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HMRC internal manual

Corporate Finance Manual

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Foreign exchange: matching: anti-avoidance: FA 2009: ‘one way exchange effect’: examples where the TAAR would not apply

Examples of arrangements that do not create a ‘one-way exchange effect’

Example 1

Company A, which is resident in the UK, acquires shares in a Eurozone subsidiary of €50 million. In order to hedge the investment, the parent company of A (‘ParentCo’) borrows €50 million from an external bank, which it on-lends to A on identical terms. However, ParentCo wishes to limit its potential exchange loss on the borrowing if the euro strengthens, so it enters into a collar arrangement with a bank (see CFM13350 if you need an explanation of a collar) under which ParentCo will not have to bear further forex losses if the euro appreciates against sterling by more than 10%, but equally it will not profit if the euro depreciates by more than 15%.

The shares in the subsidiary held by company A, the €50 million external borrowing, the intercompany loan and the collar contract between ParentCo and the bank are all part of the same arrangement.

In year ended 31 December 2011, the euro actually appreciates against sterling by 12%. Considering the last day of the accounting period as a test day, ParentCo’s exchange loss on the external borrowing is - because of the existence of the collar - limited to 10%. The counterfactual assumption would be that the euro depreciated by 12%. In that case, ParentCo would benefit from, and bring into account for tax purposes, the full 12% exchange gain. Clearly, in this situation, amount A is not equal to amount B.

An arrangement will not, however, produce a ‘one-way exchange effect’ if precisely the same asymmetry would occur in the absence of any forex matching rules (CFM63140). This is the case here.

The intra-group borrowing by company A is fully matched with the shares in the euro subsidiary, so company A does not bring into account any exchange differences on the loan. What would happen if there were no forex matching rules? A 12% appreciation of the euro would result in company A bringing into account a forex gain, but a 12% depreciation would result in a precisely equal forex loss being allowed. (Similarly, there is no one-way effect at ParentCo’s end of the intra-group loan).

Thus the asymmetry introduced by the collar arrangement has nothing to do with forex matching, and would exist to precisely the same extent if the matching rules were disregarded. The arrangement therefore does not produce a one-way exchange effect within CTA09/S328A.

Example 2

The facts are as in the example at CFM63140 - a company holding shares in an Australian subsidiary enters into a put option over the Australian dollar as a hedge. In this case, however, the option is not fully matched with the shares. If the Australian dollar weakens, the company will exercise the option and an exchange gain will arise. If the Australian dollar strengthens, the company will not exercise the option, and neither a gain nor a loss will ensue.

In year ended 31 December 2011, the company exercises the option and there is an exchange gain. Because the derivative is only partially matched with the shares, part of the gain is disregarded, but part is brought into account for tax purposes. If the Australian dollar had strengthened by the same percentage, nothing would have been brought into account for tax purposes. So amount A will not be equal to amount B. Moreover, in this case we can not say that exactly the same asymmetry would have occurred if the forex matching rules were disregarded. Without forex matching, the whole of the exchange gain would be taxable: so amount A would be different. Amounts A and B would still be unequal, but by a different amount.

The situation does not, however, create any tax advantage for the company. If the company had not entered into this arrangement, it is likely that it would have hedged the shares in a way that did not involve options (for example, by means of a loan or a cross-currency swap). Even if such a loan or derivative was not fully matched, the unmatched portion would give rise to exchange gains if the Australian dollar weakened, or losses if it strengthened. Over a period of time, such a course of action might be expected to give a tax-neutral result. If the company did not hedge at all, it would of course have neither gain nor loss.

The actual arrangement, on the other hand, means that the company may realise a taxable gain from the option, but can never have a countervailing exchange loss. It therefore does not give rise to a tax advantage - rather, it represents a tax disadvantage. There is no restriction of the matched gain under CTA09/S 606(4E).

HMRC would not take the view, in this scenario, that the payment of (tax-deductible) premium for the option in itself gives rise to a tax advantage.