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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Foreign exchange: matching: anti-avoidance: FA 2009: ‘one way exchange effect’: meaning of ‘counterfactual assumption’

The counterfactual currency movement assumption

The computation of amount A (CFM63150) is based on what has actually happened in the accounting period of company A, and companies connected with it. Computation of amount B requires us to imagine what would have happened had the currency moved the other way. CTA09/S328D and CTA09/606D set out how this imaginative leap is to be made.

It is necessary to make two key assumptions. First, if the relevant foreign currency has appreciated with respect to the company’s operating currency (CFM63190) over the test period, or any part of it, it must be assumed for the computation of amount B that the relevant foreign currency has depreciated by the same percentage. Conversely, if the foreign currency has depreciated over a period, it must be assumed to have appreciated by the same percentage over the same period.

The reference here to ‘part of a period’ is important. Suppose that - as in the example at CFM63150 - a company is considering the test period 1 January to 2 October 2010. However, the company has a loan denominated in the relevant foreign currency (which was part of the arrangements) and which was repaid on 31 March 2010. If, in the period to 31 March, the relevant foreign currency appreciates by 10%, it must be assumed - in computing the contribution to amount B made by that loan - that it had actually depreciated by 10%. It does not matter, in considering the loan, how the currency moved over the entire period 1 January to 2 October.

The second key assumption is that - except for the treatment of options and contingent contracts - the company has acted in precisely the same way as it has acted in reality. Thus in the above example of the loan repaid on 31 March 2010, it cannot be argued - either by the company or HMRC - that if the foreign currency really had depreciated by 10% up to 31 March, it would not have repaid the loan, or would have repaid it on a different date.

But where an option is exercised on the test day, or where the company could have exercised the option but did not do so, it is necessary to consider whether the company would have made the same choice if exchange rates had moved the other way. The test is whether, in all the circumstances, it is more likely than not that a different decision would have been made.

The economic effect of exercising, or not exercising, an option will normally be a key factor. For example, it will be normally be ‘more likely than not’ for a call option over a particular currency to be exercised if the spot price of the currency has risen above the strike price. But other circumstances may need to be considered. Thus if an avoidance arrangement hinges on an option not being exercised, even where this goes against the company’s economic interest, the agreements or understandings between the parties would also be a relevant consideration.