Guidance

FRS 101 overview paper - tax implications

Updated 21 July 2017

Introduction

The purpose of this overview paper (hereafter ‘the paper’) is to assist companies who are thinking of choosing or have already chosen to apply Financial Reporting Standard (FRS) 101. In particular, it provides an overview of the key accounting changes and the key tax considerations that arise for those companies that transition from Old UK generally accepted accounting principles (GAAP) ^{[footnote 1]} to FRS 101.

This paper is split into 2 parts:

• part A of this paper provides a comparison of the accounting and tax differences that arise between Old UK GAAP and FRS 101
• part B of this paper provides a summary of the key accounting and tax considerations that arise on transition from Old UK GAAP to FRS 101

The paper concentrates on the Corporation Tax position. It may also assist individuals (and other entities) that are within the charge to income tax as many of the accounting and tax issues will be similar. However, there are significant differences between the 2 tax regimes which are not reflected in this paper. In particular, there are specific rules for loan relationships, derivative contracts and intangible fixed assets which only apply for the purposes of Corporation Tax.

For companies that transition from Old UK GAAP to FRS 102, a separate paper providing an overview of the key accounting and tax considerations is available.

This paper reflects the current thinking of HM Revenue and Customs (HMRC) and it’s based on the law as it stands at the date of publication. It’s intended that this paper will be updated as further information is available and as new accounting standards and tax law develop.

The commentary provided in the paper is of a general nature. Companies should not rely on the commentary in isolation and it’s not intended as a substitute for referring to the accounting standards and tax law. Changing the basis on which accounts are prepared is a complex area and companies may wish to consider discussing the implications of transition with its advisers and/or consult the detailed guidance in the HMRC manuals.

It remains the responsibility of the entity or individual to ensure that it prepares accounts in accordance with relevant GAAP and submits a self-assessment in line with UK tax law. Note that where HMRC considers that there is, or may have been, avoidance of tax, the analysis as presented will not necessarily apply.

Updated version

This paper is an update of a previous overview paper published in January 2014. The primary changes from the original paper are:

• additional commentary in relation to non-interest bearing loans
• updated commentary on the application of the Disregard Regulations and Change of Accounting Practice Regulations, reflecting the changes made to these statutory instruments in December 2014
• accounting commentary updated to reflect the amendments to FRS 101 issued in September 2015 (particularly in respect of the format of the profit and loss account and balance sheet, permitting contingent consideration to be measured at fair value and prohibiting the reversal of impairment losses on goodwill)

Other amendments to FRS 101 (September 2015) not addressed further in this paper include:

• amending FRS 101 to make it explicit that the Application Guidance is an integral part of the accounting standard
• amending FRS 101 to make it explicit that companies preparing accounts in accordance with FRS 101 are Companies Act accounts and not International Accounting Standard (IAS) accounts

This paper does not reflect:

• amendments to FRS102 or FRS102 section 1A – please see separate overview paper
• FRS103 – Insurance Contracts
• FRS104 – interim Financial Reporting
• amendments to European Union (EU) endorsed International Financial Reporting Standards (IFRS), yet to be effective
• new IFRS, yet to be EU endorsed

Noting that many companies will be looking to adopt FRS 101 for the first time in 2015, this paper has not been updated for changes to the tax rules included in Finance (No.2) Act 2015 or that are included in Finance Bill 2016. In particular, it does not reflect changes to the loan relationship and derivative contract rules and changes to the intangibles legislation.

Background

Summary of the changes to the accounting standards

There currently exists a suite of accounting standards in the UK. Subject to certain restrictions detailed in the respective standards themselves, companies may choose or may be required to prepare their accounts under one of the following:

• EU endorsed IFRS/IAS: those accounts prepared in accordance with International Accounting Standards within the meaning of s395 of the Companies Act - hereafter ‘IAS’ for the purposes of this paper
• new UK GAAP: FRS 100, FRS 101, FRS 102, including Section 1A of FRS 102 and FRS 105 - entities applying New UK GAAP will, within the framework of FRS 100, apply one of the following:
  • FRS 101 is effectively the recognition and measurement requirements of IAS but with reduced disclosure requirements - FRS 101 requires some adjustments, to ensure alignment with UK Companies Act
  • FRS 102 is a new suite of accounting requirements which are closely aligned to, but are not the same as, IFRS
  • section 1A of FRS 102, available to small companies, is aligned to FRS 102 but with reduced disclosure and presentation requirements
  • FRS 105 is based on the recognition and measurement requirements of FRS 102, with some accounting simplifications and reduced disclosures for eligible micro entities

Hereafter ‘New UK GAAP’ for the purposes of this paper:

• Old UK GAAP: substantively the FRS’s, SSAP’s, UITF’s and relevant accepted practice in existence and applied prior to the introduction of New UK GAAP, for purposes of this paper this is described as ‘Old UK GAAP’ - for the avoidance of doubt this paper includes FRS 26 (and related standards) within its meaning of Old UK GAAP unless otherwise stated
• FRSSE: the Financial Reporting Standard for Smaller Entities - companies that meet the eligibility criteria may prepare and file abbreviated accounts
• micro entities: Companies that meet the eligibility criteria may prepare and file abridged accounts, with effect for periods commencing on or after 1 January 2016 these requirements are contained in FRS 105

For periods commencing on or after 1 January 2015 UK medium and large companies will not be permitted to prepare their accounts in accordance with Old UK GAAP. Instead such entities which applied Old UK GAAP will need to transition from Old UK GAAP to one of the alternatives. It’s expected that for many companies currently applying Old UK GAAP they will transition to one of FRS 101 or FRS 102.

For periods commencing on or after 1 January 2016 small companies will not be permitted to prepare their accounts in accordance with the FRSSE. Instead such companies will need to transition to one of the New UK GAAP alternatives. It’s expected that for many entities currently applying the FRSSE they will transition to Section 1A of FRS 102.

Transition to New UK GAAP will impact on the accounts in 2 key ways:

• assets and liabilities at the accounting transition date will be identified, recognised and measured in line with the requirements of the new standards
• thereafter, profits and losses will be recognised in accordance with the new standards - these may differ from those profits and losses that would have been reported had Old UK GAAP been retained

Interaction of these changes with tax

Tax legislation for companies requires that the profits of a trade are calculated in accordance with generally accepted accountancy practice, subject to any adjustment required or authorised by law in calculating profits for Corporation Tax purposes (section 46 Corporation Tax Act 2009). Similar rules exist in other parts of the tax legislation.

Generally accepted accountancy practice for Corporation Tax purposes is defined at section 1127 Corporation Tax Act 2010 and is either:

• UK Generally accepted accountancy practice – generally accepted accountancy practice in relation to accounts of UK companies (other than IAS accounts) that are intended to give a true and fair view
• in relation to a company that prepares IAS accounts means generally accepted accountancy practice in relation to IAS accounts

As noted above, the Corporation Tax treatment for companies relies heavily on the accounting treatment adopted in the company’s accounts. With the introduction of IAS in 2004/2005, a number of changes were made to the tax legislation to deal with certain issues that arose for companies that transitioned to IAS in their entity accounts. In many cases, the effect of these rules is to provide tax treatment which is broadly equivalent to companies that continued to use the previous UK GAAP.

The changes made to the tax statute are not generally restricted to companies that prepare IAS accounts. So the rules will also apply to companies that have, for example, adopted FRS 26 with the result that derivative contracts have been fair valued. The rules are also likely to be relevant for companies which adopt FRS 101, FRS 102 or Section 1A of FRS 102 where they face similar issues to those encountered by companies adopting IAS.

Non-UK incorporated companies

It’s possible for companies incorporated outside of the UK to be resident in the UK. In addition, the tax statute can require consideration of the application of generally accepted accounting practice to companies that are not resident in the UK (for example, Controlled Foreign Companies).

In most cases the same statutory definition of generally accepted accounting practice applies. As such, where the company prepares IAS accounts, these will be used to calculate profits; and in other cases the profits will be calculated on the basis of UK GAAP (as it would be applicable for such a company).

PART A – Comparison between Old UK GAAP and FRS 101

This part of the paper provides a comparison of the ongoing accounting and tax differences that arise between Old UK GAAP and FRS 101.

1. Reporting financial performance

Accounts prepared in accordance with Old UK GAAP are required to present, amongst other things, a profit and loss account (P&L), balance sheet and where applicable a statement of total recognised gains and losses (STRGL). The format of the P&L and balance sheet are determined by company law, whilst the format of the STRGL is set by FRS 3.

FRS 101 applies the requirements of IAS 1 but only to the extent they are not contrary to the Companies Act. Therefore, Companies will be required to present a balance sheet; the format of which must comply with the requirements of the Companies Act. In addition, accounts prepared under FRS 101 will, to the extent permitted by FRS 101, present a statement of comprehensive income as either:

1. a single statement of comprehensive income, in which case the statement presents all items of income and expense recognised in the period
2. 2 statements; an income statement and a separate statement of comprehensive income

Note that further guidance on the interaction of the Companies Act and the presentation of the accounts is provided in the Application Guidance of FRS 101.

IAS 1 also requires that a statement of changes in equity is presented. In summary this presents the entity’s profit or loss for a reporting period and other changes in equity such as the effects of changes in accounting policy, corrections of material errors recognised in the period, and the amounts of investments by, and dividends and other distributions to, equity investors during the period. Accounts prepared under FRS 101 will therefore, be required to present a statement of changes in equity.

While format requirements of the Company Act remain, in many cases the terminology used in FRS 101 (via its requirement to apply recognition and measurement of IAS) differs from Old UK GAAP. As a result, it’s possible that certain items and statements will be described differently compared with previously and from one entity to another. The amendments to FRS 101 allow greater flexibility in relation to the format of the profit and loss account and balance sheet, which will allow entities choosing this option to adopt a presentation that is closer to that applied by entities preparing IAS accounts.

The following table sets out the statements which are broadly equivalent:

Old UK GAAP	FRS 101
Profit and loss account	Income statement
Statement of total recognised gains and losses	Statement of comprehensive income (sometimes referred to a statement of other comprehensive income)
Balance sheet	Statement of financial position
Cash flow statement	Statement of cash flows
Reconciliation of movements in shareholders funds	Statement of changes in equity

Notes:

• Old UK GAAP includes a choice as to whether to present the reconciliation of movements in shareholders funds as a primary statement
• as previously stated IAS 1 (and hence FRS 101) permits an entity to prepare a single performance statement rather than a separate income statement and a separate statement of comprehensive income - this combined statement is typically called a statement of comprehensive income or a statement of profit or loss and other comprehensive income

If, on adoption of FRS 101, an entity chooses to use the terminology prevalent in IAS such an amendment will not affect the tax treatment. A reference in statute to the ‘income statement’, for example, will take its normal accounting meaning.

2. Consolidated accounts/separate financial statements, investments in associates and joint ventures

Whether prepared using Old UK GAAP or New UK GAAP the relevance of consolidated accounts and equity accounting is very limited in UK tax law. Only a few areas of tax law have regard to consolidated accounts (such as aspects of the finance leasing arrangements (Chapter 2 Part 21 CTA 2010), intangible fixed assets rules (Part 8 CTA 2009) and the World Wide Debt Cap rules (Part 7 of TIOPA 2010)).

Nor typically does the treatment of associates, joint ventures for example, in separate financial statements have relevance for tax under current UK law.

However consolidated accounts can be informative and can provide useful information which does not show up on the face of the individual accounts.

3. Accounting policies, estimates and errors

Accounting for a change in accounting policy

FRS 3, Reporting financial performance, requires that changes in accounting policy are applied retrospectively and that the cumulative effect of prior period adjustments are presented at the foot of the STRGL.

Accounts prepared in accordance with FRS 101 apply the requirements of IAS 8 in respect of changes in accounting policy. IAS 8 requires that a change in accounting policy resulting from a change in the requirements of IFRS are accounted for in line with the requirements of that revised/new IFRS.

Where the standard does not contain specific requirements, the change in policy will be applied retrospectively to the earliest date which is practicable as if the new policy had always applied.

The requirement to apply the policy retrospectively is similar between Old UK GAAP and IAS 8, but there is a difference in how this is presented. As noted above, under Old UK GAAP, FRS 3 requires that the cumulative effects of prior period adjustments are presented at the foot of the STRGL. In contrast IAS 8 requires that the change is recognised in the statement of change in equity.

Accounting for change in estimate

Old UK GAAP requires that a change in estimate is applied prospectively. For example where an entity changes the useful estimated life of a tangible fixed asset it does not adjust the depreciation brought forward. Instead the depreciation is adjusted prospectively to reflect the revised useful economic life.

Accounts prepared in accordance with FRS 101 must apply the requirements of IAS 8 in respect of changes in accounting estimates. IAS 8 is consistent with Old UK GAAP in respect of changes in estimates and hence no change in the accounting is expected.

Accounting for errors

Where a fundamental error is identified FRS 3 requires that this is accounted for by restating the prior period comparative figures. Errors that are not considered fundamental are accounted for in the period they are identified.

FRS 101 (via the application of IAS 8) requires that, to the extent practical, an entity shall correct material errors retrospectively in the first financial statements authorised for issue after the error is discovered, through restating the prior period comparative figures. Errors that are not considered to represent material errors are accounted for in the period they are identified.

Tax treatment

For trading profit Chapter 14 Part 3 CTA 2009 provides that where there is a change from one valid basis on which the profits of a trade are calculated to another valid basis (for example on a change of accounting policy), an adjustment must be calculated to ensure that business receipts will be taxed once and once only and deductions will be given once and once only. For Corporation Tax purposes, adjustments are treated as receipts or deductions in computing the trade profits.

That approach will continue to apply for prior period adjustments arising in accordance with FRS 101.

The above applies to changes from one valid basis to another. Where the change is from an invalid basis (such as may occur when a material error is identified in the accounts), UK tax law requires the invalid basis to be corrected for tax purposes in the period it first occurred with subsequent periods also corrected for tax purposes. Whether tax can be collected or repayments claimed for earlier periods is dependent on the time limits for making or amending self-assessments.

Similar tax rules apply for changes in accounting policies or errors on non-trade items, such as loan relationships, derivative contracts and intangible fixed assets.

4. Financial instruments

4.1 Introduction

In accounting terms a financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another. Examples of common financial instruments include; cash, trade debtors, trade creditors, bonds, debt instruments and derivatives.

Companies applying Old UK GAAP fall into 2 main camps – those applying FRS 26 and those that don’t. FRS 26 is aligned to IAS 39 and is mandatory for companies with listed debt or equity that are not using IAS. It’s optional for all other entities, and they can take advantage of the option to use fair value accounting that is part of UK company law. As such, companies that have already adopted FRS 26 will not see significant (if any) change on adoption of FRS 101 and are therefore not covered in this paper. Companies that have not adopted FRS 26 are likely to see significant changes as a result of adopting FRS 101 and therefore this paper concentrates on those companies.

In July 2014 the International Accounting Standards Board (IASB) published IFRS 9 as a replacement of IAS 39, which is intended to be mandatory for affected companies from 2018. This paper does not consider the accounting and tax interaction where IFRS 9 is adopted.

This section of the paper is applicable for accounting periods commencing before 1 January 2016. For accounting periods commencing on or after 1 January 2016 there are changes to the loan relationship and derivative contract rules which may affect the tax treatment. In particular, the tax treatment now follows the amounts recognised in profit or loss. Given that many UK companies will be adopting FRS 101 for the first time in 2015, the paper has not been updated for these changes.

Note that this paper deals with borrowing costs in chapter 14, foreign currency translations in chapter 17 and liabilities and equity in chapter 18.

4.2 General requirements

Old UK GAAP

For companies not applying FRS 26 there is no specific, comprehensive standard for financial instruments in Old UK GAAP. Instead accounting for financial instruments is primarily determined by the requirements of FRS 4 (issuer of capital instruments), SSAP 20 (foreign currency transactions), FRS 5 (substance over form, including some recognition/derecognition issues).

Otherwise, for companies not applying FRS 26, the accounting for financial instruments is based largely on the general principles in FRS 18, particularly the accruals concept, and relevant provisions of company law. The Companies Act provides that current assets (such as cash and trade debtors) are recognised at purchase price/cost while the accruals concept is applied in determining, for example, the recognition and measurement of interest income in lenders.

FRS 101

As noted above, FRS 101 applies the measurement and recognition criteria of IAS (with a few limited exceptions to ensure compliance with the Companies Act). As such companies applying FRS 101 will apply the recognition and measurement requirements of IAS 39 in respect of financial instruments.

In contrast to Old UK GAAP (where FRS 26 is not applied), IAS 39 provides specific requirements for the recognition and measurement of financial instruments. For simple financial instruments such as cash and trade receivables, the requirements of IAS 39 typically result in accounting which is comparable to Old UK GAAP; following initial recognition^{[footnote 2]}, such instruments are written down/impaired for any doubtful or bad debt exposure. Similarly for most loan payables/receivables the accounting under IAS 39 is comparable to Old UK GAAP with such items measured on an amortised cost basis.

However, IAS 39 differs from Old UK GAAP in respect of the following financial instruments:

• assets and liabilities held for trading purposes or speculatively
• assets and liabilities designated at the outset by the company as at fair value through profit and loss
• assets and liabilities which are taken out on non-market terms
• all derivative financial instruments

IAS 39 requires such instruments to be measured at fair value, with gains or losses recognised in profit and loss.

Note that under IAS 39, debt instruments designated as ‘Available for Sale’ (AFS) will be measured at fair value with fair value gains and losses recognised directly in Other Comprehensive Income (OCI) while interest income, foreign exchange and impairment losses will continue to be recognised in profit or loss.

Fair value accounting in respect of financial instruments is not permitted under Old UK GAAP where FRS 26 is not applied. Companies needing to apply fair value accounting would have been required to adopt FRS 26.

Tax treatment

For companies most financial instruments will fall to be loan relationships (under Part 5 CTA 2009), non-lending money debts (treated as loan relationships under Chapter 2 of Part 6 CTA 2009) or derivative contracts (under Part 7 CTA 2009). UK tax law provides in general that the accounting treatment of these types of instruments is followed for tax purposes. This paper does not cover those financial instruments that fall outside of these categories – for example, equity instruments in the form of shares and guarantees.

A particular aspect of the taxation of loan relationships and derivative contracts is that it departs from the normal principle of looking only at the profit and loss account (or income statement). The legislation ensures that most items taken to ‘reserves’ are brought into account.This would include amounts recognised in the STRGL under Old UK GAAP and amounts recognised as items of OCI under FRS101 or IAS. A further rule ensures that where a profit or a loss from a loan relationship or derivative contract is recognised directly to equity, then this would be brought into account in the same way as if it was recognised to profit or loss or through reserves.

As a result, where the accounts measure the instrument at fair value, either with profits going to profit or loss, or as items of other comprehensive income, these fair value movements will typically be brought into account for tax.

There are, however, certain exceptions where the tax statute specifies a particular accounting treatment. The most common example is where there is a loan relationship between connected companies. In this case, section 349 CTA 2009 requires the profits to be calculated for tax purposes on the basis of an amortised cost basis. Also, there are specific rules dealing with derivative contracts which form part of a hedging relationship (these are explained in more detail below).

In addition where under IAS 39 financial assets are treated as ‘held-to-maturity’ (HTM) there is an expectation that such assets are held to maturity. These are measured at amortised cost. However, a sale of a small number of such assets prior to maturity can result in all the HTM assets becoming ‘tainted’, such that the assets would be required to be accounted for as being AFS. Specific tax rules apply in this scenario - see CFM33150 for further details.

Transitional adjustments

Where a financial instrument is measured on a different basis under IAS 39 compared with Old UK GAAP it’s likely that transitional adjustments on adoption of FRS 101 will arise. For further guidance on the transitional provisions applying to financial instruments see Part B of this paper.

Further detail on specific transactions involving financial instruments where the requirements of FRS 101 differ from the requirements of Old UK GAAP are set out below.

4.3 Debt-equity swap

Where debt is extinguished through the issue of an entity’s own equity the accounting applied in accordance with Old UK GAAP may differ from that required by FRS 101.

Old UK GAAP, where FRS 26 has not been adopted, permits an accounting policy choice as regards the recognition of a gain or loss. In certain situations it may be appropriate to adopt a no gain/no loss policy, so that the value of the equity issued is treated as being equal to the carrying value of the debt given up. However, companies are permitted to adopt a policy of recognising a gain or loss on such transactions. Under both approaches, it’s necessary to consider the interaction with the requirements of company law as regards the amount of share premium to be recorded and the requirements as regards realised profits. [^4]

In contrast the accounting for debt-equity swaps under FRS 101 is based on the requirements of IAS 39 and International Financial Reporting Interpretations Committee (IFRIC) 19. IAS 39 and IFRIC 19 don’t provide a policy choice. They require that any difference between the carrying amount of the financial liability extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, is recognised in profit or loss. However, companies will need to consider the specific facts and nature of the debt for equity swap. For example, company law considerations regarding realised profits and share premium accounts will need to be considered and may impact on the accounting treatment.

Tax treatment

Under general principles of the loan relationship regime, an amount of profit recognised to the profit and loss account, or to reserves, would be brought into account. However, section 322 CTA 2009 will typically exempt gains arising where a debt is released in consideration of ordinary shares. See CFM33200 onwards for further details of this exemption.

4.4 Debt restructuring/derecognition

Debt may be restructured or have its terms modified such that, in accordance with FRS 5 and Old UK GAAP, no gain or loss would be recognised in the accounts.

In contrast, FRS 101 preparers will apply the requirements of IAS 39 when determining the accounting for debt restructuring. IAS 39 requires that, where the modification or restructuring to the debt is considered substantial, the original debt instrument will be derecognised and the ‘new’ debt instrument recognised at its fair value. To the extent that the fair value of the new instrument differs from the carrying value of the original debt instrument a gain or loss will typically be recognised as an item of profit or loss. This gain or loss should reverse over the remaining life of the instrument.

Tax treatment

The loan relationship would normally be taxed in line with the amount recognised in the accounts. As such, the profit or loss on derecognition/rerecognition will typically be brought into account.

Note that the government has included within the Finance (No.2) Act 2015 an exemption to cover distressed debt, which would apply to certain cases where the loan is modified or replaced. The proposal is that the exclusion would apply to modifications and releases from 1 January 2015.

Transition

This difference in accounting may also result in adjustments to the carrying value of such debt on transition. This is considered further in Part B of this paper.

Appendices B – C of IFRS 1 provide details of the exceptions and exemptions available on transition. In respect of previously derecognised financial instruments a choice is available to either (i) apply the derecognition requirements of IAS 39 prospectively or (ii) apply it retrospectively from a date of the companies choice.

However, no exclusions apply where the derecognition occurs after the accounting transition date – ie after the start of the prior period comparatives. As a result, the company may be required to derecognise/recognise the debt.

The Change of Accounting Practice Regulations were amended in December 2014 to address this issue in certain instances of distressed debt. For further guidance on the transitional provisions applying to financial instruments see Part B of this paper.

4.5 Initial recognition – non-market instruments

Old UK GAAP where FRS 26 is not applied typically requires that financial instruments are initially recognised at cost. This cost may or may not equate to the fair value of the financial instrument.

In contrast under FRS 101 (IAS 39) financial instruments are measured on initial recognition at fair value. The transaction cost will typically, but may not always, equate to the fair value of the instrument. Where the transaction cost differs from the fair value of the instrument it’s possible that a day-one gain or losses could arise.

Tax treatment

The loan relationship would normally be taxed in line with the accounts. As such, any day-one gain or loss will typically be brought into account. However consideration should be given to the facts which led to the transaction price differing from fair value.

In particular, there are in particular 2 sets of provisions which may alter this position.

Provision 1

Where the loan arises between connected companies, the amounts to be brought into account on the basis of an ‘amortised cost basis of accounting’ as required by sections 313 and 349 CTA 2009. In particular this requires the tax treatment to be based on the loan shown in the accounts at ‘cost’ and adjusted for amortisation and impairments

What constitutes ‘cost’ will depend on the particular facts in question. HMRC would normally accept that this equates to the cost of the loan under Old UK GAAP (where FRS 26 has not been applied), such that in this case the tax treatment under FRS 101 will largely follow the Old UK GAAP position (where FRS 26 has not been applied).

See CFM35000 for further details of the rules for taxing loans between connected companies.

Provision 2

Secondly, if the loan did not arise as a result of a transaction between persons acting at arm’s length it may be necessary to apply the transfer pricing rules in Part 4 of TIOPA 2010. Where any tax advantage is already negated by the connected companies’ rules then the transfer pricing rules are unlikely to apply

See the International Manual for further details of the transfer pricing rules.

HMRC has published draft guidance on this issue.

Transition

Potentially this could result in a transitional adjustment. For further guidance on the transitional provisions applying to financial instruments see Part B of this paper.

4.6 Hedging relationships/synthetic instruments

Old GAAP, where FRS 26 has not been adopted, requires derivatives that are entered into as part of a company’s hedging strategy to be accounted for on an historic cost basis equivalent to that used for the underlying asset, liability, position or cash flow.

In contrast IAS 39 requires derivatives to be accounted for separately and to be measured at fair value. IAS 39 then provides certain ‘hedge accounting’ rules.

Hedge accounting under IAS 39 is only permitted when certain conditions are met and where the company prospectively designates there to be a hedging relationship. In addition on achieving a hedge for accounting purposes the mechanics for hedge accounting under IAS 39 differ to Old UK GAAP (for those that have not adopted FRS 26).

Tax treatment

Without special rules, hedge relationships would not typically be effective for tax purposes, whether or not they were designated as a hedge for accounting purposes. The ‘Disregard Regulations’ (SI 2004/3256) were introduced to address this issue.

Broadly speaking, where a derivative is part of a hedging relationship the rules operate to restore the Old UK GAAP position (for example, where FRS 26 is not applied). In particular, there are specific regulations for derivatives dealing with currency, commodities, debt and interest rates. The rules apply in a number of different circumstances and they also contain particular elections that may be made.

For periods of account commencing on or after 1 January 2015, the default setting is for the tax treatment of derivative contracts to follow the profit and loss account. Companies have the option of electing into computational provisions in the Disregard Regulations. Previously, companies had the ability to elect out from the Regulations.

For companies that already apply fair value accounting in respect of derivatives which potentially fall within the scope of the Disregard Regulations, they will continue with their existing treatment - these companies can, if they so wish, change their status in the future on a prospective basis

Companies that will be applying fair value accounting for the first time in a period of account commencing on or after 1 January 2015 will need to decide whether to elect-in to regulations 7, 8 and 9 - there are strict deadlines for making these elections

It’s also likely that transitional issues could arise in such cases. For further guidance on the transitional provisions applying to financial instruments and the interaction with the Disregard Regulations see Part B of this paper.

Further information

HMRC has recently published additional guidance to help companies with hedging instruments making the transition to new accounting standards. This is available at: Corporation Tax: Disregard Regulations for derivative contracts.

Further information is available in the Corporate Finance Manual (CFM) as follows:

• derivative contracts are explained at CFM13010 onwards
• hedge accounting is explained at CFM27000 onwards
• the tax treatment of derivatives is explained at CFM57000 onwards

4.7 Hybrid instruments / synthetic instruments

This paper does not address in detail the position of hybrid instruments and the embedded derivatives. This is a complex area and affected companies will need to consider the accounting and tax treatment carefully.

In summary, FRS 26 and IAS 39 require companies to separate out (‘bifurcate’) embedded derivatives from host contracts. However, bifurcation in the holder is not typically permitted under Old UK GAAP (where FRS 26 is not applied). In all cases the issuer of compound financial instruments will still separate out the equity component under FRS 25 or IAS 32. Links to the relevant guidance is set out in chapter 18 (Liabilities and Equity) of this paper.

4.8 Companies that currently apply FRS 26

The above commentary focuses on companies that don’t currently apply FRS 26. Companies that have adopted FRS 26 and choose to adopt FRS 101 are likely to see no change in the accounting of financial instruments.

5. Inventories/stock

FRS 101 (IAS 2) differs from Old UK GAAP and SSAP 9 insofar as it specifically excludes from its scope WIP in the course of construction contracts (covered in IAS 11), agricultural produce and biological assets (covered in IAS 41) and financial instruments (IAS 32 and 39).

For many entities these differences will have no impact on the recognition or measurement of stock.

However for entities operating in the agriculture sector, for example, the requirement to apply IAS 41 will result in a change from valuing stock at the lower of cost and net realisable value model to a fair value based measurement (for example agricultural produce harvested form the companies biological asset is measured at fair value less costs to sell at the point of harvest). This is likely to represent a significant change in the measurement basis of stock and hence the timing of profits/losses on such stock.

For tax purposes there are 2 acceptable valuation bases for stock, either the lower of cost and net realisable value, or mark to market (fair value). If either of these methods are used no ongoing adjustment is required for tax purposes.

Where mark to market is used there is no tax law that requires the profits or losses disclosed by the accounts to be adjusted for tax purposes. Note there are particular tax rules, the ‘herd basis,’ that can be applied to particular farm animals. Guidance on this and the valuation of farming stock is in the Business Income Manual.

6. Investment property

Old UK GAAP (SSAP 19) requires an entity to carry investment property at their open market value with movements in value recognised each period in the STRGL unless they represent a permanent diminution in value in which case they are recognised in the P&L. Where investment properties are let to and occupied by another group entity for its own purpose, SSAP 19 contained an exemption which excludes such properties from its scope (hence they would be included as part of fixed assets).

For preparers of accounts in accordance with FRS 101 the relevant IAS is IAS 40. IAS 40 permits an accounting policy choice in respect of investment properties – an entity may apply the fair value model or the cost model.

Where the fair value model is adopted the investment property is initially recognised at cost^{[footnote 5]} and subsequently measured at fair value. However in contrast to SSAP 19, FRS 101 (IAS 40) requires those fair value movements to be recognised in the P&L.

Where the cost model is adopted IAS 40 requires that the investment property is held at cost less accumulated depreciation and impairment in line with the requirements of IAS 16. The exception to this being those that meet the criteria to be classified as held for sale in accordance with IFRS 5. Such property is instead held at lower of carrying value and fair value less costs to sell.

In addition IAS 40 does not contain an exemption comparable to that present in SSAP 19 for property let to and occupied by group entities. Hence certain properties treated as fixed assets under Old UK GAAP may now be classified as investment property under FRS 101.

The accounting treatment of investment properties does not determine, for tax purposes, whether the property is held as an investment property (giving a capital receipt on disposal) or whether it’s part of a trading transaction (and so is on revenue account and forms part of the company’s trading profits).

Assuming the property is held, for tax purposes, as an investment, the income arising on the property is bought into tax as it’s recognised in the accounts (for example rental income would be bought into tax as recognised in profit or loss). In this case, movements in fair value of investment properties are not taxable. The disposal of the investment properties will typically give rise to a chargeable gain.

In certain circumstances a company holding investment property as a lessee under an operating lease may, under IAS 40, account for it as an investment property. Where it does so, the property is accounted for under the fair value model. The corresponding creditor is accounted for as a finance lease. Where this happens the tax rules applying to finance leases will apply.

7. Property, plant and equipment

Entities that adopt FRS 101 will apply the recognition and measurement requirements of IAS 16 in respect of Property, plant and equipment (PPE). The Old UK GAAP equivalent is FRS 15 (‘fixed assets’ to use the Companies Act and FRS 15 terminology). Both standards are broadly consistent in principle. However differences are present in particular:

• IAS 16 requires that major spare parts are included in PPE
• IAS 16 requires that cost is measured by reference to the present value of all future payments where the asset is acquired under terms beyond normal credit terms
• IAS 16 does not permit the use of Renewals Accounting
• IAS 16 requires that residual values are based on current prices rather than historic prices

While such differences for accounting purposes are present, UK tax law departs from the accounting standards by disallowing depreciation and revaluations in respect of capital assets, and instead granting capital allowances (on some assets). Hence accounting changes are not expected to have a significant tax impact.

In some cases where ‘revenue’ expenditure is added to the cost of an asset, tax law follows the accounts by recognising for tax purposes amounts reflected in profit and loss account by way of depreciation charge to the extent that they are a write off of revenue expenditure. In those cases where depreciation under FRS 101 differs from that under FRS 15 (for example, because of revaluation of residual values) tax will follow the amount as per FRS 101.

As noted above there is no equivalent to ‘Renewals accounting’ (FRS 15 paragraph 97) under IAS 16/FRS 101, so there may be an adjustment for tax purposes made under the change of basis legislation.

8. Intangible assets including goodwill

Intangible assets and goodwill arising on business combinations

The definition of an intangible asset in Old UK GAAP (FRS 10) states that intangible asset are “Non-financial fixed assets that don’t have physical substance but are identifiable and are controlled by the entity through custody or legal rights.’’

FRS 101 requires that intangibles are accounted for in accordance with IAS 38. IAS 38 defines an intangible asset (other than goodwill) as an “identifiable non-monetary asset without physical substance’’ where “identifiable’’ is an asset that is separable or arises from a legal contract or other legal right. This definition is different from that present in Old UK GAAP in so far as the intangible asset need not be separable from the business. Consequently either on transition (where the exemption to retain previous GAAP figures is not used) or on subsequent business combinations, more intangible assets may be recognised under FRS 101 than would have been recognised under Old UK GAAP.

For tax purposes Sections 871-879 of Part 8 CTA 2009 provide a comprehensive set of rules for changes in accounting for intangibles and especially for cases where what is included entirely as goodwill under Old UK GAAP is disaggregated into different types of intangible property with different amortisation rates or impairment factors under FRS 101.

Intangible assets and goodwill - Useful Economic Life (UEL)

FRS 10 states that goodwill and intangibles should be amortised over their UEL. It also states that there is a rebuttable presumption that the UEL will not exceed 20 years. FRS 10 does permit the use of an indefinite UEL in which case it’s not amortised but is instead subject to annual impairment reviews.

FRS 101 differs from Old UK GAAP in respect of UEL. Firstly goodwill is not amortised under FRS 101. Instead goodwill is reviewed annually for impairment. However, this requirement is contrary to the requirements of the Companies Act to amortise goodwill (see A2.8 of FRS 101 for more detail). Other intangibles may have finite or indefinite life. Where a finite life is evident then, like Old UK GAAP, the intangible is amortised over this period. Where an intangible has an indefinite life it will not be amortised and will instead be tested annually for impairment.

In general tax relief is provided on either the amortisation/impairment of goodwill and intangibles recognised in the accounts. Sections 871 to 873 of CTA 2009 ensure that any write up on the transition from Current UK GAAP to FRS 101 will be a taxable credit for Part 8, and section 872 ensures that any such credit is limited to the net amount of relief already given. Any subsequent impairment from written up cost will be deductible.

Tax relief is unlikely to be affected if an entity has elected for a fixed rate of 4%. Note that a fixed rate election must be made within 2 years of the end of the accounting period in which the expenditure was incurred and cannot be reversed.

Measures to restrict tax relief for amortisation of goodwill and certain customer related intangible assets were brought in by the Summer Finance Act 2015 and take effect from 8 July 2015.

Software costs

FRS 10 requires that software costs which are directly attributable to bringing an item of IT into use within the business are recognised as part of tangible fixed assets. Where such costs did not relate to bringing an item of IT into use they would typically have been written off direct to the P&L. In addition UITF 29 provides that, where certain criteria are met, website development costs are recognised as part of tangible fixed assets.

FRS 101 (IAS 38) requires that the nature of the item should be considered in determining its treatment. It’s possible that having considered the nature of the software that it’s recognised as an intangible asset; for example where software is not an integral part of the related hardware it would be recognised as an intangible asset.

For companies where costs on expenditure such as software have previously been written off to profit and loss account and claimed as a deduction in a Case I computation in respect of expenditure on a tangible asset, the following tax consequences will apply in respect of the change of accounting policy. First the adjustment in respect of the change of accounting basis will be taxed under Chapter 14 Part 3 CTA 2009. For example, a positive adjustment is brought into account as a taxable receipt. Second, capitalised expenditure in respect of an intangible asset will be relieved under the rules in Part 8 CTA 2009 as it’s written down in the accounts (subject to the normal exclusions, including the pre-FA 2002 rule).

Guidance on many of these issues is in HMRC’s CIRD Manual (in particular see CIRD12300 which address changes in accounting policies for intangible assets within Part 8 CTA 2009).

9. Business combinations

FRS 101 (IFRS 3) is broadly comparable to FRS 6 and FRS 7. However particular differences are present:

• because of the difference in the definition of an intangible asset an acquisition under FRS 101 may result in a different balancing figure being assigned to goodwill on a business combination
• the look back period in which provisional fair values can be amended is different (FRS 101/IFRS 3 look back period is 12 months since acquisition date)
• a change in step acquisitions in some circumstances

FRS 6 and 7 of Old UK GAAP are relevant in UK tax law only where the carrying value of an asset or liability acquired in a business combination is relevant for tax purposes, for example for loan relationships. This also applies where a company is applying FRS 101.

Tax law determines the value of trading stock for the business ceasing and its value for the successor business – see Chapter 11 Part 3 CTA 2009.

In respect of goodwill on business combinations please see chapter 8 of this paper.

10. Leases

Entities that apply Old UK GAAP will use SSAP 21, UITF 28 and FRS 5 in determining the accounting treatment of leases. Entities that adopt FRS 101 will apply the recognition and measurement requirements of IAS 17 and IFRIC 4.

Both Old UK GAAP and FRS 101 consider whether a lease transfers substantively the risks and rewards of the leased asset. However it should be noted that SSAP 21 includes a presumption that if the present value of the minimum lease payments is 90% or more of the fair value of the leased asset that it would typically be classified as a finance lease. Neither IAS 17 nor IFRIC 4 contains this presumption.

Nevertheless the emphasis on the transfer of risk and rewards is such that in most cases the classification of leases will be consistent between Old UK GAAP and FRS 101. Once the lease has been classified the accounting treatment thereafter is also comparable. However differences, even where the classification is the same, do exist and the interaction with tax is noted below.

UITF 28 requires that operating lease incentives in the lessee are spread over the period ending on the date from which it’s expected that the prevailing market rent will be payable (if this period is shorter than the lease term, otherwise over the lease term).

IAS 17 (leases) requires that lease incentives are spread over the term of the lease unless another way would better reflect the reality. Consequently there may be differences in respect of the period over which such incentives are recognised.

Since the accounting is followed where the incentive is not capital (for example, a rent free period) the difference may alter the timing of income recognition for tax purposes.

UK tax law is not entirely consistent with SSAP 21 (see Statement of Practice 3/91). But accounts figures (including where appropriate consolidated accounts) are recognised for the purposes of Chapter 2 Part 9 CTA 2010 and Chapter 2 Part 21 CTA 2010 which deal with Leasing and Finance leases with return in a capital form.

For lessors, FRS 101 requires use of the ‘net investment’ method for finance leases, whilst SSAP 21 permits the ‘net cash investment method’. There may be differences in the timing of income recognition under the 2 bases. In some cases these affect the timing of income for tax purposes, for example, where Schedule 12 Finance Act 1997 applies.

Legislation in sections 228B to 228F Capital Allowances Act 2001, and Chapter 5A Part 12 ICTA (inserted by FA 2006) brings the tax treatment of both lessors and lessees of finance leases of plant & machinery into line with the accounting basis in FRS 101 or SSAP 21 as appropriate.

Note that it’s not envisaged that s.53 FA 2011 will apply to entities on transition to FRS 101 by virtue of subsection 3 of s.53 FA 2011.

Note: In January 2016 the IASB issued their new standard for lease accounting (IFRS 16). The new standard is intended to be mandatory from 1 January 2019. This paper does not cover the accounting and tax treatment under IFRS 16.

11. Provisions

There is no significant difference between IAS 37 and FRS 12, although company law requires more disclosure than that required by IAS 37. For tax purposes the recognition and measurement of provisions in the accounts forms the basis for the quantum and timing of tax relief (subject to adjustment where the expenditure is capital for tax purposes or otherwise disallowable).

Consequently, for most companies it’s not expected that FRS 101 will have a significant tax impact in this area.

12. Revenue recognition

In general, reporting of revenue in accounts is followed for tax purposes. There is no specific standard for revenue recognition in Old UK GAAP. However, Application note G of FRS 5 provides revenue recognition guidance in respect of the sale of goods and services as well as other specific revenue recognition scenarios, SSAP 9 provides guidance in respect of long term contracts and UITF 40 addresses service contracts.

The general principles of revenue recognition within FRS 5 Application note G are that revenue is recognised when the seller obtains the right to consideration in exchange for the goods, services, or work performed. The right to consideration typically derives from the performance of its obligations under the terms of the exchange with the customer. FRS 5 application note G requires that, on recognition, revenue is measured at the fair value of the consideration received or receivable.

Revenue recognition under FRS 101 will primarily be determined by IAS 18 Revenue and IAS 11 Construction Contracts. The recognition criteria within these standards are broadly aligned with Old UK GAAP. In addition, where the respective recognition criteria are met IAS 18 and IAS 11 also require that revenue is recognised at the fair value of the consideration received or receivable.

Hence while there are a few differences between Old UK GAAP and FRS 101 (for example the latter expressively addresses and defines construction contracts through IAS 11), for many entities there will be no change following adoption of FRS 101.

Consequently for many companies there will be no accounting or tax impact.

Note: In January 2016 the IASB issued their new standard for revenue recognition (IFRS 15). The new standard is intended to be mandatory from 1 January 2018. This paper does not cover the accounting and tax treatment under IFRS 15.

13. Government grants

SSAP 4 requires that grants are recognised when there is reasonable assurance that related conditions, if any, will be met. Where reasonable assurance is present grants are then recognised in the accounts based on the relationship between the grant and the related expenditure.

FRS 101 (IAS 20) is comparable with grant income recognised when there is reasonable assurance that grant conditions, if any, will be met and the grant receivable. Subject to this the grant is recognised on a systematic basis over the term of the grant in line with the related expenditure (if any).

For tax purposes grants which meet revenue expenditure, such as interest payable, are normally trading receipts and this will continue where FRS 101 applies.

14. Borrowing costs

FRS 101 (IAS 23) and FRS 15 are very similar in their requirements on capitalising borrowing costs. However IAS 23 requires capitalisation where the relevant criteria are met whereas it remains a policy choice under Old UK GAAP. Hence differences may arise between Old UK GAAP and FRS 101.

For companies section 320 CTA 2009 provides specific rules which allow relief for capitalised borrowing costs but only where they relate to a fixed capital asset or project. However, relief is not available where the costs are capitalised in the carrying value of an intangible fixed asset which falls within Part 8 CTA 2009. The same approach will continue where FRS 101 (IAS 23) is applied. See CFM33160 for further details.

15. Share based payments

Accounting for share-based payments under Old GAAP (FRS 20) and FRS 101 (IFRS 2) are aligned with few differences.

Tax deductions in respect of share based payments are governed by specific legislation in Part 12 CTA 2009.

16. Employee benefits

Pension schemes

In respect of accounting for pension schemes FRS 101 preparers will apply the requirements of IAS 19. While IAS 19 does differ from FRS 17, none of the differences are expected to have an impact for tax.

Under current UK tax law, sections 196, and 246 FA 2004 and sections 1290-6 CTA 2009 provide relief on a contributions paid basis.

Holiday pay accrual

Under Old UK GAAP many entities did not accrue or provide for holiday pay. FRS 101 requires that when an employee has rendered services to an entity during a period any related holiday pay or similar is accrued for.

For tax purposes this accrual would be treated in line with the treatment of unpaid remuneration which is dealt with at Part 20 Chapter 1 CTA 2009.

Employee benefit trusts

Under Old UK GAAP, UITF 32 provides guidance on how to account for employee benefit trusts.

FRS 101 does not have a direct equivalent to UITF 32. Nevertheless in determining the nature of any payments/settlements with an employee benefit trust similar considerations will apply.

For tax purposes the treatment of employee benefit contributions is dealt with at Part 20 Chapter 1 CTA 2009.

17. Foreign currency translation

Under Old UK GAAP a company would account for its currency transactions in line with either SSAP 20 (where FRS 26 is not applied) or FRS 23 (where FRS 26 is applied). Companies which apply FRS 101 will apply IAS 21 to account for foreign currency transactions.

For companies which have adopted FRS 23 (and FRS 26) the transition to FRS 101 is not expected to result in any significant changes. For companies that applied SSAP 20 many will not encounter differences but when they do they may be significant. 5 main areas of difference are set out below.

17.1 Functional / presentational currency

Determination of functional currency under FRS 101 (IAS 21) requires consideration of the currency of the primary economic environment in which the entity operates. Key factors in determining this are the currency that mainly influences the sales prices for goods and services and the currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services.

Consideration is also given to the currency in which funds from financing activities are generated and the currency in which receipts from operating activities are usually retained. This is in line with SSAP 20.

However, in contrast to SSAP 20, FRS 101 (IAS 21) also specifically requires consideration of the influence of the parent on the company’s operations and activities.

It may be that when these factors are taken into account this will result in a different assessment of the company’s functional currency. This could have a significant impact on the calculation of the profits recognised in the company’s accounts. In particular, this can create exchange rate volatility where the company’s assets and liabilities are denominated in a different currency to that of its functional currency.

In addition, FRS 101 (IAS 21) allows an entity to have a ‘presentation currency’ which is not necessarily the same as the functional currency. This typically has less impact on the calculation of the company’s profit for a period (just that it’s expressed / presented in a different currency).

Chapter 4 of Part 2 CTA 2010 provides detailed rules as to how the company’s profits are to be calculated for tax. CFM64000 explains the operation of these rules. It should be noted, though, that where an investment company changes its functional currency, exchange gains and losses arising on loan relationships and derivative contracts are excluded from tax if they arise as a result of a change in functional currency in the period of account in which the gains or losses arise and a period of account ending in the 12 months preceding that period. See CFM64120 for details.

Where a company is a UK investment company it may be eligible to make a ‘designated currency election’. This must be made in advance of the date it’s to take effective. See CFM64500 onwards for further details.

17.2 Foreign operations (including branches)

Income and expenditure of foreign operations (including branches) are translated into the company’s functional currency at actual or average rates not at closing.

For tax purposes, the calculation of the company’s profits from a trade or business undertaken through a foreign operation will typically be based on the amounts of profit or loss translated into the company’s function currency in accordance with GAAP. Exchange differences arising from the retranslation of the net investment are not typically brought into account for Corporation Tax purposes.

17.3 Contract rate accounting

Where a company enters into a contract to settle a transaction at a particular rate of exchange, SSAP 20 stated that the exchange rate fixed by the contract may be used to record the transaction.

The position is different under FRS 101 (IAS 21). The use of a contracted rate of exchange to translate monetary items is not permitted. The closing rate as at the balance sheet date should be used instead. The contract would typically represent a derivative financial instrument which would then be separately recognised and measured at fair value in the accounts.

This is a further example of a hedging relationship where under FRS 101 (IAS 21) the hedged item and the hedging instrument need to be recognised separately in the accounts. The accountancy and tax treatment of hedging relationships is discussed above (see chapter 4.6 of this paper).

The Disregard Regulations (regs 7 and 10) apply to restore the Old UK GAAP position (where FRS 26 has not been adopted). Guidance on the application of this is available at CFM57000 onwards.

Note that where the forward contract is taken out as a hedge of qualifying expenditure, the amount of capital allowances is based on the amount of actual qualifying expenditure incurred (for example, translated at the spot rate at the date of that the expenditure is incurred) - see CA11750.

Transitional adjustment may also arise - see Part B of this paper for commentary on this.

17.4 Net investment hedging (also known as the ‘Cover method’ or ‘SSAP 20 matching’)

Where an equity investment denominated in a foreign currency is hedged by a loan, SSAP 20 allows a company to re-translate the investment at the balance sheet date as if it were a monetary item. Exchange differences on the shares are taken to reserves. Exchange differences on the hedging loan are also taken to reserves, and offset against the gain or loss on the shares. Any excess on the loan that cannot be offset is taken to profit and loss account. This method of accounting is sometimes called the ‘cover method’ or ‘net investment hedging’.

S328 and S606 CTA 2009 ensure that exchange movements taken to reserves are not immediately brought into account. Potentially an adjustment would be made to any chargeable gain calculation where the shares are subsequently disposed of.

There is no equivalent in IAS 21 for the ‘cover method’ of hedging non-monetary assets. Hedge accounting is dealt with by IAS 39 – see chapter 4.6 of this paper. However, net investment hedging in respect of a shareholding in a subsidiary company is only permitted at consolidation or in financial statements that include a branch.

Where a company has a loan liability or a derivative to act as a hedge of the exchange risk from holding an investment in shares, the regulations 3 and 4 of the Disregard Regulations (SI 2004/3256) would typically mean that the exchange gain or loss on the loan or derivative would be ‘disregarded’ for tax. Potentially an adjustment would be made to any chargeable gain calculation where the shares are subsequently disposed of.

For further details of net investment hedging see CFM62000 onwards.

17.5 Permanent-as-equity debt

The following commentary concerns ‘permanent-as-equity’ loans, for example made by a parent to a subsidiary undertaking, which represent an arm’s length provision. Where the loan is not undertaken on at arm’s length terms, then special rules apply for calculating the amount of exchange gains and losses to be taxed. See CFM38500 for further details.

For companies that apply SSAP 20 it’s possible for ‘permanent as equity’ loans to be treated as non-monetary items and be carried at historic rates on the balance sheet rather than be retranslated as at each period end. In such cases, the cumulative exchange movement is reflected in any gain or loss on eventual disposal of the instrument. Tax would typically follow the accounting in this case.

Alternatively, it’s possible that the ‘permanent as equity’ loan is retranslated at the year end, but with exchange movements recognised through reserves. This might arise in respect of a standalone loan investment, or it may arise where the company has applied the cover method in respect of borrowings or a currency contract matching the loan investment. S328 and S606 CTA 2009 ensure that exchange movements taken to reserves are not immediately brought into account. The cumulative exchange gain or loss would typically be brought into account when the loan investment is subsequently disposed of.

In both cases, accounting for such exchange differences is only possible where companies have applied SSAP 20 and is not permitted for companies applying FRS 101 (IAS 21). As a result, under FRS 101 (IAS 21) such instruments will need to be retranslated at the year end, with exchange movements being recognised in profit or loss.

In most cases such amounts will be brought into account for tax. There is a specific rule to deal with cases where a loan asset or derivative contract ‘matches’ the company’s own share capital – see CFM62850 for further details.

In addition, in December 2014 the Disregard Regulations were extended so to exclude exchange movements on certain instruments that were previously accounted for as permanent as equity debt under SSAP 20. These exchange amounts are disregarded and brought back into account on disposal of the loan instrument (in line with the treatment under the old accounting).

Transitional adjustments may arise where the debt was not previously retranslated at the year end, although the amendment to the Disregard Regulations may also apply to this transitional amount. See Part B of this paper for commentary on this.

18. Liabilities and Equity

Accounts prepared in accordance with Old UK GAAP will apply the presentation and disclosure requirements of FRS 25 in respect of financial instruments and in particular liabilities and equity.

FRS 101 requires the application of IAS 32 (which FRS 25 is aligned to). Consequently on transition from Old UK GAAP to FRS 101 no changes are expected in respect of the classification or presentation of liabilities and equity that currently fall within the scope of FRS 25. For example, the accounting on issue of a compound financial instrument is comparable across Old UK GAAP (FRS 25) and FRS 101 (IAS 32). In all cases the issuer will be required to account for the debt and the equity components separately (see CFM21260).

Guidance on the taxation of hybrid and compound instruments in both issuer and holder is available in the HMRC Corporate Finance Manual. In particular, see:

• CFM37600 (Bifurcated instruments under the loan relationship rules)
• CFM50410, CFM50420, CFM50430 and CFM52500 (Bifurcated instruments under the derivative contract rules)
• CFM55200 (Holder of convertible or share-linked securities)
• CFM55400 (Issuer of convertible or share-linked securities)

For further guidance on the transitional provisions applying to hybrid instruments see Part B of this paper.

PART B - Transitional adjustments (Old UK GAAP to FRS 101)

This part of the paper provides a summary of the key accounting and tax considerations that arise on transition from Old UK GAAP to FRS 101.

19. Accounting

In accounting terms transition to FRS 101 is determined by the requirements of FRS 101 itself and IFRS 1, although the disclosure requirements must also be consistent with company law.

On transition IFRS 1 requires that the balance sheet presented in respect of the transition date:

• recognises all assets and liabilities whose recognition is required by IAS
• does not recognise assets and liabilities if IAS does not permit such recognition
• reclassifies assets, liabilities and equity components to ensure presentation is consistent with IAS
• measures all recognised assets and liabilities in accordance with IAS

The transition date, for accounting purposes, is the first day of the earliest accounting period presented in the accounts. For example, for entities preparing their accounts at 31 December 2015 the transition date will be 1 January 2014.

IFRS 1 contains certain transitional exceptions and exemptions to the above requirements. These are not repeated here in detail but cover areas such as business combinations, estimates, intangibles and investment property.

However, even with such exceptions and exemptions it’s expected that on transition there may be a significant number of adjustments both to the carrying value of assets and liabilities recognised previously under Old UK GAAP and in terms of newly recognised assets and liabilities. For accounting purposes these adjustments will be made to the assets and liabilities as at the accounting transition date with a corresponding adjustment made directly to the opening P&L reserves.

For trading profit Chapter 14 Part 3 CTA 2009 provides that where there is a change from one valid basis on which the profits of a trade are calculated to another valid basis (for example on a change of accounting policy), an adjustment must be calculated to ensure that business receipts will be taxed once and once only and deductions will be given once and once only. For Corporation Tax purposes, adjustments are treated as receipts or deductions in computing the trade profits. Details of the calculation are set out at BIM34130.

20. General Trading

The relevant legislation for companies is in CTA 2009 Chapter 14 Part 3. Section 180(4) reads;

(4) A “change of accounting policy” includes, in particular —

(a) a change from using UK generally accepted accounting practice to using generally accepted accounting practice with respect to accounts prepared in accordance with international accounting standards, and

(b) a change from using generally accepted accounting practice with respect to accounts prepared in accordance with international accounting standards to using UK generally accepted accounting practice.

So while it details UK GAAP to IAS and vice versa, the key phrase is that a ‘change of accounting policy includes in particular’ those 2 cases. While the change from Old UK GAAP to FRS 101 is not listed it’s still included within the scope of this provision.

For companies with property income sections 261-2 CTA 2009 deal with adjustment income or expenditure where the basis on which the profits are calculated changes.

21. Intangibles

The relevant legislation is in CTA 2009 at Part 8, Chapter 15.

Where there is a change of accounting policy in drawing up a company’s accounts from one period of account to the next, and both those accounts are drawn up in accordance with GAAP in relation to those periods then the provisions of Chapter 15 will apply.

No taxable credit or allowable debit is to be brought into account under Chapter 15 to the extent that it’s already brought into account by CTA09/PART8/S723 (revaluations), 725 or 732 (reversals). See Section 878 CTA 2009.

Change in accounting value

When there is a change of accounting policy it’s possible that there will be a difference between the accounting values recognised at the end of the earlier period and the opening balance in the later period for certain intangible fixed assets. Where such a difference arises and no section 730 election has been made section 872 treats an increase as a taxable credit, and a decrease as an allowable debit, arising at the start of the later accounting period.

The amount of the debit or credit is the difference multiplied by the fraction tax written-down value/accounting value, where both these values are those at the end of the earlier period. Section 872(5) caps the amount of any credit to the net amount of previous debits on the asset less previous credits on the asset.

Chapter 15 also contains different rules to deal with a change of policy involving disaggregation or where the asset is subject to a fixed-rate writing down election under section 730.

Primacy of other parts of Part 8

Section 878 contains provisions to ensure that where all or part of the difference is brought into account under other sections of Part 8 that part is not brought into account again. The relevant other paragraphs are section 723 (gain on revaluation CIRD13050, section 725 (reversal of accounting loss CIRD13090) and section 732 (reversal of accounting gain CIRD12560).

Section 872 does not apply to a chargeable intangible asset in respect of which a fixed rate election has been made under section 720 (see CIRD12905)

22. Financial instruments

Transitional adjustments - general

Adjustments on loan relationships as a result of changes in accounting policy can arise under 2 separate parts of the regime.

Prior period adjustments

In cases where a company stays within the same accounting framework, or otherwise does not restate its opening figures, the accounts will normally show a prior period adjustment (PPA) either in reserves or in equity. For loan relationships section 308 ensures that this amount is brought into account for tax purposes where it’s taken to the statement on total recognised gains and losses (in Old UK GAAP) or statement of changes in equity (in FRS 101, FRS 102 or IAS).

A transitional adjustment which takes the form of a PPA will also be adjusted for tax purposes by any relevant provision. For example, if the company changes the accounting treatment of a loan to a connected company so that it is in future accounted in its accounts on a fair value basis, there will be a PPA reflecting the difference between the carrying value under an accrual method and fair value. However, s349 CTA 2009 requires the profits and losses on the asset continue to be brought into account for tax purposes as if the change to fair value accounting has not been made. Therefore the PPA is in this example ignored.

No prior period adjustment

In some cases there may be no PPA even though there is a change in accounting measurement for a particular instrument. For example, no PPA will be recognised where there is a change to the overall accounting framework and the opening figures have been restated. This will often be the case where a company adopts IAS, FRS 101 or FRS 102 for the first time.

In these cases sections 315 to 319 CTA 2009 will apply. These calculate the transitional adjustment by comparing the opening accounting value in the current accounting period with the closing accounting value for the previous accounting period. Accounting carrying value is defined to mean the carrying value of the asset or liability as shown in the balance sheet of the company subject to adjustments for specific tax provisions which have the effect of changing the carrying value for tax purposes (for example, s349 CTA 2009 for connect party debt).

The derivative contract regime has equivalent rules in sections 597 and 613 to 615 CTA 2009. The overall effect in either case is to ensure that no amount should fall out of account as a result of a change in accounting policy.

Change of Accounting Practice Regulations

In 2004 and 2005, the Government considered various representations about the impact of the transitional rules when a company moves from Old UK GAAP to either IAS or FRS 26. In view of the size of some of the known impacts, and the fact that many of the impacts could not be determined until companies made the calculations after the year end, the Government decided to defer the tax impact of all transitional adjustment. This deferral was given effect in the Loan Relationships and Derivative Contracts (Change of Accounting Practice) Regulations SI (2004/3271) (the COAP Regulations), which have been the subject of subsequent amendments.

The COAP Regulations apply to most transitional adjustments arising in respect of loan relationships or derivative contracts from change in accounting practice. As such, the Regulations are applicable to transitions to FRS 101 and FRS 102 in the same way as they applied to transitions to IAS or FRS 26. In most cases, the effect of the Regulations is to spread the transitional adjustment over 10 years, starting with the first period in which the new accounting policy applies.

Example

A company has designated a financial instrument as AFS with maturity in 5 years. Under Old UK GAAP it measures the financial instrument on a historic cost basis. Under FRS 101 it’s required to measure the financial instrument at fair value. On transition, the difference between the closing value for the previous period and opening value in the current period is to be brought into account, with the amount spread over a period of ten years.

There are certain exclusions from the COAP Regulations. In these cases the COAP Regulations don’t apply at all. This is likely to mean that the transitional adjustment will be brought into account in full on transition (for example, subject to the normal rules). The main exclusions are for transitional adjustments in respect of:

• a loan relationship which comes to a natural end in the accounting period that the transition takes place because it’s repaid or redeemed on the date which is the latest date on which, under its terms, it falls to be repaid or redeemed
• an embedded derivative that is bifurcated out of a loan asset or liability described in the first bullet
• a derivative contract which hedges a loan asset or liability described in the first bullet

Example

A company has a designated a financial instrument as AFS with maturity in 6 months. Under Old UK GAAP it measures the loan and derivative on an historic cost basis. Under FRS 101 it’s required to measure the derivative at fair value. On transition, the difference between the closing value for the previous period and opening value in the current period is to be brought into account in full in the current period.

The COAP Regulations also include provision for some further cases where transitional adjustments will never be brought into account. These specific issues are explained below, but are intended to ensure that the correct amounts are brought into account overall for loan relationships and derivative contracts.

Transitional adjustment – specific issues

(1) Convertible loans and asset-linked instruments (pre-2005)

There are rules which grandfather the previous tax treatment for most convertible debt and asset linked instruments issued before the company’s first period of account beginning on or after 1 January 2005 (see CFM37680 to 37710 for further details).

The COAP Regulations (reg 3C(2)(a), reg 3C(2)(aa) and reg 3C(2)(f)) require that amounts that arise on transition in respect of such contracts are never brought into account. This ensures that there is continuity of treatment.

(2) Embedded derivatives where the host instrument is not a loan relationship

Going forwards under FRS 101 (IAS 39), embedded derivatives in a contract are typically required to be bifurcated in the accounts. However, where section 616 CTA 2009 applies, the embedded derivative is treated as if it were closely related to the host contract and therefore not separated out. The COAP Regulations (reg 3C(2)(b)) requires that amounts that arise on the transition to FRS 101 on such contracts are never brought into account. This ensures that there is continuity of treatment.

(3) Interest rate contracts in a hedging relationship (Reg 9 contracts)

Under FRS 101 derivative contracts will typically be measured at fair value in the company’s accounts. Regulation 9 of the Disregard Regulations deals with interest rate contracts used for hedging. Amounts on such contracts are brought into account on an ‘appropriate accruals basis’. In effect, the tax treatment of such contracts under ‘Old UK GAAP’ continues where regulation 9 of the Disregard Regulations applies.

The COAP Regulations (reg 3C(2)(c)) means that no transitional adjustments arising on such contracts are to be brought into account under these Regulations. This ensures that there is continuity of treatment. The amounts will be brought into account under the Disregard Regulations in priority to the COAP Regulations.

(4) Currency, commodity and debt contracts in a hedging relationship (Regs 7 or 8 contracts)

Under FRS 101 derivative contracts will typically be measured at fair value in the company’s accounts. Regulations 7 and 8 of the Disregard Regulations deals with currency, commodity and debt contracts used to hedge a forecast transaction or firm commitment. Amounts on such contracts are brought into account under regulation 10. Generally, the effect of these regulations is that the tax treatment of such contracts follows the Old UK GAAP accounting treatment.

The Disregard Regulations (regs 7(1) and 8(1)) provide that no transitional adjustments arising on such contracts are to be brought into account – these amounts are disregarded. This ensures that there is continuity of treatment – the amounts will subsequently be brought into account under the Disregard Regulations in priority to the COAP Regulations.

(5) Designated cashflow hedges (Reg 9A contracts)

Under FRS 101, derivative contracts will typically be measured at fair value in the company’s accounts. Under a designated cash flow hedge, the company will recognise certain movements in the fair value through other comprehensive income, and maintained as part of a cash flow hedging reserve.

Regulation 9A will apply in respect of designated cash flow hedges, unless the instrument is within regulation 7, 8 or 9 of the Disregard Regulations. The effect of this regulation is to disregard for tax purposes the amounts recognised in the statement of equity (as items of other comprehensive income) until they are recycled to the income statement.

The COAP Regulations (reg 3C(2)(e)) exempts the spreading on transition amounts to the extent that they hedge future cashflows. It’s aimed at the opening adjustments to the cashflow hedge element of shareholders’ equity reserves. These amounts will subsequently be recycled through the income statement and so ensures continuity of treatment.

(6) Contract rate accounting

Under Old UK GAAP where FRS 23 (and FRS 26) does not apply, a company can translate a foreign currency amount on a monetary item (typically a money debt or a loan relationship) using the rate implicit in a contract (typically a derivative contract). This is not permitted under FRS 101 which requires the foreign currency amount to be translated using the spot exchange rate. Typically the derivative contract will be required to be recognised separately and measured at fair value. Potentially the company may apply hedge accounting in respect of the hedging relationship in its accounts.

Where regulation 9 of the Disregard Regulations applies, any adjustment to the derivative contract is effectively ignored – see (3) above. Where this happens, the COAP Regulations (reg 3C(2)(d)) disregards any loan relationship adjustment as well.

(7) Reversal of previous exchange gains and losses

Very occasionally an issue can arise where transitional adjustments represent the reversal of previous exchange gains and losses, typically where the company treats the loan as an equity instrument. The COAP Regulations (reg 3C(2)(ca) and reg 3C(2)(da)) provide that such transitional adjustments are not to be brought into account to the extent that those previous exchange gains or losses had been disregarded for tax.

(8) Permanent as equity debt

Under Old UK GAAP where FRS 23 (and FRS 26) does not apply, a company can translate permanent as equity debt at its historic cost. This is not permitted under FRS 101 which requires the foreign currency amount to be translated using the spot exchange rate.

In certain cases, regulation 12A of the Disregard Regulation can apply to exclude the transitional adjustments on permanent as equity debt.

(9) Modification and replacement of distressed debt

FRS 101 requires that where a borrower and lender exchange debt instruments on substantially different terms, or where a modification to the terms of an existing debt instrument is considered substantial the original debt instrument will be derecognised and the ‘new’ instrument recognised at its fair value. This contrasts with the position under Old UK GAAP (excluding FRS 26), where it would be less common (or more unusual) for a gain to be recognised in such circumstances.

In certain cases where the company is in financial distress, the COAP Regulations (reg 3C(2)(g)) exempts the credits arising on transition, together with any debits representing the reversal of these amounts.

Further details

For further details of the treatment of transitional adjustments for loan relationships and derivative contracts see CFM76000 onwards.

1. Defined, for purposes of this paper only, on page 3 ↩

2. IAS 39 requires initial recognition at fair value. In most cases this will equate to the cost under Old UK GAAP but, as noted in 4.5 of this paper, that may not always be the case ↩

3. If payment terms are deferred beyond normal credit terms, the cost is determined by reference to the present value of the future payments ↩