A New Medley Of Tunes

DAVID SOUTHERN, barrister, summarises the Revenue's Consultative Document of 26 July 2001 on loan relationships and derivative contracts.

SOME 800,000 COMPANIES will be affected by major tax changes announced in the Revenue's Consultative Document of 26 July 2001, which included draft legislation. These changes are in the area of foreign exchange, financial instruments and loan relationships. Some changes took immediate effect on and from 26 July 2001.

The rest of the changes apply from the start of company accounting periods beginning on or after 1 January 2002. The full details of the changes will only be known in Finance Bill 2002. These extensive alterations in tax law will only be given legal authority when Finance Act 2002 becomes law towards the end of July 2002.

Thus Finance Act 2002, rather than changing the law in these areas, will have the function of ratifying changes which have already taken place without any legal basis. This is legislation by Consultative Document. The only thing of which one can be certain is that this method of proceeding substantially reverses the result of the constitutional struggles of the seventeenth century. What is needed is some John Hampden (the Case of Ship Money, 1637) to challenge the powers that be under the banner: 'No accruals accounting for debtor convertible bonds'.

This individual may not be immediately forthcoming, and in any case his protest may lack popular resonance. On the assumption that these changes, which have already happened or will soon come to pass, and will one day (barring unforeseen disasters) receive a legal basis, this article seeks to summarise the changes and their effects.

Changes with immediate effect

The main changes which took effect on and from 26 July 2001 are:

(1) The definition of convertible security in section 92, Finance Act 1996 is made more restrictive and exchange differences are taxable under the loan relationships rules. Accruals accounting is prescribed for debtor instruments.

(2) The definition of asset-linked security in section 93, Finance Act 1996 is also made more restrictive and exchange differences are taxable under loan relationships rules.

(3) The 'unallowable purpose' rule in paragraph 13 of Schedule 9 to the Finance Act 1996 is extended into the financial instruments rules: new section 168A, Finance Act 1994.

(4) A statutory definition of 'implied forward premium' and 'implied forward discount' is introduced. An implied forward discount/premium is taxable/relieved as a payment received/made: new section 153(5)(a)(b), Finance Act 1994.

(5) A special rule is introduced for guaranteed equity bonds: new sections 93A and 93B, Finance Act 1996.

Forthcoming changes

Other changes are to take effect in the first accounting period beginning on or after 1 January 2002.

The main changes under this heading are:

Assimilation of two régimes

Foreign exchange gains and losses on loan relationships are assimilated to Finance Act 1996, in accordance with new section 84A, Finance Act 1996. Gains and losses on currency contracts fall under new sections 153(2A) and (2B), Finance Act 1994.

This new régime will:

• treat exchange gains and losses on currency contracts as falling within the Financial Instruments legislation;
• treat exchange gains and losses on debts which are loan relationships as profits, gains and losses from loan relationships;
• bring into the loan relationships rules exchange gains and losses on money debts which are not loan relationships.

The foreign exchange transitional rules go in their entirety.

The assimilation of the foreign exchange to the loan relationship rules automatically has the consequence that the 'unallowable purpose' rule applies to loan relationship denominated in a foreign currency, but exchange gains will not be taxed where the loan relationship has an unallowable purpose.

Derivatives

As regards derivatives, it is proposed that the specific categories of six 'qualifying contracts' defined by reference to 'qualifying payments' (see Chapter II of Part IV, Finance Act 1994) should be replaced by one general category of 'derivative contract'. This covers all types of derivative, including credit derivatives, except equity derivatives held by non-traders and derivatives related to land. The term 'financial instruments' is replaced by the term 'derivative contracts'.

Derivative contracts will be brought within the scope of the general transfer pricing provisions in Schedule 28AA to the Taxes Act 1988.

Sections 92 to 94, Finance Act 1993 as amended will determine the currency and rate of exchange to be used for calculating currency gains and losses, in place of section 150, Finance Act 1994 which is to be repealed.

Forex

The forex matching rules are replaced in their entirety. When hedge accounting ('cover accounting') under Statement of Standard Accounting Practice 20 is used, i.e. gains and losses on hedging items are taken to reserves, the same approach must be adopted for tax purposes. The new matching rules will not include ships and aircraft, unless exchange differences are taken to reserves in the accounts. Matching may be possible on a consolidated as well as a single company basis. It has not been decided whether the deferred gains (or losses) will be taxed (or relieved) under the capital gains rules (as hitherto) or under the loan relationship rules, when the asset with which the liability is matched is disposed of.

Loan relationships

The test of control in establishing whether debtors and creditors are 'connected' under the loan relationship rules (with consequent non-allowability of bad debts and non-taxability of releases) is to be based on section 840, Taxes Act 1988 (voting power) rather than section 416, Taxes Act 1988 (voting power, entitlement to profits and entitlement to assets): new section 87A, Finance Act 1996. However, a new test of connection is introduced in the form of a 'major interest'. The corporate participator close company test is to become two way. The connected party rules will be extended to cover a situation where the loan creditor debtor is a partnership in which a member is a company. Where a company acquires impaired debt and at the same time becomes connected with the debtor, no write back of the debt to par value will be required where the price paid for the debt is less than 75 per cent of par value. Where the parties are connected, release of debt will be brought into charge to tax by the borrower, unless the lender is within the charge to United Kingdom corporation tax.

Broad effect of changes

As a result of these changes, three sets of rules will be combined into the following two:

(1) The loan relationships rules in Finance Act 1996 dealing with all forms of on balance sheet debt, interest and interest equivalents, including foreign exchange gains and losses in respect thereof. The rules also deal with debtor loan relationships used for hedging purposes, where the effect of the hedge is recognised for accounting purposes.

(2) The derivative rules in Finance Act 1994 dealing with all forms of off balance sheet derivatives contracts, i.e. contracts which under accruals accounting are not quantitatively recognised as assets or liabilities on the balance sheet but whose financial results are recorded in the accounts.

The intention would appear to be to assign currency contracts in their entirety to the derivative contracts rules, so that there are no areas of overlap between the loan relationships and derivative contracts rules. However, as currently drafted, the proposed changes do not conform with such an intention, because it would seem that, in the case of a cross currency swap with a real exchange of principals, or forward contracts which are expected to run to delivery, firstly exchange differences will fall under the derivative contract rules (see new sections 94(4A) and (4B), Finance Act 1993; new sections 153(2A) and (2B), Finance Act 1994), and secondly only the closing rate can be used if the contract runs over a year-end.

Detailed changes in relation to forex

Paragraph 4 of Schedule 9 to the Finance Act 1996 took exchange differences out of the loan relationship rules. Its repeal automatically brings them within Finance Act 1996. New section 84A, Finance Act 1996 is essentially declaratory. Exchange differences simply become a sub-heading of loan relationship debits and credits.

Exchange differences on currency contracts go to Finance Act 1994. The derivative contracts rules will extend to exchange differences arising from a derivative contract as a result of comparing at different times the expression in one currency of the amount payable under the contract in another currency (new sections 153(2A) and (2B), Finance Act 1994).

The old list of qualifying assets and qualifying liabilities disappears. Everything is to be a loan relationship, a derivative contract or stock in trade (e.g. foreign currency denominated shares held as trading stock).

Matching is retained as a fundamental part of the loan relationship rules. Where matching is used in the accounts, it will have to be used for tax purposes. The Consultative Document implies that matching will be available on a group basis (Statement of Standard Accounting Practice 51 plus 57 and 58). On ships and aircraft, unless exchange differences on both asset and liability go to the reserves, there will be no matching for tax purposes. On the published proposals, only a foreign currency borrowing can be matched with an asset. However, the Revenue has indicated that the liability leg of a currency contract can be used. It is unclear how gains or losses on the matching liability will be brought into account when the eligible asset is disposed of. In prescribed circumstances it is mandatory for income of a company to be computed in a foreign currency ('the relevant foreign currency') for accounting periods beginning on or after 21 March 2000. This is the 'functional currency' under Statement of Standard Accounting Practice 20. The only change is a proposed new anti-avoidance rule in new section 94A, Finance Act 1993 that the relevant foreign currency will not apply if the main benefit of using a functional currency is to avoid taxation of an exchange gain.

Convertible debt undergoes two changes with effect from 26 July 2001:

(a) the definition is changed and made more restrictive (see below); and

(b) in the case of convertible debt expressed in a foreign currency foreign exchange differences are moved from the capital gains to the loan relationship régime. Where these changes bite, there is a deemed disposal and reacquisition of the security for market value immediately before 26 July 2001. Market value will mean including foreign exchange gains or net of foreign exchange losses.

For asset-linked securities also there are two changes with effect from 26 July 2001:

(a) the definition is changed and made more restrictive (see below); and

(b) in the case of convertible debt expressed in a foreign currency foreign exchange, differences are moved from the capital gains to the loan relationship régime. Again, complex transitional issues will arise.

Deferral relief and excess gains and losses go, as do the transitional rules in their entirety. Those who have each year sedulously recorded the relief to which they are entitled under the kink test will have to console themselves as best they can, as the prize is suddenly whipped from their grasp.

Detailed changes in relation to loan relationships

As already noted, exchange differences are to fall within the loan relationship provision of the Finance Act 1996.

Exchange differences on items which are not loan relationships are brought within Finance Act 1996 by section 100.

An authorised accounting method for loan relationship purposes must conform with Statement of Standard Accounting Practice 20. This is an exception to the general accruals basis of accounting.

Foreign exchange bad debt relief rules are brought into line with the loan relationship rules.

Convertibles

The definition of convertible security within section 92, Finance Act 1996 has been made more restrictive on and from 26 July 2001 by the addition of four further pre-conditions to the requirements existing before that date. The new conditions are:

(i) the conversion must be into ordinary shares;

(ii) if conversion occurs, that must substantially replace the whole convertible debt;

(iii) an excluded indexed security cannot also be a section 92 convertible;

(iv) there cannot be arrangements to sell the security to another person who could then redeem at a deep gain.

The commentary suggested a further condition which is that conversion must only be shares listed on a recognised stock exchange of a company which is a trading company or a holding company as defined in paragraph 22(1) of Schedule A1 to the Taxation of Chargeable Gains Act 1992. However, the Revenue has apparently dropped this idea as being one condition too far.

As regards 'qualifying ordinary shares' in the company as defined in new section 92(14), i.e. any shares other than fixed rate preference shares. Premium put operations will now take securities outside section 92. There must not be 'premium put' arrangements. Issue costs relating the share element rather than the loan element will not be deductible under the loan relationship rules. There is a transitional rule, which applies where a security satisfies section 92 before 26 July 2001 but fails to satisfy it after the date. The capital gain or loss arising on a disposal of the security is calculated at that date, and brought into charge or relieved as income or expenditure on the disposal of the security. However, the precise impact of these rules will also deserve careful scrutiny.

Asset-linked securities

The definition of asset-linked security is made more restrictive on and from 26 July 2001. 'Chargeable asset' is thereafter confined to shares listed on a recognised stock exchange or land. This is achieved by defining 'chargeable asset' in new section 93(10) as follows:

'(10) … as asset is a chargeable asset, in relation to a loan relationship of a company, if the asset is –

Again, there is a transitional rule, which a security satisfies section 93 before 26 July 2001 but fails to satisfy it after the date. The capital gain or loss arising on a disposal of the security is calculated at that date, and brought into charge or relieved as income or expenditure on the disposal of the security.

Where a loan relationship would fall under section 93, Finance Act 1996 but arrangements involving futures and options are in place which will produce a guaranteed return on the security, i.e. a return analogous to interest on a loan, Schedule 5AA to the Taxes Act 1988 will apply to tax the gain as Schedule D, Case VI income: new section 93A. This is specifically directed at guaranteed equity bonds.

Control and connected persons

For accounting periods beginning on or after 1 January 2002, the test of control in establishing whether debtors and creditors are 'connected' under the loan relationship rules is to be based on section 840, Taxes Act 1988 (voting power) or major interest rather than section 416, Taxes Act 1988. The section 840 test of control is much narrower that the section 416 test, because it only looks to the voting power test of control, and does not include the economic tests of entitlement to profits on an income or capital distribution. However, an alternative 'major interest' test of connection is introduced. This means that in some situations where under the pre-2002 law two companies would not have been connected, under the new rules they are connected.

Section 840, Taxes Act 1988 says:

' "control", in relation to a body corporate, means the power of a person to secure

This reappears in new section 87A(1), Finance Act 1996. Subsections (3) and (4) of new section 87(1A) then go on to define the alternative new test of 'major interest'. 'Major interest' is defined in the same terms as the controlled foreign companies and transfer pricing legislation as existing where two people each have 40 per cent of the voting power. There will be a connection only if both companies have entered a creditor or debtor loan relationship with the company in which they hold the major interest.

New section 87(1A)(2) provides that if two or more persons, taken together, have control or a major interest, each is treated as having control or a major interest. New section 87A(5) applies to situations where two or more persons together have control or a major interest by attributing to them the rights and powers of connected persons and treating options as equivalent to ownership. 'Connected person' is defined in terms at section 839, Taxes Act 1988 but omitting section 839(7) (which says that two connected persons who exercise control are treated as connected with each other). The rights and powers in question are rights to secure that the direction of a company is directed according to one's wishes, option rights, rights of beneficial owners to direct nominees and similar rights of connected persons.

The introduction of a 'a major interest' test means that two 50:50 deadlock companies will each have a major interest in the company in which they hold shares, provided that each has lent money to or borrowed money from that company. This test will be of particular importance in relation to joint ventures.

The connected party rules are extended to cover a situation where the loan creditor debtor is a partnership in which a member is a company. Where a company is a member of a partnership, and it has a sufficient interest in the partnership to control it, he is treated as controlling it. This reverses the Revenue's Statement of Practice 4/98.

Under transitional rules to apply to the changes taking effect in accounting periods beginning on or after 1 January 2002, if parties to a loan relationship would under the new rules have been connected in the two accounting periods preceding the accounting period beginning on or after 1 January 2002, there is no carry forward of the change of status.

Other changes

For accounting periods beginning on or after 1 January 2002, a restriction is imposed on the rule (paragraph 5(3) of Schedule 9 to the Finance Act 1996) that no credit need be brought in by the debtor company when connected party debt is released. Where the parties are connected, release of debt will be brought into charge to tax by the borrower, unless either the release forms part of a relevant arrangement or compromise (Condition A) or the lender is within the charge to United Kingdom corporation tax (Condition B). This will alter the treatment of situations where a foreign company is a participator in or controls a United Kingdom company, and has made loans to the United Kingdom company which it intends to write off, e.g. to cover start-up costs. This will affect releases of loans by non-United Kingdom members of a group. Thus a parent or participator in another European Union Member State will suffer a disadvantage to which a United Kingdom parent or participator is not exposed. This is unlikely to conform with Community law.

As regards impaired debt, for accounting periods beginning on or after 1 January 2002 where a company acquires impaired debt and at the same time becomes connected with the debtor in an arm's length transaction, no write back of the debt to par value will be required where the price paid for the debt is less than 75 per cent of par value. Thus where the creditor becomes connected in these circumstances, he is not required to bring in as a credit the difference between the face value of the debt and the amount paid for it.

Re Toshoku Finance UK plc [2000] STC 301 is reversed by legislation for accounting periods beginning on or after 1 January 2002. A company in insolvent liquidation is not required to bring in bad or doubtful debts as credits.

Detailed changes in relation to financial instruments

If hedge accounting was used showing assets and liabilities at the contract rate, this could be kept off balance sheet and was outside the charge to tax. It will now be necessary to identify these items for tax purposes. Forward foreign currency purchases more than one year in advance will now be in the charge to tax. The new rules will no longer allow use of the rate implied by the contract to be used ('implied rate accounting' or 'hedge accounting') in valuing currency contracts, but instead either the closing rate used in the accounts as a whole or the spot rate must be used.

The new definitions

The various detailed definitions of 'qualifying contract' in sections 147 to 148A, Finance Act 1994 (to be repealed) are – under the proposals contained in the Consultative Documents of 26 July 2001 – to be replaced by a general provision that all derivative contracts (as defined in new section 152A) are qualifying contracts, unless they are excluded contracts (as defined in new section 152B). Various definitions of terms are contained in new section 152C. Under new section 152D the Treasury would have power to modify by regulation sections 152A to 152C.

The difficulty about this approach is that, given the rejection of the classification of contracts by reference to their economic function, it will become more difficult to delimit the spheres of respective application of the derivative contracts, loan relationships and capital gains rules.

While this idea has much to commend it, the proposed definition of 'derivative contract' in new section 152A is inadequate.

There are many points which can be raised about it, but it is essentially proposing as a substitute for six clearly defined contracts three vaguely defined ones, namely 'an option, a future, or a contract for differences'.

The 'unallowable purposes' rule is now extended to foreign exchange and financial instruments generally from 26 July 2001.

New medley

When the band of the Grenadier Guards played a selection from Richard Strauss's Salome, King George V sent a message to the bandmaster that he did not know what the band had played, but they were not – repeat not – to repeat it. The same might be said of the manner in which these changes are being introduced.

What of the substance? It is said that a string quartet consists of four people who think that the other three cannot play music. The draftsmen of the foreign exchange rules in Finance Act 1993, and the financial instruments rules in Finance Act 1994 were different individuals. Each went about his job in a completely different way, and each had a low opinion of the legal abilities of the other. The loan relationship rules in Finance Act 1996, which build on the Finance Act 1994 provisions, constitute a masterpiece of legal drafting. The demise of the foreign exchange rules will attract little mourning, but they did represent a remarkable pioneering effort. The changes constitute a significant deformalisation of the law. That may of itself be no bad thing, but the highly legalistic debt/equity distinction does set severe limits to the degree to which detailed legal rules can be dispensed with in this area. Moreover, it will be increasingly difficult to distinguish a loan relationship from a cash-settled derivative.

The changes of the greatest practical importance to most people will be the new connected party rules for loan relationships. While significantly relaxed, this will continue to be an area richly laced with heffalump traps.

David Southern is a barrister in practice at 3 Temple Gardens Tax Chambers, and can be contacted at 020 7353 7884, e-mail clerks@taxcounsel.co.uk. He is also editor of the ACT Manual of Tax and Accounting in Corporate Treasury Transactions (Gee Publishing).

Based on material in Tolley's Taxation of Corporate Debt, Foreign Exchange and Financial Instruments fifth edition (November 2001), by David Southern and the PricewaterhouseCoopers Foreign Exchange Tax Team.

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