Policy paper

Statement of Practice 2 (2002)

Published 30 September 2002

Statement of Practice 2 (2002)

Introduction

1. This Statement of Practice sets out HM Revenue and Customs (HMRC) practice in relation to the tax treatment of exchange rate fluctuations in the tax computations of persons who are carrying on a trade, other than companies within the charge to Corporation Tax. It is put forward as a practical guide to facilitate the preparation and agreement of tax computations of such taxpayers, and takes account of case law and of the enactment of Finance Act (FA) 1998 section 42 which requires the profits of a trade or profession (and hence, by virtue of Taxes Act 1988 section 21A, a property business) to be returned on a basis that reflects a true and fair view. It is not relevant for concerns which are companies within the charge to Corporation Tax for which the rules relating to exchange differences are contained in FA 1993 sections 92 to 94AB and FA 1996 Part 4 Chapter 2 (loan relationships) and FA 2002 Schedule 26 (derivative contracts). The general rules it contains may need to be modified in the way in which they are applied in particular circumstances, for example, where the local currency of an overseas trade or property business is a currency other than sterling.

The case law - Marine Midland

2. The most recent relevant case law on the subject of exchange differences is Pattison v Marine Midland Ltd (1984) STC 10, 57 TC 219. In that case a UK resident bank carried on business in international commercial banking. For the purpose of making dollar loans and advances in the course of its banking business, it borrowed 15 million US dollars in the form of subordinated loan stock, redeemable in 10 years. As a result of exchange rate fluctuations, the sterling value of the loans to its customers increased, but so also did the liability in sterling terms of the loan stock. Its general aim was to remain matched in each foreign currency and for the most part the dollar borrowings remained invested in dollar assets. After 5 years the loan stock was repaid out of existing dollar funds and at no time was any of the 15 million dollars converted into sterling.

3. Each year in the accounts, the monetary assets and liabilities denominated in a foreign currency were valued in sterling at the exchange rate at the balance sheet date but to the extent that currency liabilities were matched by currency assets, no profit or loss was shown for accounts purposes. The Court of Appeal and the House of Lords held that in these circumstances no profit or loss arose for tax purposes. On the other hand the company brought into its profit and loss account any increase or decrease in the sterling value of excess dollars - ie, to the extent that it was in an unmatched position - and this had been accepted as a profit or loss for tax purposes. Lord Templeman said that this practice “reflected the success or failure of the company in acquiring and holding excess dollars which could be converted into sterling”. He noted without disapproval HMRC acceptance of the practice and said it was “… not inconsistent with the company’s submission that no profit or loss was attributable to dollar assets equal in dollar terms to dollar liabilities”.

Definitions

4. In this statement:

• translation into sterling is regarded as the valuation of a foreign currency asset or liability in terms of sterling at a particular date
• conversion into sterling is the exchange of that asset or liability for sterling
• local currency is the currency of the primary economic environment in which the trade or business is carried on and net cash flows are generated

The recognition of exchange differences - accounts treatment and tax consequences

5. Before the enactment of FA 1998 section 42 (which has effect for periods of account beginning after 6 April 1999) it was the general practice in the case of trading companies to bring exchange translation adjustments, other than those in respect of capital items, into account for tax purposes where they have similarly been brought into account in arriving at the accounting profit or loss. Since the accounting treatment is sanctioned by Statement of Standard Accounting Practice 20 (Foreign Currency Translation) (SSAP 20), it follows that accounts which observe this practice are, in this regard, giving a true and fair view, and since there is no rule of law which would overturn this practice, it must be followed for tax purposes.

6. It has also been the practice in some circumstances - mainly in the case of certain overseas trading activities dealt with for accounts purposes on what is now generally referred to as the ‘closing rate/net investment’ basis - to translate the net profit or loss for tax purposes (the so called ‘profit and loss account’ basis). HMRC considers that, following FA 1998 section 42, where this basis is used in the accounts in accordance with SSAP 20 it also must be followed for tax purposes.

Capital and current liabilities

7. Nothing in FA 1998 section 42 or in the case law regarding the computation of trading profits requires the distinction between capital and revenue items to be decided other than by reference to principles well established in tax case law. In computing trading profits for tax purposes, the question whether a loss or profit on exchange on a foreign currency loan made to the taxpayer is respectively an allowable deduction or assessable receipt is determined by the nature of the loan and whether it is to be properly regarded as a capital or current liability. The case law (such as Marine Midland and Beauchamp v F W Woolworth plc (1989) STC 510, 61 TC 542) shows that the distinction between capital and current liabilities is essentially between loans providing temporary financial accommodation and loans which can be said to add to the capital of the business. The answer in any particular case must turn on its facts and circumstances, which have to be considered in detail.

8. The Court of Appeal and the House of Lords did not find it necessary to decide whether the borrowing by Marine Midland was a capital or current liability, the House of Lords indicated that it would have needed further evidence and argument to decide the issue. The Commissioners and the High Court, however, agreed with HMRC view that the borrowing was a capital liability. HMRC remains of the view that the liability in question in the Marine Midland case was of a capital nature.

Matched assets and liabilities

9. The Court of Appeal and House of Lords judgments in Marine Midland indicate that where foreign currency borrowings are matched by assets in the same currency the capital or current nature of the borrowing would no longer be relevant in determining whether adjustments are to be made for the purposes of computing trading profits or losses for tax. In these circumstances exchange differences, whether profits or losses, arising on long-term borrowings are not to be distinguished and adjusted in computing trading profits or losses for tax.

Gains and losses taken to reserve

10. Under SSAP 20, some gains and losses on monetary assets and liabilities may be taken to reserve rather than to the profit and loss account. This may happen where SSAP 20 paragraphs 27 to 29 (liabilities hedging investments in certain equity holdings) and SSAP 20 paragraphs 15 to 20 (closing rate/net investment method) apply. In such cases, the gains and losses are not recognised for tax purposes even if they are not capital items.

Same currency

11. Liabilities and assets of the same trader are regarded as matched in the way described in paragraph 9 above to the extent that foreign currency denominated monetary assets are equalled by liabilities in the same currency and a translation adjustment on 1 would be cancelled out by a translation adjustment on the other. In general, therefore, where there are transactions in more than 1 foreign currency the question of matching must be considered separately for each currency (see paras 15 to 34 below). However, it is possible for assets and liabilities in different currencies to be regarded as effectively matched when hedging transactions, such as forward foreign currency contracts, are taken into account (see paras 41 to 43 below).

Matching of capital assets in foreign currency with current liabilities

12. There may be circumstances where foreign currency assets which for tax would be treated as capital assets are matched with current liabilities in the same currency - the reverse of the situation in Marine Midland. This may arise for example in the case of certain monetary assets, eg, where loans to subsidiary companies, which for tax would be treated as capital, are matched by short term currency borrowings, which for tax may fall to be treated as current liabilities. HMRC takes the view that the Marine Midland matching principle applies in such circumstances, with the result that again exchange differences arising on the assets or liabilities are not to be distinguished and adjusted.

Assets and liabilities not matched

13. In general, an adjustment is required to the tax computation of trading profits in respect of exchange differences that have been debited or credited to the profit and loss account in respect of capital items. It will be for the trader to demonstrate matching of capital currency liabilities, or assets, by reference to the position both during and at the end of the accounting period; and where such liabilities or assets are wholly or partly matched, to show the effect if any on the tax computation.

14. However, in practice, the extent to which currency assets are matched with currency liabilities will in most cases fluctuate in the course of an accounting period, so that it would be impracticable to measure and take account of such fluctuations on a day-by-day basis in determining what adjustment is required in the tax computation to the net exchange difference debited or credited in the profit and loss account. Instead, the practice outlined in paragraphs 17 and 34 below may be adopted, provided it is applied on a consistent basis from year to year.

A practical approach

15. In essence the practice offered at paragraphs 17 and 34 below assumes that the extent to which currency assets and liabilities are matched during an accounting period is reflected in the size of the net exchange difference debited or credited to the profit and loss account. The rules suggested for determining the adjustment to be made for tax purposes in respect of the exchange difference arising on capital assets or liabilities which are unmatched, or only partly matched, are based on the premise that capital liabilities are matched primarily with capital assets in the same currency. Any capital liabilities not matched by capital assets in the same currency are regarded as matched by current assets of the same currency only to the extent that the current assets exceed the current liabilities in that currency.

16. Where this practice is not adopted, capital liabilities and assets will be regarded as matched only to the extent that this can be demonstrated by reference to the trader’s currency assets and liabilities during the accounting period.

17. Under the practice referred to in paragraph 15 above, the first step will be to ascertain the aggregate of exchange differences, positive and negative, on capital assets and liabilities in the profit and loss account figure.