Introduction
On June 24, 2024, the Federal Inland Revenue Service ("FIRS") issued Information Circular No. 2024/04 (the "Circular") to provide information and guidance to the general public, taxpayers, tax practitioners, and tax officials on the appropriate tax treatment of foreign exchange transactions in line with the provisions of the relevant tax laws. The Circular withdraws the previous Information Circular No. 2024/3 of June 14, 2024, which—until its withdrawal—regulated the treatment of foreign exchange transactions.
The FIRS noted that while the International Financial Reporting Standards (IFRS) prescribe the treatment of foreign currency transactions in the financial statements of an entity, such treatment prescribed by the IFRS may only be sufficient for accounting purposes. This is because such treatments may not be in accordance with extant tax rules which would necessitate making relevant adjustments when computing tax payable.
Accordingly, the Circular aims to clarify the relevant adjustments that may be required to determine the tax position from such transactions.
1. Legal Framework
In line with sections 24(1) and 27 of the Companies Income Tax Act (CITA), sections 20 and 21 of the Personal Income Tax Act (PITA), and sections 10 and 13 of the Petroleum Profits Tax Act (PPTA); the FIRS maintains that only expenses that are wholly, exclusively, necessarily and reasonably incurred in the production of a taxable income may be deducted in order to ascertain the assessable profits for the relevant year of assessment. This implies that even in foreign exchange transactions, the FIRS would only assess taxable income after all necessary expenses incurred in the production of taxable income have been deducted.
The provisions of the CITA, PITA, and PPTA as mentioned above provide that in determining the assessable profits of a company or individual, expenses incurred wholly, exclusively, reasonably, and necessarily for the provision of profits (in the case of a company) or income (for an individual) are deducted before arriving at assessable profit/ income. Allowable deductions under applicable laws include; the sum payable by way of interest on debt borrowed and employed as capital in acquiring the profits of a company, any expenses incurred for repair of premises, plant, machinery or fixtures employed in acquiring the profits, or for the renewals, repair or alteration of any implement, utensil or articles so employed, and so on.
In relation to the tax treatment of foreign exchange transactions, computation of profits made from a realised exchange difference will arise after other expenses which are wholly, exclusively, necessarily, and reasonably incurred in the production of profits have been deducted.
2. Foreign Exchange Differences
The FIRS identifies that foreign exchange differences may arise where the foreign exchange rate used in booking a foreign-currency transaction differs from the rate used on a subsequent reporting or settlement date. This could arise when a currency fluctuates between the time of entering into a foreign-currency transaction and the time of its settlement. By this Circular, the rise or fall of foreign exchange rates are issues to be considered in determining the taxable income arising from a foreign exchange transaction.
In line with the above, it is also important to note that the rise or fall in foreign exchange rates could lead to either a loss or a gain to the paying party.
3. Realised and Unrealised Exchange Differences
The FIRS classifies foreign exchange differences as either realised or unrealised differences.
Unrealised exchange differences occur where the gain or loss accruing from the revaluation of a foreign currency which rises between the date of the initial transaction and its settlement is only accounted for but not realised.
Realised foreign exchange difference occurs where the revaluation of a foreign currency from a transaction is settled/ paid and the gains or loss accruable therefrom have been realised.
For example, Moni Nig. Ltd on January 1, 2024, buys electronic items from ABC Inc., a US-based electronics company for $1,000, and the prevailing exchange rate at the date of the transaction is ₦1500: $1, payable by June 31, 2024. This would imply that upon settlement of the purchase credit, Mr. is to pay the sum of ₦1,500,000, applying the exchange rate. However, where on May 1, 2024, the exchange rate becomes ₦2000: $1, this would mean that at the close of the transaction, Mr. A would pay the sum of ₦2,000,000. But since this liability is not due, it would only amount to an unrealised exchange loss of ₦500,000 (₦2,000,000 – ₦1,500,000). In the same vein, if before the close of the transaction, the exchange rate revalues to ₦1000: $1 Moni Nig. Ltd would have a credit liability of ₦1,000,000 at the close of the transaction which is a gain of ₦500,000 (₦1,500,000 – ₦1,000,000). But since the debt is still unsettled, the ₦500,000 is only an unrealised foreign exchange gain.
On the other hand, whereas at June 31, 2024, the exchange rate is placed at ₦500: $1, Moni Nig. Ltd will only pay the sum of ₦500,000 which is a realised exchange gain of ₦1,000,000 (1,000,000 - 500,000); where the currency revalues to ₦2000: $1, Moni Nig. Ltd would have incurred (realised) a foreign exchange loss of ₦500,000 (₦2,000,000 – ₦1,500,000).
In this regard, the FIRS provides clarity to the effect that unrealised exchange gains and losses should be ignored when determining tax liability as they do not increase or decrease tax liability. The IFRS through IAS 21 – The Effects of Changes in Foreign Exchange Rates (ISA 21), requires unrealised gains or losses to be recorded as profit or loss in the financial statements of a company unless they arise from hedged transactions in which case, they may be deferred until the hedged is realised as either profit or loss. The FIRS however maintains that they do not determine tax liability and should be ignored.
Realised exchange differences should be considered in computing tax liability as they would either increase (in the case of a realised exchange gain) or decrease (in the case of a realised exchange loss) tax liability. Realised exchange gains or losses could either serve as taxable income or deductible expenses.
The IFRS in, IAS 21 – The Effects of Changes in Foreign Exchange Rates, provides that the functional currency, for the purpose of presenting the financial statements of an entity engaged in foreign currency transactions, should be the currency of the primary economic environment in which the entity operates. This would be the Naira currency, assuming Moni Nig. Ltd, in our example above, is an entity for this purpose. Again, IFRS requires that while initial financial statements are to be recorded at the exchange rate at the date of the transaction, subsequent financial statements should be recorded using the prevailing rate at the close of the transaction. This is relevant because, like the IFRS, the FIRS requires a company to record and report its transactions at the prevailing exchange rates in order to arrive at any realised or unrealised exchange gains or losses which would determine whether there will be tax liability on a foreign currency transaction or not.
4. Monetary and Non-Monetary Items
The FIRS determines exchange differences in the light of monetary and non-monetary items as follows:
a. Exchange differences on the settlement or recovery of a monetary item are treated as realised exchange differences. Monetary items are items that have fixed numerical value in any given currency. They come in form of cash, deposit in bank or cash receivable or payable. Non-monetary items, on the other hand, are items that do not have an immediate currency value. They include tangible assets such as inventory, plants, equipment, and so on; or intangible assets such as shares, patents, or copyrights. In determining exchange differences, cash paid out or recovered at the close of a foreign currency transaction will be treated as a realised exchange difference.
b. Exchange differences on foreign currency transactions would be realised upon conversion to another currency or another class of monetary or non-monetary item.
c. Exchange differences on any item that is monetary in nature are treated as taxable income or deductible expense for income tax purposes. This is because, unlike unrealised exchange differences, exchange differences determine tax liability for a company in any foreign transaction.
5. Hedging Transactions
Foreign exchange differences arising from hedging transactions are not taxable income or deductible expenses until the hedged item is realised.
6. Tertiary Education Tax (TET)
The FIRS maintains that the tax treatment of exchange difference in a foreign currency transaction shall also apply to TET. Exchange differences which are treated as taxable income or deductible expenses when computing Companies Income Tax (CIT) will also be treated in computing taxable profits when computing TET.
7. Other Taxes and Applicable Tax Exemptions
Unrealised exchange differences do not adjust the computation for taxes such as the National Agency for Science and Engineering Infrastructure (NASENI) levy at 0.25% of the profit before tax for eligible companies, National Information Technology Development Agency (NITDA) levy at 1% of profit before tax payable by companies specified in the NITDA Act, minimum tax payable under the CITA (which is paid at the rate of 0.5% of gross turnover less franked investment income pursuant to section 33(2) of CITA ). Again, exchange differences arising from an item that is exempt from tax are not taxable or deductible. An example is any realised exchange profit or loss arising from the disposal of the Federal Government of Nigeria's (FGN) Eurobonds.
8. Documentation and Returns
The FIRS mandates every company to keep detailed records of all foreign currency transactions which records must reflect the dates, amounts, counterparty, and applicable exchange rates of the transaction. Companies are also required to provide a reconciliation of exchange differences recognised in their financial statements. This is to ensure consistency in the financial records of the company while avoiding discrepancies so as to allow for accurate tax computation.
9. Artificial Transaction
In a bid to prevent tax avoidance by companies, the FIRS is (by the Circular), empowered to make necessary adjustments where it determines that a taxpayer manipulates its realised profits or losses in a foreign transaction with the principal purpose of tax avoidance.
The FIRS also notes that commissions, fees, and other charges associated with foreign exchange transactions shall be subject to the wholly, reasonably, exclusively, and necessarily (WREN) test to determine tax deductibility.
Conclusion
While the IFRS provides guidance on the treatment of foreign exchange transactions in the financial statements of companies, the guide does not address how foreign transactions should be treated for tax purposes. With the Circular, the FIRS provides clarity on what will be the taxable income in a foreign exchange transaction. Taxpayers need to have a firm grasp of the complex nature of foreign exchange transactions and the fluctuations in the exchange rates in order to ensure financial records are prepared in line with the prevailing exchange rates. This would aid the FIRS in arriving at an accurate computation of their tax liability.
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