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Loan relationships, derivative contracts and forex gains and losses

Category Technical Articles
AuthorTechnical Department
CIOT representations on the Technical Discussion Note on loan relationships, derivative contracts and foreign exchange gains and losses

Article by Adrian Rudd, published in the May 2002 issue of Tax Adviser. Adrian Rudd of PricewaterhouseCoopers is Tax Adviser’s representative on the Technical Committee.

This month’s article highlights some of the points made in the Institute’s response to the Inland Revenue Technical Discussion Note on issued on 19 December 2001. Since these representations were submitted the Inland Revenue have held a workshop for representative bodies to consult on proposed changes to the draft legislation that they were considering in the light of representations, and following that workshop they circulated revised draft definitions for the new derivative contract legislation. John Lindsay and Roger Muray from the Institute’s working party also prepared a response to the draft definitions. At the time of writing the Finance Bill had yet to be published, but the Institute understands that the Revenue have taken on board many of the points made in its representations.

Start dates

The Institute welcomed the decision to delay the general start date for the new legislation, but hoped that the Revenue might accelerate the start date for the provisions dealing with companies in liquidation, administration etc, as well as where ‘second hand’ loan relationships are purchased at a discount. These are relieving provisions, so any backdating of the date they take effect would not contravene the Human Rights Act 1988 (HRA 1988).

Foreign exchange

Translation rules

Where a company receives income or incurs expenditure in a currency other than its reporting currency, the company should be permitted to use the exchange rate that it uses in its accounts to translate the income or expenditure into its reporting currency, so long as the use of that exchange rate complies with United Kingdom (UK) generally accepted accounting principles (GAAP). Under the proposed changes the company is required to use an arm’s length exchange rate for the date on which the translation takes place.

Where, however, a company enters into a derivative contract to hedge the income and/or expenditure in question it should be permitted to use the exchange rate implied in the derivative contract to translate the item that is being hedged.

In other cases, a company might use a monthly average rate to translate such items of income and expenditure into its reporting currency. It should be permitted to use such an exchange rate so long as the use of this rate complies with UK GAAP. The Revenue consider that the drafting permits hedge accounting to be used. This Institute suggested that the point is put beyond doubt by a legislative change.

Long periods of account

The Institute asked for guidance on how exchange gains and losses should be determined where a company prepares accounts for a period which exceeds 12 months in length. This will be a new point, as previously a translation period would have arisen at the end of the first 12 months for the purposes of the foreign exchange legislation. Presumably exchange gains and losses should be determined under the statutory accounts and should then be apportioned between the two accounting periods on a time basis under the provisions of section 834(4).

New derivative contracts legislation

The Institute expressed concern about the wide scope of the proposed definition of the derivative contracts falling within the derivative contracts legislation, particularly as such definitions could have brought contracts that would not generally be considered to be derivative contracts within the new legislation. The Institute raised concerns in particular about mixed contracts, for example:


  • Where an agreement for the forward sale of shares provides that the purchase price is to be adjusted by reference to an interest rate factor, as the delivery of the shares would take place at a future date, the purchase and sale agreement could be considered to be a ‘future’;
  • Where shares or land are purchased with a commodity (eg a power station is purchased together with stocks of coal – a real life example) the contract would be a ‘future’ that falls within the derivative contracts legislation where there is a gap between exchange and completion.

The draft amendments to the derivative contract legislation which were recently circulated for comment should resolve many of these issues.

Amendments to the loan relationships legislation

‘Stranded’ losses

The Institute considered that the proposed amendments to Finance Act (FA 1996) s. 83 could give rise to stranded losses.

The proposed section 83(3A) provides that the ‘default’ way of relieving a non-trading deficit is for the deficit to be carried forward and set against the company’s non-trading profits of the next accounting period. If the non-trading profits of that next accounting period are insufficient to relieve the deficit, the unrelieved deficit will not be eligible to be carried forward for relief against non-trading profits of future accounting periods.

It also appears that that a company cannot elect to carry forward any amount of a deficit that is carried forward under the provisions of s. 83 (3A), and which remains unrelieved at the end of that next accounting period, under the provisions of s. 83 (2)(e). This is because such an amount is not treated as a non-trading deficit arising in the next accounting period, and thus it would not be possible for a claim to be made under this subsection.

In the Institute’s view the proposed amendments do not adequately deal with cases where companies have substantial foreign source income.

A company has two years from the end of the accounting period following that in which the deficit arose to make a claim under section 83(2)(e). In practice a two-year time period is often not sufficient and, as the Inland Revenue have noted, there is a risk of a ‘stranded’ non-trading deficit arising under the current provisions. Moreover, for onshore pooling purposes a company has six years from the end of the accounting period in which eligible unrelieved foreign tax arose in order to decide whether to set off such surplus foreign tax credits against its other foreign source dividends of that accounting period, or to surrender such surplus foreign tax credits as group relief (see Income and Corporation Tax Act 1988 (ICTA 1988) s806G and SI 2001/1163 Reg 9.

Given the complexities of double tax credit relief, particularly following the recent ‘reforms’, the Institute called for a six-year time limit for a claim under the provisions of section 83(2)(e) in a case where a company has foreign source income for which double tax credit relief is available.

A better solution, however, would be to abandon the proposed section 83(2)(e), and to provide that a deficit is automatically carried forward under section 83(3A). A company should be permitted to determine how much (if any) of the deficit it wishes to relieve against its non-trading profits of a future accounting period. Again, where in a future accounting period a company has foreign source income which carries with it an entitlement to double tax credit relief, the company should have six years from the end of the relevant future accounting period to specify what proportion (if any) of the deficit that the company wishes to relieve against its non-trading profits of that accounting period.

The Institute understands that the Revenue have decided to adopt its suggestion, but that the Revenue have decided against extending the time limit from two years after the end of the relevant accounting period to six years, which is to be regretted.

Connected party bad debt

The Institute asked for an amendment to be made to the existing provisions of FA 1996, Sch 9 para 6(4), (5). These provisions prevent bad debt relief from being clawed back in a case where a company becomes connected with a borrower as a result of treating a loan relationship as discharged by the issue of ordinary shares by that company. The provisions do not afford any relief where the lender is a party to other creditor loan relationships with the same company in the same accounting period and thus bad debt relief could be clawed back on those other loan relationships, even if the creditor ceases to be a party to those other loan relationships before the share for debt swap takes place.

The Institute proposed that:


  • There should be no automatic clawback of bad debt relief where a creditor company becomes connected with a debtor company;
  • The creditor company should be prevented from claiming bad debt relief for any losses which accrue after the date that the two companies become connected (and not the start of the accounting period in which the two companies become connected);
  • The creditor company should be required to include any releases of bad debt provisions for which tax relief has been obtained in computing its profits or losses on the loan relationship in question for the purposes of the loan relationships legislation and, further, to the extent that there is a release of a bad debt provision and it later becomes necessary to make a further provision against that loan relationship, the creditor company should be able to obtain tax relief for the lower of:
  • the amount of the provision made against the loan relationship in question; and
  • the amount for which bad debt relief had been claimed up to the time at which the two parties became connected.

Were such a measure to be introduced, this would remove one of the last remaining pitfalls of the loan relationship connected party rules.

Discounted securities of close companies

The Institute welcome the amendments that are proposed to the provisions of FA 1996, Sch. 9 para. 18. One of the current difficulties with the provision is that it can apply even where a participator is within the charge to the loan relationships legislation on the discount accruing on the relevant discounted security in question.

The proposals do not entirely resolve the present anomaly, and where a participator that is within the charge to the loan relationships legislation holds a security for part of an accounting period, as currently drafted, the provisions of para. 18 would still apply. It is understood that the Revenue intend to resolve this anomaly.

A partnership would be treated as a participator for the purposes of para. 18. The Institute is calling for an exclusion from the provisions of para. 18, to the extent that the partners in the partnership are companies subject to the loan relationships legislation. It is understood that this point will be addressed in the revised legislation that will be included in the Finance Bill.

Technical Department
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