In the microfinance environment, foreign exchange differences arise naturally from loans, deposits, nostro balances, cross-border liabilities, customer settlements, and foreign currency-denominated assets and liabilities. The Income Tax Act however draws a distinction between realised and unrealised exchange differences as well as capital versus revenue nature foreign exchange differences. Four conditions should be satisfied for an exchange difference to be taxable or deductible:
There Must Be a Variation in Exchange Rates: An exchange difference can only arise where there has been a movement in the applicable foreign exchange rate between the date the transaction was initially recognised and the date of settlement. If the exchange rate remains unchanged throughout the transaction period, no exchange gain or loss arises for tax purposes.
The Variation Must Affect the local Currency Value of the Transaction: The movement in the exchange rate must result in a change in the Zimbabwe Gold (ZWG) value of the underlying foreign currency obligation. In other words, the taxpayer must experience an actual increase or decrease in the local currency equivalent of the amount payable or receivable. If the exchange rate movement does not alter the ZWG value of the transaction, then no taxable/deductible exchange difference arises.
There must be actual settlement: Exchange differences are regarded as realised only when settlement or payment occurs. The transaction must be completed and where balances remain unsettled at year-end the resulting exchange differences are deemed unrealised.
Revenue versus Capital Transactions: Revenue exchange differences are those arising from taxpayer’s ordinary operations and circulating capital. In contrast, capital in nature exchange differences are those associated with capital assets, equity, reserve capital, long term loan or fixed capital transactions. Only revenue exchange differences are taxable or deductible.
Exchange differences in common transactions
Customer Deposits and Liabilities: Gains and losses arising from customer current accounts, savings accounts etc, are revenue in nature, taxable or deductible when the underlying customer transaction is actually settled.
Foreign Currency Balances: Foreign exchange differences arising from mere translation of nostro balances into ZWG for reporting purposes are notional gains or losses which are neither taxable nor deductible. Where the gain or loss is a result of year- end translation and no settlement has occurred, the resulting exchange difference may be regarded as unrealised rather than immediately taxable or deductible item.
Borrowing and lending in foreign currency: Where loans are denominated and repaid in the same currency, exchange differences arising purely from accounting translation may not necessarily create taxable or deductible events. However, where borrowing or lending is in one currency and settlement is another realised exchange differences may arise. These would be taxable or deductible if they arise from day to day banking operations or circulating capital.
Capital Reserves and Equity-Related Exchange Differences: Exchange differences upon acquisition, construction or disposal of equity, reserve capital, or fixed assets are generally regarded as capital in nature and therefore fall outside taxable income and allowable deductions.
Importance of Supporting Documentation: Supporting evidence is critical during tax audits. Appropriate documentation may include board resolutions, ledger analysis, proof of payments, underlying transaction documents (invoices, contract, loan agreement etc) Documents should clearly demonstrate the nature of underlaying transaction, the exchange rates applied, whether settlement occurred and the basis which the exchange difference was classified as revenue or capital in nature.
Why This Matters
Foreign exchange differences remain a major ZIMRA audit focus area. Incorrect classification between realised and unrealised exchange differences, or between capital and revenue transactions, may result in material understatements or overstatements of taxable income.