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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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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 the start of the year is $1.6/£, and at the end is $1.5/£.

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

During 2006, the borrower’s financial circumstances change for the worse, so in the preparation of accounts to 31 December 2006, the directors of Chaklaw Ltd decide that a 50% provision should be made against the loan. Accordingly the loan is written down to $500,000. Assume that 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.

Had the debt not been partially bad, its sterling value at 31 December 2006 would have been £666,666, so the company would have brought in an exchange gain of £41,666 (£666,666 - £625,000). As matters stand, it credits to profit and loss only the exchange gain on the good portion of the debt - that is, £20,833. At the same time, it writes off to profit and loss account half of the £625,000 loan, i.e. £312,500.

For tax purposes, the company is entitled to a debit of £312,500 in respect of the impairment, while bringing in a credit of £20,833 in respect of the foreign exchange gain. Where an impairment loss is recognised, the tax treatment of exchange differences on the debt will simply follow the accounts.

Example 2: connected party debt

Suppose that Chacklaw Ltd lends the $1m to a subsidiary, and has adopted FRS26 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 ($1 million at £1/$1.5). The company would be required to bring in a credit of £20,833 representing the exchange gain on the unimpaired value of the loan.

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

Example 2: periods beginning before 1 January 2005

Assume the facts are as above. Under FA96/SCH9/PARA6, the company gets no bad debt relief for the £312,500 by which the loan is written down. But credits and debits in respect of exchange gains and losses are determined in exactly the same way as in the unconnected case - the company has a credit of £20,833. It is not required to bring in a further credit in respect of the exchange gain on the bad portion of the loan.