement of Practice SP 10/12 (December 2012) required Mauritian companies to choose between two methods of taxing exchange differences: realized or unrealized. This election was binding. Companies formed before 2013 had to make the choice in their 2013 tax return. Companies incorporated after 2013 made the election in their first tax return.

But what does this mean?

If a company has elected to be taxed on a realised basis, all the unrealised loss and gain would be treated as non-allowable and non-taxable respectively.

If a company has elected to be taxed on an unrealised basis, both realised and unrealised loss and gain would be subject to tax.

Exchange difference relating to capital item does not fall under the purview of taxation and hence must be adjusted in the tax computation.

However, the case of Sotravic Ltee vs Director General, MRA which centred on the tax treatment of unrealized foreign exchange gains create doubt around the tax treatment of foreign exchange differences. During the year ended 31^st December 2005, Sotravic Ltee has an unrealised gain of Mur 1,153,041 which was treated as non-taxable income given that such income has not been realised. It is important to note that the treatment was adopted prior to the introduction of the SP 10/12.

The Assessment Review Committee(“ARC”) held that gains or losses arising from a translation exercise are not subject to tax since a translation is a legal fiction unlike a real business transaction. The ARC thus concluded that unrealised gains arising on the translation of foreign bank accounts is not deemed to have been earned and therefore do not constitute income subject to tax.

Conclusion

While SP 10/12 doesn't define realized and unrealized exchange differences, nor does the Income Tax Act 1995 of Mauritius, its practical application by taxpayers has been widespread due to its flexibility. It offers relief from the administrative burden of distinguishing between these types of transactions, which can be substantial in volume, for businesses choosing not to be taxed on a realized basis.