Introduction Details of the Schedule
2.Paragraph 2 contains the main operative provision for loan relationships. Section 328(3) and (4) of CTA 2009 provide that foreign exchange gains or losses arising on a company’s loan relationships are left out of account in certain circumstances. In particular, this caters for net investment hedging by a company – where a company, which is exposed to currency risk because it has invested in a foreign operation, such as an overseas subsidiary, borrows in the same currency to hedge that risk. Exchange gains or losses on the borrowing offset the exchange losses or gains arising on the investment.
3.For tax purposes, however, a mismatch occurs because exchange differences on the borrowing are taxable, but those arising on a shareholding are not. Section 328(3) allows exchange gains and losses on a loan relationship, to the extent that the loan is “matched” with shares, to be disregarded for tax purposes where under the accounting policies adopted by the company such exchange differences are taken to reserves. Section 328(4) provides a regulation-making power: this has been used to make similar provision for cases where borrowing is intended as a hedge of currency risk arising from investment in a foreign operation, but where a different accounting treatment is employed.
4.Since exchange rate movements are unpredictable, these “forex matching” provisions are normally just as likely to result in a loss being excluded from tax as a gain. But some avoidance arrangements do away with this unpredictability and use forex matching to procure that exchange gains within a group of companies are sheltered from tax, whereas losses are not. Paragraph 2 inserts a new subsection (4A) into section 328, to provide that that the disregard of exchange gains or losses under section 328(3) or (4) does not apply where the loan relationship on which they arise is part of arrangements that have such a “one-way exchange effect”. It follows that if a company is party to arrangements that do not involve any disregard of exchange gains or losses under section 328(3) or (4), it will not have to consider the application of the one-way exchange effect provisions.
5.New subsection (4A)(c) further restricts the operation of the rule by requiring that the arrangements must result in a non-negligible tax advantage for either the taxpayer company or some other company. This guards against the possibility of companies that are not engaged in avoidance being caught by the legislation because, for whatever reason, their hedging arrangements produce a very small “one-way exchange effect”. It would also exclude any company whose foreign exchange arrangements operate in an asymmetric manner, but which pays more tax as a result. “Tax advantage” is defined for the purposes of the loan relationships legislation at section 476(1) of CTA 2009. It has a wide meaning that takes in both a decrease in taxable receipts or an increase in allowable deductions.
6.Paragraph 3 inserts new sections 328A to 328H. These set out what is meant by a “one-way exchange effect”.
7.New section 328A contains the test for determining whether arrangements have a one-way exchange effect. “Arrangements” are given a wide definition in new section 328H(3).
8.New section 328A(1) provides for there to be a one-way exchange effect if two conditions are fulfilled. The first, in new section 328A(2), excludes arrangements from consideration if they do not include an option or a relevant contingent contract (both of these terms are explained later in the legislation). This means that most commercial hedges of investment in a foreign operation, involving only “plain vanilla” loans, cross-currency swaps or forward currency contracts, will not need to be tested for a “one-way exchange effect”.
9.The second condition, in new section 328A(3), provides for a test to be carried out on each of a number of defined “test days” in an accounting period of a company. If the condition is satisfied on any one of those test days, there is a one-way exchange effect. In broad terms the test consists of a comparison between the net allowable exchange losses arising on arrangement instruments (“amount A”), and the taxable gains that would have arisen had the foreign currency involved moved the other way (“amount B”). For the condition to be satisfied, amounts A and B must be unequal.
10.New section 328A(3)(b), however, further requires that the same inequality would not be produced if the rules for forex matching did not exist. (New section 328A(7) explains what is meant by “the matching rules”). This excludes from the anti-avoidance provision those cases where forex matching is not integral to the production of a one-way exchange effect. For example, a group finance company may borrow from a bank, and on-lend the funds to a “water’s edge” company that holds shares in an overseas subsidiary. The holding company will not be taxed on exchange differences arising on the internal loan, because it is “matched” to the shares. The finance company might, however, enter into option arrangements designed to limit its losses if the currency of the bank loan appreciates substantially. The option arrangements may produce asymmetry between exchange gains and losses, but this is unrelated to the “forex matching” by the holding company. These arrangements would not be caught by the legislation.
11.New section 328A(4) defines “amount A”. It is the sum of “relevant” exchange losses that arise to company A, and companies connected with company A, in accounting periods of the company ending on the test day, less the sum of “relevant” exchange gains arising to those companies in the same accounting periods. Amount A may be negative if the company has more exchange gains than losses.
12.New section 328A(5) contains the definition of “amount B”. This introduces the idea of the “counterfactual currency movement assumption”. The company must look at what exchange gains and losses would have arisen had the exchange rate in question moved by the same amount in the other direction. Amount B is the sum of “relevant” exchange gains of company A and of companies connected with it, arising – on the basis of this hypothesis - in accounting periods ending on the test day, less the sum of exchange losses computed on the same basis. As with amount A, it may be positive or negative. Amounts A and B will be equal if, for example, they are either both +100 or both -100.
13.New section 328A(6) deals with the case where the “test day” is a day other than the last day of a company’s accounting period. For the purposes of arriving at the exchange gains or losses involved in computing amounts A and B, the period is treated as ending on that day. For example, suppose that a company has an accounting period 1 January 2010 to 31 December 2010, but in respect of particular arrangements, 1 September 2010 is a test day. If the company is party to a loan relationship (which is part of the arrangements) both before and after 1 September, it must look at the exchange gain or loss arising on the loan relationship in the period 1 January to 1 September, as if it had drawn up a balance sheet on 1 September.
14.New section 328B sets out when an exchange gain or loss is “relevant” and hence must be included in the computation of amounts A and B. Three conditions must be satisfied. First, it must arise on a loan relationship or a relevant contract (see paragraph 17 below). Second, that loan relationship or relevant contract must be part of the arrangements. Finally, a debit or credit has to be brought into account for CT purposes in respect of the exchange gain or loss – so, in particular, where exchange differences are disregarded because of the “forex matching” rules, they will not enter into the computation. But, in ascertaining whether a debit or credit would be brought into account, the “one-way exchange effect” provisions themselves are ignored (to avoid circularity), as is the effect of the “unallowable purpose” anti-avoidance rules (since these may of themselves create asymmetries).
15.New section 328H(11) applies certain terms from the derivative contracts rules (Part 7 CTA 2009). Thus “relevant contract” in section 328B means an option, a future or a swap. It also includes derivatives that are embedded in other financial instruments or non-financial contracts.
16.New section 328C defines “test day”. The avoidance arrangements targeted by these provisions must involve either options, or arrangements having the effect of options (referred to as “relevant contingent contracts”). Such instruments allow one thing to happen in the case of a certain contingency – commonly, the contingency that sterling strengthens (or weakens) against a particular foreign currency – but something else to happen if it does not.
17.Subsection (2) deals with the case where the arrangements involve one or more options. If an option is actually exercised, the day on which the option is exercised is a test day; and the same applies where the company sells or novates the option, or its terms are changed. If it is not exercised in the accounting period, each day on which it might have been exercised is a test day. Finally – to cover cases where a one-way exchange might be produced through changes in fair value, even if it cannot be exercised in the period – the last day of the accounting period is a test day. In practice, it will usually only be necessary to consider one of the possible test days.
18.Subsection (3) of new section 328C makes similar provision where the arrangements include one or more relevant contingent contracts.
19.New section 328D sets out the assumptions that need to be made when applying the counterfactual currency movement hypothesis. It operates with respect to the “relevant foreign currency”, which is defined in subsection (6) as the currency in which the loan relationships or derivative contracts, on which the exchange gains or losses arise, are denominated. Arrangements may involve more than one foreign currency. For example, an arrangement may include one loan in US dollars and another loan in euros; or the companies involved in an arrangement may have different functional currencies, so that sterling (for example) may be a “foreign currency” for one company but not another. In such cases, each currency involved that gives rise to exchange differences is a “relevant foreign currency”.
20.If the relevant foreign currency appreciates over the accounting period (or deemed accounting period up to the test day) against the operating currency of the company, it must be assumed that the currency had instead depreciated by the same percentage – subsection (2). Similarly, if the currency depreciated by a particular percentage against the operating currency, it must be assumed that it had instead appreciated by the same amount – subsection (3). The same applies if the currency appreciates or depreciates over any part of the period. Suppose, for example, the test is being applied over a period 1 January to 30 June, but the company repaid a foreign currency loan on 31 March. The foreign currency appreciated by 10% in the period 1 January to 31 March, and an exchange loss on repayment of the loan. In applying the counterfactual hypothesis, the company must compute what exchange gain would have arisen on repayment of the loan had the currency depreciated by 10% over the same period.
21.Subsections (4) and (5) provide that except in relation to the treatment of options to which section 328E applies, the counterfactual computation must be made on the basis of what the company has actually done. Thus in the example above, the counterfactual calculation must assume the same loan repayment on 31 March – the company does not need to consider whether, had the exchange rate moved in the opposite direction, it would have done something different.
22.Subsection (7) defines the “operating currency”. This is tied to provisions in the 1993 Finance Act for foreign currency accounting – it is the currency in which the company prepares its tax computations. Where, under the tax provisions for loan relationships and derivatives held by a partnership, a company is deemed to be party to a loan relationship or a relevant contract, the “operating currency” in relation to such loans or relevant contracts is the partnership’s “operating currency”.
23.New section 328E deals with the application of the counterfactual hypothesis where an option is part of the arrangements. Two cases are covered: where the option was exercised on the test day, and where it was not (but was, in fact, exercisable on that day). Where the options was exercised, subsection (4) provides that the calculation should be made in on the basis that it was not exercised if, in all the circumstances, it is more likely than not that the company would have refrained from exercising it under the “counterfactual currency movement assumption”. Subsection (5) similarly covers the case where the option was not exercised. If it is more likely than not that the company would have exercised the option had the exchange rate moved the other way, the computation is made on the basis that the option was exercised.
24.New section 328F extends the meaning of “option” for the purposes of applying section 328E and other parts of the one-way exchange effect provisions. For the purposes of the derivative contracts provisions, an option that can only be cash settled is not an “option” (it is a contract for differences). Subsection (1) disapplies this rule. Subsection 2 extends the scope of the provisions that treat derivatives embedded in loan relationships, “hybrid derivatives” or other contracts as separate relevant contracts. These rules only apply where, under Generally Accepted Accounting Practice (GAAP), the embedded derivative is not closely related to the host contract and is accounted for separately. For the purposes of the one-way exchange effect provisions, a financial instrument or other contract contains an option if it contains provisions which could, if they stood alone, be regarded as an option. It does not matter whether the company does, or could, account separately for the option element.
25.New section 328G deals with contracts whose effects are contingent on currency movements, but which are not options (because the holder has no choice over whether a particular provision is triggered). These are referred to as “relevant contingent contracts”. In order to be a relevant contingent contract, a contract must contain an “operative condition”. This is a condition which alters any right or liability under the contract, contingent on the exchange rate between the relevant foreign currency and the operating currency of the company – subsection (3). The “trigger” may relate directly to an exchange rate, or indirectly – for example, it may relate to an asset whose value is closely tied to an exchange rate.
26.New section 328H contains interpretative provisions. In particular:
27.Subsection (4) provides that, when deciding whether a loan relationship or relevant contract is part of any arrangements, regard must be had in particular to the circumstances in which the company became party to it, its currency, and its likely effect.
28.Subsection (5) defines the currency in which a relevant contract is denominated as the currency of its underlying subject matter.
29.Subsections (6) and (7) make clear what is meant by one currency (“currency A”) appreciating or depreciating relative to another currency (“currency B”). Thus suppose currency A is US dollars and currency B is sterling, and $1 is worth £0.60 at the beginning of a period and £0.65 at the end, the US dollar will have appreciated against sterling (0.65 – 0.60)/0.60 x 100% = 8.33%.
30.Subsections (9) and (10)  apply the loan relationships definition of “connection” to these provisions. Two companies are connected for an accounting period if, at any time in the period, one company controls the other or they are under common control. Exclusions that apply for loan relationships purposes – for example, two companies that are both under the control of a Government department or Minister of the Crown are not connected – apply here as well.
31.Paragraphs 4 to 6 amend the derivative contracts rules in Part 7 of CTA 2009. For the most part, these changes are analogous to these made for loan relationships. There are, however, some differences.
32.Paragraph 6 amends section 606 CTA 2009, which deals with exchange gains and losses on derivative contracts. The existing section 606(3) disregards exchange gains or losses, which are taken to reserves in the company’s accounts, in two circumstances. The first is where the derivative is a currency derivative. This covers the case where a currency swap or forward contract is used to hedge currency risk arising from the company’s investment in a foreign operation. The second is where the exchange difference arises from retranslation of the profits of part of a company’s business.
33.Subparagraph (4) of paragraph 6 rewrites these cases as two separate conditions. The second case is reproduced in a new section 606(4B). The first case – the “forex matching” case – is in new subsection (4A). But new subsections (4C) and (4D) apply a restriction where the exchange gain or loss is not calculated by reference to spot rates of exchange. In such a case, the overall exchange difference is to be treated for the purposes of the derivative contracts computational rules as if it consisted of two elements – an exchange gain or loss calculated by reference to spot rates, and a residual amount. The first element can be matched, the second cannot.
34.This means that where the profit or loss computed on a forward currency contract includes “forward points” – a profit or loss dependent only on interest rates for the currencies concerned, and independent of movements in foreign exchange rates – it is only the “forex” element of the profit or loss and not the forward points that is eligible for matching. This change counters avoidance schemes involving a predictable profit from “forward points” on a currency contract that is eliminated through forex matching, while the corresponding loss arising to the counterparty is utilised for tax. .
35.The residual amount is described by the legislation as an “exchange gain or loss”, even though it would not be regarded as such in accountancy terms. This is so that other references in the derivative contracts provisions to exchange gains and losses continue to apply to both elements of the overall amount.
36.A new subsection (4E) makes provision corresponding to that for loan relationships. Exchange gains cannot be matched, either under section 606(3) or through regulations made under section 606(4) where the exchange gain or loss arises from a one-way exchange effect, and they bestow a non-negligible tax advantage.
37.Paragraph 7 inserts new sections 606A to 606H. These function in almost exactly the same way as the corresponding loan relationships provisions. The main difference is in the interpretative provisions, since many of the expressions used (such as “relevant contract”) are already defined for the purposes of Part 7.
38.Paragraphs 8 and 9 insert references to the Part 5 and Part 7 one-way exchange effect provisions into the index of defined expressions in CTA 2009.
39.Paragraph 10 revokes SI 2006/843 – The Loan Relationships and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses) Regulations – in its entirety. This statutory instrument disallows losses in certain arrangements that have a “one-way exchange effect”, but is rendered otiose by the new primary legislation. It ceases to operate on 22 April 2009, when the primary legislation comes into effect, thus removing any possibility of double taxation.
40.Paragraph 11 is the commencement provision. The new rules apply to accounting periods beginning on or after 22 April 2009. Where a company’s accounting period straddles 22 April 2009, exchange gains or losses are to be computed as though there were two separate accounting periods, one ending immediately before 22 April and the next one beginning on that date. The amendments will apply to the second of those notional accounting periods, but not the first.