Loans to Connected Persons in Foreign Currency
04 April 2013
Posted by: Author: Prof Alta Koekemoer & Doria Cucciolillo
Source: Prof Alta Koekemoer & Doria Cucciolillo
When a South African resident company enters into a loan agreement with a connected person (which may include a controlled foreign company) and the transaction involves a foreign currency, certain income tax implications may arise.
The repayment of the loan that was initially granted is not included in the calculation of taxable income since the amount is capital in nature. Therefore the receipt of such an amount (the capital portion, excluding interest) will not be subject to normal income tax and the debtor will not be entitled to an income tax deduction when the loan is repaid.
However, in the event where the transaction involved a foreign currency, the income tax implications that may arise from exchange differences must be considered. Since the exchange rate fluctuates from day-to-day, it is almost certain that the exchange rate on the date that the loan agreement was concluded (hereafter referred to as the transaction date) will differ from the ruling exchange rate when repayment of the loan takes place.
The abovementioned exchange differences may have the following income tax implications for the resident company: If the company borrowed funds to a connected person in a foreign currency an increase in the exchange rate on the date payment is received will result into additional income (when converted to the Rand-equivalent) for that company. Consequently, the resident company will be taxed on the capital portion of the payment to the extent that it relates to a difference in the exchange rate. The opposite implications will apply if payment is received on a date which reflects a decreased exchange rate. In such an instance, the Rand-equivalent of the amount received will be lesser than the debt originally made available to the debtor. Therefore, the exchange difference will represent an allowable deduction for the resident company.
The exchange difference resulting from the realisation of the debt needs to be included in the calculation of the resident company’s taxable income. Realisation of a debt instrument normally takes place when the loan is repaid.
Therefore, the exchange rate on transaction date must be compared to each exchange rate that applies when payment is received (realisation date). If a difference in the exchange rate is observed, it must be multiplied with the payment that is received and included in the resident company’s taxable income as a foreign exchange income or loss. This evaluation needs to be done each time payment is received in respect of such loans.
From the above it is clear that, according to the old rules, the recognition of foreign exchange differences were deferred until the date on which the debt instrument was realised. Therefore, no exchange difference was included in taxable income during a year of assessment in which the parties entered into the loan agreement. It was rather postponed until the year of assessment in which payment was received.
New rules were introduced in 2012 and with it a deemed realisation provision which provides that if the resident company’s year of assessment commences on or after the first day of January 2014, the outstanding balance of any foreign loans will be deemed to have realised at the end of the year of assessment that precedes the year of assessment that commence on or after the first day of January 2014. The difference between the exchange rate that applied when the loan was granted and the exchange rate at the end of the company’s year of assessment needs to be determined. This exchange difference must be multiplied with the total outstanding balance on 1 January 2014 to determine the amount that needs to be included as a foreign exchange profit or loss in taxable income. In my opinion, no further tax implications will arise when actual realisation takes place (therefore, when future payments are received) since deemed realisation already occurred for tax purposes.
Amendments were made to Income Tax legislation and different rules will apply on certain transactions between companies in the same group and connected persons if it takes place during a year of assessment that commence on or after the first of January 2013. Recognition of exchange differences are still deferred until realisation date, but instead of comparing the exchange rate on transaction date with the exchange rate on the payment date (realisation date), the exchange rate at the end of the year of assessment preceding the year in which payment is made, will be used to calculate the exchange difference.
Effect of exchange differences on interest
If interest is receivable on foreign exchange loans, the full amount thereof must be included in the taxable income of the resident company. In the event where the payment is received in a foreign currency, the interest portion is converted to its Rand-equivalent using the exchange rate applicable on the date that the interest was paid or had accrue to the resident company, and this amount is included in its taxable income.
In order to illustrate the above, let us assume the following situation: A South African resident company grants a loan of $1 million to a company in the same group which is situated in the United States. The transaction took place on 1 July 2010, when the exchange rate amounted to $1 = R7.41. During its current year of assessment (ending on 30 September 2013), the foreign company repaid a capital portion of the loan amounting to $500 000. In addition, an amount of $60 000 was received as interest. The exchange rate on the date of this payment was $1 = R9.20.
When a comparison is made between the Rand-equivalent of a Dollar on the date the loan was granted and the date payment is received, it is clear that the resident company received a higher amount (when converted to Rand-equivalent) in relation to the amount initially borrowed to the foreign company. Therefore the resident company has to include a foreign exchange profit in its taxable income that is calculated as follows: The payment received ($500 000) multiplied with the difference between the exchange rate on the date the loan agreement took place and the exchange rate on the date payment was received, amounting to R1.79 (R9.20 – R7.41). The foreign exchange difference will therefore result into a profit of R895 000 (R1.79 x $500 000) that needs to be included in the resident company’s taxable income. If there is still an outstanding balance on the loan at the year of assessment ending on 30 September 2014, that amount is deemed to have realised on the before mentioned date. Therefore the exchange rate on 30 September 2014 must be compared to the R7.41 on 1 July 2010. The exchange difference will be applied to the full outstanding balance of the loan on 30 September 2014 in order to determine the amount that must be included in the taxable income for that year. Therefore, under the old rules, any unrealised gain or loss becomes taxable or deductible on 30 September 2014.
In order to illustrate the impact which recent amendments to the Act will have on similar transactions, let us assume that the initial loan was granted on 1 November 2013 when the exchange rate was $1 = R8.50. Also assume that the exchange rate on 30 September 2014 will be $1 = R8.20 and that the company receives the first installment on 1 November 2014 when the exchange rate is $1 = R7.30.
Since the loan was granted during a year of assessment that commenced after 1 January 2013, the calculation of the foreign exchange difference is based on the exchange rate at the end of the year of assessment that immediately precedes the year of assessment in which payment is received. Therefore the exchange difference will be set at the difference between the exchange rate on 30 September 2014 (R8.20) and the exchange rate on the transaction date (R8.50). An exchange difference of R0.30 arises and since it represents a decline in the exchange rate, a deduction will be allowed for income tax purposes for the foreign exchange loss that was incurred. The company will be entitled to a deduction of R150 000 (R0.30 x $500 000) for income tax purposes during its year of assessment ending on 30 September 2015. No tax implications will arise on the date payment is received, although it represents the actual realisation date of a portion of the loan. Although the wording of the Act is not specific in this regard, it seems that in terms of the calculation that is prescribed by the Act, deemed realisation occurred at the end of the year of assessment preceding the year in which payment was received.
The full amount of interest that is received will be included in the South African company’s taxable income once it is converted to its Rand-equivalent using the exchange rate applicable on the date payment is received. In this instance an amount of R552 000 ($60 000 x R9.20) will be included in taxable income during the year of assessment it is received.
List of References
Republic of South Africa. 1962. Income Tax Act 58 of 1962, as amended. Government Gazette.
Stiglingh, Koekemoer, van Schalkwyk, Wilcocks & de Swart, SILKE: South African Income Tax 2013(Durban: LexisNexis Butterworths, 2012), 712 – .714