Tax Matters – Treatment of foreign exchange differences

THE current economic turmoil in the world is giving rise to constant fluctuations in foreign currencies, and the ringgit is no exception. The ringgit has weakened substantially against the US dollar and the Singapore dollar, but it has also strengthened against certain currencies. Businesses have to deal with fluctuations that can either lead to a gain or a loss, increasing or decreasing their cost of doing business.

The tax treatment of foreign exchange (forex) differences does not follow the accounting treatment although it can be referred to for guidance. The tax rules applied here strictly follow the provisions under the Income Tax Act 1967. The underlying principle of the taxation of forex gains is premised on whether the underlying transactions are trade or non-trade, revenue or capital, realised or non-realised.

Bearing in mind that Malaysia does not tax capital gains, there is a tendency for taxpayers to classify forex gains as capital and taking a deduction on the forex losses under a revenue classification as part of tax planning to reduce taxes.

Complications

Generally, businesses face forex losses on purchases and sales of goods and services, borrowing of monies, and translation of foreign operations such as subsidiaries, branches, associates, joint ventures.

Transactions of purchases and sales of goods and services happen in the course of carrying on a business, and the differences arise between the date the transaction is booked into the accounts and the date the payment is made.

Normally these transactions, being of a trade nature, would be brought to tax. If the booking date and the settlement date are in different accounting periods, the forex differences at the year-end translation will not be taxable since they are not realised.

Businesses that have significant foreign transactions and whose inputs and outputs are all in foreign currency, such businesses will maintain their books of accounts in a foreign currency and will maintain foreign currency accounts. The Malaysian tax law requires such companies to file their tax returns in the Malaysian currency. Throughout the financial period, the trading transactions conducted in the respective foreign currency provide a natural hedge and therefore do not give rise to any forex gain or less since there is no conversion of the currency into ringgit.

When businesses purchase fixed assets from overseas, the exchange difference should be adjusted to determine the amounts eligible for capital allowance. However, if the exchange difference arises in the subsequent year because the payment for the asset is purchased after the year-end, the capital allowance has to be revised in the following year.

Although in practice the Inland Revenue Board (IRB) allows a revision of the claim in the following year, there is a gap in the tax law and, technically, there is no provision to make these adjustments. It is incorrect to use an error or mistake claim or to revise the tax liability downwards.

Raising finance in foreign currency is another issue. To determine whether the forex differences arising from foreign currency borrowings will be taxable or not will largely depend on the underlying nature of the transaction. If the borrowings relate to providing capital to the business or providing permanent working capital to the business, the forex differences will not be taxable.

Permanent working capital is the minimum level of assets to be maintained at all times by an entity to ensure a minimum level of uninterrupted business operations.

The timing of the taxation of forex differences is at the time the gain or loss is realised.

Be careful

Taxpayers should analyse the forex differences carefully. Otherwise, you could be challenged by the IRB that your forex losses may not be deductible, and the forex gains should be brought to tax.

It is also important to understand the timing of the taxation of the forex differences.

This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai (www.thannees.com).