The foreign exchange market is larger than any other financial market, including traditional stocks or commodities. The global foreign exchange market has recently been calculated to be worth an estimated $6 trillion. It shouldn’t be any surprise to learn then that Australians have been quick to get a piece of this highly liquid market.
What is forex trading and what are the tax implications?
Let’s start with a basic understanding of what forex trading is. Forex or foreign exchange trading involves speculating on the increase or decrease of an exchange rate between two chosen currency pairs. It’s highly speculative stuff but the rewards for correctly judging the movement of your chosen currencies against each other can be substantial (but so can the losses if you get it wrong!).
As a foreign currency trader is regarded as running a business, the profits from dealing in foreign currencies are taxed as assessable income, in the same way as any other trade (such as in goods, shares, etc).
The tax treatment of foreign currency gains and losses is set out in Division 775 of the Income Tax Assessment Act 1997. This part of the legislation covers all types of foreign currency transactions, including having a foreign currency-denominated bank account, as well as the foreign currency gains that can arise from dealing in foreign shares, overseas rental properties, trading stock, hedging transactions and the purchase and subsequent disposal of foreign capital assets. It is a complex area, which hinges on fitting the transaction into one of five defined forex events.
Division 775 contains rules under which foreign currency gains and losses are brought to account when they have been ‘realised’. This is the case even if the monetary elements of the transaction are not converted to Australian dollars. These rules apply when one of the following forex realisation events happens:
- Forex realisation event 1 – disposal of foreign currency.
- Forex realisation event 2 – ceasing to have a right to receive foreign currency.
- Forex realisation event 3 – ceasing to have an obligation to receive foreign currency.
- Forex realisation event 4 – ceasing to have an obligation to pay foreign currency.
- Forex realisation event 5 – ceasing to have a right to pay foreign currency.
These rules apply unless the foreign exchange gain is of a domestic or private nature, such as when you go travelling overseas on holidays or purchase goods for personal use.
Assessable income or allowable deductions
The forex measures set out rules for expressing the Australian currency values of amounts that are denominated in foreign currency, and explain how to calculate gains and losses that are attributable to currency exchange rate fluctuations. The measures treat many of those gains and losses as assessable income or allowable deductions.
If you are merely depositing money and make withdrawals from a foreign currency-denominated bank account, this can give rise to a gain or loss being made but an exemption from the taxing rules applies so that it would only be assessable if your account balance was more than $250,000. However, to take advantage of this exemption you must make an election to disregard any realised foreign currency gains or losses for accounts with a balance under this threshold.
Note that if you are actively trading, the resulting transactions would not be of a private or domestic nature. Instead, they would constitute a business activity and therefore any profits would be assessable regardless of your balance. The exemption was designed to apply where people merely had some money sitting in an offshore bank account and the effect of the exemption is that people in that situation don’t have to report movements in exchange rate fluctuations for tax purposes.
In addition, Subdivision 960-C of the ITAA 1997 provides for a general foreign currency translation rule which, broadly, expresses all tax-relevant amounts (income and deductions) in Australian currency. Under the general translation rule, all tax-relevant amounts that are denominated in a foreign currency must be translated into Australian currency (unless falling within certain limited exceptions). This enables all gains and losses to be calculated using a common unit of measurement – the Australian dollar. The general translation rule applies regardless of whether the foreign income is remitted to Australia or not. In relation to ordinary income, for example, the rules prescribe that you must convert to Australian dollars at the earlier of the time the income is derived and the time it is received.
The tax implications of trading foreign currency can be complex and you should make sure that you consult a tax adviser (like H&R Block (NYSE:HRB)) before you commence your trading and at regular intervals thereafter.
Author Mark Chapman is Director of Tax Communications at H&R Block.