Recognition of Foreign Exchange Gain/Loss
Relevant Accounting Standard
Paragraph 23(a) of NAS 21 “The Effects of Changes in Foreign Exchange Rates” states that foreign currency monetary items shall be translated using the rate at the end of each reporting period. This is known as translation/restatement of monetary items at the end of reporting period.
Relevant Tax Laws
The monetary items that are receivable/payable in foreign currency are termed as foreign currency assets/liabilities. Foreign currency assets/liabilities are business assets under Section 2(KaTa) of ITA. Section 7(2)(c) of ITA states that net gains from the disposal of the person’s business assets/liabilities should be included in computing entity’s income from business during any income year. The event of “accounting cut off” at the end of income year doesn’t qualify as being a criteria for disposal of business assets under Section 40(1) and Section 40(2) of the Act.
Hence, the forex gain/loss derived by the restatement of monetary items at the end of income year (also termed as unrealized forex gain/loss) is not allowed for inclusion/deduction for tax unless the receivable/payable in foreign currency is actually received/paid. However, the forex gain/loss arising from the event of “asset being redeemed” or “liability being satisfied” (also termed as realized forex gain/loss) is allowed for tax.
Example
| This example follows an expense incurred in Year 1 and settled in Year 2 | |||||||
| Year | Event | Ledger | Dr/Cr | Accounts | Tax | Difference | Reason for difference |
| Year 1 | Expense of 1 USD incurred | Expense | Dr | 110 | 110 | – | |
| (Rate: 110NPR/USD) | USD Payable | Cr | (110) | (110) | – | ||
| Restatement at end of Income Year | Forex | Dr | 5 | – | 5 | Realized forex of 0 allowed for tax. | |
| (Rate: 115NPR/USD) | USD Payable | Cr | (5) | – | (5) | ||
| Year 2 | Actual Payment Date | Forex | Dr | 5 | 10 | (5) | Realized forex of 10 (Including unrealized forex of 5 from Year 1, now realized) allowed in tax. |
| (Rate: 120NPR/USD) | USD Payable | Dr | 115 | 110 | 5 | ||
| Bank | Cr | (120) | (120) | – | |||
| Total | – | – | – | ||||
| This example follows an expense incurred in Year 1 and settled in Year 1 | |||||||
| Year | Event | Ledger | Dr/Cr | Accounts | Tax | Difference | Reason for difference |
| Year 1 | Expense of 1 USD incurred | Expense | Dr | 110 | 110 | – | |
| (Rate: 110NPR/USD) | USD Payable | Cr | (110) | (110) | – | ||
| Actual Payment Date | Forex | Dr | 10 | 10 | – | ||
| (Rate: 120NPR/USD) | USD Payable | Dr | 110 | 110 | – | ||
| Bank | Cr | (120) | (120) | – | |||
| Total | – | – | – | ||||
Regarding use of Average Rates
Relevant Accounting Standard
In line with paragraph 21 and 22 of NAS 21 “The Effects of Changes in Foreign Exchange Rates”:
21. A foreign currency transaction shall be recorded, on initial recognition in the functional currency, by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.
22. The date of a transaction is the date on which the transaction first qualifies for recognition in accordance with NFRSs. For practical reasons, a rate that approximates the actual rate at the date of the transaction is often used, for example, an average rate for a week or a month might be used for all transactions in each foreign currency occurring during that period. However, if exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate.
Relevant Tax Law
Section 28 of Income Tax Act “Forex Adjustments” states:
Section 28(1): For the purposes of this Act, a person’s income as well as amounts to be included and deducted in calculating that income shall be quantified in Nepali Rupees if they are quantified in currency other than the Rupees.
Section 28(2): Where an amount to be included or deducted in calculating a person’s income for an income-year is quantified in a currency other than Nepali Rupee, the amount shall be converted at the prevalent exchange rate applying between the currency and Nepali Rupee at the time the amount is derived, incurred, made, received, or otherwise taken into account for tax purposes.
Section 28(3): Notwithstanding Section 28(2), for the purposes of the Section 28(2) and where the Department permits by notice in writing, a person may use the average exchange rate applying during the income-year as determined by the Department.
Relevant Companies Law
An entity registered in Nepal under Companies Act 2063 it is obliged to follow section 108(2) of Companies Act:
Section 108(2): The accounts to be maintained under Section 108(1) shall be maintained according to the double entry system of accounting and in consonance with the accounting standards enforced by the competent body under the prevailing law and with such other terms and provisions required to be observed pursuant to this Act, in such a manner as to clearly reflect the actual affairs of the Company.
Conclusion on Financial Accounting
The accounting standards enforced by competent authority in Nepal is Nepal Financial Reporting Standards (NFRS) issued by Institute of Chartered Accountants of Nepal (ICAN). The above excerpt on NAS 21 is from NFRS issued by ICAN. A company that has only few foreign currency transactions, and major transactions in local Nepali currency, NPR will be the functional currency for accounting purposes as per NFRS.
Since, NPR is the functional currency, other foreign currency transaction shall have to be translated to NPR for accounting purpose. For practical reasons, average rate of week or month maybe used for translation, if the currency fluctuation is not very significant. As far as practicable, the spot exchange rate at the date of transaction should be taken for accounting purposes.
Conclusion on Tax Accounting
Income tax act requires that income and expenses denominated in currencies other than NPR should be converted to NPR using the prevalent exchange rate. Income Tax Directive 2073 has required that expenses are translated using selling rates and buying rates as follows:
Let’s say the direct quote for 1 USD is NPR 122 (Buying) and NPR 123 (Selling) for any date. An expense of 1 USD at that date would be reflected at NPR 123 (Selling Rate) and an income of 1 USD at that date would be reflected at NPR 122 (Buying Rate).
For practical reasons, Income tax act has the provision of using average annual rate for translation of foreign currency into NPR. However, IRD has not released any notice for average annual rates as of now for such translation purposes in line with Section 28(3) of the Act.
As per Income Tax Directive 2073, the taxpayer can obtain permission and average annual rates from IRD by making a written application to IRD. However, it is to be noted that: IRD will provide the permission and annual average translation rates by
1. Considering the practical difficulty faced by taxpayer to account using spot exchange rates.
2. The level of foreign currency fluctuations seen in the market over time.
3. The actual exchange rates prevalent over the income year.