Tax Perspective of Interpretations of the National Accounting Board I-42 and I-43
In January 2021, we informed you about newly issued interpretations of the National Accounting Board I-42 and I-43 that cover the financial reporting of the exchange rate risk in receivables denominated in foreign currency with a recognised provision and prepayments made in foreign currency. In today’s article, we would like to follow up on that and analyse these two interpretations from the tax perspective.
Read the whole article from the Accounting section New interpretations of the National Accounting Board I-42 and I-43 which covers financial reporting of the exchange rate risk in receivables denominated in foreign currency with a recognised provision and prepayments made in foreign currency.
Interpretation I-42 ‒ Receivables denominated in foreign currency with a recognised provision
If we are to summarise the proposed alternative approach by Interpretation I-42 in one sentence, then “an exchange rate difference in a foreign currency receivable arises only from the value of the receivable decreased by its provision, i.e. the net value of the receivable which is a representation of the expected cash flow“. The interpretation itself admits that this approach differs from the so far established approach to accounting for foreign exchange rate differences in these situations, with the accounting presentation being a key starting point in foreign exchange rate differences and provisioning for the tax base.
The so far used accounting method was based on the fact that a receivable denominated in foreign currency, as an asset denominated in foreign currency, must be translated to the Czech currency in line with the accounting regulations using the exchange rate applicable at the transaction date and subsequently as of the end of the balance sheet date. Such foreign currency difference is then calculated from the entire balance sheet value of a receivable denominated in foreign currency. In taxes, we build on that by applying the recognised foreign exchange rate differences in the tax base and, under the Act on Reserves (Act No. 593/1992 Coll., on Reserves), we adjust the relating statutory provisions, because the recognition of the foreign exchange rate difference changes the balance of the receivable’s balance sheet value. In accordance with the text of the Coordination Committee No. 79/12.10.05 – Provisions for receivables in foreign currencies, adjustments to provisions are treated as changes in their balances rather than as a foreign exchange rate difference.
Consider the difference in approaches on a simplified illustrative example where we account for a receivable of EUR 100 (using the exchange rate as of the recognition date, which is CZK 25/EUR, we recognise the amount of CZK 2,500). At the end of the balance sheet date, the exchange rate will be CZK 26/EUR, with the entity recognising a 50% provision for the receivables in the reporting period.
The above example shows that if the entity recognised a statutory provision for the receivable in line with the Act on Reserves, i.e. a provision the recognition and release of which has an impact on the tax base, the accounting method proposed by Interpretation I-42 would not necessarily impact the tax base in this specific case. However, if the entity recognised accounting provisions that are excluded from the tax base in general,
a difference would arise in the amount of the reported foreign exchange rate difference, i.e. taxable income in our case.
Interpretation I-43 – Prepayments made in foreign currency
If we, again, summarise the procedure proposed by Interpretation I-43 in a very brief and simple manner, then “the foreign exchange rate risk arises only in the foreign currency assets and liabilities where changes in the foreign exchange rate have an impact on the amount of future cash flows”. If the return of the prepayment made is not likely, the prepayment, as a separate (sub-)part of the total cost of the purchased asset (or a service), is not a receivable denominated in foreign currency and does not bear foreign exchange rate risk.
The current practice has been based on the Czech Accounting Standards for Businesses, which indicate the origination of a foreign exchange rate difference at the moment of the transfer of prepayments and advances for the payment of receivables and debts. And we generally apply the recognised foreign exchange rate differences in the tax base. Again, let us show the difference in approach in an illustrative example.
A company purchases a manufacturing facility for the total price of EUR 200. The prepayment made is EUR 100
(under foreign exchange rate of CZK 25/EUR), the exchange rate as of the use of the prepayment in the total purchase price is CZK 26/EUR.
The above indicates that, in an ideal situation when the value of acquired assets is fully reflected in tax deductible expenses, be it in the form of depreciation for tax purposes or tax residual value, it is actually only
a “shift in time” from the tax base perspective as the tax base from this transaction will be ultimately decreased by the same amount, i.e. CZK 5,100. However, the tax authority might try to additionally assess the missing income in the form of a foreign exchange rate gain in the year of the asset acquisition, if the taxpayer follows Interpretation I-43.
What is the opinion of the financial administration on these interpretations?
As the proposed recognition of the foreign exchange rate risk in line with the above-discussed interpretation affects the calculation of the tax base, taxpayers started to be interested in the opinion of the financial administration on its use. An unofficial opinion received by the Chamber of Tax Advisors of the Czech Republic is rather cautious. The financial administration emphasises that the interpretations of the National Accounting Board are an opinion of a certain group of professionals and are not legally binding. When assessing individual cases, the tax authority abides by the law and other regulations of the Czech Republic.
In general, the financial administration does not contest the interpretations of the Czech Accounting Board and admits them as supporting arguments where there is no direct legislation. However, if such legislation exists in Czech accounting regulations, the taxpayer may depart from such binding procedure only in exceptional cases described in the Accounting Act, and only with a reference to the principle of a true and fair presentation of the subject matter of accounting. However, such change must be duly justified, documented and must meet all the conditions of a change in the accounting method in line with accounting regulations, including a proper presentation of the impacts of such a change.
As a result, it can be summarised that if a taxpayer wants to proceed according to the above-described interpretations, the burden of proof will be on its side in case of tax proceedings, and it will have to document all reasons to the tax authority pertaining to why the statutory procedure is incompatible, in its case, with the true and fair view of accounting. It can be assumed that the burden of proof will be even more difficult, primarily in a situation when the difference in the procedure is not the mere “shift in time”, but where specific profit and loss items will be missing, as compared to the current practice.
Examples listed in the article are only illustrative and it is necessary to assess every individual situation on a case by case basis.