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News & Press: Opinion

Connected Person Forex Rules To Provide Limited Protection

12 June 2013   (0 Comments)
Posted by: Author: David Warneke
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Author: David Warneke (BDO)

The current Income Tax rules that defer tax effects for related party debts and other exchange items are to be replaced with new, revised rules. The revised rules are generally narrower than the current rules and the replacement of the old rules will trigger both one-off and ongoing tax effects for many taxpayers, the majority of which, one suspects, are unaware of the consequences.

The current rules are contained in section 24I(10) of the Income Tax Act (‘the Act’). If, for example, a forex gain arises on a loan owing by a South African resident subsidiary and its non-resident parent that is hedged by a forward exchange contract (‘fec’) or a foreign currency option contract (‘fcoc’), the gain is deferred until realisation in terms of these rules. However, a recent amendment to section 24I(10) provides that such a gain will be deemed to have been realised and will have to be accounted for on ‘the last day of the last year of assessment... ending before the year of assessment ... commencing on or after 1 January 2014’. This means that such gain will have to be accounted for on such last day if it has not been realised by such last day. For taxpayers with a year of assessment that ends on 31 December, such last day will be 31 December 2013. For taxpayers with a year of assessment that ends on the last day of February, it will be 28 February 2014. [By contrast, the new rules are effective in respect of years of assessment commencing on or after 1 January 2013. There is therefore a timing overlap between the rules]. Where the loan is fully hedged the associated loss on the hedge will also be triggered, thereby offsetting the financial effect of the deemed realisation treatment. However, if the loan is only partially hedged, the deemed realisation treatment will apply to the full amount of the loan and the partial hedge, with potentially severe consequences. 

It should however be noted that if the forex gain or loss falls within the protection afforded by the new rules, it would appear to be the intention that this deemed realisation treatment will not apply and the protection afforded by the new rules, which also amount to a deferral of unrealised forex gains and losses, will kick in. The new rules are contained in section 24I(10A) of the Act.

The new rules are generally more limited in scope than the current rules and there are a number of instances in which the new rules will not apply. In such instances, the deemed realisation treatment referred to above will be triggered. The aim of the new rules appears to be to more closely align the deferral treatment with that under IFRS. 

Unlike the old rules, the new rules apply to debts only, and not to other types of exchange items. The old rules cater for exchange differences arising between a resident and a controlled foreign company (‘CFC’) in relation to the resident or in relation to any other resident company which is part of the same group of companies as the resident and to exchange differences arising on exchange items between two CFC’s of the same resident. The new rules, however, require that the parties to the exchange item must, at the end of the year of assessment, either be connected persons in relation to each other or form part of the same group of companies. Therefore, the new rules will not afford protection in circumstances where an exchange item arises between a resident (‘A’) and a CFC (‘B’) that is not a connected person and does not form part of the same group of companies as A. For example, if B is a CFC by virtue of the holding of the majority of the participation rights by other unconnected residents, but the holding of the participation rights in B by A (and other companies in the same group as A) is insufficient to make B a connected person in relation to A. 

The wording of the new rules suggests that the deferral treatment will not apply at all to debts that are hedged, even if only partially. In other words, the deferral will not apply to any amount of such debts. 

The provision housing the old rules, section 24I(10), suffers from the defect that, although it triggers the deemed realisation treatment referred to above, it does not state that it ceases to apply thereafter. However the intention appears to be for the new rules to take the place of the old and hence I have referred to the replacement of the old rules with the new rules.

An ambiguity in section 24I(10) has been addressed in section 24I(10A) in that the new provision makes it clear that if the parties to the contractual provisions of the exchange item are not connected persons in relation to each other and no longer form part of the same group of companies at the end of the year of assessment, the exchange item is deemed to be realised. Under section 24I(10) it was unclear at which stage the determination of whether the parties were connected persons, or otherwise met the requirements of the provision, had to be made.

It should also be noted that in the case of debts that are current assets or current liabilities for purposes of IFRS, the new rules only give deferral if the debt is not funded externally. In other words, if the debt is not directly or indirectly funded by any debt owed to a person that does not form part of the same group or is not a connected person in relation to either of the parties to the contractual provisions of the debt. By contrast, the old rules potentially afforded deferral treatment under these circumstances.

The new rules are wider than the old in that the deferral treatment under the old rules only applied where the resident and a company were party to the exchange item. The new rules merely require the parties to be connected persons.

In summary, where a taxpayer currently enjoys deferral treatment under section 24I(10) it is important to ascertain whether or not the deferral can continue to be enjoyed under section 24I(10A). In particular it should be noted that the new rules will not afford deferral treatment in respect of exchange items that are:

  • Hedged;
  • Current assets or current liabilities that are funded externally; or
  • Contractually between a CFC and another person where the CFC is neither a connected person nor a member of the same group of companies as the other person.

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