CFM61160 - Foreign exchange: tax rules on exchange gains and losses: loan relationships and derivative contracts: special rules on fair value accounting

Identifying exchange gains and losses where fair value accounting is used

The guidance at CFM61030 to CFM61060 applies where a company uses an accruals or amortised cost basis of accounting for a loan relationship or a currency contract. But the definitions of ‘exchange gains and losses’ at CTA09/S475 and CTA09/S606 are not easy to apply where the company uses fair value (or mark to market) accounting. (See CFM21620 for more on fair value accounting).

For example, suppose that a company holds a US dollar denominated bond, which it accounts for at fair value through profit or loss. The profit and loss account credit or debit, representing the change in the fair value of the bond during the period of account, will in part reflect the change in the dollar/sterling spot rate of exchange over the period. But it will also reflect movements in interest rates, and perhaps changes in the credit quality of the bond.

In order to identify an exchange gain or loss, it is necessary to ‘dissect out’ the exchange rate element from the overall fair value profit or loss. The Loan Relationships and Derivative Contracts (Exchange Gains and Losses using Fair Value Accounting) Regulations 2005 (SI 2005/3422 - usually abbreviated to the Exchange Gains and Losses, or EGL, Regulations) allow this to be done.

The Loan Relationships and Derivative Contracts (Exchange Gains and Losses using Fair Value Accounting) Regulations 2005 (SI 2005/3422)

Until 2005 fair value accounting was used relatively rarely in UK financial statements. The EGL Regulations have effect for periods of account beginning on or after 1 January 2005, when the accounting standard FRS 26 Financial Instruments: Recognition and Measurement (and its international equivalent IAS 39) introduced the fair value concept much more widely into company accounts. Regulations 5 and 6 define what is meant by ‘exchange gain or loss’ arising from a loan relationship where fair value accounting is used, and regulation 7 does the same for derivative contracts. CFM61170 explains these definitions.

Regulations 8 and 9 specifically allow an overall fair value profit or loss to be divided into an exchange gain or loss and a ‘residual profit or loss’. The exchange gain or loss, and the residual amount, are each treated for the purposes of CTA09/S308 and CTA09/S597 (previously FA96/S85B(1) or FA02/SCH26/PARA17B(1)) as if they were separate, independent credits or debits to profit or loss account or reserves.

However, a transitional debit or credit arising on a company’s first-time adoption of FRS 26, New UK GAAP or International Financial Reporting Standards (see CFM21160 onwards) cannot be split up in this way - no part of it is an exchange gain or loss.

Calculating the residual amount

The rules take a common sense approach. If the company has a fair value profit, you compute the residual amount by subtracting any exchange gain from that profit, or adding any exchange loss.

For example, if the company’s accounts show a fair value profit of £400,000 on a currency swap, of which £300,000 is an exchange gain, there is a residual credit of £100,000 (£400,000 less £300,000). If the company instead has an exchange loss of £50,000 on the swap, the company has a residual credit of £450,000 (£400,000 plus £50,000).

If the exchange gain exceeds the fair value profit, the difference between the two is a residual loss. Thus if, in the above example, the exchange gain were £550,000, the company would have a residual debit of £150,000 (the difference between £400,000 and £550,000).

Similarly, if the company has a fair value loss, you get to the residual amount by subtracting the amount of an exchange loss from the fair value loss, or adding an exchange gain. If an exchange loss exceeds the fair value loss, the difference between them is a residual gain.

For example, suppose that the company has a fair value loss of £600,000 on the currency swap, of which £250,000 is an exchange loss. The residual debit is £350,000. If, instead, there were an exchange gain of £250,000, there would be a residual debit of £600,000 plus £250,000, or £800,000. And if there were an exchange loss of £700,000, the company would have a residual credit of £100,000.

Base currency

The regulations refer to the ‘base currency’ - the currency in which the company computes its taxable profits or losses, in accordance with FA96/S92 - 92E (CFM64000). It will be the currency in which the company prepares its accounts, or, the functional currency disclosed in its accounts, if that is different.