ATO ID 2005/321: Foreign exchange (forex) gains and losses: acquisition of foreign currency under a forward exchange contract
Date of decision: 11 November 2005
Year of income: Year ended 30 June 2005
Business line: Private Groups and High Wealth Individuals

Issue
Does forex realisation event 2 (FRE 2) happen under subsection 775-45(1) of the Income Tax Assessment Act 1997 (ITAA 1997) when foreign currency is acquired under a forward exchange contract?

Decision
Yes. FRE 2 will happen under subsection 775-45(1) of the ITAA 1997 when foreign currency is acquired under a forward exchange contract.

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 dollar (AUD)/USD exchange rates, the taxpayer entered into a forward exchange contract on 1 November 2004, under which it would receive USD 1,000,000 at an agreed exchange rate of AUD 1.00 = USD 0.7400 on 1 June 2005. On 1 June 2005 the forward exchange contract was settled by the taxpayer paying AUD 1,351,351 in return for receiving USD 1,000,000. The actual exchange rate on that date was AUD 1.00 = USD 0.7600 giving the USD received an equivalent value of AUD 1,315,789.

Reasons for decision
Summary: On entering into the forward exchange contract, the taxpayer acquired a right to receive an amount of foreign currency in return for it agreeing to pay AUD. Under subsection 775-45(1) of the ITAA 1997, FRE 2 happens if an entity ceases to have a right to receive foreign currency. Subsection 775-45(2) of the ITAA 1997 provides that FRE 2 happens when the entity ceases to have the right. The taxpayer ceased to have the right to receive foreign currency when it acquired the USD 1,000,000 on 1 June 2005. A forex realisation loss is made under subsection 775-45(4) of the ITAA 1997 if the AUD equivalent of the amount received in respect of FRE 2 happening falls short of the forex cost base of the right as determined at the tax recognition time. In this instance, the forex cost base under section 775-85 of the ITAA 1997 is the money the taxpayer is required to pay for acquiring the right. That is the AUD1,351,351 the taxpayer paid for the USD1,000,000. The 'tax recognition time' is essentially when an event occurs which creates tax consequences. Item 4 of subsection 775-45(7) of the ITAA 1997 provides that for a right acquired in return for agreeing to pay AUD, the tax recognition time is when the amount is paid. Subsection 775-45(4) of the ITAA 1997 provides that the forex realisation loss is the amount of shortfall 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. The AUD equivalent of the USD 1,000,000 received by the taxpayer on 1 June 2005 is $1,315,789. This is the AUD equivalent value of the USD converted using the spot rate on the day the amount is received (item 11 of the table in subsection 960-50(6) of the ITAA 1997). The AUD equivalent of the amount the taxpayer is required to pay, as set by the forward exchange contract, is $1,351,351. The taxpayer has made a forex realisation loss under subsection 775-45(4) of the ITAA 1997 of $35,562, as the amount the taxpayer received fell short of the forex cost base of the right. The shortfall is attributable to a currency exchange rate effect and is deductible from assessable income pursuant to subsection 775-30(1) of the ITAA 1997 in the income year in which FRE 2 happens, being the year ended 30 June 2005.

Legislative references: Income Tax Assessment Act 1997 subsection 775-30(1) subsection 775-45(1) subsection 775-45(2) subsection 775-45(4) subsection 775-45(7) section 775-85 subsection 775-105(1) subsection 960-50(6)
Subject references: Currency exchange rate Financial derivatives Foreign currency Foreign currency rights Foreign exchange gains and losses Forex cost base Forex realisation event Forex realisation loss Forward rate agreements Hedging Tax recognition time