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HMRC internal manual

Corporate Finance Manual

Foreign exchange: matching: bringing amounts back into account: priority order for matching

Cases where priority rules are needed

A company may have more than one investment in a foreign operation - where those investments take the form of shareholdings, long-term loans, or both. A company may have (for example) a portfolio of US dollar assets, which are hedged on a portfolio basis by a ‘pool’ of US dollar debt liabilities and currency contracts. The company may even have further portfolios of assets with different underlying currencies.

In such a situation, when there is a disposal of a particular asset it becomes much more difficult to identify those liabilities or currency contracts that are, or have been, fully or partially matched with the asset concerned and work out what exchange gains or losses have accrued on those hedging instruments.

Where a company

  • owns more than one matched asset, and
  • exchange gains or losses arise on matching liabilities or currency contracts in an accounting period beginning on or after 1 October 2002 but before 1 January 2005, and have been taken to reserves; and
  • the assets are denominated and the liabilities expressed in the same currency

regulation 7(7) of the EGLBAGL Regulations provides a solution to the problem, in the form of a statutory order of matching. The liabilities or currency contracts concerned are regarded as having been been matched to the greatest possible extent

  • first of all, to assets consisting of loan relationships, ships or aircraft;
  • next, to shares (other than foreign business assets) which would give rise to a chargeable gain on disposal;
  • and finally, to shares where a disposal would attract substantial shareholding exemption (SSE), on the assumptions set out below, or which are foreign business assets.

For accounting periods beginning after 1 January 2005, the same order of priorities is given by regulation 5 of the Disregard Regulations (SI 2004/3256) - see CFM62820.

The examples at CFM62380 and CFM62390 illustrate how the statutory order applies in practice. The effect of the rules is to maximise the occasions on which the asset disposed of can be regarded as fully matched, where the disposal actually has tax consequences.

Assumptions about SSE

Suppose that a company, which owns several matched assets, makes a disposal in a particular accounting period - for example, the disposal might occur on 15 November 2004 in accounting period ended 31 December 2004. It is necessary to slot each of the assets owned, or previously owned, by the company into one of the three categories above. This necessitates deciding whether particular shares would attract SSE on a disposal, even if no such disposal actually occurs.

For this purpose, it is assumed that a disposal takes place more than 12 months after the date of the ‘relevant disposal’ - in this example, at a date later than 15 November 2005. Thus the condition in TCGA92/SCH7AC/PARA7 for the shares to have been held throughout a 12-month period is deemed always to have been satisfied.

It is possible, however, that there may be a subsequent real disposal of the shares being tested. If this happens within 12 months of the ‘relevant disposal’, and SSE does not apply because the TCGA92/SCH7AC/PARA7 test is failed, then the shares in question do not fall into the third category above. In the above example, if the company actually sold the shares in question on 1 February 2005, and they had not been owned for 12 months at that date, they would fall into the ‘chargeable gain arises on disposal’ category when applying the statutory order of matching in year ended 31 December 2004.

More than one currency

If the company has matched assets denominated in more than one currency, the rules described above must be applied on a currency-by-currency basis. Suppose, for example, it has investments in one or more subsidiaries with a euro functional currency, and other investments in subsidiaries with a US dollar functional currency. It must apply the priority rules to ascertain the extent to which loans and derivatives used to hedge its euro exposure are matched to the euro assets, and then do the same for its US dollar assets.

Although regulation 7(6) refers to the loans, or the obligations under currency contracts, being in the ‘same currency’ as the asset, regulation 7(8) relaxes that requirement. They are treated as being in the same currency provided it is reasonable to regard the loan or derivative as hedging the exchange rate risk arising from holding the asset.