Article by Paul Minness, Senior Tax Manager in the Finance & Treasury Tax Team, PricewaterhouseCoopers. This article appeared in the October 2002 issue of Tax Adviser.
Legislation dealing with foreign exchange, financial instruments and corporate debt was enacted in 1993, 1994 and 1996 respectively. While they have their problems, it is fair to say that the principles are largely understood among tax professionals and that various unintended results arising from the problems have been well publicised.
Despite this, the Inland Revenue decided that it was necessary to rewrite the legislation and embarked on a consultation process in December 2000. Their aim in the rewrite was to allow the legislation to catch up with the developments that have taken place since 1994 in derivatives and also to bring accounting and tax treatment more closely together. Whether or not the rewrite is ultimately considered a success, the new rules do include a number of significant changes outlined below.
The commencement date for the majority of the changes introduced by Finance Act 2002 (FA 2002) is the start of accounting periods beginning on or after 1 October 2002. However, it should be noted that some of the anti-avoidance legislation will come into effect earlier, with some already in force for accounting periods ending after 26 July 2001.
The 1993 rules that deal with foreign exchange gains and losses have been completely repealed with exchange movements on corporate debt assimilated into the corporate debt rules and exchange movements on derivatives taken into the new derivatives legislation.
One important principle that has survived the changes, albeit in amended form, is that of matching. The matching rules permit taxable foreign exchange differences on liabilities that are used to hedge certain qualifying assets (mainly overseas subsidiaries) to be deferred until the underlying asset is disposed of. In order to ‘match’ for tax purposes, a company needed to make an election identifying the relevant asset and liability and, although the election can be made from any point in time, it can also be made on a retrospective basis if it is made within 92 days of the acquisition of the asset.
As it was possible for companies to use the 92-day time limit to review historic exchange movements and choose the most beneficial date at which to match, the Revenue have amended the rules so that matching is both immediate and compulsory.
Under the new rules, if a company has a qualifying asset and a qualifying liability that are hedged for accounting purposes in accordance with statement of standard accounting practice 20 (SSAP 20) (i.e. the exchange differences on both the asset and the liability are taken to reserves) then they will automatically be matched for tax purposes. Although this seems simple in practice, it is important that companies know what assets are matched and which liability is being matched with which asset. Without this understanding, companies may find their position has changed; for example, if a company had an asset and a liability that were hedged for accounting purposes, but not matched for tax purposes, the company may now find that the exchange movements on the liability are excluded from their tax computation.
In order to ascertain what is matched, the company will need to identify all of the assets and liabilities that are hedged for accounting purposes. Then, the assets and liabilities will need to be grouped according to currency and they will be matched according to the following statutory order:
- items taxed as income (e.g. loan relationship assets);
- assets which give rise to a chargeable gain or allowable loss; and
- assets, the capital gains on which are exempt under the substantial shareholdings regime.
Further problems may arise if a company has two or more assets held within any of the categories shown above. In these instances, the matched liabilities will be apportioned on a just and reasonable basis.
Where a matching election is currently in place, it will be disregarded once the company enters the new rules, although any gain or loss associated with the matched liability will continue to be deferred to the ultimate disposal of the asset. If the gain or loss on the matched asset will be exempt due to the substantial shareholdings exemption, then the foreign exchange movements arising on the liability will also be exempt.
One important point to note with regard to matching is that, amongst the list of eligible assets, the Revenue will now include loans that are regarded as permanent as equity (e.g. some long-term interest free loans). The test for whether a loan will qualify for matching treatment will be whether the company’s accounts treat the loan in this way.
Old transitional rules
The new foreign exchange rules have finally resulted in the end of the transitional provisions introduced in the earlier act. Under the transitional provisions, loans were split into three categories: ‘fixed loans’, ‘fluctuating loans’ and ‘Regulation 6 (3) items’, being those assets that would have been taxed as capital gains under the rules predating FA 1993or items that were taxed on a realisation basis.
For fluctuating loans, the transitional provisions have already ended and the exchange movements on such items have been brought back within the tax net.
Where there are fixed loans companies have had to calculate, for each accounting period, the amount of gain within the charge to tax using a method known as the ‘kink test’. The kink test will no longer be required: going forward, fixed loans will be fully within the charge to tax, with exchange movements calculated with reference to their value on the first day within the new rules.
For Reg. 6(3) assets and liabilities, there is likely to be a pre-commencement gain or loss that has been held in suspense and will be crystallised for tax purposes when the company ceases to be entitled to the asset or subject to the liability. Under the old transitional rules, exchange movements on the item are wholly or partly offset against this held-over gain or loss, adjusting the amount that would crystallise on disposal. All these adjusted held-over exchange movements crystallise immediately before the company’s first accounting period beginning on or after 1 October 2002. The company will then be able to choose to have the gains and losses subject either to immediate taxation or, by election, to defer the movements coming into charge until the disposal of the relevant asset or liability. A separate election may be made for all realisation basis assets and for all chargeable gains assets.
The new legislation sees the end of deferral relief. It will no longer be possible for companies to defer the taxation of unrealised exchange gains on long-term capital assets and liabilities. Where a deferral claim is in existence, the deferred amounts will be brought into tax at the start of the first accounting period unless the company makes an election to treat the deferred gain as arising equally over six years.
One significant change in the legislation follows the assimilation of the foreign exchange rules into the corporate debt rules. Under the new rules, the legislation dealing with interest for unallowable purposes (FA 1996, Sch. 9, para. 13 ) is extended to cover exchange differences. In addition to denying exchange losses, however, the new rules work to disregard any exchange gains arising on transactions for unallowable purposes.
The anti-avoidance legislation in FA 1993, s. 136, 136A and 137 which acted to ring-fence losses on debts and currency contracts that were on non-arm’s length terms has not been replicated within the new rules.
Now, if foreign exchange differences arise on debts, they will be subject to the debt anti-avoidance rules. This means that if a borrowing is deemed to be equity such that interest is disallowed or treated as a distribution under Income and Corporation Taxes Act 1988 (ICTA 1988), s. 209 then the foreign exchange movements will not be taken into account in the tax computation. Equally where part of an interest deduction is denied due to it being excessive, the foreign exchange differences arising to the borrower on that excess will be disregarded.
Another piece of anti-avoidance legislation which has been repealed is FA1993, s. 135A which allowed the Revenue to recalculate a tax computation in sterling if the main benefit of accounting in a foreign currency was to avoid an exchange gain. The rules now follow the accounts and require a non-sterling denominated company to calculate the taxable profits in the non-sterling currency, and then to translate that figure into sterling.
The new rules have simplified what exchange rate should be applied in preparing a tax computation. Now, in most cases, the exchange rates required by United Kindom (UK) generally accepted accounting principles (GAAP) will also be used for tax purposes and, where hedge accounting takes place, the rate to be used will be the one that is implied by the currency contract.
The Revenue have used the FA 2002 to replace a narrow financial instruments regime, which covered futures, options and options on interest rates, currency and loan relationships, with a broader derivative contract regime. The new rules are based on accounting definitions and include all options, futures and contracts for differences, which are derivative financial instruments according to financial reporting standard (FRS) 13. The only exceptions to this broad definition are when the underlying subject matter of the contract is:
(b) tangible moveable property (other than commodities);
(c) intangible fixed assets within the scope of the intangible property rules in FA2002;
(d) shares and unit trust holdings; and
(e) convertible, exchangeable and asset-linked securities within FA 1996, s. 92 and 93.
If a derivative contract falls within the new rules, then all profits and losses relating to the contracts will be taxed or allowed as income. Equally, if a derivative contract has an excluded underlying subject matter within categories (d) or (e) above, then the contract is within the income regime if it is dealt in as part of a trade, if it forms part of a scheme to produce a guaranteed return or if it is held to provide insurance benefits equivalent to interest.
Once in the new rules, the tax treatment of a contract will follow the accounts treatment (providing that either an accruals method or mark to market method of accounting is used). If the derivative is for the purpose of the trade, then profits and losses will form part of the D Case I calculation. If the contract is not for the purposes of the trade the profits and losses will result in non-trade debits or credits, which will be dealt with in the same way as non-trade debits and credits arising from loan relationships.
If a derivative contract is ‘mixed’ (i.e. there are two underlying subject matters one of which is excluded) then the treatment will depend on the type of contract. A future or option will be split into two notional contracts with one contract in the new rules and one excluded, whereas a contract for differences will be treated as wholly within the new income regime.
In order to prevent companies entering into derivatives solely for tax advantages, the Revenue have introduced an anti-avoidance provision based on the loan relationships FA 1996, Sch. 9, para 13 (see above). This new provision provides for debits on a derivative contract to be denied to the extent that they relate to an unallowable purpose. Unlike the loan relationship equivalent, the derivatives rule works on a cumulative basis such that a disallowed loss is also available to reduce future profits on the same contract. This rule came into effect for accounting periods ending on or after 26 July 2001 in respect of all interest rate, currency and debt contracts in place at that time.
The current anti-avoidance legislation within FA1993, s. 165-167 which deal with transfers of value and arm’s length rules have been repealed and the derivative contracts will now be subject to the general transfer pricing rules in ICTA 1988, Sch. 28AA.
Finance Act 1993, s. 153(4) and s. 153(5) have been amended to ensure that where a premium or discount relating to a currency contract is recognised in a company’s accounts, it will be brought into account for tax purposes. This change - effective for all accounting periods ending on or after 26 July 2001 - is to ensure that the accounts and tax position are the same.
The new legislation also ensures that derivative contracts that are transferred within a capital gains group will be tax neutral, which follows the same principles as transfers of loan relationships, as set out in FA 1996, Sch. 9, para. 12, .
The 1996 loan relationship rules have largely been retained in their existing form, although there have been some significant changes to the definitions of control and connection Also, the Revenue have taken the chance to amend the problem area where a company acquires a loan relationship at a discount and have addressed the issue of convertible and asset linked debts, which are often used for planning purposes.
Control and connection
Under the 1996 rules, there is one test for control and connection, being defined at FA 1996, s. 87 and ICTA1988, s. 416 respectively. If a company was connected with another one it was compelled to use an accruals method of accounting, was not able to get bad debt relief on loans and was possibly subject to the anti-avoidance legislation concerning the late payment of interest and the deductibility of discount (FA 1996, Sch. 9, para. 2, 17, 18, ). The legislation also incorporated a two-year look back period, where connection was deemed to exist if two parties were under common control, or one company controlled the second, at any time in the last two years.
The new legislation takes a different view of control, using a definition based on voting control. Now, control requires 50 per cent of the voting rights as dictated by the memorandum and articles of a company. The two-year look back period has been removed. If two companies are connected by virtue of this test then they must apply accruals accounting to any loan relationships between them, and also the lender will not be entitled to any bad debt relief.
In addition to this narrow test, there is a new ,major interest rule’ (FA 1996, Sch. 9, para. 20) that applies if there are two shareholders who, after taking into account connected parties, have at least 40 per cent of the shares each. If two companies are connected under this wider test, then the loan relationships between them are subject to the rules concerning late interest and connected party discount. The benefit of these two tests is that it is now possible for a minority shareholder to claim bad debt relief on any loans to its joint ventures.
However, in order to prevent double relief in consortia, new rules concerning the interaction of bad debt and consortium relief have been introduced. Broadly they are:
- bad debt relief is reduced by any consortium relief claimed in the same period;
- bad debt recoveries are first attributed to disallowed bad debt provisions and not taxed unless they reflect the reversal of bad debt relief given previously; and
- consortium relief is reduced by the cumulative bad debt relief allowed in earlier periods.
Existing discounted securities which would become connected party loans due to the introduction of the wider connection test or the change in definitions, will continue to be treated as non-connected party loans.
Acquisition of debt at a discount
One of the most publicised, unintended consequences of the 1996 legislation concerns when a company acquires a new subsidiary and, simultaneously, acquires a debt owed by that company at less than face value. The 1996 rules require the new parent to assume that the debt will be repaid in full, thus making it write up the debt to full value, with the credit relating to the write up being taxable on the parent.
The new rules have relaxed this requirement. Providing there has been no connection between the acquiring company and the debtor at any time in a three-year period ending twelve months before the date of acquisition, the acquirer will not be taxed on the difference between acquisition and face value unless it is accrued for in the accounts. The change does not mean that the new lender will be able to have complete bad debt relief as the amount paid for the loan remains subject to the usual rules on connected party bad debts.
Convertibles and asset-linked debts
The Revenue have long regarded intra-group convertible debts and asset-linked debts as areas that are abused for tax planning. They have taken this opportunity, therefore, to amend FA 1996, s. 92, 93 to ensure that the scope for planning is very restricted.
In respect of s. 92, additional tests were added with effect from 26 July 2001 and 19 December 2001 to restrict the number of items that qualified as capital gains tax assets in the hands of a lender. The most significant of these restrictions was added in December and it effectively stops any intra-group convertible from being a s. 92 asset. Where a company has an intra-group convertible prior to these dates, the gain accruing up to the relevant point (either 26 July or 19 December) is calculated and then deferred until the asset is disposed of, converted or redeemed.
In terms of s. 93, the assets to which the debt can now be linked are restricted to shares that are quoted on a recognised stock exchange or land; in short, the Revenue have prevented them being linked to assets where the returns can be both predictable and guaranteed.
The new rules have gone a long way to address the key issues and uncertainties that arose from the earlier legislation in this very complex area. An initial review of the legislation, however, has identified some new uncertainties (e.g. how mixed derivatives will be split in practice). The Revenue have indicated that there will be no wholesale changes to the legislation for the next couple of years, unless they identify any significant risk to tax revenues, and have said that any clarification required from the new rules will be in the form of guidance notes.
Whether or not FA 2002 has removed all of the uncertainties it is likely that it will need to be replaced within the next few years to reflect accounting changes such as the proposed requirement for derivatives to be valued on a mark to market basis and the move towards International Accounting Standards.
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October 2002 by