ATO ID 2005/322: Foreign exchange (forex) gains and losses: initial exchange of currency under a foreign exchange swap contract
Date of decision: 11 November 2005
Year of income: Year ended 30 June 2005
Business line: Private Groups and High Wealth Individuals

Issue
Will forex realisation event 4 (FRE 4) happen under subsection 775-55(1) of the Income Tax Assessment Act 1997 (ITAA 1997) on the initial exchange of currency under a foreign exchange swap contract (FX swap), where the agreed rate under the swap and the spot rate are the same?

Decision
Yes. FRE 4 happens under subsection 775-55(1) of the ITAA 1997 on the initial exchange of currency under a FX swap where the agreed rate under the swap and the spot rate are the same. However, no forex realisation gain or loss is made as there is no currency exchange rate effect.

Facts
The taxpayer entered into a business transaction requiring it to pay United States dollars (USD) at a future date. As part of a hedging strategy to protect against adverse movements in the Australian dollars (AUD)/USD exchange rates, the taxpayer entered into a FX swap on 30 May 2005. Under the terms of the swap, the taxpayer exchanged USD for AUD at an agreed exchange rate on the contract date. The AUD is then re-exchanged for USD at an agreed exchange rate at a future date. The initial exchange is agreed to be at the spot rate on 30 May 2005. To effect the initial exchange, the taxpayer arranged for USD to be acquired and transferred to the counterparty to the FX swap via electronic transfer on the same day. The acquisition and disposal of USD under the initial exchange took place at the same spot rate.

Reasons for decision
Summary: On entering into the FX swap the taxpayer had an obligation to pay an amount of foreign currency incurred in return for it receiving AUD. Under subsection 775-55(1) of the ITAA 1997, FRE 4 happens if an entity ceases to have an obligation to pay foreign currency. Subsection 775-55(2) of the ITAA 1997 provides that FRE 4 happens when the entity ceases to have the obligation. The taxpayer ceased to have the obligation to pay foreign currency when it paid the USD on 30 May 2005 and received AUD in exchange. Subsection 775-55(3) of the ITAA 1997 provides that a forex realisation gain is made if the amount paid in respect of FRE 4 happening, falls short of the proceeds of assuming the obligation at the tax recognition time. In this instance, the proceeds of assuming the obligation under section 775-95 of the ITAA 1997 is the money the taxpayer received for incurring the obligation, that is the AUD the taxpayer received in exchange for the USD under the swap. The 'tax recognition time' is essentially when an event occurs which creates tax consequences. Item 8 of subsection 775-55(7) of the ITAA 1997 provides that for an obligation incurred in return for receiving AUD, the tax recognition time is when the AUD is received. A forex realisation loss is made under subsection 775-55(5) of the ITAA 1997 if the amount paid in respect of FRE 4 happening exceeds the proceeds of assuming the obligation as determined at the tax recognition time. The amount paid in respect of FRE 4 happening is converted to AUD using the spot rate applicable on the date the payment is made (item 11 of the table in subsection 960-50(6) of the ITAA 1997). The amount of forex realisation gain or loss is so much of the shortfall or excess that is attributable to a currency exchange rate effect. A currency exchange rate effect is defined in subsection 775-105(1) of the ITAA 1997. It is described as any currency exchange rate fluctuation, or as the difference between an expressly or implicitly agreed currency exchange rate for a future time and the actual currency exchange rate at that time. Although the taxpayer ceases to have an obligation to pay foreign currency at the time of the initial exchange resulting in FRE 4 happening, no forex realisation gain or loss is made as there is no currency exchange rate effect. The AUD value of the USD paid by the taxpayer was equal to the value of assuming the proceeds of the obligation. This is because the agreed rate under the swap was equal to the spot rate on 30 May 2005 when the initial exchange of currencies took place.

Legislative references: Income Tax Assessment Act 1997 subsection 775-55(1) subsection 775-55(2) subsection 775-55(3) subsection 775-55(5) subsection 775-55(7) section 775-95 subsection 775-105(1) subsection 960-50(6)
Related ATO interpretative decisions: ATO ID 2005/322
Subject references: Assuming an obligation Currency exchange rate Currency swaps Financial derivatives Foreign currency Foreign currency obligations Foreign exchange gains and losses Forex realisation event Forex realisation gain Forex realisation loss Swaps Tax recognition time