By Jeff Wallace
Greenwich Treasury Advisors

Managing a foreign entity on a non-local currency basis can often lead to volatile local currency earnings and tax planning problems.

Foreign entities are typically local currency functional for local-tax purposes, even if under FAS 52 they may be dollar functional (see IT, 2/10/03). So, while under GAAP, the affiliate’s FX balance sheet exposure may be flat, the foreign entity can be exposed (and often is) on a local currency basis because of its dollar position.

This can lead to volatile and unpredictable local-currency taxable income as a result of local-currency FX gains/losses on the dollar position. And that, in turn, can make local tax planning (see IT, 4/8/02) at least difficult and often impossible. Therefore, it is best that if the sub is dollar functional for GAAP, it is dollar functional for local tax.

Overseas subsidiaries do not necessarily have to be local-currency functional for the purpose of local taxes. Indeed, if properly approached, especially at the beginning of the investment, local tax authorities can be persuaded to allow dollar functionality for tax reporting purposes.

Admittedly, this is easiest to achieve for tax-advantaged treasury vehicles such as Belgium Coordination Centers, Dublin Docks Companies, and various Swiss canton SPEs.

Possible pitfalls

If there is a mismatch between the functional currency for GAAP and for local tax, however, then the FX hedging must take into account all tax-related impacts; these may include:

• Hyperinflation. There is a functional currency mismatch when FAS 8 rules apply due to hyperinflation. Under FAS 8, non-monetary items, such as inventory and PP&E are accounted for at historic dollar rates, whereas local-currency monetary assets/liabilities are translated at current rates with FX gain/loss going to P&L. This results in a hybrid local currency/dollar functionality from a GAAP standpoint, which often conflicts with local-currency functionality maintained for local tax purposes.

Case in point: Consider what happens to local, taxable profits after a major devaluation, if the inventory on hand can be sold at prices that cover or nearly cover the deval impact in dollar terms. The local tax authorities will charge taxes on the devaluation profit in local terms, i.e., a real cash tax on phantom economic profits. In dollar terms, however, the operating margin remains the same as it was pre-deval.

The result is that the effective tax rate increases enormously. There were instances in Brazil in the ‘70s/‘80s in which the local tax rate exceeded 100 percent of the dollar pre-tax operating profit. However, if the inventory is funded by dollar AP, there will be a corresponding local-currency FX loss that will offset the local currency inventory profits.

Treasury’s hedging efforts can get more complicated if the local tax rules adjust for inflation, such as Brazil’s monetary correction. In this situation, there’s often a significant basis risk between the actual dollar/local currency deval and the local tax inflation adjustment.

• Local tax traps. Further complications can arise if, as is the case in some countries, unrealized local currency FX losses on foreign currency liabilities (especially long-term debt) are not taxable until realized when the foreign- currency debt is repaid.

Another common complication is when local tax loss carryforwards can postpone the benefit of deducting FX losses for local-tax purposes. In this latter situation, treasurers can use some sort of discounted tax rate to hedge properly the underlying economics, but US GAAP does not recognize deferring taxes on a discounted rate basis, nor will it allow deferring taxes when it is not probable that the tax benefits will be realized in the foreseeable future.

• Asymmetric tax treatments. Further, treasurers must also consider the possibility of asymmetric tax treatments. While relatively uncommon, local-currency FX gains/losses on balance sheet exposures are usually taxed at ordinary rates, while the offsetting gain/loss on locally held derivatives could be taxed as a capital gain.

When a foreign unit’s FX exposures is hedged by an offshore derivative, e.g., a non-deliverable forward (NDF), there will almost always be different tax rates on the local gain/loss vs. the derivative gain/loss since the latter, by definition, is held by a unit in a different country under a different tax regime.

The most common occurrence of asymmetric tax rates is when a parent is hedging an affiliate’s net investment. FAS 133 requires that the parent hold the derivative, which will be taxed at the parent’s tax rate (usually ordinary), while of course there is no local tax offset on the foreign unit’s translation gain/loss.

In such cases, it is important to note that FAS 133 allows hedging of both cash flow and net investment exposures on an after-tax basis, i.e., MNCs can gross-up the amount of a derivative hedge so that after-tax, the derivative hedge covers the after-tax change in the value of the hedged position.

Conclusion

The key take-away is that that all FX exposures should be managed on an after-tax basis, factoring in local and US tax consequences on the local currency and non-local currency FX exposures. In many cases, risk managers may find that the pre- and after-tax position are not one and the same.

Mr. Wallace can be reached by email at jeff.wallace@greenwichtreasury.com.