Comments submitted on 15 October 2001 by the Chartered Institute of Taxation on the Inland Revenue's Consultative Document issued on 26 July 2001.
Our main comments are in the main body of the letter; more detailed comments are contained in Appendix 1.
Appendix 2 sets out our comments on “matching” and related issues in tabular form.
Starting date
In our view the proposed timetable for introducing the new legislation, with effect from accounting periods beginning on or after 1 January 2002, is too hasty. There are some issues that are not even resolved at a policy level, such as how much wider the scope of the financial instruments provisions should be and whether some derivatives might fall within the legislation as regards income but outside as regards capital gains and losses. It is clearly unacceptable that companies should enter an accounting period on, say, 1 January 2002, with no clear idea as to the likely tax treatment afforded to derivative instruments.
Even where the policy issues may be closer to resolution, there is a long way to go before drafting issues are resolved - notably in the case of the operative provisions for financial instruments and the related party debt rules.
As anti-avoidance measures are already in force, there is little risk to the exchequer in deferring the start date for at least some of the provisions so that they apply only to accounting periods beginning on or after 1 July 2002. By this time the Finance Act 2002 will have either been enacted or will be close to enactment.
The key issue is that companies which have established derivative or loan contracts for commercial reasons, where tax avoidance is not at issue, should have some time, say a month, to review the draft legislation at a stage at which it is in the form likely to be enacted, in order to make the necessary changes to their arrangements. We have no desire for delay for its own sake, and where the principle set out in the previous sentence is not infringed (for example in the case of clearly relieving provisions) we would understand a decision to adhere to the original timetable notwithstanding that in general we would prefer to avoid multiple start dates. In this case it is more important that taxpayers should see the legislation and know where they stand prior to its entry into force.
Following GAAP
There are now numerous references in the tax code, including the draft clauses, to normal accountancy practice. This is unfortunate, because the phrase conveys no particular meaning to an accountant. All of these references should be replaced by "Generally Accepted Accounting Practice", a phrase which is widely understood, backed up by numerous accounting standards, and in relation to which expert evidence could be obtained in the event of dispute.
Assimilation of Forex
In our view the legislation simply cannot be made to work unless the financial instruments operative provisions are rewritten. The current prescriptive approach of applying an accounting approach to a restrictively defined set of qualifying payments has led to problems, either because profits or losses are incorrectly calculated, because certain payments do not fall within the definition of "qualifying payment" or because, particularly in the case of hedge accounting, inappropriate amounts may be recognised. These problems are likely to disappear if tax is based on profits, gains, losses, expenses and charges, along the lines of the loan relationships operative provisions.
Our view is that, in the interests of simplicity it should be possible to translate currency amounts for tax using the rate in the accounts in virtually all circumstances. The exceptions should only arise where the rate used is manifestly different from the spot rate and this does not arise from hedge accounting. Where hedge accounting applies, the rate implied by the hedge should be applied for tax, unless that rate was manifestly different from the spot rate (or appropriate forward rate) at the time the hedge was entered into.
Once the operative rules are amended, hedge accounting becomes easier to deal with. In our view, s93 FA 1993 should have a rule permitting a currency contract to be translated at the implied rate, so long as that is in accordance with GAAP and the rate was an arms length rate when the hedge was entered into. If the hedged item falls with the FA 1994 or 1996 provisions it should also be recognised at that rate. Ideally the same should apply whatever code the hedged item falls within, be it capital gains (overriding the Bentley v Pike principle), capital allowances, a Case V Schedule D dividend, or whatever. Even if amendment to the other codes is put off to a later period, permitting hedge accounting will be a large step towards matching tax and accounting treatment.
In a similar vein it should be possible to use an accounts rate during as well as at the beginning and end of accounting periods, so long as this is an arm’s length rate and the accounting follows GAAP.
We also raise a number of important points of details in Appendix 1 to this letter in the aim of improving the effectiveness of the provisions.
Extension of scope of financial instruments regime
At the moment it is not clear that there is consensus as to the ideal scope of these provisions. This is an area in which the view of industry groups will be particularly important. We do, however, have a number of observations.
Is it really necessary for the FA 1994 provisions to apply at all, where a company deals in a particular type of derivative in the course of its trade? As the recognition of profits would be based on accounts, is there any need for the additional complications imposed by the FA 1994 regime?
So far as non-traders are concerned we could see some possibility of benefiting from applying the FA 1994 rules to a central treasury and/or risk management company. If such activities are currently hindered by the risk that Case I Schedule D treatment might not apply, the extension of FA 1994 would be beneficial to include, for instance, commodity, weather and credit derivatives. We do not have sufficient evidence to tell whether there is a major problem, in practice.
Equity derivatives pose complex problems. In general we believe that the tax treatment of derivative contracts should be assimilated to the tax treatment of the underlying arrangements being hedged. Otherwise anomalies result, creating pitfalls and difficulties for commercially motivated transactions and, from the Revenue's perspective, avoidance opportunities. Equity derivatives, and other derivatives like total return swaps, typically hedge underlying arrangements which are subject to more than one type of tax treatment (eg interest, dividends and capital gains). One approach would be to exclude derivatives which are "tainted" by partially relating to non-income/deemed-income type items (the approach of the current financial instruments regime). Another approach would be to include in full all derivatives which partially relate to such items, or at least do not fully relate to clearly excluded items such as dividends or capital gains. (This is the implied preferred course in the consultative document.) Both of these approaches however violate the principle of assimilating the treatment of derivatives to the treatment of the underlying, and we would prefer to avoid them if this is feasible.
Accordingly our preferred approach would be to bifurcate, or trifurcate derivative contracts according to the underlying items which they hedge, namely income/deemed income, dividends or capital gains. We do not however underestimate the challenge of drafting suitable rules in the limited time available, and we accept that the result might prove very complex in practice. Accordingly, we would suggest as an intermediate step that equity derivatives, other than those held during the course of a trade encompassing trading in such derivatives, or the equity positions they hedge, should be afforded capital gains treatment within s143 TCGA 1992 and s128 ICTA 1988. Thus, in particular, total return equity swaps would be treated in the same way as futures and options. This would bring some income-like elements into a capital gains regime; any concerns about possible abuse could be addressed by relatively minor changes to Sch 5AA ICTA 1988.
Derivatives relating to real property give rise to similar issues, although the s143 approach may not be viable here, and accordingly we would suggest that until an overall solution is found they should be excluded from the regime.
Connected Party Debt
There are a number of difficulties both with the existing situation, and with the proposals in the consultative document, which we deal with in detail in Appendix 1. Some general comments are however called for.
We understand that bad debt relief is a difficult area from the Revenue's perspective in that the same underlying economic misfortune can give rise to more than one tax deduction, firstly to a borrower who suffers the direct economic loss and secondly to a lender whose debt due from the borrower is thereby impaired. We would suggest that this is inevitable in a profits-based tax system, particularly one in which closer alignment with accounting results is sought, as both taxpayers have suffered economic and commercial loss (whether temporary or permanent), notwithstanding that it may have a common underlying cause. The Revenue's concerns should be directed specifically at arrangements made to engineer double deductions, or to situations in which more than one deduction is obtained in a group situation. Moreover, the approach taken to tackling these problems should avoid creating tax incentives for banks and other lenders to foreclose on companies in difficulties, as well as avoid creating tax charges directly and immediately on such companies as a result of rescue arrangements.
Accordingly we believe that:
- the full burden of the connected party debt rules should only apply where there is a s840 ICTA 1988 control relationship between the borrower and lender (ie where the parties are potentially in a position to manipulate events for tax purposes), and only to debits or credits arising after the parties became connected in that sense (to avoid a disincentive on lenders from taking shares in the borrower); and
· in joint venture situations these rules should not apply, at least not unless consortium relief is claimed from the joint venture to a consortium member who is also a lender to it. General
We would be pleased to take part in further discussions on any matters relating to these proposals. Overall, we support simplification, and greater alignment with the accounts, in this area but are concerned that if proposals are enacted too hastily, and without taxpayers having the opportunity to understand the legislation before it applies to commercial transactions, new anomalies will arise in
place of the old. In particular, we would be pleased to review draft legislation, but think that a period of at least three months should be allowed, given the complexity of the subject matter.
Appendix 1
Appendix 2
Technical Department
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