The taxation of foreign-currency transactions in companies

Operating and/or transacting in non-Euro currencies is now commonplace for an increasing number of Irish companies. There are many reasons for this, including:

The UK and US markets have traditionally been significant overseas markets for Irish companies. The sluggish nature of the economy in recent years has meant that an even greater number of Irish companies have had to look to overseas markets in the UK, US and farther afield to grow their businesses. These companies now find themselves transacting in currencies other than the Euro.

The trend toward corporate inversions has seen a large number of Irish companies being acquired by foreign parents. These companies are often required to operate in the functional currency of the parent, which is typically a currency other than the Euro.

Such activities frequently result in gains and losses arising from exchange-rate movements, with resulting accounting implications. Increased volatility in currency markets in recent months, due to the debt crisis in Greece and the weakening of the Euro, has also contributed to significant foreign-currency movements for companies.

This article examines some of the common tax issues that arise for Irish companies undertaking transactions in non-Euro currencies and those with a non-Euro functional currency in both a trading and a non-trading context. However, deferred-tax considerations are outside the scope of this article.

Accounting Aspects

The applicable standards when accounting for foreign-currency transactions have to date been IAS 21 (FRS 23) and its Irish GAAP equivalent, SSAP 20 (for companies not applying FRS 23). However, for accounting periods beginning on or after 1 January 2015, “old Irish GAAP” is withdrawn, and companies are required to prepare their accounts under either IFRS or “new Irish GAAP” (FRS 101 or FRS 102).

For companies currently applying SSAP 20, a transition to IFRS or to new Irish GAAP may result in some  differences in the accounting for foreign currency. Many companies will not encounter any differences, but when they do, these may be significant, and the tax consequences will need to be considered. Some areas to  watch are outlined below:

• Functional currency: IFRS/FRS 101 and FRS 102 provide detailed guidance on the factors to consider in determining a company’s functional currency, which include the influence of the company’s parent on its operations and activities. Although the functional currency of most companies (e.g. traders) is likely to be the same as its local currency under SSAP 20, it may be the case that there is a different assessment of the company’s functional currency. This is especially true for intermediate parent companies and group treasury companies.
• Foreign branches: The results of foreign operations, including branches, must be translated to the company’s presentation currency at the actual or average rate (provided that the average rate approximates the actual rates), and not at the closing rate, as permitted under SSAP 20.
• Contract-rate accounting: Transactions in a foreign currency can no longer be measured at the forward contract rate. Such transactions are required to be translated at the transaction-date rate, with the forward foreign-currency contract being separately recognised and measured at fair value.
• “Permanent-as-equity” debt: Under SSAP 20, it was possible for “permanent-as-equity” loans to be treated as non-monetary items and be carried at historical rates on the balance sheet or, alternatively, retranslated at the period end, but with exchange movements recognised through reserves. Under IFRS/FRS 101 and FRS 102 these balances will need to be retranslated at the period end, with exchange movements being recognised in the profit and loss account.
• Net investment hedge: Under SSAP an equity investment denominated in a foreign currency and hedged by a loan could be treated as if it were a monetary item. Exchange differences on the shares and the related loan were then taken to reserves. Any excess on the loan that could not be offset was taken to profit and loss account. This accounting treatment is not permitted under IFRS/FRS101 and FRS 102 when preparing entity financial  statements.

IFRS/FRS101 and FRS 102 permit a company to adopt a presentation currency that is different from its functional currency when preparing its financial statements. There is still a requirement for the company to measure its performance and its assets and liabilities etc. in its functional currency, but for the purposes of the company’s financial statements, these items are translated to its presentation currency, and any resultant  foreign-exchange gains or losses are not reflected in the profit and loss account. Foreign exchange gains and losses arising from the conversion from the functional currency to presentation currency can be ignored for tax purposes.

Determining a company’s functional currency

Functional currency is the currency of the primary economic environment in which the company operates and must be determined on an entity-by-entity basis. The primary economic environment in which a company operates is usually the economic environment in which it primarily generates and expends cash.

In determining the functional currency, consideration is given to primary and secondary indicators. Primary indicators are closely linked to the environment in which the company operates and are therefore given more weight, with secondary indicators providing supporting evidence.

The primary indicators are the currency that mainly influences:

• sales and cash inflows and
• expenses and cash outflows.
• the secondary indicators are the currency in which:
• funds from financing activities are generated and
• receipts from operating activities are retained.

The relative importance of the various indicators will vary from company to company. The primary and  secondary indicators should be clear in the case of a company supplying goods or services but may be less  relevant to other types of entities, including holding entities, treasury entities and special-purpose entities.

Furthermore, when determining the functional currency of a foreign operation (such as a subsidiary, branch, associate or joint venture), management will need to examine additional indicators such as:

• the degree of autonomy,  the frequency of transactions with the reporting company,
• the cash-flow impact on the reporting company and
• financing.

IFRS/FRS 101 and FRS102 require consideration of the influence of the parent on the company’s operations and activities in determining the functional currency of the subsidiary. Broadly, when companies undertake transactions in currencies other than their functional currency, they are required to translate those transactions into their functional currency at the spot rate applying on the date on which the transaction occurred.

Non-monetary assets and liabilities should continue to be carried in the company’s accounts at that value (i.e. not retranslated). However, monetary assets and liabilities are required to be retranslated at the rate applying at the balance sheet date, with any resultant gains or losses being taken to the profit and loss account.

Trading transactions

Section 79 TCA 1997 sets out the tax treatment for trading companies of foreign-exchange gains and losses arising in the profit and loss account on any “relevant monetary item or relevant contract” and on any “relevant tax contract”. Such exchange gains and losses typically arise when the company undertakes trading transactions in currencies other than its functional currency for accounting purposes. This would include:

• a company with a Euro functional currency undertaking trading transactions in Sterling and
• a company with a Sterling functional currency undertaking trading transactions in Euro.

Relevant monetary items and relevant contracts

Under s79 TCA 1997, exchange gains and losses arising on the above items are brought into the computation of the company’s Case I trading income for corporation tax purposes, and hence taxed or allowed at the rate of 12.5%, as and when they are properly credited or debited to the profit and loss account of the company. The provisions apply both to Irish-resident trading companies and to non-Irish-resident companies trading in Ireland through a branch or agency.

A “relevant monetary item” is defined as “money held or payable by the company for the purposes of a trade carried on by it”. Broadly, this includes foreign-currency-denominated trade-related payables (e.g. trade creditors and trade borrowings) and cash balances. Monies receivable for trade purposes, such as trade debtors, are not strictly included in the definition of “relevant monetary item” as they do not constitute “money held”. However, Revenue generally accepts that exchange gains and losses arising on trade debtors are taxable/deductible as trading income as and when they arise in the profit and loss account of the company. As outlined below, in determining whether s79 applies to an exchange gain or loss, care needs to be taken to ensure the appropriate classification of assets and liabilities as trading/non-trading.

A “relevant contract” is a contract to hedge foreign-exchange movements on a “relevant monetary item”. This includes currency swaps and forward rate agreements. Symmetry is therefore achieved on the tax treatment of relevant monetary items and their related hedges.

Following the accounting treatment in the manner set out in s79 overrides any distinction that would otherwise be drawn between long-term and short-term payables and between realised and unrealised exchange gains and losses. Thus, exchange gains and losses (whether realised or unrealised) arising on long-term trade-loan payables or on borrowings drawn down to fund the acquisition of fixed assets for use in the trade are taxable or deductible for corporation tax purposes as they arise in the profit and loss account.

A “relevant monetary item” or a “relevant contract” may be a chargeable asset for capital gains tax (CGT) purposes (e.g. non-Euro cash balances held or hedging contracts involving the acquisition and disposal of non-Euro cash balances), with any chargeable gains arising on disposal being taxed at 33%.

Exchange-rate movements occurring between the date of acquisition and the date of disposal of the asset are prima facie incorporated in the CGT computation in accordance with s552(1A) TCA 1997. Section 79(3) TCA 1997 clarifies that any portion of the chargeable gain or loss that is attributed to an exchange-rate movement, and hence incorporated in the Case I trading computation, is excluded from the CGT computation.

(The exclusion of items brought into Case I is also provided for in the CGT provisions contained in ss551 and 554 TCA 1997.)

In preparing the corporation tax calculations of a trading company, care must be taken to distinguish money held or payable for trading purposes from money held or payable for non-trading purposes. For example:

• Does the company hold surplus non-Euro cash balances over and above the amounts required to fund the working capital/future investment requirements of the trade? If so, s79 would not apply to the surplus, and any unrealised or realised gains or losses credited/debited to the profit and loss account should be excluded from the computation of the company’s trading income. On disposal of the cash balances, any realised gains or losses arising by virtue of exchange-rate movements would therefore be included in the CGT calculation (subject to s79C, discussed below).
• Were borrowings drawn down to fund the acquisition of shares in a subsidiary? As the borrowings were not drawn down for the purposes of the company’s own trade, s79 would again not apply, and any unrealised or realised gains or losses credited/debited to the profit and loss account should be excluded from the company’s trading-income computation. As the borrowings are a liability of the company, any realised gains or losses should not be liable to CGT.
• Conversely, borrowings drawn down to fund the acquisition of the trade and assets of an overseas branch would be regarded as being for the purposes of the company’s own trade and should hence fall within the provisions of s79.

Relevant tax contracts

Companies with a non-Euro functional currency and a Euro corporation tax liability may wish to hedge against risk arising from exchange-rate movements between that functional currency and Euro in the time period before the corporation tax liability falls due to be paid. Because a corporation tax liability is not regarded as money payable for trading purposes, it is not a “relevant monetary item” and the hedge is not a “relevant contract”. Section 79(4) TCA 1997 therefore separately provides that exchange gains and losses arising to a  trading company on a “relevant tax contract” are also excluded for CGT purposes. However, the amount of the gain or loss that is excluded is capped. A gain is excluded only to the extent that it does not exceed the exchange loss that would, absent the hedge, have arisen on the corporation tax liability, and vice versa. A mismatch could arise where, for example, the final corporation tax liability is lower than the amount hedged. Care is therefore required in entering into such hedges, and the position should be carefully monitored.

Foreign branches

Where an Irish-resident company undertakes trading activities in a foreign territory through a branch or agency and the branch’s trading results and assets/liabilities are denominated in a currency other than the company’s presentation currency, the branch results will need to be translated to the company’s presentation currency for inclusion in the financial statements of the company. Under IFRS/FRS 101 and FRS 102, broadly, income and expenditure of foreign branches are translated into the company’s presentation currency at the rate applying at the date of each transaction or at an average rate for the period (if that approximates the actual rates).

Monetary assets and liabilities are translated at the rate applying at the balance sheet date, and non-monetary assets and liabilities are translated at historical rates. To the extent that exchange gains or losses flow through the company’s profit and loss account by virtue of movements between the company’s functional currency and the currency of the branch, s79 should apply, as outlined above.

Tax paid in the foreign territory on the branch’s trading profits should be available by way of a credit or deduction (depending on whether it is governed by a double tax agreement) against the Irish tax payable on those foreign-branch profits. This credit/deduction should be translated to Euro at the spot rate on the date of payment. In practice, however, the credit/deduction is sometimes translated into the company’s functional currency at the same exchange rate as that used to translate the branch’s profit and loss account for the period.

Capital allowances and trading losses

Section 402 TCA 1997 deals with a number of computational matters where a company’s functional currency is non-Euro or assets are acquired in a different currency. Broadly, the provisions allow companies to calculate capital allowances and trading loss relief in the functional currency, thereby preserving their value in functional-currency terms. The provisions also cover the restatement of these items where there is a change in the functional currency of the company.

Capital allowances

Where an asset qualifying for capital allowances is acquired in a currency other than the functional currency of the company (for example, a company with either a Euro or a Sterling functional currency buys an asset in US Dollars), s402 provides that the cost of the asset should be translated to the functional currency at the rate of exchange applying at the date on which the expenditure is incurred, which is defined as the date on which it becomes payable.

Capital allowances and balancing adjustments are then calculated in the functional currency of the company and are treated as trading expenses and receipts in computing the tax-adjusted trading income/loss expressed in that functional currency.

Trading losses

The trading loss is first computed in the company’s functional currency. Where it is to be offset against profits earned in an earlier or subsequent period, it is then translated to Euro at the same rate of exchange used to translate the trading income of the period in which the loss is to be set off. (This is typically the average exchange rate for the period in question.)

This effectively preserves the value of the trading losses in functional-currency terms, giving the same result as if both the trading loss and the profit to be sheltered were stated in the company’s functional currency and the net trading profit were then translated to Euro for the purpose of computing the tax liability at the average exchange rate for the period in which the profit arose.

Underpayment of preliminary corporation tax Revenue issued eBrief No. 34/2009, setting out the position where a company with a non-Euro functional currency underpays its preliminary corporation tax liability solely as a result of currency fluctuations. If the company meets the conditions set out in the eBrief, it may make a written application to the Collector-General for a waiver of interest.

Non-Trading Transactions

The tax treatment applying to foreign-exchange gains and losses arising on transactions/balances that do not fall within the provisions of s79 TCA 1997 is significantly different. First, neither realised nor unrealised exchange-rate gains/losses recognised in the profit and loss account are taken into account for corporation tax (Case I trading) purposes.

Each non-trading transaction must be considered on an individual basis to determine whether there has been a disposal of a chargeable asset for CGT purposes. In contrast to the position for trading transactions to which s79 applies, any exchange-rate movements occurring between the date of acquisition and the date of disposal of the asset will be incorporated in the CGT computation and hence be taxable/allowed at the 33% rate.

Of course, CGT will not apply to the disposal of a liability in a non-trading context. It is noteworthy that realised and unrealised exchange gains and losses arising on liabilities within s79 (e.g. arising on trade payables) are taxed/allowable in the Case I trading computation, whereas there are no tax consequences associated with exchange movements on non-trade liabilities.

Chargeable assets

Section 532 TCA 1997 defines “assets” for CGT purposes. The definition includes “any currency other than the  currency of the State” and “debts”.

Foreign currency

Each time that a disposal occurs of a non-Euro currency that is not held for trading purposes, a company is required to prepare a CGT computation. Following the principles of Bentley v Pike [1981] STC 360, taxpayers are required to compute the capital gain or loss arising on the disposal of foreign currency by reference to the

Euro equivalent spot rates prevailing at the date of acquisition and the date of disposal of the currency. This can present a significant administrative burden for companies. The impact of this was addressed by Revenue in s79C TCA 1997 in the context of non-Euro currency held in a bank deposit account of qualifying companies.

This is considered further below.

Non-Euro-denominated debts

As outlined above, all “debts” are assets for CGT purposes, and any disposal of a debt, including by way of repayment by the creditor or by assignment, is therefore a chargeable event for CGT purposes. This is subject to some exceptions, which are discussed below.

Although it may typically be expected that no gain or loss would arise on, say, the repayment of a loan at face value, a chargeable gain or loss may arise for CGT purposes when the computation is prepared under s552(1A) TCA 1997 owing to foreign-exchange movements occurring between the dates on which the debt is drawn down and is repaid.

Section 541(1)(a) TCA 1997 provides that the disposal of a debt by the original creditor does not give rise to a chargeable gain (or a loss by virtue of s546(3)), meaning that any foreign-exchange movements will be irrelevant for CGT purposes. However, this general rule does not apply where the debt is either (1) a “debt on a security” or (2) non-Euro currency held in a bank account. These are discussed further below.

Care should be taken in situations where a debt is assigned. Issues can arise for companies as the recipient is not the “original creditor” in respect of the debt and does not meet the conditions of s541(1) TCA 1997. Any gain or loss arising on the disposal of the debt would therefore be subject to CGT.

Where the debt is novated rather than assigned, the original loan agreement is extinguished and it is replaced by a new loan agreement between the borrower and the person who is replacing the original lender. A subsequent disposal of the debt by the new lender should qualify for relief under s541(1) as the new lender should be considered the original creditor in respect of this debt.

Debt on a security

As outlined above, the provision that the disposal of a debt by the original creditor does not give rise to a chargeable gain or loss for CGT purposes does not apply to a “debt on a security”. The term “debt on a security” is not defined in Irish legislation, but the meaning given to the term has been considered by both the UK and the Irish courts. The key characteristic of a debt of security, as determined by the Irish High Court case of J.J Mooney (Inspector of Taxes) v Noel McSweeney [1997] ITR 163, is that the debt must have the “potential to increase in value”. This is generally taken to mean that the loan is capable of being dealt in or realised at a profit and that it has the necessary characteristic of “marketability”.

The matter was considered again in the case of O’Connell (IOT) v Keleghan [2001] IESC 43, which identified other key characteristics of a debt on a security, including: “the capability of having an enhanced value”, which is generally taken to mean the presence of share conversion rights; a reasonable commercial rate of interest; and a structure of permanence – determined, inter alia, by the term of the loan note and whether the borrower  can repay it at any time. McCracken J in his judgment also noted that the debt in question should not constitute a debt on a security on the basis that the loan was non-transferable (i.e. the loan note was not capable of being assigned). The case was appealed to the Supreme Court, which upheld the original judgment. However, Murphy J held that:

“whilst the right to assign a debt in whole or in part and the arrangements made to facilitate such an assignment may be material in determining whether a particular debt has the requisite characteristic of marketability the clear analysis provided by the President [of the High Court in the McSweeney case] shows the decisive importance of the underlying commercial potential of the debt to appreciate in value if it is to qualify as a debt on a security for Capital Gains Tax purposes”.

In group situations there may be a requirement for companies to advance intra-group loans denominated in a foreign currency. Care needs to be taken in determining whether any such loans bear the features of a debt on a security in the hands of the lender.

Generally, where a loan:

• is interest-free,
• is repayable on demand and
• carries no conversion rights,

it would be expected that the loan should not constitute a debt on a security. The repayment of this loan should not, therefore, give rise to any chargeable gain or loss.

Foreign-currency bank accounts

Section 541(6) TCA 1997 provides that s541(1) does not apply to a debt owed by a bank that is denominated in a non-Euro currency (e.g. a non-Euro deposit account), meaning that disposals of non-Euro currency from such accounts can give rise to chargeable gains and losses. In computing the CGT, deposits are treated as acquisitions, and withdrawals are treated as disposals. The “first in, first out” (FIFO) basis of calculation applies, and calculations must be prepared on a daily basis. Where multiple bank accounts exist or frequent transactions occur, the CGT calculations can become quite cumbersome.

The impact of this was addressed to some degree by Revenue in s79C TCA 1997, a measure that was introduced in 2012 to enhance Ireland’s holding-company regime. Where the necessary conditions are met, s79C provides that the non-Euro bank account is not an asset for CGT purposes, thus removing the requirement for companies to prepare CGT calculations for each individual movement in the non-Euro bank account (i.e. deposit and withdrawal) during an accounting period.

Instead, the net exchange gains reflected in the profit and loss account are chargeable to corporation tax under Schedule D, Case IV (at a rate of 25%), rather than CGT (at a rate of 33%). To remove any benefit that may be obtained by virtue of this tax-rate differential, the chargeable amount is subject to an adjustment to make the tax payable equate to the amount that would have been payable if CGT applied instead of Case IV.

However, s79C applies only to a “relevant holding company”, which is broadly defined as a company that has at least one wholly owned trading subsidiary or which acquires/sets up such a subsidiary within one year of a net exchange gain being credited to its accounts. This requirement makes the scope of the new provision quite narrow, as it excludes any companies that are not direct holding companies. Thus, even holding companies which have a significant number of trading subsidiaries but that are not directly wholly owned by the holding company concerned are unable to meet the conditions of s79C.

A further point should be borne in mind in relation to withdrawals of non-Euro currency from a bank account in light of the fact that the currency itself is an asset under s532 TCA 1997. For example, where a company withdraws funds and holds them for a period of time (before using them, say, to acquire an asset), there may be a tax exposure in relation to exchange movements arising during that holding period. Applying the funds on the day of withdrawal should prevent an exposure arising.