Determination G14A: Forward Contracts for Foreign Exchange and Commodities: An Expected Value Approach This determination may be cited as ``Determination G14A: Forward Contracts for Foreign Exchange and Commodities: An Expected Value Approach''. 1. Explanation (which does not form part of the determination) What is a Forward Contract for Foreign Exchange and Commodities? A forward contract for foreign exchange or commodities is a contract to buy or sell specified amounts of foreign currency or commodities at some future date at a specified contract rate. For example, a forward contract for foreign currency is a contract to buy or sell specified amounts of a currency at a future date at a price fixed (in terms of another currency) at the time the contract is entered into. Each party contracts simultaneously to sell one currency and purchase another currency. The same forward contract can always be viewed as either the sale of one currency or the purchase of the other currency. For example, a person who sells NZD forward against purchase of USD can view the contract as either The forward sale of NZD; or The forward purchase of USD. A forward contract has characteristics that are very similar to a swap contract. In fact, swaps are often structured as a series of forward contracts. If you are a party to a swap, however, you may not apply this determination as swaps are subject to Determination G27. The only exception is a swap contract for fixed amounts, to be exchanged at a single fixed date. This type of swap is, in substance, a forward contract. Therefore, if you are a party to this type of financial arrangement, you have to apply this determination instead of Determination G27. What methods can be used to calculate income or expenditure under a Forward Contract for Foreign Exchange and Commodities? Expected Value Approach This determination sets out an expected value approach to calculate gross income or expenditure from a forward contract. This expected value approach can only be used for forward contracts within the scope of this determination, which is narrower than Determination G14: Forward Contracts for Foreign Exchange and Commodities. If you elect to use this determination, you must not use Determination G14 for any such forward contract, and you must not use Determination G9A: Financial Arrangements that are Denominated in a Currency or Commodity other than New Zealand Dollars for any financial arrangement within the scope of Determination G9B: Financial Arrangements that are Denominated in a Currency other than New Zealand Dollars: An Expected Value Approach. Mark to Spot Approach You can use Determination G14: Forward Contracts for Foreign Exchange and Commodities to calculate gross income or expenditure of any forward contract within the scope of this determination if you have not used this determination or Determination G9B: Financial Arrangements that are Denominated in a Currency Other than New Zealand Dollars: An Expected Value Approach. Alternatively, you may use the mark to market method if you satisfy the requirements of section EH 1 (6) of the Act. You may also use a method allowed by the proviso to section EH 1 (5) (a) of the Act. How do I use the method set out in this determination? Under this method, the gross income or expenditure from a forward contract is the total of an expected component and an unexpected component. A typical forward contract drawn at the forward rate for no consideration, however, has no expected component. To apply this method: ignore any offsetting of payments between the parties, so that every amount that would be payable under the forward contract is taken into account under this determination. choose one of the currencies under the forward contract as a base currency. determine the expected component by taking into account all the base currency payments and payment dates in relation to the forward contract when you become a party to the contract. the base currency payments in relation to the forward contract consist of: (a) the base currency value of the payment or receipt, if any, made in consideration of entering into the contract; (b) the base currency value of the non-base currency payment to be made under the contract valued at the forward rate; and (c) the base currency value of the non-base currency payment to be made under the contract valued at the contract rate. convert the expected base currency payments, where the base currency is not NZD, into expected NZD payments on the basis of forward rates available at the time you become a party to the forward contract. spread the expected NZD net amount over the term of the forward contract. calculate the gross income or expenditure of a forward contract entered into before the income year you elect to use this determination as set out above, except that you must: (a) use actual NZD payments up to the income year you elect to use this determination and expected NZD payments for the remaining term of the financial arrangement in determining the expected component of the gross income or expenditure; and (b) use the relevant forward rates at the end of the income year you elect to use this determination for the purpose of calculating the expected NZD payments. perform the base price adjustment under section EH 4 of the Act when the forward contract you are a party to matures or is disposed of. This adjustment contains the unexpected component of the gross income or expenditure of the forward contract. How do I elect to use the method outlined in this determination? You may elect to use this determination by returning your gross income or expenditure on the basis of this determination for the 19981999 income year, or the 19992000 income year, or in the first income year in which you become a party to any forward contract that is within the scope of this determination. In the income year you elect to use this determination to calculate gross income or expenditure from a forward contract entered into before the income year, you must perform a transitional adjustment calculation. This determination provides for a transitional adjustment calculation that is comparable to Determination G25: Variations in the Terms of a Financial Arrangement. How do I calculate the transitional adjustment? The transitional adjustment must be made in the income year you elect to use this determination. The transitional adjustment calculation must be made for each forward contract entered into before the income year you elect to use this determination. It requires that you treat the difference between the total amount that would have been gross income or expenditure calculated as described in this determination and the total amount actually recognised over the previous income years, as gross income or expenditure in the income year of the adjustment. How is income or expenditure calculated in the year the forward contract matures or is disposed of? Regardless of which method you choose to use, you must calculate income or expenditure under the base price adjustment in section EH 4 of the Act. If you are a party to a forward contract, you are both a vendor and a purchaser. As such, you are a holder under the definition of ``holder'' in section OB 1 of the Act. This categorisation is important for the purpose of calculating income or expenditure in accordance with section EH 4 of the Act. 2. Reference This determination is made pursuant to section 90 (1) (c) of the Tax Administration Act 1994. 3. Scope (1) This determination applies to the calculation of gross income or expenditure from a forward contract for foreign exchange and commodities. (2) This determination will not apply to (a) A futures contract; (b) A security arrangement; (c) A forward contract for foreign exchange and commodities where the forward rates of the currency cannot be determined; or (d) Any financial arrangements covered by the following determinations Determination G19: Exchange Traded Option Contracts; Determination G20: Discounted Value of Amounts Payable in Relation to Trade Credits Denominated in a Foreign Currency; Determination G21: Discounted Value of Amounts Payable in Relation to Deferred Property Settlements Denominated in a Foreign Currency; Determination G21A: Agreements for Sale and Purchase of Property Denominated in Foreign Currency: Discounted Value of Amounts Payable; Determination G27: Swaps; Determination G29: Agreements for Sale and Purchase of Property Denominated in Foreign Currency: Exchange Rate to Determine the Acquisition Price and Method for Spreading Income and Expenditure; except as specifically allowed by those determinations. (3) You may use this determination if (a) an election to use this determination is made by returning your income or expenditure on the basis of this determination in the 19981999 income year or the 19992000 income year or the first income year in which you become a party to a forward contract within sub-paragraphs (1) and (2) above; and (b) Determination G14: Forward Contracts for Foreign Exchange and Commodities is not used to calculate gross income or expenditure of any forward contract that is within sub-paragraphs (1) and (2) above; and (c) Determination G9A: Financial Arrangements that are Denominated in a Currency or Commodity other than New Zealand Dollars is not used to calculate gross income or expenditure of any financial arrangement that is within the scope of Determination G9B: Financial Arrangements that are Denominated in a Currency or Commodity other than New Zealand Dollars: An Expected Value Approach. (NOTE: A determination to which Determination G14A refers may be changed or rescinded by a new determination made by the Commissioner. In such a case, a reference to the old determination is extended to the new determination.) 4. Principle (1) If you are a party to a forward contract to which this determination applies, the gross income or expenditure in respect of the forward contract is calculated by taking into account all amounts arising from the fluctuations of exchange rates or commodity prices. (2) The gross income or expenditure from the forward contract is the total of an expected component and the unexpected component. You must measure the expected component at the time you become a party to the forward contract. You must also recognise the unexpected component by performing the base price adjustment required under section EH 4 of the Act. (3) To measure the expected component you must convert the base currency payments into expected NZD payments on the basis of forward rates at the time you become a party to the forward contract, and spread the expected NZD net amount over the term of the contract. (4) You may use this determination to calculate gross income or expenditure of forward contracts entered into before the income year in which you made the election and in respect of which section EH 4 of the Act does not apply. You must then use this determination for all such forward contracts. In this case, you must follow the principle set out above except that you must calculate the expected NZD net amount using actual NZD payments up to the end of the income year in which you elect to use this determination and the forward rates at the end of that income year. Transitional Adjustment (5) You must perform the transitional adjustment calculation in the income year in which you elect to use this determination to calculate gross income or expenditure of any forward contract entered into before that income year. (6) This adjustment ensures that the gross income or expenditure up to the end of the income year in which you elect to use this determination is equal to that that would have been returned if the actual NZD payments and the forward rates, as described in sub-paragraph (4), were known and this determination had been used since you become a party to the forward contract. 5. Interpretation In this determination: (1) A reference to the ``Act'' is a reference to the Income Tax Act 1994. (2) ``Base currency'' in relation to a person and a forward contract, means the currency under the forward contract which is adopted by the person as a reference currency for the purposes of this determination. ``Commencement date'' of a forward contract means the date on which the contract was entered into, or the date on which it was acquired, if later. ``Contract rate'', in relation to a forward contract means the price of one currency expressed in terms of the other currency under the forward contract. ``Covered interest parity'' means the theoretical proposition that the differential between forward and spot exchange rates is equal to the interest differentials. That is, the forward rate for a foreign currency exchange at time t for 1 period ahead is equivalent to the spot rate at time t, S[in't'], multiplied by one plus the foreign interest rate, i[in'f'], divided by one plus the domestic interest rate, i[in'd']. Forward rates at time t for n periods, Fwd[in't'][in','][in'n'], can thus be derived based on the principle of covered interest parity as: (1 i[in'f'])[su'n'] [li-5]Fwd[in't'][in','][in'n'] S[in't'][li5] (1 i[in'd'])[su'n'] [li-5] [li5] ``Currency'' includes any commodity used as a medium of exchange or account, whether in general use or for the purpose of an arrangement. ``Exchange rate'' means the price of one currency expressed in another currency. ``Forward rate'' means the exchange rate for a forward contract as defined in Determination G6D: Foreign Currency Rates or the forward exchange rate calculated using the principle of covered interest parity or other methods that are commercially acceptable. In the case of a forward contract for commodities, the forward rate is the future value of the commodities (in NZD). ``Future value'' in relation to a commodity and a future date means the value of the commodity at the future date, on a given date, derived from any commercially acceptable, market-based method of valuation. ``NZD'' means the currency of New Zealand. ``Non-base currency'' means the currency under a forward contract that is not the base currency. ``Spot contract'' means a contract for the sale or purchase of a currency for delivery in 2 business days. ``Spot rate'' means the exchange rate for a spot contract as defined in Determination G6D: Foreign Currency Rates or in the case of a commodity, the spot value (in NZD) of the commodity. ``Spot value'' in relation to a commodity and a day means the value of the commodity on that day derived from any commercially acceptable method of valuation. ``USD'' means the currency of the United States of America. (3) All other terms used have the same meaning given to them for the purpose of the qualified accruals rules in the Act. 6. Method (1) Your gross income or expenditure in an income year from a forward contract under this determination is the total of: (A) the expected component, calculated in accordance with sub-paragraphs (4) to (7); and (B) the unexpected component, calculated in accordance with sub-paragraph (8). (2) To calculate the income or expenditure in relation to a forward contract, you must first nominate a base currency. (3) If the terms of the forward contract provide for the netting off or offsetting of any amounts payable to or by one party to the forward contract with any amounts payable to or by the other party to the forward contract, you must ignore such netting off or offsetting for the purpose of this determination. (4) You must calculate the expected component for each income year of the remaining term of the forward contract at the time you become a party to the contract. The expected component is calculated by first taking into account all base currency payments in relation to the forward contract. The base currency payments of a forward contract consist of: (a) the base currency value of the payment or receipt, if any, made in consideration of entering into the forward contract; (b) the base currency value of the non-base currency payment to be made under the contract valued at the forward rate; and (c) the base currency value of the non-base currency payment to be made under the contract valued at the contract rate. (5) You must convert the base currency payments into NZD using forward rates at the time you become a party to the financial arrangement, if the base currency is not NZD. (6) The expected NZD net amount is the difference between items (b) and (c) in sub-paragraph (4), adjusted for any amount as described in item (a). You must spread the expected NZD net amount using the yield to maturity method consistent with Determination G3 and, where necessary, allocate it to the income year on the basis of Determination G1A. This will give the expected component for each income year. (7) You must spread the expected NZD net amount of a forward contract that has been written for no consideration at a rate other than the forward rate using the straight-line method. (8) The unexpected component is the difference between the actual NZD value of the payments during the year and the expected NZD value of those payments as calculated under sub-paragraph (5). You need not calculate the unexpected component separately as it is part of the base price adjustment required under section EH 4 of the Act. Transitional Adjustment for Existing Forward Contracts for Foreign Exchange and Commodities (9) If you elect to use this determination to calculate gross income or expenditure of any forward contract entered into before the income year you made the election, you must follow the method set out in sub-paragraphs (1) to (8) to calculate gross income or expenditure of these contracts, except that (a) the NZD net amount to be spread under sub-paragraph (6) consists of actual NZD payments that have occurred since you become a party to the forward contract until the end of the income year you elect to use this determination, and expected NZD payments in the remaining term of the forward contract; and (b) the expected NZD payments in the remaining term of the forward contract must be calculated on the basis of the forward rates available at the end of the income year you elect to use this determination. (10) You must perform a transitional adjustment calculation in the income year in which you elect to use this determination to calculate gross income or expenditure of any forward contract entered into before the income year you made the election. You must perform the transitional adjustment calculation for each of those forward contracts in accordance with the following formula: a b c d where a is the sum of all amounts that would have been income in respect of the forward contract from the time it was entered into until the end of the income year, if this determination was applied from the time you become a party to the forward contract; b is the sum of all amounts that would have been expenditure in respect of the forward contract from the time it was entered into until the end of the income year, if this determination was applied from the time you become a party to the forward contract; c is the sum of all income in respect of the forward contract since it was acquired until the end of the previous income year; d is the sum of all expenditure in respect of the forward contract since it was acquired until the end of the previous income year. A positive net amount is gross income while a negative net amount is gross expenditure in the income year you elect to use this determination. 7. Examples (1) A New Zealand corporate borrower enters into a long term forward foreign exchange contract to buy 1 million US dollars (USD) against delivery of New Zealand dollars (NZD) in 2 years time. The contract was entered into on 30 April 1999 for no consideration and the corporate borrower has a balance date of 30 June. The contract rate is 0.5919 USD to 1 NZD, so settlement will require delivery of NZD $1,689,475. The corporate chooses NZD as the base currency for this contract. (2) At the time the New Zealand corporate becomes a party to the forward contract, the expected NZD net amount is zero and so the expected component of the gross income or expenditure from the forward contract is zero. The New Zealand corporate will recognise the unexpected component of the gross income or expenditure from the forward contract when performing the base price adjustment under section EH 4 of the Act. Signed on the 27th day of April 1998. ROBIN OLIVER, General Manager, Policy.