INTM551030 - Hybrids: financial instruments (Chapter 3): overview: quasi-payments - foreign exchange losses of a UK company

Quasi-payments

An amount is a quasi-payment if

  • an allowable deduction would arise in calculating the taxable profits of the payer for a taxable period, if Part 6A (or a non-UK equivalent of Part 6A) did not apply, and
  • the circumstances giving rise to the deduction may reasonably be expected to result in ordinary income of one or more persons, were certain relevant assumptions to apply

See INTM550540 for a fuller definition.

Foreign exchange losses

A foreign exchange loss that results from a change in the value of a financial instrument and is attributable solely to the relevant company’s functional currency will not usually be a quasi-payment (see below).

A foreign exchange loss may be a quasi-payment where it arises because

  • an instrument is a hybrid financial instrument, or
  • the payer or the payee is a hybrid entity, or
  • there is a mismatch involving either a multinational company (see INTM554030) or a dual resident company (see INTM558030)

Where there is reason to suspect that an arrangement involving foreign exchange losses is being used to avoid the application of Part 6A in circumstances in which Part 6A might otherwise apply, details should be forwarded to the Base Protection Policy Team, BAI to consider whether the targeted anti-avoidance rule applies, see INTM561500.

Debt instruments - exchange loss of a UK company

Relevant deduction

A simple debt instrument denominated in a particular currency will not give rise to an exchange difference if that currency is the same as the company’s functional currency. For instance, a bond or loan denominated in euros will not give rise to an exchange difference in the accounts of a company where that company’s functional currency is the euro. If, however, the company’s functional currency were sterling, an exchange gain or loss may arise because of changes in the value of the euro relative to sterling.

An exchange loss on a debt denominated in a currency that is not the company’s functional currency will normally give rise to a UK tax deduction under the loan relationships regime. This deduction is a ‘relevant deduction’ within s259BB(2)(a).

It might be argued that if the exchange rate had changed in the opposite direction, there would have been an exchange gain and thus no relevant deduction. There is nothing in the definition of a quasi-payment that requires any consideration of alternative outcomes. The symmetry of treatment between an exchange gain and an exchange loss on a financial instrument under the loan relationship rules does not prevent an exchange loss being a relevant deduction under Part 6A TIOPA 2010.

Assumptions under s259BB(4)

If there is a relevant deduction, the next step is to consider whether, making the assumptions in s259BB(4), it would be reasonable to expect an amount of ordinary income to arise to one or more other persons as a result of the circumstances giving rise to the relevant deduction.

The assumptions to be made when considering whether it would be reasonable to expect ordinary income to arise are

  • the status of the payee as a separate entity is determined under the law of the payer jurisdiction (s259BB(4)(a)),
  • the payee applies the same approach to accounting as the payer (s259BB(4)(b)),
  • the payee is resident in the same tax jurisdiction as the payer and is carrying on business there (s259BB(4)(c))

In the context of a foreign exchange loss on a financial instrument, the ‘payee’ will be the corresponding debt creditor(s).

Accounting approach

Where a UK company is the debtor under a debt instrument and has a deduction in respect of an exchange loss in connection with that instrument, the assumptions require consideration of what ordinary income might be expected to arise to the creditor of that instrument if

  • the creditor were a UK company carrying on a business in the UK, and
  • the creditor applied the same approach to accounting. For example, if the debtor applies UK GAAP standard FRS 102 or IFRS, it must be assumed that the creditor does the same

The accounting condition will normally be met where the debtor and creditor companies have different functional currencies. This is because the application of the same approach to accounting will not necessarily result in the use of the same functional currency by both debtor and creditor entities. The functional currency is determined by applying the relevant accounting standard and taking into account its fact pattern. In essence, under both section 30 of FRS 102 and IAS 21, the functional currency of an entity is the currency of the primary economic environment in which the entity operates. That in turn requires consideration of the entirety of the entity’s business and, in some cases, how independent its business is from that of its parent.

Consequently, a debtor may have a sterling functional currency and the creditor a euro functional currency, despite adopting the same approach to accounting, because of their differing primary economic environment. In these circumstances, if the financial instrument is a euro-denominated debt, an exchange loss of the debtor will not necessarily be matched by an exchange gain for the creditor.

Ordinary income

There is no expectation that a deduction for a foreign exchange loss relating to a financial instrument would result in ordinary income for the creditor to that financial instrument, if the creditor were a UK company. This will also be the case where both debtor and creditor are UK companies (adopting the same approach to accounting).

For example, UK1 borrows externally in US dollars and then on-lends to a group company (UK2) which in turn invests equity in a US company. UK1 and UK2 might be expected to recognise the same exchange loss or gain if both have sterling as their functional currency. (Note that in these circumstances Regulation 3 of the Disregard Regulations may apply, so that the foreign exchange difference is not brought into account by UK2, if the liability is intended to hedge its investment in the US Company).

The unmatched deduction for any foreign exchange losses in this scenario is similar to the deemed deductions provided by some jurisdictions for interest free loans under s259BB(3), in that the circumstances giving rise to the deduction do not include economic rights existing between UK 1 and UK2.

Conclusion

Making the assumptions required by s259BB(4), where the debtor company suffers an exchange loss which is tax-deductible, it would not be reasonable to expect an amount of ordinary income to arise to another person. The requirements of s259BB(2)(b) are not met and the exchange loss of the debtor company does not give rise to a quasi-payment.

It follows that where a UK payer suffers an exchange loss, the deduction for that loss is neither a payment nor a quasi-payment. An actual mismatch will not be subject to counteraction because there cannot in these circumstances be a ‘hybrid or otherwise impermissible deduction/non-inclusion mismatch’ in relation to a payment or quasi-payment.