The Malaysian Institute of

Certified Public Accountants

DISCUSSION PAPER

TAX IMPLICATIONS
RELATED TO THE
IMPLEMENTATION OF
FRS 121: THE EFFECTS
OF CHANGES IN
FOREIGN EXCHANGE
RATES

Prepared by:
Joint Tax Working Group on FRS

Date of issue: 22 January 2010

 Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in
Foreign Exchange Rates

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 Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in
Foreign Exchange Rates

Contents
Page
No.

1 Introduction 1
1.1 Background of FRS 121
1.1.1. Rationale 1
1.1.2. Scope of FRS 121 1
1.1.3. Definition of essential terms 1
1.1.4. Effective date 1

2 Scope of the comments 1

3 Changes introduced by the FRS regime 2

3.1 The MASB Regime (MASB 6) 2
3.1.1 Foreign Currency Transactions 2
3.1.2 Financial Statements of Foreign Operations 2
3.2 The FRS Regime (FRS 121) 2
3.2.1 Foreign Currency Transactions 2

4 Tax treatment before FRS implementation 3

5 Tax issues arising from FRS 121 implementation 3

5.1 Claim of capital allowances 3
5.2 Translation of functional currency to presentation currency 4
5.3 Valuation of inventories 7
5.4 Disallowable expenditure : Amount to be added back 7
5.5 Computation of interest restriction 9

6 Proposals/ Recommendations of tax treatments 9

Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in Foreign Exchange Rates

1. INTRODUCTION

1.1 BACKGROUND OF FRS 121

1.1.1 Rationale

FRS 121 stipulates the accounting principles underlying the recognition of

foreign currency transactions and the translation of foreign currency financial
statements into the local currency as presented in the financial statements.

1.1.2 Scope of FRS 121

FRS 121 shall be applied:

a. In accounting for transactions and balances in foreign currencies,
except for those derivative transactions and balances that are within
the scope of FRS 139;
b. In translating the results and financial position of foreign operations
that are included in the financial statements of the entity by
consolidation, proportionate consolidation or the equity method; and
c. In translating an entitys results and financial position in a presentation
currency.

1.1.3 Definition of essential terms

a. Closing rate is the spot exchange rate at the balance sheet date;
b. Foreign currency is a currency other than the functional currency of
the entity;
c. Functional currency is the currency of the primary economic
environment in which the entity operates;
d. Monetary items are units of currency held and assets and liabilities to
be received or paid in a fixed or determinable number of units of
currency; and
e. Presentation currency is the currency in which the financial statements
are presented.

1.1.4 Effective date

Annual periods beginning on or after 1 January 2006

2. SCOPE OF COMMENTS

This paper covers the effects of a two stage translation of currency, as introduced by
the FRS 121, where the presentation currency is not the functional currency.

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Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in Foreign Exchange Rates

3. CHANGES INTRODUCED BY THE FRS REGIME

3.1 THE MASB REGIME (MASB 6)

3.1.1 Foreign Currency Transactions

Foreign currency transactions are recorded, on initial recognition, at the spot
rate. At each balance sheet date:
a. Foreign currency monetary items are reported at closing rate, unless
there are related or matching forward contracts in respect of trading
transactions, in which case, the contract rates are used;
b. Non-monetary items which are carried at historical cost are reported
using the exchange rate at the date of the transaction; and
c. Non-monetary items which are carried at fair value are reported using
the exchange rates at the date when the values were determined.

Exchange differences at this juncture are recognised in the income statement.

3.1.2 Financial Statements of Foreign Operations

If the foreign operations are integral to the operations of the reporting
enterprise, the financial statements of the foreign operations are translated as
in 3.1.1 above.

Otherwise, the reporting enterprise uses the following procedures:

a. The assets and liabilities, both monetary and non-monetary, of the
foreign entity are translated at the closing rate;
b. Income and expense items of the foreign entity are translated at the
exchange rates at the dates of the transaction; and
c. All resulting exchange differences are recognised in equity.

3.2 THE FRS REGIME (FRS 121)

3.2.1 Foreign Currency Transactions

Stage 1 Translation to Functional Currency

Foreign currency transactions are recorded, on initial recognition, at the spot
rate. At each balance sheet date, translation from foreign currency to
functional currency is done as follows:
a. Foreign currency monetary items are reported at closing rate;
b. Non-monetary items which are carried at historical cost are reported
using the exchange rate at the date of the transaction; and
c. Non-monetary items which are carried at fair value are reported using
the exchange rates at the date when the values were determined.
Exchange differences at this juncture are recognised in the income statement.

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Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in Foreign Exchange Rates

Stage 2 Translation to the Presentation Currency

The results and financial position of the entity are translated from the
functional currency to the presentation currency as follows:
a. Assets and liabilities for each balance sheet presented are translated
at the closing rate;
b. Income and expenses for each income statement are translated at
exchange rates at the dates of the transactions; and
c. All resulting exchange differences are recognised as a separate
component of equity.

4. TAX TREATMENT BEFORE FRS IMPLEMENTATION

There are no specific provisions in the Income Tax Act, 1967 on exchange profits and
losses. Generally, for income tax purposes, exchange profits or losses are not
considered to have not arisen until they are realised.

Foreign exchange gains or losses of a capital nature, whether realised or unrealised,

are not taxable or allowable for income tax purposes. Whether a transaction is capital
or revenue in nature depends on the facts and circumstances of each case.

Foreign exchange gains or losses of a revenue nature are taxable or allowable only
when they are realised. Such gains or losses are realised when the foreign
currencies are physically converted into or exchanged for currencies of the business.
In this regard, businesses would need to trace each individual transaction to establish
if physical conversion of foreign currencies has occurred.

The Deemed Realised in the Following Year basis in respect of revenue items has
been allowed by the IRB.

5. TAX ISSUES ARISING FROM FRS 121 IMPLEMENTATION

In general, FRS 121 requires companies which have determined and adopted the
functional currency (eg USD) to record all their transactions in that currency.
Accordingly, if USD is used as the functional currency, all transactions which are not
denominated in USD will need to be converted into USD using the rate specified by
FRS 121. Thereafter, for presentation purposes, these USD amounts will be
converted back to RM by using the closing rate for balance sheet items and at
exchange rates at the dates of transactions for profit and loss statement items.

5.1 CLAIM OF CAPITAL ALLOWANCES

FRS 121 requires the use of closing rate method for balance sheet items. Under this
method, assets and liabilities are to be translated using the closing rate. As such, all
property, plant and equipment (PPE) acquired during a financial year are converted to
RM based on the closing rate instead of the actual foreign exchange rate on the date
of transaction or settlement date.

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Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in Foreign Exchange Rates

Example

Balance as at Additions Exchange Balance as

01.01.2008 Difference for at 31.12.2008
Additions

RM RM RM RM
(i) (ii) (iii) (iv)
Industrial building 40,000,000 1,000,000 (95,000) 40,905,000
Plant and machinery 25,000,000 800,000 (65,000) 25,735,000
Motor vehicles 5,000,000 80,000 - 5,080,000
70,000,000 1,880,000 (160,000) 71,720,000

Issue: Should capital allowances be claimed on qualifying expenditure in respect of

the additions which are based on the exchange rate on the actual transaction date
[column (ii)] or on qualifying expenditure based on the closing rate [column (ii) less
(iii)] used in the audited accounts?

Suggested tax treatment: Capital allowances should be claimed on RM1,880,000 as

provided in the existing legislation. If we were to follow the conversion which is based
on the closing rate, the amount eligible will be reduced or increased by the exchange
difference as the case may be (in this case reduced by RM160,000).

5.2 TRANSLATION OF FUNCTIONAL CURRENCY TO PRESENTATION CURRENCY

MASB 6

Under the previous MASB 6, companies are required to keep their accounting records
in a reporting currency.

Scenario 1

A Berhad has a 31 December financial year end with the RM as its reporting currency.
In 2009, A Berhad recognised a sale transaction of RM7,000 during the financial year.
As at 31 December 2009, the customer has yet to remit payment. Subsequent to the
year end, the customer makes full payment.

A Berhad
Sales invoiced in RM7,000

2009:
At balance sheet date (RM)
DR Trade receivables 7,000
CR Revenue 7,000

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Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in Foreign Exchange Rates

2010:
At balance sheet date (RM)
DR Bank 7,000
CR Trade receivables 7,000

With implementation of FRS 121

FRS 121 has introduced the concept of functional currency and presentation currency.
With this, the results and financial position of a company adopting USD as its
functional currency if translated into presentation currency in RM may give rise to the
following scenario:

Scenario 2

A Berhad has a 31 December financial year end with the USD as its functional
currency and RM as its presentation currency. During the last month of 2009, A
Berhad recognised a foreign currency sale transaction of RM7,000 during the financial
year with a spot exchange rate of USD1.00:RM3.50. As at 31 December 2009, the
customer has yet to remit payment and the closing exchange rate was
USD1:00:RM3.40. Subsequent to the year end, the customer makes full payment and
the spot exchange rate on the payment date is USD1.00:RM3.60.

A Berhad

Sales invoiced in RM = RM7,000

Exchange Transaction Functional

rate currency currency
RM USD
Transaction date 3.5 7,000 2,000
Balance sheet date (2009) 3.4 7,000 2,059
Settlement date 3.6 7,000 1,944
Balance sheet date (2010) 3.8

STAGE 1 : Recording in functional currency

2009:
At transaction date (USD) (USD)
DR Trade receivables 2,000
CR Revenue 2,000
Being sales transaction recorded in functional currency

At balance sheet date

DR Trade receivables 59
CR Unrealised forex gain (P&L) 59
Being unrealised forex gian resulting in translation of monetary items using closing rate

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Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in Foreign Exchange Rates

STAGE 2 - Translation to Presentation Currency

At balance sheet date 2009 (RM) (RM)

DR Trade receivables 7,000
DR Exchange reserve 200 (ii)
CR Revenue 7,000
CR Unrealised forex gain (P&L) 200 (i)
Being translation to presentation currency at balance sheet date

2010:
At settlement date (USD) (USD)
DR Bank 1,944
DR Realised forex loss 114
CR Trade receivables 2,059
Being settlement of trade receivables

At balance sheet date 2010 (RM) (RM)

DR Bank 7,389
DR Realised forex loss (P&L) 412 (iii)
CR Trade receivables 7,000
CR Exchange reserve 801
Being translation to presentation currency at balance sheet date

Issue: Should a tax adjustment be made on these foreign currency differences in

determining the chargeable income?

Current tax treatment:

Note (i): The exchange gain in the P+L of RM200 is not taxable as it is an unrealised
gain at the balance sheet date. Hence the amount must be deducted in the tax
computation.

Note (ii): The exchange reserve of RM200 in the balance sheet is merely a translation
loss at balance sheet date as a result of FRS requirements. No tax adjustment is
required.

Note (iii): The exchange loss of RM412 is a realised loss, hence is an allowable loss
(assuming it relates to trade).

In preparing the income tax computation, additional resources is required to obtain

detailed breakdown and movement of all transactions with the view to ascertaining
whether these are realised or unrealised and trade or non trade items.

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Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in Foreign Exchange Rates

5.3. VALUATION OF INVENTORIES

Based on the scenario below, there is the effect of exchange rate differences in the
opening and closing balance of inventories. This arose due to the different
exchange rates used for the conversion of say, USD functional currency to RM
presentation currency in the balance sheet (which is translated at the closing rate
prevailing at the balance sheet date) and the income statement (which is translated at
average exchange rate for the year).

Notes to the Financial Statements 2008 2007

At Cost:
Raw materials 3,100,000 4,000,000
Work in progress 11,000,000 18,000,000
Finished goods 2,000,000
14,100,000 24,000,000

Detailed Income Statement 2008 2007

Revenue 200,000,000 300,000,000
Less : Cost of sales
Opening inventories 2,000,000 1,000,000
Effects of exchange rate difference in opening
balance 60,000
Opening inventories (1,940,000) (1,000,000)
Cost of goods manufactured (184,000,000) (185,000,00)
185,940,000 186,000,000
Less: Closing inventories - (2,000,000)
Gross Profit 14,060,000 112,000,000

Issue: Is there a need to adjust for the exchange difference in the opening balance
(i.e. RM60,000) in the tax computation?.

Suggested tax treatment: As the inventories are artificially reduced by RM60,000,

the profit has been accordingly increased. Therefore, there is a need to adjust for tax.

5.4 DISALLOWABLE EXPENDITURE : AMOUNT TO BE ADDED BACK

When there is a difference in the conversion rate used to convert the actual RM
incurred (based on invoices) into the functional currency (based on the exchange rate
on the transaction date) and the rate used to translate from functional currency to RM
for presentation purposes in the audited accounts at the financial year end, there is an
issue on disallowable expenditure and the amount to be added back.

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Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in Foreign Exchange Rates

Advertisement Account
Translate to Translate from
Actual functional functional currency
Expenditure currency presentation
USD1:RM3.65 currency
USD1:RM3.58

(RM) (USD) (RM)

Recruitment advertisement 1,095,000 300,000 1,074,000
Complimentary 11,680 3,200 11,456
advertisement
1,106,680 303,200 1,085,456

The amount to be disallowed using actual RM figure for analysis is as follows:

Actual Amount added back

(RM) (RM)
Recruitment advertisement 1,095,000
Complimentary advertisement 11,680 11,680
Translate to presentation currency - exchange (21,224)
rate difference
Per audited accounts 1,085,456 11,680

Using RM analysis and allocating the exchange difference to the respective sub
category of expenditure, the amount to be added back is as follows:

After
Allocated translation to Amount
to each presentation added
category currency back

(RM) (RM) (RM) (RM)

Recruitment advertisement 1,095,000 (21,000) 1,074,000
Complimentary advertisement 11,680 (224) 11,456 11,456
1,106,680 21,224 1,085,456 11,456

Issue: The complimentary advertisement expenditure is not an allowable expenditure.

Should the amount to be disallowed in the tax computation be RM11,680 or
RM11,456?.

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Tax Implications Related to the Implementation of
FRS 121: The Effects of Changes in Foreign Exchange Rates

For the amounts incurred in RM in Malaysia, the final converted amount as shown in
the audited accounts may be different from the actual amount incurred as reflected in
the invoices. The amounts do not reconcile to the source documents/invoices since
the original RM amounts have been translated at the rate prevailing on transaction
date to USD and then translated back to the presentation currency in RM in the
audited accounts thus giving rise to lengthy and unnecessary explanations during field
audits. If the strict legal position is adhered to, additional efforts would be involved to
trace each transaction in order to establish physical conversion of the foreign
currencies into the functional currencies of the business had taken place before the
foreign exchange gains or losses could be recognised for income tax purposes.

Also, for companies eligible for double deduction for premium on marine cargo
insurance for example, the issue is whether the double deduction claim should be
based on the actual RM incurred as supported by invoices or the RM amount as
reflected in the audited accounts as the FRS converted net profit before tax is used as
the starting point to determine the chargeable income in the tax computation.

Suggested tax treatment: To adopt the amounts shown in the audited account,
i.e.RM11,456.

5.5. COMPUTATION OF INTEREST RESTRICTION

Issue : Where the computation of interest restriction is prepared based on month end
balances, what is the conversion rate to be adopted for the first 11 months (say from
January to November)?

Suggested tax treatment : Since the year end amount is based on the closing rate,
all the months should use similar rate. However, for simplicity, propose to use the
actual RM amounts.

6. PROPOSALS/ RECOMMENDATIONS OF TAX TREATMENT

Clear guidelines setting out the tax treatment to be adopted by taxpayers in filing the
tax returns should be issued by the authorities to address the tax issues arising from
the adoption of FRS in the audited accounts.

Taxpayers may be allowed an irrevocable election to present the audited financial

statements for the purposes of preparing the tax computation:-
a. In presentation currency (ie in RM); or
b. In functional currency (where RM is not the companys functional currency)
and then convert to RM to ascertain the tax payable; or
c. In RM as per the actual transactions (without applying the FRS 121)- this may
give rise to maintaining 2 sets of accounts.