When businesses engage in cross-border transactions, they sometimes incur foreign exchange losses or generate foreign exchange gains. The Income Tax Act, 2015 (Act 896) contains rules on the amount of exchange loss that a business can deduct in a year. This article reviews the proposed new rules that are likely to apply in addition to the existing rules and concludes that the existing rules are sufficient. The new rules create some problems.
Under the repealed Internal Revenue Act, 2000 (Act 592), which operated between 2001 and 2015, not every exchange loss was deductible. In 2002, the Internal Revenue Regulations, 2001 (L.I. 1675) was amended to provide that only exchange losses and gains which were realised were to be considered in tax computations. The amendment went ahead to explain what it meant for an exchange difference to be realised. It said, “A foreign currency exchange gain or loss is realised when the liability under a contract in foreign currency is discharged or when the right to receive a foreign currency under a contract is satisfied by actual receipt.”
These old rules under L.I. 1675 were difficult to follow. This was because it required a business to track every unrealised exchange difference recorded in the past and make a note when the liability was discharged or there was actual receipt. The accounting rules do not contain this separation and so the financial accountants do not track exchange differences this way. Extra effort was needed to accurately confirm that an exchange difference from the past was realised. Some taxpayers developed a rule that any unrealised exchange difference became realised the next year.
The existing rules, which we started using from 2016, were simpler to apply. They are less advantageous to the taxpayer, but the taxpayer does not need a lot of work to claim a deduction. The 2016 rules say that a taxpayer does not need to worry about realisation of an exchange loss. The accounting rules that allowed the taxpayer to deduct unrealised exchange loss will be followed by the tax rules. However, not every exchange loss can be deducted by a taxpayer. There is a limit.
The limit on exchange loss to be deducted, realised or not, needs to be calculated each year. The formula uses financial gain and loss. For most businesses, this translates entirely to exchange differences. The limit is determined by two variables. The first is the total exchange gain earned by the taxpayer. The other variable is 50% of the chargeable income that is calculated as if no exchange gain was earned or no exchange loss was incurred. The sum of these two variables is the limit for deduction of exchange loss. Any exchange loss that cannot be deducted in a year must be carried forward for up to five years. If at the end of the fifth year the exchange loss has not been deducted, the taxpayer loses the right to deduct it forever. So, a taxpayer must match its exchange loss against any exchange gain. If in a year there is no exchange gain then unless the taxpayer already has a tax profit, no exchange loss can be deducted. Essentially, a taxpayer who makes a tax loss and has no exchange gain cannot deduct any exchange loss.
The Government is now proposing to revert to the old rules by denying tax deduction for any unrealised exchange loss. The Income Tax (Amendment) (No.2) Bill, 2022, which is still in Parliament, will restrict deduction of exchange losses to actual losses. It says, “An unrealised foreign exchange loss shall not be allowed as a deduction.” That means for exchange losses alone, we will now have two separate rules. The first rule is that only realised exchange losses will be eligible for tax deduction. Secondly, these realised exchange losses will have a limit. The way the Bill is written means there will be no change to the existing rule. So, the limit for deduction of realised exchange losses will continue to be the sum of the total financial gain and 50% of the chargeable income that is calculated without any financial
gain or cost.
The proposed amendment does not mention anything about unrealised exchange gain. As you may note from the old rules, both unrealised exchange losses and gains were excluded until they became realised. The new rules focus only on the losses. This means unrealised exchange gains must be taxed, even if the losses are not deducted. This creates a problem.
Let’s assume a business enjoys the services of a foreign company in January 2023. In February 2023, the business receives an invoice of US$10,000. The exchange rate at the time of booking this invoice is US$1/GHS12. So, the business accrues GHS120,000 (US$10,000 * 12). At the end of 2023, the exchange rate becomes US$1/GHS10. The business therefore remeasures the invoice to GHS100,000 and records an exchange gain of GHS20,000 (120,000-100,000). The new rules do not affect this unrealised exchange gain and so it will be taxed. Let’s continue to assume that in 2024, this invoice remains unpaid and at the end of 2024, the exchange rate reverts to US$1/GHS12. That means the invoice value goes back to GHS120,000. The business must record an exchange loss of GHS20,000. The new rules say this GHS20,000 cannot be deducted unless the invoice is paid. The 2024 exchange loss is a reversal of the 2023 exchange gain. Since the rules only affect one side, it creates this problem of taxing any unrealised gain, but if that gain is reversed, the tax reversal can only be done
when there is an actual payment.
Countries with exchange loss rules either have the existing rules or the old rules. Ghana’s attempt to blend the old rules with the existing rules is unusual. A taxpayer that defers deduction of unrealised exchange losses in a year can pretend those losses have not been realised after two years. There is incentive to do this if the taxpayer notices that due to the existing rules, if it treats the losses as realised, it will be unable to deduct the full amount. Rather than treat the losses as realised and potentially lose it after five years, it will wait till a time it can deduct the full amount. Taxpayers will then be able to determine the time for deducting such expenses Further, taxpayers may stop separating exchange losses from gains in their general ledger. They will report a net amount such that only the net unrealised exchange loss will be excluded.
It is possible that the new rules are being introduced due to the performance of the Ghanaian cedi in 2022. The Government has not explained any deficiency in the existing rules, which the Memorandum to the Bill should have captured. Further, the new rules will only apply from 2023 and will not affect the losses from 2022. Our view is that the existing rules are very robust, and these new rules are not needed, especially with difficulties in confirming realisation. With the existing rules, even if a taxpayer incurs significant exchange losses, unless it has a commensurate amount of exchange gain, it cannot deduct the full amount. If in a year, a taxpayer fails to deduct an exchange loss, it only has five years, regardless of whether the loss is realised or not. The new rules allow the taxpayer to defer the start of the five years until it can be proven that the liability that generated the exchange loss has been settled.
Parliament’s Finance Committee has already reviewed this Bill and proposed some amendments to the Bill. Some Members of Parliament have also proposed some other amendments. We urge Parliament to consider a further amendment when the Bill gets to the Consideration stage to ensure unrealised exchange gains are also not taxable until they are realised.
This further amendment should correct the taxation of unrealised gains that used to be unrealised losses. It is better for Ghana to either apply the old rules fully or stick to the existing rules. This combination of rules will create a lot of problems, especially when the possibility of huge exchange loss deductions is already controlled by Act 896. Finally, the conditions for realisation of exchange differences, which existed under the old rules should be repeated for certainty.
Laura T. FIAGOME and Odzangbateh DAKE are chartered accountants and members of the Chartered Institute of Taxation, Ghana. The comments below are their personal views. Email [email protected] or [email protected] to react to this article.