The Federal Inland Revenue Service (FIRS) recently issued an Information Circular to provide clarity on the appropriate tax treatment of foreign exchange (forex) transactions. This guidance is crucial for taxpayers, tax practitioners, and tax officials, especially in light of the complexities inherent in forex dealings. In this newsletter, we highlight the key points of the circular, drawing parallels with the treatments prescribed under the International Financial Reporting Standards (IFRS).
1. Introduction
While IFRS outlines the accounting treatment for foreign currency transactions, the FIRS highlights that these treatments may not align with Nigeria’s tax rules. Adjustments are often necessary to determine the correct tax liabilities. This Information Circular aims to clarify these adjustments to ensure compliance with Nigerian tax laws.
2. Legal Framework
According to the FIRS, only expenses that are wholly, exclusively, necessarily, and reasonably incurred in generating taxable income can be deducted. This aligns with the provisions of the Companies Income Tax Act (CITA), Personal Income Tax Act (PITA), and Petroleum Profits Tax Act (PPTA).
3. Foreign Exchange Differences
Foreign exchange differences arise when there is a variation between the exchange rates at the transaction date and the reporting or settlement date. IFRS similarly addresses this in IAS 21 – The Effects of Changes in Foreign Exchange Rates, which requires that transactions be recorded at the rate prevailing at the date of the transaction and subsequently revalued at the reporting date.
4. Classification of Foreign Exchange Transactions
The FIRS categorizes forex differences into revenue and capital differences. Revenue differences stem from income-generating transactions and are included in the assessable profits for tax purposes. Capital differences arise from non-revenue transactions and impact capital gains tax.
Illustration:
- Revenue Difference: A bank granting a loan and the exchange difference impacting its income.
- Capital Difference: A customer using a loan to purchase a non-current asset.
Under IFRS, the classification aligns with the nature of the underlying transaction and whether the item is monetary or non-monetary.
5. Realized and Unrealized Exchange Differences
Realized exchange differences occur when the transaction is settled at a rate different from the initial booking rate, thus affecting the tax computation. Unrealized differences, however, arise from revaluations for reporting purposes and do not impact the tax liability.
IFRS Insight: IAS 21 mandates that unrealized gains and losses be recognized in profit or loss unless they arise from a qualifying cash flow hedge, where they might be deferred in equity until the hedge transaction affects profit or loss.
6. Treatment of Capital Exchange Differences
Realized capital exchange losses from non-current assets are not tax-deductible but can be added to the asset’s cost for capital allowances. Conversely, capital exchange gains are subject to capital gains tax.
Illustration:
- Loss: Importing equipment at N120/$1 and paying at N150/$1 results in a realized loss added to the asset’s cost.
- Gain: If the rate falls to N100/$1 at payment, a realized gain occurs, subject to CGT.
7. Monetary and Non-Monetary Items
For monetary items, exchange differences are treated as taxable income or deductible expenses unless tied to a capital transaction. Non-monetary items’ exchange differences depend on the transaction nature.
IFRS Comparison: IAS 21 differentiates between monetary items, revalued using closing rates, and non-monetary items, valued at historical rates, with their forex differences recognized in equity or profit and loss based on the item classification.
8. Hedging Transactions
Forex differences from hedging are not taxable until the hedged item is realized, aligning with IFRS 9 – Financial Instruments, which governs hedge accounting.
9. Tertiary Education Tax (TET)
The tax treatment for forex differences for CIT purposes similarly applies to TET, ensuring consistency in tax computations.
10. Other Taxes and Tax Exempt Items
Unrealized forex differences do not adjust the computation for 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; or minimum tax under CITA. Additionally, forex differences from tax-exempt items, such as FGN Eurobonds, are not taxable or deductible.
11. Documentation and Returns
Entities must maintain detailed records of forex transactions, including dates, amounts, and exchange rates. A reconciliation of exchange differences must also be provided in the financial statements.
12. Artificial Transactions
The FIRS warns against artificially manipulating forex gains or losses to avoid taxes. Necessary adjustments will be made to counteract such practices, particularly in related-party transactions.
Conclusion
Navigating the tax treatment of foreign exchange transactions requires careful consideration of both local tax regulations and international accounting standards. By understanding the nuances highlighted by the FIRS and aligning them with IFRS, taxpayers can ensure accurate reporting and compliance.
For professional assistance on these matters, feel free to contact us at Vi-M Professional Solutions, via our email, clients@vi-m.com. We are here to help you navigate these complexities and optimize your tax positions.