Raymond Yeung Tax Consultant former Assessor of Inland Revenue Department 前稅局評稅主任楊輝洪

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Profits Tax - Exchange loss / Exchange gain

The basic question is whether the losses are deductible? and whether the gain assessable? The basic answer is: the losses are deductible and gains assessable if they are: (a) incurred in the production of assessable profits, and (b) of a revenue nature.

In general, exchange differences that arise from an investment or from an appreciation or devaluation of currency outside the scope of trading should not be taken included in the assessable profits. In other words, only those exchange differences in connection with the profit earning activities should be brought into the calculation of assessable profits / losses.

Normally, exchange differences arising from the settlement of trade debts due to trade creditors or due from trade debtors are of a revenue nature. Likewise, exchange differences arising from receipt of revenue and payment of expenses are of a revenue nature too. In other words, these exchange differences should be included in the assessable profits.

On the other hand, the exchange losses or gains on acquisition of fixed assets or long-term loans should be excluded from the computation of assessable profits. This is because they have a capital nature.  

In the case Beauchamp v. Woolworth 61 TC 542, it was held that a loan was a revenue transaction if it was temporary, fluctuating and incurred in defraying the running costs of the business. In that case, the loan did not form part of the daily operating activities in earning profits. It was a fixed amount for 5 years. It was used as an additional capital. In the circumstances, the loan was a capital transaction. 

When dealing with incomes received in foreign currency, the gains or losses resulting from currency fluctuations between the transaction generating the income and the settlement of the amounts due from the debtor are revenue in nature.

In the court case Davis v. Shell Co. of China Ltd., 32 TC 133, exchange gains from bank deposits were held as having a capital nature. That was because the deposits were not arising from the trading activities --- the sale of goods and services. 

In practice, the IRD regards those foreign currency funds placed on current accounts with banks held for trading purposes (that is for purchase of trading stock or payment of operating expenses). Hence, any losses are deductible or gains assessable. As regards fixed deposits, the IRD regards them having a capital nature.

The Hong Kong court case CIR v. Li & Fung Ltd. 1 HKTC 1193 concerned exchange gains from bank deposits --- some 7 days call deposits in US banks. In fact, the fund was generated from sales proceeds of exported goods. Unquestionably, it was originated from trading activities. But it was held that its nature was changed to capital investment when it was placed on the bank deposits. The exchange difference after the change was of a capital nature.

In the Hong Kong case CIR v. Chinachem Finance Co. Ltd. 3 HKTC 529, it was held that when deciding whether a loss arising from borrowing was capital or not, regard should be paid to the length and the terms of borrowing, as well as to the nature of the trade. In that case, because of the short-term nature of the loan, the exchange losses were held as having a revenue nature.

Gains or losses from speculations in foreign currencies are generally excluded from computation of assessable profits unless such activities have constituted a trade.

When preparing final accounts, some trade debtors or creditors accounts denominated in foreign currency are translated into Hong Kong dollars. The generally accepted accounting practice is that the exchange gains or losses from such conversions are to be recognized in the Profit and Loss Account. This accounting practice is acceptable to IRD, although strictly speaking, such gains or losses are unrealized at the balance sheet date. Of course, the IRD should not reject the exclusion of the unrealized gains / losses from the assessable profits because it is well established law principle that profit shall not be taxed until realized. See the case Willingale v. International Commercial Bank Ltd.

If a taxpayer keeps his books and accounts in a foreign currency, his accounting profit will be, of course, computed in that foreign currency. In that case, the taxpayer has to convert the accounting profit into Hong Kong dollars when computing the assessable profit. In practice, the IRD adopts the "average rate of exchange during the year" for the conversion. The average rate of various currencies are published on the IRD's website from time to time.

The IRD has published a Departmental Interpretation Practice Note No. 42 regarding financial exchange difference arising from financial instruments for the year of assessment 2005/06 and onward. The definition of “financial instruments” follows the definition of the same term in the Hong Kong Accounting Standard No. 32, namely “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity”. In brief, financial instruments include debts such as debtors’ and creditors’ balances. In the DIPN, the IRD says: “On the whole, the Department will follow the accounting treatment stipulated in HKAS 39 in the recognition of profits or losses in respect of financial assets of revenue nature. Accordingly, for financial assets or financial liabilities at fair value through profit or loss, the change in fair value is assessed or allowed when the change is taken to the profit and loss account... For loans and receivables.., the gain or loss is taxable or deductible when the financial asset is derecognized or impaired and through the amortization process. Valuation methods previously permitted for financial instruments, such as the lower of cost or net realizable value basis, will not be accepted... Besides, the IRD does not accept the argument that when the financial instruments are marked to market, the profits recognized in the profit and loss account are unrealized profits and therefore not taxable until realized in later periods. Such argument is essentially based on the decision in Willingale v. International Commercial Bank Ltd, [1978] STC 75... A financial asset or financial liability at fair value through profit or loss includes a financial asset or financial liability that is held for trading. It is classified as trading if it is acquired or incurred principally for the purpose of selling or repurchasing; or there is a pattern of short-term profit-taking. Therefore, the change in fair value and the gain (or loss) on disposal, recognized in the profit and loss account, are taxable (or deductible)."


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