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All legislative references made in this document are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise specified.
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Entities may be exposed to foreign currency fluctuation risk, particularly when a transaction is denominated in a foreign currency.
To mitigate this risk, entities often enter into foreign currency hedging transactions. The purpose of a foreign currency hedge is to offset all, or part, of any currency fluctuation on an underlying transaction. This is generally achieved through the use of derivatives such as forwards, futures, options and swaps.
For the purposes of the foreign currency gains and losses rules contained in Division 775, any forex realisation gain or loss on the underlying transaction is calculated separately to any forex realisation gain or loss arising on the hedge contract.
On 7 July 2003 'A Co' enters into a contract with 'US Co' to sell goods to US Co for an agreed price of US$1,000,000 (the market value of the goods). On entering into the contract, A Co acquires a right to receive foreign currency (the agreed price of US$1,000,000). At the time of entering into the contract, the exchange rate is A$1 = US$0.6845. Delivery and ownership of the goods passes to US Co on 7 January 2004, and A Co receives the consideration in US dollars on that day.
In order to mitigate the risk of an adverse movement in currency exchange rates between the date of the contract and the date of receipt of the US currency, A Co enters into a forward exchange contract on 7 July 2003 to sell US$1,000,000 to 'B Co' at an exchange rate of A$1 = US$0.6845. At the time of entering into the forward exchange contract, A Co assumes an obligation to pay foreign currency (being the US$1,000,000 payable by A Co on settlement). Settlement of this contract also occurs on 7 January 2004.
On 7 January 2004 A Co receives US$1,000,000 from US Co. At that time, the exchange rate is A$1 = US$0.7677. At the same time, under the forward exchange contract, A Co has an obligation to sell US$1,000,000 to B Co at an exchange rate of A$1 = US$0.6845.
The forex realisation gain or loss on these transactions is set out below.
Contract
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Date
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US$
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Exchange rate
A$1 = US$
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A$
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Sale of goods
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7 Jul 2003
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1,000,000
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0.6845
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1,460,920
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Proceeds from sale
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7 Jan 2004
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1,000,000
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0.7677
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1,302,592
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Loss
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158,328
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When A Co receives the US$1,000,000 on 7 January 2004 from US Co, forex realisation event 2 (section 775-45) happens as A Co ceases to have the right to receive foreign currency. A Co makes a forex realisation loss of A$158,328 (subsection 775-45(4)), as the amount received (A$1,302,592) is less than the forex cost base of the right (A$1,460,920) and all of the shortfall is attributable to a currency exchange rate effect.
The forex realisation loss A Co makes is deductible in the 2003-04 income year under section 775-30.
The gain or loss made on the forward exchange contract that A Co entered into with B Co is worked out separately to the gain or loss made on the sale of goods contract.
Contract
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Date
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US$
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Exchange rate
A$1 = US$
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A$
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Amount paid by
A Co under the contract
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7 Jan 2004
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1,000,000
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0.7677
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1,302,592
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AUD value of the US paid (sold) by A Co
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7 Jan 2004
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1,000,000
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0.6845
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1,460,920
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Gain
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158,328
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When A Co pays US$1,000,000 on 7 January 2004, forex realisation event 4 (section 775-55) happens as A Co ceases to have the obligation to pay foreign currency. A Co makes a forex realisation gain of A$158,328 (subsection 775-55(3)), as the amount paid (A$1,302,592) is less than the amount the US$1,000,000 is sold for under the contract (referred to as 'the proceeds of assuming the obligation', which is A$1,460,920), and the entire shortfall is attributable to a currency exchange rate effect.
The forex realisation gain A Co makes is included in assessable income in the 2003-04 income year under section 775-15.
In this example, in practical terms, the hedge is fully effective in mitigating the risk of any adverse movement in foreign currency exchange rates on the sale of goods contract during the period the sale proceeds remained outstanding. The forex realisation loss on the sale of goods will offset the forex realisation gain made on the forward exchange contract, even though the forex outcomes of each transaction have to be calculated separately.
Last Modified: Monday, 31 October 2005