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ADVISERS OFTEN WORRY if a 'cap' on foreign exchange profits is drafted so as to permit a foreign exchange gain of more than 0.5 per cent a year. This worry is unnecessary.
I consider that the deep gains calculation, in paragraph 3 of Schedule 13 to the Finance Act 1996, excludes potential profits arising by reason of foreign currency fluctuations. In other words, foreign exchange fluctuations are irrelevant to determining whether or not a particular loan note is a relevant discounted security or not.
I am grateful to the Inland Revenue Financial Institutions Division for confirming that it agrees with the conclusion of this article, which the Revenue is aware will be published. I should say that this confirmation does not extend to either agreement or disagreement with the reasons for my conclusion and that the Revenue has understandably reserved its position with the basis of this conclusion, albeit that it agrees with the conclusion itself.
Statutory references are to the Taxation of Chargeable Gains Act 1992 unless otherwise specified.
The exclusion of foreign exchange fluctuations is particularly important for taxpayers outside the corporation tax charge, who are subject to capital gains tax, who wish, for, example, to structure a loan note to be a non-qualifying corporate bond, by reason of section 117(1)(b), by inserting a foreign exchange redemption clause, exercisable at the option of the holder. The spot rate is usually selected by reference to a date falling ten days or more prior to redemption; the date of redemption itself cannot be taken, as section 117(1)(b) will then not apply. The ten-day gap between the selected date and the date of redemption has become conventional, because the Revenue appears to consider that any shorter a period between those two dates makes the prospect of foreign exchange profits sufficiently weak so as to permit it to ignore the foreign exchange option altogether.
Potential deep gain
However, clearly a loan note which is issued in sterling but is redeemable at the option of the holder (or, indeed, at the issuer's option if paragraph 3(1A)(a) of Schedule 13 to the Finance Act 1996 is disapplied by paragraph 3(1C)) potentially gives rise to a deep gain (should the option foreign currency appreciate against sterling). Conventional practice is to insert a cap which precludes the prospect of a deep gain arising by reason of foreign exchange fluctuations into every debenture, limiting potential foreign exchange profits to 100.5 per cent of the redemption sterling value a year. Since redemptions part way through a year are relevant to the deep gains calculation (see paragraph 3(4) of Schedule 13 to the Finance Act 1996), the cap must itself limit potential foreign exchange gains to take account of redemptions during the course of a year. For example, suppose a debenture issues at £100 (and redeems at £100) with an option on the part of the holder to take the principal in United States dollars, the spot rate is taken at 11 days prior to the date of redemption.
Potential movements between the dollar and sterling between that date and the redemption date give rise to the prospect of a deep (foreign exchange) gain, irrespective of whether the option is actually exercisable on the date of redemption, or whether the date of exercise of the option is in fact the date 11 days prior to the redemption date. If the loan note is redeemable after six months from the date of issue, the cap should be set at 100.25 per cent of the sterling principal, by reference to the spot rates at the date of redemption. Indeed, if, as is common, redemption can occur on the event of a sale or listing of the issuer's shares, whether or not within six months after issue of the loan note, the cap should be pro rated even further, or set at 100 per cent of the principal, if redemption occurs for that reason.
Is a cap necessary?
However, it is considered that no such cap is necessary as a matter of law. A loan note, with the sort of option described above, might, it is true, give rise to a foreign exchange profit greater than the 0.5 per cent/15 per cent mentioned above but is not (by reason of that potential foreign exchange profit alone) a relevant discounted security (which would automatically be a qualifying corporate bond: section 117(2AA)), on the footing that foreign exchange fluctuations are excluded from the calculation of deep gains for Schedule 13 to the Finance Act 1996 purposes. Such a loan note would therefore be a non qualifying corporate bond by reason of section 117(1)(b).
All corporate bonds issued after 13 March 1984 are qualifying corporate bonds: section 117(7). Section 117(1) defines a corporate bond as a security:
'(a) the debt on which represents and has at all times represented a normal commercial loan [within Schedule 18 of Taxes Act 1988]; and
'(b) which is expressed in sterling and in respect of which no provision is made for conversion into, or redemption in a currency other than sterling …'
On the other hand, section 117(2AA) further provides that 'corporate bond also includes any asset which is not included [in section 117(1)] and which is a relevant discounted security for the purposes of Schedule 13 to the Finance Act 1996'. Put shortly, a relevant discounted security is automatically a qualifying corporate bond, so that even if it is convertible, or redeems in a non-sterling currency, it will (other than in respect of rolled over gains within section 116) be outside the capital gains tax net altogether (see section 115). Profits and losses arising in relation to relevant discounted securities, are taxed or relieved as income (Schedule D, Case I or Case III) under Schedule 13 to the Finance Act 1996.
Thus, if foreign exchange fluctuations were indeed relevant to the calculation of a deep gain for Schedule 13 to the Finance Act 1996 purposes, debentures issued in sterling but redeemable in a foreign currency would almost all be outside the scope of section 117(1)(b), unless a (very artificial) cap of 0.5 per cent (pro rated for debentures redeeming within 12 months of issue) were inserted. In other words, the inclusion of foreign exchange gains in a calculation for Schedule 13 to the Finance Act 1996 purposes almost completely emasculates the application of section 117(1)(b) to the second type of security it refers to.
Surely not the intention
The draftsman could not possibly have intended to include foreign currency fluctuations in the calculation of a deep gain for Schedule 13 to the Finance Act 1996 purposes, to so emasculate section 117(1)(b). Such a conclusion can legitimately be described as an absurdity. A loan note can give rise to a profit for the holder by reference to:
- the payment by the issuer for the use of the monies lent (in the form of interest, discount or premium); and/or
- the value of any assets into which the redemption amount can be converted (such as shares, securities or foreign currency).
The first type of profit represents the cost of the use of money over time, while the second cannot be described as such a cost and indeed may be a true windfall profit, in the hands of the holder, being outside the control of both holder and issuer and with little or nothing to do with the period for which money is lent (since the fluctuations in value of the assets or foreign currency to which a loan is converted can occur at any time and over a very short period). The rationale of section 117(1)(a) and (b) is self-evident. Loan notes, which are capable of producing the second type of profits, which profits would otherwise escape tax altogether, should have those profits taxed to capital gains tax.
Both types of loan within section 117(1)(b) are aptly described as 'synthetic chargeable assets'. Foreign currency is itself a chargeable asset for those outside the corporation tax charge: see section 21(1)(b). Profits and losses on such debentures should be taxed and relieved to capital gains tax, since their value is dependent (in the main, ignoring interest rate fluctuations) upon the value of the chargeable assets (foreign currency) into which they convert. This conclusion accords perfectly with the observations of Lord Justice Nolan (as he was then) in Capcount v Evans [1993] STC 11: '… for the purposes of the tax and capital gains foreign currency is not money but is an asset: it cannot be both'.
However, the rationale underpinning Schedule 13 to the Finance Act 1996, (and indeed Schedule 4 to the Taxes Act 1988 (deep discount provisions) Schedule 11 to the Finance Act 1989 (deep gains security legislation) has a completely different (but equally readily identifiable) rationale. A debenture which has been issued at a price below face value (that is, at a discount) will generate an economic return to the holder, which will represent the cost of borrowings to the issuer. The discount is consideration for money lent to the issuer. That discount is not, of itself, interest for the purposes of the Taxes Acts and cannot be encompassed by provisions which refer only to interest. This is clear not only from the terms of section 18(3)(a) and (b), and section 18(3A)(c), Taxes Act 1988, but also as a matter of authority: see in particular Ditchfield v Sharp [1983] STC 590.
Discount is not interest
Furthermore, it is equally clear (see Ditchfield v Sharp) that a discount might be commercially indistinguishable from interest, that is, payment by time for the use of money, albeit that the two are conceptually and legally distinct (see the explanation of both the deep discount and deep gains régimes in Schedule 4 to the Taxes Act 1988, and Schedule 11 to the Finance Act 1989, as 'a certain and consistent basis of taxation … [to] ensure that discounts and premiums which take the place of interest are properly taxed as income' (emphasis added): Inland Revenue Budget press release 14 March 1989).
Thus the purpose of the deep discount legislation in Schedule 4 to the Finance Act 1989, (as supplemented by the deep gains provisions in ibid., Schedule 11) and the relevant discounted security legislation in Schedule 13 to the Finance Act 1996, is to ensure that disguised interest (i.e. payment over time for the use of money) on discounted notes is taxed and relieved to income. This explains why options only exercisable by the issuer were ignored in the old deep gains provisions (see paragraph 1(3) of Schedule 11 to the Finance Act 1989,) and now in Schedule 13 to the Finance Act 1996 (see paragraph 3(5)(a), pre Finance Act 1999); a return which can only arise at the option of the issuer is not disguised interest. It is 'outside the control of the investor'. (See Hansard debate on Schedule 11 to the Finance Act 1989, 12 July 1989, column 1068.) Incidentally, the changes made to paragraph 3 of Schedule 13 to the Finance Act 1996 by section 65, Finance Act 1999, merely confirm the draftsman's realisation that, in certain cases, even the exercise of issuer options can give rise to disguised interest, hence the inclusion of returns on issuer options for securities issued between connected parties and securities issued as part of a tax avoidance exercise in the relevant discounted securities provisions. Thus it is clear that the relevant discounted securities provisions are designed solely to catch effective interest and nothing else.
Foreign exchange fluctuations
Foreign currency fluctuations are not relevant to the rationale which informed Schedule 4 to the Taxes Act 1988, and Schedule 11 to the Finance Act 1989, and now underpins Schedule 13 to the Finance Act 1996. Foreign exchange fluctuations can result in a profit or a loss to the holder of a loan note. The right to such profits is part of the consideration given by the issuer for the monies lent to it. However, foreign exchange fluctuations give rise to true windfall profits and losses. They do not represent payment by time for the use of money. A foreign exchange profit, which arises by chance, cannot be described as interest. The same is true for such a loss borne by the issuer. Foreign exchange fluctuations have got nothing to do with the length of time for which money is lent. They are also outside the control of issuer and lender. It therefore makes perfect sense for foreign exchange fluctuations to be excluded from the calculation of the excess of the 'amount payable on redemption' of a debenture, over the 'issue price' for the purposes of paragraph 3(3) of Schedule 13.
This proposition is reinforced by the fact that the contrary view entirely cuts across the rationale which underpins section 117(1)(b), which positively tries to bring in loan notes subject to foreign currency fluctuations within the capital gains tax net, by emasculating the application of section 117(1)(b) in the real world. Thus the exclusion of foreign currency fluctuations from the deep gain calculation in paragraph 3 of Schedule 13 gives rise to a sensible result, in the context of the purpose of what is now the relevant discounted security legislation in Schedule 13 to the Finance Act 1996, while their inclusion gives rise to absurdity and frustrates the intentions of the draftsman of section 117(1)(b). Also, although Schedule 13 is not part of section 117, the draftsman of Schedule 13 was well aware of the terms of section 117(1)(b), in inserting section 117(2AA).
Put another way, the requirement, for capital gains tax purposes, to translate non-sterling amounts into sterling values (Bentley v Pike [1981] STC 360) is not appropriate for income tax purposes. So, in the case of a trading transaction, given 'the multiplicity and diverse character of the transactions which may be expected to take place in any given trade during any given year, [it] would normally be impracticable to effect instantaneous translations into sterling of every debit and credit. Even if it were possible in the exceptional case, it would still appear … inappropriate in principle because of the fact that … the income tax legislation, unlike the capital gains tax legislation, is not generally concerned with the measurement of a gain or loss on a single disposal but with a balance at the year end computed on accounting principles'. (Lord Justice Nolan in Capcount distinguishing the Bentley v Pike approach for capital gains tax from the correct approach for Schedule D Case I purposes, which ignores foreign currency fluctuations, approving the approach taken in Pattison v Marine Midland Ltd [1984] STC 10). Similarly, where the rationale of Schedule 13 to the Finance Act 1996 is to tax payment over time for the use of money, foreign currency fluctuations which have little or nothing to do with an economic return being consideration for monies advanced, over a period of time, as opposed to a windfall profit due to foreign exchange fluctuations, should be ignored.
Sensible construction
Does, however, the actual wording of paragraph 3(3) of Schedule 13 admit of a sensible construction, which accords with the policy considerations discussed above? The short answer is 'yes'. Paragraph 3(3) provides that: '… the amount payable on redemption of a security involves a deep gain if – '(a) the issue price is less than the amount so payable; and '(b) the amount by which it is less represents more than the relevant percentage of the amount so payable'.
The 'relevant percentage' is defined as 0.5 per cent a year or 15 per cent overall in paragraph 3(4).
In the case of a debenture which, say, issues at £100 and redeems at £100, subject to the sort of foreign exchange election mentioned above, the 'issue price' is £100. The 'amount payable on redemption' is also £100. It is true that the holder can require the issuer to apply the £100 otherwise payable on redemption, to acquire, in this example, United States dollars. It is also true that those United States dollars might be worth considerably more than £100.50, or, indeed, more than £115, at the date of redemption.
However, the 'amount' payable on redemption remains £100, albeit applied, on exercise of the option, to acquire money's worth (in the form of United States dollars). The fact that the 'value' of that £100, in the form of United States dollars, may be more than £100.50/£115, at the date of redemption, is neither here nor there. 'Amount' and 'value' are two entirely different things (certainly, the terms are used in contra-distinction for tax purposes: see, for example, section 209 (4), Taxes Act 1988 and sections 38(1)(a) and 42(2)(a), Taxation of Chargeable Gains Act 1992). The amount payable on the redemption of a loan note is the nominal amount to which the holder is entitled and which the issuer must pay.
The value of the redemption monies is the market value (however calculated) of those redemption monies (as an asset or a liability) in the hands of the holder, or issuer, as the case may be. This is most clearly demonstrated by the fact that the foreign exchange option is (or could be) risk free for the issuer, in that if the relevant spot rates, for the foreign exchange option, are those prevailing on a specified, fixed date set out in the loan note (e.g. 'ten business days before the [specified] date of redemption'), the issuer can always acquire a sufficient amount of the relevant foreign currency, in contemplation of the exercise of the option, to limit the value of the liability to the nominal amount of the principal, which is subject to the option. Even in the case of a foreign exchange option which is not exercisable on a fixed, specified date (for example, an option exercisable on a date governed by when notice of exercise is given), the issuer can hedge its liability by acquiring sufficient dollars at the date of issue of the loan note. In other words, whenever the option is exercisable by the holder, the amount of the liability remains £100, albeit the value of the liability may change. In the case of the loan note issuing and redeeming at £100, subject to a foreign exchange option, it is £100, no other figure, which must be applied to acquire foreign currency, to discharge the debt. The foreign exchange option is merely a mechanism to achieve redemption of £100; it is not a mechanism to define the amount which must be paid on redemption.
Other foreign currency loans
This conclusion is reinforced by the attitude of the Revenue to loan notes which issue and redeem in the same non-sterling currency. So a note which issues at $100 and redeems at $100 is not treated as a relevant discounted security, although foreign exchange fluctuations between the date of issue and date of redemption could well give rise to a more than 0.5 per cent a year sterling profit in the hands of the holder, in the absence of any cap (see [1993] 47 STI, 25 November 1993, in relation to the deep gains régime in Schedule 11 to the Finance Act 1989; this practice holds good for Finance Act 1996 purposes). This makes perfect sense. One should measure any discount by reference to the currency of issue, if the rationale of Schedule 13 is simply to tax what is disguised interest as income. Why should it make any difference if the loan note is issued in sterling at £100 and redeems in the United States dollars equivalent of £100? Any foreign exchange profit arising to the holder would be calculated in the same way as for the loan note which issues in dollars and redeems in dollars, namely, by reference to the spot rates as between the United States dollar and sterling at the date of issue and at the date of redemption. There is no conceptual reason to exclude a foreign exchange fluctuation from a deep gain calculation from the first type of note but not the second.
Indeed, if one postulated a loan note in which the holder had the option to subscribe in either sterling or dollars, and also the option to redeem in either sterling or dollars, where there was parity between issue and redemption price at the date of issue, it would be very odd to treat the note as a relevant discounted security, simply because the holder chose to subscribe in sterling and redeem in dollars rather than subscribe in dollars and redeem in dollars.
Moreover, the analysis which excludes any reference to the market value of the foreign currency payable on redemption also accords perfectly with the analogous approach for debentures which convert into shares in the issuer. Suppose a loan note which issues at £100 converts into shares, on the basis that every £1 of loan note converts into a share with a nominal value, also of £1. The amount repayable on demand is £100, applied to subscribe for shares, in the issuer, with a nominal value of £100, fully paid up. The market value of the conversion shares is wholly irrelevant to whether or not the loan note is a relevant discounted security. Indeed, this explains the need for paragraph 5 of Schedule 13, (redemption to include conversion). In the absence of the application of paragraph 5, the market value of the conversion shares would be completely outside the Schedule 13 régime altogether.
Specific régime
Indeed, Schedule 10 to the Finance Act 1990 enacted a specific régime to exclude, from the deep discount and deep gains régimes, profits arising on the transfer, or redemption, of certain convertible loan notes, which converted into quoted shares (see paragraph 21 of Schedule 4 to the Taxes Act 1988, and paragraph 22B(1) of Schedule 11 to the Finance Act 1989). Schedule 10 to the Finance Act 1990 was irrelevant to the question of whether a security was capable of yielding a deep gain or not. The rationale was to exclude any profits attributable to the conversion shares, on transfer, or redemption, from a charge to income:
'… [It] was felt that the premium in [the case of convertible securities, issued with an option to redeem at a premium, which would be prima facie deep gain securities] had to be regarded partly as income, because it was a guaranteed profit, but that part of the return might be akin to gains on the underlying equities which should be taxed to capital.' (Hansard debate on what became Schedule 10 [guaranteed return in the form of discount or premium taxed to income but profit attributable to the value of conversion shares taxed to capital] to the Finance Act 1990, Standing Committee E, 7 June 1990, col 144.)
Thus the draftsman of Schedule 10 recognised that the deep discount and deep gains régimes sought only to catch disguised interest and nothing else and therefore even securities which would (or might) produce a deep gain had certain profits carved out of the income tax (and corporation tax on income) net. Although the draftsman of Schedule 13 to the Finance Act 1996 has not re-enacted Schedule 10 to the Finance Act 1990, so that market value transfers/redemptions of relevant discounted securities, which are convertible, might tax profits attributable to the value of the conversion shares to income, what Schedule 10 to the Finance Act 1990 demonstrates is the continuing limitation of the intention underlying the deep discount and deep gains régimes to catch disguised interest alone.
As it happens, the conclusion that foreign exchange profits are excluded from the deep gains calculations can be reached in a different way in that the terms of paragraph 3(3) of Schedule 13 to the Finance Act 1996, should, it is considered, be read as defining a 'deep gain' by reference to '… the amount payable on redemption of the security [excluding foreign exchange fluctuations] …' to avoid the absurdity of the emasculation of section 117(1)(b) by section 117(2AA). Certainly words may be read into a provision to give effect to the intention of Parliament: Inco Europe Ltd v First Choice Distribution [2000] 1 WLR 586, 592; this approach has been adopted in relation to tax statutes: O'Rourke v Binks [1992] STC 703, 707. However, this approach is not necessary for the above conclusion to prevail: amount and value are separate and different concepts; there is no need to rely on reading words in to paragraph 3(3). However, the Inco Europe principle demonstrates that the approach of the courts is robust when giving effect to parliamentary intention and it is considered that the courts would adopt this approach, if necessary, in order to exclude foreign exchange fluctuations from any deep gains calculation.
Julian Ghosh is a member of Pump Court tax chambers. This article first appeared in Volume 3, Issue 4 of Corporate Tax Review published by Key Haven.
