The outbreak of the coronavirus (COVID-19) pandemic has affected the global foreign exchange (forex) market, as reflected by the increased volatility in forex.
In addition to the adverse effect that COVID-19 has had on the South African economy, the crisis has affected the valuation of the Rand against other major currencies and the volatility in the forex rates is evident from the recent fluctuations in the Rand-dollar exchange rate.
Section 24I of the income tax law governs the income tax treatment of forex gains or losses made in respect of both realised and unrealised forex transactions. Simplistically, unrealised forex gains and losses are treated as taxable or deductible unless the deferral provisions apply. In the context of deferred unrealised forex differences, a cash event will only occur upon settlement of the exchange item.
Assuming the taxpayer is not in an assessed loss position, there is a tangible cash tax impact in instances when the deferral provisions are not applicable to unrealised gains or losses. This impact is magnified in periods of forex volatility. This is especially relevant when an unrealised forex gain is recognised and does not result in any cash inflow but the same non-cash gain creates taxable income which results in a tax cash outflow. The converse is, however, also true for an unrealised forex loss that does not result in any cash outflow but the same non-cash loss creates a reduction in taxable income and tax cash payable.
Impact of unrealized forex for real estate investment trust (REIT)
There are two key aspects REITs need to consider:
A REIT or “controlled company” (CC) must include both realised and unrealised forex gains and losses in the calculation of its taxable income. However, dividends or qualifying distributions that the REIT declares and pays to its investors are generally limited to actual cash the REIT or CC has earned, and therefore the REIT or CC would exclude unrealised forex differences.
Accordingly, there may be a mismatch between the timing of the inclusion of the unrealised forex gain in the taxable income and the corresponding inclusion of the forex gain in the qualifying distributions. This mismatch may result in the REIT or CC not being able to make a large enough qualifying distribution to reduce its taxable income to zero. In the subsequent year when the forex gain is realised, the REIT or CC may have surplus cash from which limited or no benefit will arise by way of a qualifying dividend deduction, as the deduction is limited to taxable income, which will exclude the prior year’s unrealised forex gain now realised.
The timing mismatch in respect of an unrealised forex loss may result in the REIT or CC having a surplus amount of cash from which limited or no benefit will arise by way of a qualifying dividend deduction, as the deduction is limited to taxable income (it may not create an assessed loss ). In the subsequent year, once the forex loss is realised, the REIT or CC may not be able to make a large enough qualifying distribution to reduce its taxable income to zero, which will exclude the prior year unrealised forex losses now realised.
Given the instability of the Rand, many REITs or CCs entered into hedging instruments that resulted in forex gains and losses, both realised and unrealised. The recent significant volatility in the Rand may result in REITs or CCs having large forex gains. Forex gains that do not fall within the rental income definition (recently amended in the 2019 Taxation Laws Amendment Act) may have a negative impact on the 75% qualifying dividend assessment.
The impact is such that both realised and unrealised forex gains are included in gross income but may not form part of the rental income definition. The result is that there may be a risk that the REIT or CC may not meet the 75% rental income-to-gross income ratio requirement. In turn this may result in the REIT or CC not being able to claim the dividend as a qualifying distribution deduction and ultimately the REIT or CC may be in a taxable income position.
Careful consideration needs to be given to these risks because the REIT or CC may fall prey to the potential adverse consequences that are described above. Other considerations also to keep in mind include:
Read a May 2020 report [PDF 1.2 MB] prepared by the KPMG member firm in South Africa
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