New Look FOREX

VIMAL TILAKAPALA of Allen & Overy considers the key aspects of the new foreign exchange gains and losses rules.

THE CURRENT RULES for taxing exchange gains and losses will, following enactment of the draft rules contained in the Finance Bill, change fundamentally for accounting periods beginning on or after 1 October 2002. Although the proposed reform is radical and requires significant legislative change, it introduces a welcome degree of simplification to a complex area resulting in a far more understandable and logical régime.

This article contains an overview of the key aspects of the new rules and how they differ from the current rules in Finance Act 1993.

Background to reform

The Finance Act 1993 rules are criticised widely for their complexity and artificiality. The rules were the Government's initial attempt to establish a coherent system for taxing exchange gains and losses. They are intended to tax a company's currency gains and losses arising on its monetary assets or liabilities and certain currency derivatives, broadly in accordance with its accounts.

The Finance Act 1993 rules are the first of three sets of legislation aimed to 'follow the accounts'; the second being the financial instruments rules in Finance Act 1994, and the third being the loan relationship rules in Finance Act 1996. They are also the least satisfactory. This is because, rather than simply following the accounting rules, they try instead to provide an exhaustive statutory framework intended to produce the same result as United Kingdom generally accepted accounting principles in most situations. In contrast, the financial instrument and loan relationship rules lay down two acceptable accounting methods.

The new rules in the Finance Bill 2002 provide for the total repeal of the Finance Act 1993 rules and the assimilation of the rules for taxing exchange gains and losses into the loan relationships rules in Finance Act 1996 and the new derivatives rules in Schedule 26 to the Finance Bill (formerly the financial instruments rules).

To appreciate the new rules, an understanding of the current ones is useful. It must also be borne in mind that the current rules will continue to be relevant for some time, as the new ones will apply only for accounting periods beginning on or after 1 October 2002.

Finance Act 1993 rules

The Finance Act 1993 rules apply only to:

• qualifying assets and qualifying liabilities; or
• currency contracts.

Each of these terms is defined exhaustively in sections 153 and 126, Finance Act 1993 respectively.

Qualifying assets and liabilities include most loan relationships and also shares held on trading account. Currency contracts include derivatives under which a company becomes entitled to receive a specified amount of one currency and subject to a duty to pay a specified amount of another currency.

Exchange gains and losses

Exchange gains and losses arising on qualifying assets and liabilities or currency contracts must be brought into account on a translations basis.

An exchange gain or loss arises for this purpose if:

• for qualifying assets or qualifying liabilities, there is a difference between the 'local currency equivalent' of their 'basic valuation' at the beginning and end of an 'accrual period' (section 125, Finance Act 1993); or
• for currency contracts, there are differences between the 'local currency equivalents' of the relevant currencies at the beginning and end of an 'accrual period' (section 126, Finance Act 1993).

The currency by reference to which a company's exchange gains and losses is determined, whether generally or in relation to a particular business (its 'local currency'), is prescribed by sections 92 and 93, Finance Act 1993. Under these sections the default local currency is sterling unless, broadly:

• the company prepares its accounts as a whole in a foreign currency in accordance with normal accountancy practice, or it prepares its accounts in sterling but, in relation to a particular business, prepares them using the closing rate/net investment method from financial statements prepared in a foreign currency; or
• in the case of a United Kingdom branch of a foreign company, the company makes a return of accounts for its branch in a foreign currency in accordance with normal accountancy practice or it makes a return of accounts for that branch in sterling but, so far as relating to a particular business, it is prepared from foreign currency financial statements.

In these cases the relevant foreign currency is the 'local currency', either for the company as a whole or in respect of a particular business.

'Accrual periods' are defined in section 158, Finance Act 1993 as periods beginning and ending with 'translation times'. These are, broadly, the times at which:

(i) it becomes party to the qualifying asset or liability or a currency contract;

(ii) it ceases to be a party; and

(iii) the end of an accounting period.

The 'basic valuation' of a qualifying asset or qualifying liability is normally the valuation the company puts on it immediately after it becomes entitled to it or subject to it or, if different, the valuation required to be put on it at that time under normal accountancy practice (section 159, Finance Act 1993). For a non-local currency debt liability, this must be expressed in its nominal currency (section 159(2)).

The 'local currency equivalent' of a foreign currency amount is determined by reference to section 150, Finance Act 1993, which specifies the exchange rate that should be used. Although this depends on the particular translation time concerned and the exchange rate adopted by the company, the general idea is that where a rate is used by the company in its accounts, that rate can be used provided that it is an arm's length one.

Exchange gains and losses are dealt with exclusively under Finance Act 1993. Paragraph 4 of Schedule 9 to the Finance Act 1996 excludes those gains and losses on loan relationships that are dealt with under Finance Act 1993 from the credits and debits to be brought into account under the loan relationship rules. Section 162, Finance Act 1994 excludes those gains and losses arising on currency contracts from being qualifying payments on qualifying contracts under Finance Act 1996.

Exchange gains and losses that arise in the course of a company's trade are treated as trading receipts or expenses (section 128, Finance Act 1993), while those that arise other than in the course of a company's trade are treated as non-trading loan relationship credits or debits (section 130, Finance Act 1993).

Divergence from the basic rules

The requirement to bring exchange gains and losses into account on a translations basis is subject to two main exceptions.

Matching

The matching rules (Statutory Instrument 1994/3227) enable a company, in certain circumstances, to match by election a qualifying liability or a liability under a currency contract with certain types of assets outside Finance Act 1993.

Where a matching election is made, exchange gains and losses on the qualifying liability or currency contract are held over until the matched asset is disposed of, at which time the aggregate exchange gain/loss is brought into account as a chargeable gain/allowable loss (or, in the case of an asset which is a ship or an aircraft, as an exchange gain or loss under Finance Act 1993). These rules enable a company to eliminate, to some extent, mismatches that would otherwise arise from hedging its balance sheet translation exposure.

The matching rules contain an exhaustive and fairly short list of assets that are suitable for matching. There are also strict rules on how and when a matching election must be made.

Deferral

In recognition of the cashflow difficulties that can arise by taxing unrealised gains, Finance Act 1993 includes a limited provision allowing a company, by election, to defer recognition for tax purposes of unrealised exchange gains on long-term capital assets and liabilities (but not currency contracts).

Where a deferral election is made under section 139, Finance Act 1993, most of the gain covered by the election is treated as arising not in the current accounting period but in the next one. Although the rules for computing how much of a gain can be deferred are exceptionally complex, particularly where the company is part of a group, the broad principle is that the amount available for deferral is reduced by ten per cent of the company's profits. The maximum of any gain that can be deferred is, therefore, 90 per cent in any year, although further deferral elections can be made in subsequent years.

New rules

As mentioned, the new rules assimilate the rules for exchange gains and losses into the loan relationship rules in Finance Act 1996 and the new derivative rules in Schedule 26 to the Finance Bill 2002.

The approach taken for loan relationships and derivatives is virtually the same, with the credits and debits to be brought into account under each of those régimes being extended to include credits and debits representing exchange gains and losses.

Loan relationships

For loan relationships, the key change is to section 84, Finance Act 1996 (the primary section that specifies the debits and credits to be brought into account under the loan relationship rules) through the introduction of a new section 84A (paragraph 3 of Schedule 23 to the Finance Bill).

New section 84A provides that, subject to certain exclusions, references to profits, gains and losses in section 84, Finance Act 1996 will:

'include[s] a reference to exchange gains and losses arising to the company from its loan relationships.'

Section 103, Finance Act 1996 is amended (by paragraph 7 of Schedule 23 to the Finance Bill) to define what exchange gains and losses are for this purpose. A new section 103(1A), Finance Act 1996 provides that:

There is a corresponding change to section 85, Finance Act 1996 (authorised accounting methods) in paragraph 4 of Schedule 23 to the Finance Bill, which provides that to be an authorised accounting method for the purpose of Finance Act 1996, an accounting method must:

'contain proper provision for determining exchange gains and losses from loan relationships for accounting periods.'

A necessary amendment is also made to the list of requirements for an authorised accruals basis of accounting. Currently, an accruals basis (unlike a mark to market basis) must take into account only income receivable or payable and amounts receivable or payable on repayment/disposal of an asset or liability. It is not required to pick up changes in the value from time to time of the asset or liability being accounted for. To make the new section 84A work, the new rules provide that an accruals basis will now have to take into account value differences from time to time of an asset as a result of exchange rate movements.

These provisions encompass pretty much all of the 'old' concepts of qualifying assets, qualifying liabilities, accrual periods, translation times, basic valuations etc. which are laid out in so much detail in Finance Act 1993. The key difference is that rather than defining them, as in Finance Act 1993, reliance is placed instead on proper accounting practice to capture the relevant exchange gains and losses for tax purposes.

Divergence from the basic rule

In the new section 84A, there are a number of exclusions from the basic obligation to bring exchange gains and losses into account. Two key exclusions are for long term loans and liabilities which are matched with assets.

Long term loans (new section 84A(3)(a))

This applies to exchange gains and losses arising on loan relationship assets that are taken to reserves in accordance with generally accepted accounting principles. It is meant to catch long term loans that are treated, in accordance with generally accepted accounting principles (Statement of Standard Accounting Practice 20), as being as permanent as equity and is intended to compensate in part for the abolition of deferral relief. It is worth noting that there is no similar relief as in Finance Act 1993 for long term liabilities. The narrow scope of the new provision is not good news for companies with unrealised gains on long term loan relationship liabilities, or long term loan relationship assets that are not regarded for accounting purposes as being as permanent as equity. Although the Inland Revenue states that the number of companies affected by the abolition of deferral relief is insignificant, there are some companies that will be required to bring in to account considerable gains which they have historically been able to defer.

Liabilities which are matched with assets (new section 84A(3)(b))

This applies to exchange gains and losses arising on liabilities which, in accordance with generally accepted accounting principles, are:

• taken to reserves; and
• set off by or against an exchange loss/gain arising on an asset of the company which is also taken to reserves.

This provision replaces the current matching rules. It differs from the current rules in two important ways. First, the new rules are mandatory, whereas the current ones are elective. If an asset and liability are matched in a company's accounts in accordance with generally accepted accounting principles (Statement of Standard Accounting Practice 20), exchange gains and losses arising on the liability will automatically be excluded from new section 84A.

Second, the current rules contain an exhaustive (and relatively short) list of assets that can be matched. Under the new rules, any assets that are matched in the accounts with a suitable liability are covered.

The treatment of held-over exchange gains and losses will be dealt with by new regulations (the 'Bringing into Account Gains or Losses Regulations'). The first draft of these (published 24 April 2002) provides, broadly, for the aggregate held-over exchange gain or loss (referred to in the regulations as the 'net gain' or 'net loss') to be dealt with as follows.

On a disposal of matched assets within the chargeable gains régime, unless the assets are holdings within the substantial shareholdings régime or 'foreign business assets', the net gain or net loss will be brought into account as a chargeable gain or allowable loss.

The draft regulations aim to follow the capital gains treatment of the matched asset disposed of. This is why net gains or net losses on holdings within the substantial shareholdings provisions are left out of account. Similarly, on disposals which, under the provisions of the Taxation of Chargeable Gains Tax Act 1992, are no gain/no loss disposals, the net gain or net loss will be brought into account only on the first chargeable disposal. Also, on a disposal to which the Taxation of Chargeable Gains Act 1992 reorganisation provisions in section 116 or section 127 apply, the net gain/loss is either brought into account as an adjustment to the market value of the 'old asset' or an adjustment to disposal consideration of a 'new holding' as appropriate. This approach is, in general, the same as under the current matching rules.

On a disposal of a matched loan relationship asset, the treatment depends on the nature of the loan relationship asset in question and whether or not it is matched with a loan relationship liability. Loan relationships that are chargeable assets, i.e. asset linked or convertible notes, are generally dealt with in the same way as other chargeable assets.

Loan relationship assets that are matched with loan relationship liabilities are not covered by the regulations. This is because the gains and losses on those assets will be offset by the gains and losses on the liabilities with which they are matched.

On a disposal of a matched asset which is a ship or aircraft, the net gain/loss will be brought into account as loan relationship debit or credit.

The draft regulations also make special provision for exchange gains and losses arising on unmatched long term loan relationship assets (within new section 84A(3)(a) above). They allow exchange gains and losses on them to be held over until disposal and then brought into account as a loan relationship credit or debit.

Where a company has a number of matched same-currency assets, a problem caused by automatic matching is identification, i.e. how to work out which asset is matched with which liability. This problem does not arise under the current matching rules, as each asset and liability must be the subject of a specific matching election.

The solution contained in the draft regulations is a statutory order of priority, which on disposal of one of a pool of matched same-currency assets, will be used to determine how any held over exchange gain or loss should be brought into account.

The order in the draft regulations is, broadly, as follows:

• first to loan relationship assets (other than those treated as chargeable assets) or to ships or aircraft;
• second to chargeable assets (other than 'foreign business assets') that would on disposal give rise to a chargeable gain or allowable loss; and
• third to assets within the substantial shareholdings rules, a disposal of which would not give rise to a gain or loss, and then to foreign business assets.

For the purpose of the new rules, a 'foreign business asset' is one which is held by part of a company's business in respect of which, in accordance with the local currency provisions, the company must compute its profits and losses for tax purposes in a currency other than its main local currency. Under normal accounting practice (Statement of Standard Accounting Practice 20), a company is required to bring exchange gains and losses arising on such assets into reserve, where they are automatically offset by exchange gains and losses arising on liabilities that hedge them. It is not, therefore, necessary for these assets to be dealt with under the new regulations.

Local currencies

It is still necessary to establish what a company's base currency should be for the purpose of determining its exchange gains and losses.

The basic principles for this determination (outlined above) stay the same, although some changes are made to the specific provisions in Schedule 24 to the Finance Bill. One change worth noting is at clause 4 of Schedule 23 (which takes effect as a new section 93A, Finance Act 1993). This makes more detailed provision for companies that prepare their accounts as a whole in one currency but which, in relation to a part of their business, prepare their accounts using the closing rate/net investment method from financial statements prepared in another currency.

Derivatives

The approach taken in the new derivatives legislation is virtually the same as that taken for loan relationships. Paragraph 15 of Schedule 26 to the Finance Bill is the main provision that requires a company to bring into account profits and losses arising on its derivative contracts in accordance with its accounts.

Paragraph 16 of Schedule 26 provides, in the same manner as new section 84A for loan relationships, that references to profits and losses include a reference to exchange gains and losses subject to certain exclusions. Exchange gains and losses for this purpose are defined in a similar way as for loan relationships (paragraph 15(2) of Schedule 26).

The main exclusion from the basic rules is at paragraph 16(4) of Schedule 26 for currency derivatives, and is equivalent to the mandatory matching rule in the loan relationship rules. The exclusion for long term assets is not replicated for derivatives.

Some points to note

The assimilation of foreign exchange gains and losses with loan relationships and derivatives makes the treatment of exchange gains and losses subject to some of the general loan relationship and derivative anti-avoidance rules (in addition to a number of the current Finance Act 1993 anti-avoidance rules which are incorporated in the revised legislation).

A wider set of anti-avoidance provisions will, therefore, be applicable to exchange gains and losses. In particular, the provisions of paragraph 13 of Schedule 9 to the Finance Act 1996 (loan relationships entered into for unallowable purposes) and the equivalent provision for derivatives in paragraph 23 of Schedule 26 to the Finance Bill will now apply to exchange gains and losses, with exchange gains as well as losses and other debits falling to be disregarded on loan relationships or derivatives that have been entered into for an unallowable purpose.

Another consequence of assimilation is that exchange gains and losses on assets or liabilities that are neither loan relationships nor derivatives will no longer be governed by a statutory code. Under the old rules, shares held in qualifying circumstances, i.e. by traders on trading account, could be 'qualifying assets'. From the introduction of the new rules, the tax treatment of exchange gains and losses arising on these assets will presumably go back to being dealt with under general principles. Although the overall tax result should be the same, an interesting result is that the specific statutory anti-avoidance provisions will no longer apply.

Hedging tax liabilities

Under the new rules, exchange gains and losses arising from certain money debts are specifically not taken into account. One of these exclusions is for money debts representing amounts of tax, whether United Kingdom or foreign. It is difficult to see the reason for this exclusion particularly given that, in our experience, it is fairly common for companies that have non-sterling local currencies to enter into hedging arrangements in respect of their obligations to pay sterling corporation tax instalments. The new rules will make the post-tax hedging of such liabilities far more difficult for non-trading companies.

Issue: 3866 / Categories: