Financial statements may be prepared using rules to account for foreign exchange gains and losses (which form part of business income) that differ from the rules to calculate foreign exchange gains and losses for income tax purposes. These differences may significantly affect the taxable income of a business and consequently a thorough analysis of how a business records foreign exchange is required in order that the proper tax treatment results. Failure to do so may trigger premature taxable income or overpayment of tax in periods of fluctuating exchange rates. Some situations which may indicate differences that should be investigated are as follows:
- Investments or marketable securities in foreign denominations written down to market value (but not if carried at cost).
- Inventory in foreign denominations.
- Cash in foreign denominations used in investment activities (but not cash used in trade activities).
- Debt financing in foreign denominations (short or long-term), where the debt is considered to be part of the capitalization of the company and not used in the normal course of trading activities.
- Future income tax liabilities and assets in foreign denominations.
- Cost of goods sold on inventory.
Generally Accepted Accounting Principles (GAAP) Treatment of Foreign Exchange
Financial statements prepared in accordance with GAAP differentiate between foreign exchange treatments based on whether the item in question is monetary or non-monetary. For example, there is a different accounting treatment between a trade accounts receivable item which is denominated in a foreign currency (such as a US dollar accounts receivable) and a inventory item which was purchased using a foreign currency (again such as an inventory item purchased in the US).
- at the date of the transaction, each asset, liability, revenue or expense item (monetary or non-monetary) arising from a foreign currency transaction should be translated into Canadian dollars at the exchange rate in effect at the transaction date except if the transaction is hedged. When hedged, the exchange rate established by the hedge should be used.
- at each balance sheet date, monetary items denominated in a foreign currency should be adjusted to reflect the exchange rate in effect at the balance sheet. This will create an exchange gain or loss on the difference between the exchange rate at the date in 1 above and the exchange rate at the balance sheet date which would be reported in the income statement.
- for non-monetary denominated items that are carried at market (for example, inventory items purchased in a foreign currency transaction that are written down to market value which is stated in terms of foreign currency or investments written down to market value which is stated in terms of foreign currency) these items are also adjusted to reflect the exchange rate in effect at the balance sheet date. This will create an exchange gain or loss on the difference between the exchange rate at the date in 1 above and the exchange rate at the balance sheet date which would be reported in the income statement.
- for all other non-monetary denominated items, there is no adjustment at the balance sheet date. The item is kept at its historical exchange rate until disposed of and then any foreign exchange gains or losses are reported as an income item.
$100 US sale on January 1. Exchange rate at that time is 1.5. Therefore, the initial transaction is recorded at $150 Canadian in revenue and $150 Canadian in accounts receivable. If the balance sheet date is December 31, the receivable is not collected, and the exchange rate is 1.3 at the balance sheet date, the business would record an exchange loss charged to income of $100 (1.5 – 1.3) = $20 which offsets the value in accounts receivable. The $20 loss appears as an expense to the income statement.
Income Tax Treatment of Foreign Exchange
The Income Tax Act does not differentiate between monetary and non-monetary items. Instead, the Act differentiates between Income and Capital items. Where the gain or loss relates to a trading activity (for example, trade accounts receivable, trade accounts payable, or purchase of inventory) it will be treated as income in nature. Where the gain or loss relates to non-trading activity (for example, the purchase of fixed assets or investments, and debt financing) it will be treated as capital in nature. There are no specific rules on situations where foreign exchange items are hedged. If taxpayers follow the approach used for GAAP, the exchange rate used in the hedge transaction would be used to record the foreign exchange amounts.
Taxation of Foreign Currency Capital Items
Exchange gains and losses of a capital nature are included in taxable income only in the taxation year that they are actually realized. This is similar to the GAAP treatment of non-monetary foreign exchange items carried at cost discussed above. In other words, after the item is recorded at the original foreign exchange amount, no subsequent changes in foreign exchange are accounted for at each balance sheet date. Only when subsequently sold are the realized foreign exchange amounts recognized for income tax purposes. Thus, any accrued capital foreign exchange gains or losses booked for financial statement purposes for exchange differences at the balance sheet date should be adjusted from taxable income in preparing the income tax return.
For GAAP purposes, the following transactions may have created foreign exchange gains or losses on an accrual basis in the income of the financial statements but which are not yet taxable for income tax purposes because they are capital in nature:
- Investments or marketable securities written down to market value (but not if carried at cost).
- Inventory written down to market value (but not if carried at cost).
- Cash used in investment activities (but not cash used in trade activities).
- Debt financing (short or long-term), where the debt is considered to be part of the capitalization of the company and not used in the normal course of trading activities.
- Future income tax liabilities and assets.
Taxation of Foreign Currency Income Items
Exchange gains or losses of income nature are included in income using either a realized basis (similar to the tax treatment for capital items and GAAP treatment of non-monetary items carried at cost discussed above) or an accrual basis (similar to the GAAP treatment for monetary items and non-monetary items written down to market discussed above). Either method is acceptable to CRA, however, the method chosen must be used consistently each year and also correspond to that used for financial statement purposes. If GAAP financial statements are prepared, then most income items such as trade accounts receivable would be accounted for using the accrual method and therefore this is the method that must be used to account for foreign exchange on income items for tax purposes.
For GAAP purposes, the following transactions may not have created accrued foreign exchange gains or losses on the financial statements, but which are required to be taxable on an accrual basis for income tax:
- Inventory carried at cost (but not if written down to market).
- Cost of goods sold on inventory carried at cost.
ROMANOVSKY & ASSOCIATES LLP
CHARTERED PROFESSIONAL ACCOUNTANTS
Keith M.J. Anderson* BCom, CPA, CA-IT, CITP
Chartered Professional Accountant and Chartered Accountant (Canada)
CA-Designated Information Technology Specialist (Canada)
Certified Information Technology Professional (US)
* Professional Corporation