Income tax: foreign exchange gains and losses of a capital nature - foreign currency bank accounts

This Ruling explains how foreign exchange gains and losses of a capital nature resulting from foreign currency bank accounts are brought to account under Division 3B of Part III of the Income Tax Assessment Act 1936 (ITAA). The Ruling proceeds on the general principles outlined in Taxation Ruling TR 93/8 in relation to the realisation of foreign exchange gains and losses.

The relationship between banker and customer in respect of a bank account is that of debtor and creditor and has its basis in contract law. That is, upon receiving proceeds under a customer's account a bank undertakes to repay that amount upon the request of the customer. Thus when customers deposit money into bank accounts, they acquire contractual rights. Similarly, when an amount is withdrawn from a bank account some or all of these previously acquired rights are extinguished or satisfied.

Where a bank account is denominated in a currency other than Australian dollars (ie a foreign currency bank account), the Australian dollar equivalent (ADE) of the amount withdrawn will typically differ from the ADE of the corresponding deposit amount. Thus, each withdrawal from a foreign currency bank account could give rise to a foreign exchange gain or loss.

Where foreign exchange gains and losses arising from a foreign currency bank account are on revenue account, the general assessing and deduction provisions of the ITAA (subsections 25(1) and 51(1)) will apply. This Ruling does not address the application of these provisions.

Where these gains or losses are on capital account, the provisions of Division 3B of Part III of the ITAA will generally apply in the first instance. Where Division 3B applies, the capital gains and losses provisions (Part IIIA of the ITAA) will not have a practical effect due to the operation of subsection 160ZA(4) and section 160ZK.

For the purposes of determining the cost to a taxpayer of the amount withdrawn (ie the ADE of the amount deposited) the first in first out (FIFO) and weighted average methods of accounting are considered acceptable. Whichever method is adopted by a particular taxpayer must be applied consistently.

This Ruling applies to years commencing both before and after its date of issue. However, the Ruling does not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).

The relationship between banker and customer in respect of a bank account is that of debtor and creditor: Foley v Hill and Ors (1848) 2 HL Cas 28; [1843-60] All ER Rep 16. Thus when a customer deposits money into a bank account the customer becomes a creditor of the bank. That is, the nature of the relationship has its essence in contract law. Thus when a customer deposits money into a bank account, this creates implied contractual rights for the customer and contractual obligations on the banker.

In N . Joachimson v Swiss Bank Corporation [1921] 3 KB 110, the nature of the terms of the contract between the banker and customer was considered in some detail. Atkin LJ, in the course of his analysis of this contractual relationship described it in part at 127 as: " I think that there is only one contract made between the bank and its customer . The terms of that contract involve obligations on both sides and require careful statement. They appear upon consideration to include the following provisions. The bank undertakes to receive money and to collect bills for its customer's account. The proceeds so received are not to be held in trust for the customer, but the bank borrows the proceeds and undertakes to repay them." (underline added)

Thus upon receiving proceeds under a customer's account a bank undertakes to repay that amount upon the request of the customer. When customers deposit money into bank accounts, they acquire contractual rights. Similarly, when an amount is withdrawn from a bank account some or all of these previously acquired rights are extinguished or satisfied.

This does not mean (or require) that each deposit made by a customer represents a new contract. Rather, the nature of the contractual relationship remains constant. That is, there is but a single chose in action in respect of the customer's right to be repaid the amount previously deposited: Hart ( Inspector of Taxes ) v Sangster [1957] 1 Ch 329; [1957] 2 All ER 208. In that case Lord Goddard CJ said at Ch 337 (2 All ER at 210) that: "I cannot agree that where a deposit account is kept between a customer and a banker there is a new contract every time money is paid in. ... There is no difference between a deposit account and a current account so far as the relationship of banker and customer is concerned. The relationship is perfectly clear. The leading case, of course, is Foley v Hill (1848) 2 HL Cas 28, mentioned in Atkin LJ's judgement in Joachimson v Swiss Bank Corporation [1921] 3 KB 110. It is that of debtor and creditor; the banker borrows the money from the customer under terms to repay it." (See also Walker v The Bradford Old Bank Limited [1884] 12 QB 511, Alcom Ltd v Republic of Columbia [1984] 1 AC 580, Halsbury's Laws of England , Volume 3(1), 4th edition, p.131.)

As referred to in this Ruling, a foreign currency bank account is a bank account denominated in a currency other than Australian dollars. The bank account can be located either in Australia or in another country.

The Australian dollar equivalent (ADE) of the amount withdrawn will typically differ from the ADE of the corresponding deposit amount. Thus each withdrawal from a foreign currency bank account could give rise to a foreign exchange gain or loss under the ITAA. An illustration of why this is the case and how that gain or loss might effectively offset a foreign exchange gain or loss arising under another contract is contained in Example 1 at paragraph 28 below.

In some circumstances foreign exchange gains and losses arising from foreign currency bank accounts will be on revenue account: see for example AVCO Financial Services Ltd v FC of T (1982) 150 CLR 510. Where this is the case, the general assessing and deduction provisions of the ITAA (subsections 25(1) and 51(1)) will apply. This Ruling does not address the application of these provisions.

For other taxpayers, foreign exchange gains and losses arising from foreign currency bank accounts will be on capital account. The relevant provisions of the ITAA are Division 3B of Part III (Division 3B) and the capital gains and losses provisions in Part IIIA.

The operation of Division 3B was outlined broadly in paragraphs 17 to 22 of Taxation Ruling TR 93/8. Broadly speaking, Division 3B generally has the effect of treating foreign exchange gains and losses of a capital nature incurred in the course of deriving assessable income, or in carrying on a business for that purpose, as on revenue account for tax purposes.

Foreign exchange gains and losses from foreign currency bank accounts will not be taken into account under Division 3B where the holding and operation of the bank account is not related to the gaining or production of the taxpayer's assessable income or to the carrying on by the taxpayer of a business for that purpose. It also has no application to gains and losses of a private or domestic nature or to those gains made, or losses incurred, in relation to the production of exempt income (subsections 82U(2) and 82U(3)). Thus only those foreign currency bank accounts that satisfy these tests will be within the scope of Division 3B. Whether this is so will need to be determined in the light of the circumstances of each case.

Division 3B applies to a gain or loss to the extent to which it is attributable to currency exchange rate fluctuations ('currency exchange gain' and 'currency exchange loss' as defined in subsection 82V(1)). Foreign exchange gains and losses realised under eligible contracts are, respectively, assessable income and allowable deductions (section 82Y and subsection 82Z(1)).

When a customer withdraws an amount from a foreign currency bank account it is in return for the disposal of some or all of his or her contractual rights against the bank. Thus each withdrawal will constitute a point of realisation of a foreign exchange gain or loss as explained in Taxation Ruling TR 93/8 (in particular at paragraphs 36 to 41). Where only part of the balance of an account is withdrawn it will constitute a disposal of that part of the balance and thus a realisation of the foreign exchange gains and losses on that portion (paragraphs 42 and 43 of Taxation Ruling TR 93/8).

Most foreign currency bank accounts involve a number of transactions, both withdrawals and deposits. Money placed into a bank account forms a single chose in action (see paragraphs 8 to 11 of this Ruling). It is thus generally not possible to specifically identify an individual withdrawal relating to any particular deposit into the account. In Drevaynes and Ors v Noble and Ors , Baring v Noble and Ors ( Clayton's case ) 1 Mer 572; 35 ER 781; [1814-23] All ER Rep 1, Sir William Grant MR observed (All ER Rep 1 at 6) that: "The present is the case of a banking account where all the sums paid in form one blended fund the parts of which have no longer any distinct existence . Neither banker nor customer ever thinks of saying: This draft is to be placed to the account of the £500 paid in on Tuesday. There is a fund of £1000 to draw upon, and that is enough. In such a case, there is no room for any other appropriation than that which arises from the order in which the receipts and payments take place, and are carried into the account. Presumably, it is the sum first paid in that is first drawn out . It is the first item on the debit side of the account that is discharged or reduced by the first item on the credit side . The apportionment is made by the very act of setting the two items against each other." (underlining added)

Accordingly for the purposes of determining the cost to a taxpayer of the amount(s) withdrawn from a foreign currency bank account (ie the ADE of the relevant amount deposited) the first in first out (FIFO) method is considered acceptable. This method assigns costs on the assumption that the outstanding balance represents the most recent deposits into the account. This method was accepted by this Office in Taxation Ruling IT 2350, in relation to the valuation of trading stock.

Another method of determining the cost of the amount(s) withdrawn is the weighted average cost method. That is, the cost of a withdrawal is the weighted average of the deposits made into the account. This weighted average can be determined for each withdrawal or for a year of income. Thus there are effectively two weighted average methods. Both these methods are also acceptable methods of determining the ADE cost of amounts withdrawn from a foreign currency bank account. (The average cost method was also accepted by this Office in Taxation Ruling IT 2350, in relation to the valuation of trading stock.)

A taxpayer can adopt the FIFO or one of the weighted average methods for the purposes of determining the cost of amounts withdrawn from foreign currency bank account(s). However the method adopted must be applied consistently, as regards all the transactions in the foreign currency bank account(s) of that taxpayer, both within any one year of income and between years of income.

The application of each of these methods is outlined in Example 2 at paragraphs 29 to 53 of this Ruling.

A deposit in a foreign currency bank account is an asset for the purposes of the capital gains and losses provisions of Part IIIA of the ITAA (paragraph 160A(a)). The capital gains and losses provisions can thus apply to foreign exchange gains and losses from foreign currency bank accounts: see broadly section 160Z, subsection 160K(5), sections 160ZH and 160ZO.

Where both Division 3B and the CGT provisions apply to foreign exchange gains and losses from a foreign currency bank account (ie the taxpayer is the creditor), then the amount of any foreign exchange gain included in, or to be included in, the assessable income of that taxpayer under section 82Y in Division 3B will reduce the amount of the capital gain commensurately by virtue of subsection 160ZA(4). Similarly the amount of any capital loss will effectively be reduced by the amount of any allowable deduction made under subsection 82Z(1) by virtue of the operation of section 160ZK.

Where Division 3B has no effective application to a foreign currency bank account, then the capital gains and losses provisions of Part IIIA may have effect. The calculation of any resulting capital gain or loss is not outlined in this Ruling.

An Australian resident company borrows $US1,000,000 on 1 July 1991 and immediately deposits this sum in its US dollar denominated bank account. On 30 June 1992, the company repays the loan by withdrawing $US1,000,000 from the bank account. Assume the ADE of this amount was $A1,000,000 on 1 July 1991 and $A900,000 on 30 June 1992. The result will be the realisation of a foreign exchange gain on the loan of $A100,000 ($A1,000,000 - $A900,000) and a foreign exchange loss on the foreign currency bank account of $A100,000 ($A900,000 - $A1,000,000). This can be summarised as: Date Loan ($ US ) Loan ( ADE ) Bank account ($ US ) Bank account ( ADE ) 1 July 1991 1,000,000 1,000,000 (1,000,000) (1,000,000) 30 June 1992 (1,000,000) (900,000) 1,000,000 900,000 Foreign exchange gain /( loss ) 100 , 000 ( 100 , 000 )

For the purposes of this example assume the following transactions of a capital nature took place in a foreign currency ($US) bank account opened on 1 July 1992 for the 1993 year of income. Assume also that the bank account is held in relation to the carrying on of a business. Date Deposit ($US) Withdrawal ($US) Account Balance ($US) 1 July 1992 100,000 100,000 15 July 1992 25,000 125,000 20 August 1992 30,000 155,000 30 September 1992 10,000 145,000 11 December 1992 16,000 161,000 4 January 1993 40,000 121,000 28 February 1993 45,000 166,000 1 April 1993 90,000 76,000 30 April 1993 20,000 96,000 7 May 1993 20,000 116,000 27 June 1993 6,000 110,000 Totals 256,000 146,000

Assume the following spot rates of exchange prevailed on those days: Date Exchange Rate 1 $ A = xUS Date Exchange Rate 1 $ A = xUS 1 July 1992 70c 28 February 1993 66c 15 July 1992 69c 1 April 1993 67c 20 August 1992 68c 30 April 1993 68c 30 September 1992 67c 7 May 1993 69c 11 December 1992 66c 27 June 1993 70c 4 January 1993 65c

Thus the Australian dollar equivalent (ADE) of the amounts deposited and the consideration received for withdrawals is: Date Deposit or Withdrawal Conversion Deposit ( A ) Withdrawal ( A ) 1 July 1992 100,000/.70 142,857 15 July 1992 25,000/.69 36,232 20 August 1992 30,000/.68 44,118 30 September 1992 10,000/.67 14,925 11 December 1992 16,000/.66 24,242 4 January 1993 40,000/.65 61,538 28 February 1993 45,000/.66 68,182 1 April 1993 90,000/.67 134,328 30 April 1993 20,000/.68 29,412 7 May 1993 20,000/.69 28,986 27 June 1993 6,000/.70 8,571 Totals 374 , 029 219 , 362

Withdrawals of $US146,000 took place during the 1993 year of income (paragraph 28 above). The ADE of this cost of these withdrawals under the FIFO method is determined as follows: Date Deposit ($ US ) Deposit ($ A ) 1 July 1992 100,000 142,857 15 July 1992 25,000 36,232 20 August 1992 21,000 30,882 Total 146 , 000 209 , 971

The ADE cost of the outstanding balance at the end of the year of income is thus $A164,058 ($A374,029 - $A209,971). The amount brought to account under Division 3B under the FIFO method is thus: ADE of consideration received $A219,362 less ADE cost (FIFO method) $A209,971 equals Foreign exchange gain/(loss) $A9,391

This gain is assessable income in the 1993 year of income under section 82Y.

Deposits of $US256,000 were made in the 1993 year of income with an ADE of $A374,029. As the account was opened in the year, the weighted average ADE cost of the amount withdrawn in the year of income ($US146,000) is calculated as follows: $A374,029 x ($US146,000 / $US256,000) = $A213,313

The ADE cost of the outstanding balance at the end of the year of income is thus $A160,716 ($A374,029 - $A213,313). The amount brought to account under Division 3B under the weighted average per year of income method is thus: ADE of consideration received $A219,362 less ADE cost (Wgt Ave year of income) $A213,313 equals Foreign exchange gain/(loss) $A6,049

This gain is assessable income in the 1993 year of income under section 82Y.

Under this method, the weighted average calculation is made at each withdrawal. As there are four withdrawals in the year of income, four calculations are required under this method, taking into account the deposits made up until that period in time.

The deposits made into the account up to 30 September 1992 were: Date Deposit ($ US ) Deposit ( ADE ) 1 July 1992 100,000 142,857 15 July 1992 25,000 36,232 20 August 1992 30,000 44,118 Total 155,000 223,207

The weighted average ADE cost of the amount withdrawn ($US10,000) is calculated as follows: $A223,207 x ($US10,000 / $US155,000) = $A14,400

The ADE cost of the outstanding balance after the withdrawal is thus $A208,807 ($A223,207 - $A14,400).

The deposits made into the account up to 4 January 1993 were: Date Deposit ($ US ) Deposit ( ADE ) Balance after last withdrawal 145,000 208,807 11 December 1992 16,000 24,242 Total 161 , 000 233 , 049

The weighted average ADE cost of the amount withdrawn ($US40,000) is calculated as follows: $A233,049 x ($US40,000 / $US161,000) = $A57,900

The ADE cost of the outstanding balance after the withdrawal is thus $A175,149 ($A233,049 - $57,900).

The deposits made into the account up to 1 April 1993 were: Date Deposit ($ US ) Deposit ( ADE ) Balance after last withdrawal 121,000 175,149 28 February 1993 45,000 68,182 Total 166 , 000 243 , 331

The weighted average ADE cost of the amount withdrawn ($US90,000) is calculated as follows: $A243,331 x ($US90,000 / $US166,000) = $A131,926

The ADE cost of the outstanding balance after the withdrawal is thus $A111,405 ($A243,331 - $A131,926).

The deposits made into the account up to 27 June 1993 were: Date Deposit ($ US ) Deposit ( ADE ) Balance after last withdrawal 76,000 111,405 30 April 1993 20,000 29,412 7 May 1993 20,000 28,986 Total 116 , 000 169 , 803

The weighted average ADE cost of the amount withdrawn ($US6,000) is calculated as follows: $A169,803 x ($US6,000 / $US116,000) = $A8,783

The ADE cost of the outstanding balance after the withdrawal is thus $A161,020 ($A169,803 - $A8,783).

The total ADE cost of withdrawals made during the 1993 year of income is thus: Date Withdrawal ($ US ) Withdrawal ( ADE ) 30 September 1992 10,000 14,400 4 January 1993 40,000 57,900 1 April 1993 90,000 131,926 27 June 1993 6,000 8,783 Total 146 , 000 213 , 009

The amount brought to account under Division 3B under the weighted average per year of income method is thus: ADE of consideration received $A219,362 less ADE cost (Wgt Ave per withdrawal) $A213,009 equals Foreign exchange gain/(loss) $A6,353

This gain is assessable income in the 1993 year of income under section 82Y.