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HMRC internal manual

Corporate Finance Manual

Loan relationships: group continuity: notional carrying value: examples

Example 1

J Ltd is a 100% subsidiary of K plc; both companies prepare accounts to 31 December. The group as a whole adopts International Accounting Standards from 1 January 2005.

In year ended 31 December 2004, J Ltd lends £2m to an unconnected company for 3 years, at a fixed rate of interest. On 1 July 2005, J Ltd assigns the loan to K plc at its fair value of £2.1m. At 31 December 2005, the fair value of the asset has fallen to £1.95m.

J Ltd classifies the loan as ‘loans and receivables’, and accounts for it at amortised cost. On disposal of the loan, it brings in a credit of £100,000. K plc designates the loan as an asset accounted for at fair value through profit and loss.

The notional carrying value of the loan at 1 July 2005 is £2m. Thus for tax purposes, J Ltd is treated as disposing of the loan for £2m. There is neither profit nor loss on the disposal; the credit of £100,000 in J Ltd’s accounts is ignored. Interest credited in J Ltd’s accounts is brought into account in the normal way.

K plc, for accounting purposes, will initially recognise the asset at £2.1m, and will therefore debit £150,000 (£2.1m - £1.95m) to the income statement for year ended 31 December 2005, to reflect the drop in fair value. For tax purposes, however, K plc is treated as acquiring the loan for £2m, so it will bring in a debit of only £50,000. In subsequent accounting periods, the tax will follow the accounts.

Example 2

Facts as in example 1, except that that J Ltd lends $2m. At 1 July 2005, the fair value of the loan is $2.1m, and at 31 December 2005 it is $1.95m. J Ltd and K plc account in sterling.

At 1 July 2005, $2m is worth (say) £1.6m when translated at the spot rate. This is the value that would appear in a balance sheet drawn up immediately before the transfer, and hence is the notional carrying value for the purposes of S338. J Ltd’s profit or loss on the disposal is therefore computed on the basis that the transfer was for £1.6m. Similarly, K plc’s debits or credits will be computed on an opening fair value of £1.6m.

Example 3

The facts are as in example 1, except that K plc also classifies the debt asset as ‘loans and receivables’, and accounts for it on an amortised cost basis.

The tax consequences of the transfer for J Ltd are as in example 1.

For accounting purposes, K plc has acquired the asset at a premium of £100,000. It must write off this premium over the remaining term of the loan - amortisation of the premium, along with interest receivable on the loan, will enter into the computation of the effective interest rate (CFM21640). For tax purposes, however, it is treated as having acquired the loan for £2m. Amortisation of the premium in the accounts of K plc is ignored. There is thus a mismatch between tax and accounts that extends over the remaining term of the loan: K plc will need to make a computational adjustment, both in year ended 31 December 2005 and in subsequent periods.

Example 4

The facts are in example 3, except on 1 July 2005, K plc enters into an interest rate swap, notional principal amount £2m and with the same maturity as the loan, under which it receives floating rate interest and pays a fixed rate. It designates the swap as the hedging instrument, and the loan as the hedged item, in a fair value hedge of interest rate risk.

K plc initially recognises the loan at £2.1m. It applies hedge accounting, so that the carrying value of the loan is adjusted for changes in fair value attributable to the interest rate risk being hedged. Thus its balance sheet value at any time represents a hybrid between amortised cost and fair value. Fair value changes are taken to the income statement (where they offset fair value changes in the hedging derivative).

Suppose that, at 31 December 2005, the carrying value of the loan in K plc’s balance sheet is £1.97m. The company has therefore debited £130,000 to the income statement. However, for tax purposes, the company is treated as acquiring the loan for £2m. The debit is therefore restricted to £30,000. There is no effect on subsequent accounting periods.