Considering the nature of the global trade system which necessitates connections between the economies of various countries, governments implement exchange rate systems in order to achieve economic and policy objectives. Exchange rates are a significant macro-economic indicator that reflect one's currency valuation and comparison to other currencies as a means to provide stability, foster trade relationships, influence investments, capital flows, and inflation, amongst others.
Over time, the Central Bank of Nigeria (CBN) has adopted different exchange rate systems, such as controlled, floating, and managed float, alongside intermittent interventions, all aimed at achieving extended market stability. The controlled exchange rate system is that in which the central bank determines a fixed exchange rate, while floating exchange rate system allows the determination of the rate by market forces. Meanwhile, the managed float exchange rate system allows the influence of demand and supply to determine the exchange rate but also allows occasional involvement by the central bank to manage persistent fluctuations.
Although, the National Bureau of Statistics (NBS) on its news page, reported growth in the country's economy, with Real Gross Domestic Product (GDP) expanding by 2.31% (year-on-year) in the first quarter of 2023, concerns have continued to linger among the citizenry over persistently rising inflation rates. Notably, the NBS in the April series of its Consumer Price Index (CPI) and Inflation Report released in May 2023, reported that headline inflation (year-on-year) climbed to 22.22% in April 2023, from 22.04% in the prior month. A collection of these indicators continued to necessitate the need for an economic policy review. During the Monetary Policy Committee (MPC) meetings held from January to May 2023, a consistent observation emerged: the Nigerian economy remained burdened by substantial import costs, leading to pressure on foreign exchange investments and a consistent rise in overall prices. Consequently, calls for monetary reforms aimed at augmenting foreign reserves to act as buffers against shocks became critical.
Given the above, policies that attract the influx of portfolio trade, and diaspora remittances, as well as foreign direct investment to Nigeria, became imperative to enhance reserve accumulation and strengthen liquidity in the foreign exchange market.
This article focuses on the potential tax implication of some of these policies and the strategies that businesses have adopted in ensuring survival during this very challenging phase. More specifically, it highlights the intricacies of the free-floating exchange rate policy vis-à-vis its current and potential future tax implications, treatments, and compliance matters.
An Overview of Floating Exchange Rate in Nigeria
In an official press release dated 14 June 2023, the CBN notified business stakeholders and the general public of immediate modifications to the Nigerian foreign exchange market operations. These changes involve the consolidation of various exchange rates into the Investors and Exporters (I&E) window, wherein all eligible transactions gain access to foreign exchange without segmentation.
The I&E market functions on a willing buyer-willing seller model, where entities seeking foreign exchange engage with those possessing it, agreeing on a price through authorized dealers. The resulting exchange rate is determined by the interplay of demand and supply forces. However, transactions involving Ministries, Departments, and Agencies (MDAs) of government will utilize the weighted average rate of the prior day's transactions. That is, the summation of the volume of Foreign Exchange (FX) traded multiplied by the various rates at which the deals are consummated, divided by total volume of trade.
The Point of Confluence
The convergence of floating exchange rates and tax implications forms a multifaceted landscape for businesses operating in Nigeria. In a globalized economy, Nigeria's embrace of a floating exchange rate system introduces both opportunities and challenges for enterprises involved in international endeavors. Navigating this terrain mandates a comprehensive understanding of strategies to manage the potential tax consequences and address compliance hurdles.
The recent foreign exchange market reforms hold the potential to enhance market transparency and attract more foreign capital inflows, contingent on the credibility of exchange rate management. This underscores the importance of employing effective policies to attract diaspora remittances, which can help alleviate exchange rate pressures. Nevertheless, the current economic reality underscores the considerable impact of floating exchange rates on diverse business aspects, ranging from material procurement, import-export trade operations, asset acquisition, inter-company loans and transfer pricing, amongst others. Consequently, these market dynamics impose complexity on financial planning and tax calculations, particularly due to the influence on cost structures, revenues, and competitiveness, thereby alarming inflationary pressures.
Potential Tax Implications of the Floating Foreign Exchange Policy on Businesses in Nigeria
Given the current complexities that the floating regime poses to the economy, tax authorities may closely scrutinize how businesses handle foreign exchange related transactions initiated during the period. Hence, the need for adequate documentation and adherence to regulations are pertinent, in order to ensure tax compliance, while striving to mitigate foreign exchange risks. We have provided below, an overview of potential tax implications that may arise for businesses due to this development:
a). Foreign Exchange Gains and Losses
Floating exchange rates precipitate foreign exchange gains or losses in cross-border transactions, potentially yielding significant tax implications for businesses in Nigeria. While accounting standards treat exchange differences without differentiation, tax regulations often distinguish between realized and unrealized gains and losses. For tax purposes, foreign exchange differences (gains and losses) arising out of settlement of transactions that are revenue in nature may be realized or unrealized. Such exchange loss will be treated as a deductible expense, to the extent that the loss is realized. In like manner, the exchange gain is taxable under Section 9 of the Companies Income Tax Act (CITA), provided the gain is realized. In contrast, unrealized exchange gains do not qualify as taxable income and are therefore treated as tax-exempt income (only to be taxed in the period the gains become realized). Similarly, unrealized exchange losses arising from foreign currency translation are non-deductible expenses which are disallowable for tax purposes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
