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HMRC internal manual

Corporate Finance Manual

Foreign exchange: tax rules on exchange gains and losses: loan relationships and derivative contracts: connected parties

Exchange differences on connected party debt

CTA09/S352(4), S354(3), and S360(2) make it explicit that, where the loan relationship connected party and consortium relief provisions (CFM35000) operate to deny relief for an impairment loss on a loan relationship between connected companies, exchange gains or losses are unaffected. The same applies in periods beginning before 1 January 2005 where bad debt relief on connected party loan relationships is denied.

Example 1: impaired debt where creditor and debtor are unconnected

For the sake of illustration, assume that the exchange rate at 31 December 2005 is $1.6/£, and at 31 December 2006 it is $1.5/£.

Chaklaw Ltd prepares accounts to 31 December 2005. It makes a loan of $1 million to an unconnected UK company which it accounts for under the amortised cost basis of accounting. On 31 December 2005, the exchange rate is $1.6/£, so the loan is translated at £625,000.

The borrower’s financial circumstances changed for the worse.  The Directors of Chaklaw Ltd performed an impairment review as at 31 December 2006 as part of the preparation of accounts to 31 December 2006, and decided that a 50% provision should be made against the loan. Accordingly the loan is written down to $500,000. At 31 December 2006, the exchange rate is $1.5/£, so the loan appears in the company balance sheet at a figure of £333,333.

Accounting standards do not contain specific guidance on how to translate impairment losses on assets denominated in a foreign currency.  General practice, as described by accounting manuals, is to calculate the value of the receivable in the currency in which it is denominated and then translate that amount into the local/functional currency at the date the impairment is recognised.  This could in certain circumstances lead to the recognition of an impairment loss and a foreign exchange gain on translation of the carrying amount into the local/ functional currency.

Using the example above, a forex gain of £41,666 is recognised in profit and loss representing the movement in exchange rates between the previous balance sheet date and the date of impairment (£666,666 – £625,000).  An impairment loss of £333,333 is also recognised, being the impairment loss of $500,000 translated into £ at the date of impairment 31 December 2006 ($500,000 at a rate of $1.5/£).   

For tax purposes, the company is entitled to a debit of £333,333 in respect of the impairment, while bringing in a credit of £41,666 in respect of the foreign exchange gain.

Example 2: connected party debt

Suppose that Chaklaw Ltd lends the $1m to a subsidiary, and has adopted FRS 26 on 1 January 2006. It chooses to account for the loan at fair value through profit or loss. The fair value of the loan at 1 January 2006 is £600,000, but because of doubts about the ability of the subsidiary to repay, it is valued at only £310,000 on 31 December 2006.

For tax purposes, the company must - under CTA09/S349 (previously FA96/SCH9/PARA6B) - compute credits or debits on an amortised cost basis. The company must first work out what credits or debits would be brought into account under an amortised cost basis of accounting. This means that it must decide what impairment provision it would have made at 31 December 2006 had it been accounting for the loan at amortised cost - in other words, it must assess the difference between the present value of expected future cash flows and the amortised cost carrying amount (see CFM35170).

If it is determined that an impairment provision of $500,000 would have been made, the amortised cost carrying value, adjusted for impairment, at 31 December 2005 would be £333,333 ($500,000 at £1/$1.5). The company would be required to bring in a taxable credit of £41,666 representing the exchange gain on the loan from 1 January 2006 until the date of impairment but it would not get relief for the impairment loss of £333,333.

The fair value loss of £290,000 shown in the accounts is added back in the tax computations.