IFM40630 - Other tax issues: exchange gains

FA22/SCH2/PARA38

Where a financial instrument is held at fair value, it can be difficult to identify the exchange gain or loss component of the fair value movement because this will also be affected by other variables such as interest rates and credit ratings.

The Loan Relationships and Derivative Contracts (Exchange Gains and Losses using Fair Value Accounting) Regulations 2005 (SI 2005/3422) were made to address this problem by identifying the exchange gain or loss component. Guidance on these regulations can be found at CFM61160.

The regulations only envisage an exchange gain or loss arising on a movement between two currencies being the base currency of the company and the currency in which the financial instrument is denominated.

Although this normally gives the correct result, it does not provide for a QAHC which holds a financial liability at fair value and uses it to fund multiple investments in different currencies. There, an exchange gain or loss will arise between the base currency of the company and the currency of each individual investment with which the liability is matched.

PARA 38 amends the regulations by adding new PARAS (4) and (5) to SI2005/3422/REG5 which apply solely to QAHCs. These new paragraphs allow the exchange gain or loss to be calculated by reference to fluctuations in the spot rate of exchange between the base currency of the QAHC and either:

• The currency in which the asset or liability is denominated, or
• Another currency which is relevant to the value of that asset or liability

These amendments mean that, where a QAHC uses a financial liability to fund investments in various currencies, each individual investment currency can be taken into account when calculating the exchange gain or loss that arises on the financial liability. It will no longer simply turn on the movement between the currency of the liability and the base currency of the QAHC.

The amendments also mean that, for Corporate Interest Restriction purposes, any foreign exchange movement arising on the financial liability will not be included in the tax-interest expense amount and so cannot be restricted under the Corporate Interest Restriction provisions. This will allow any such movement to be offset against corresponding movements on the financial assets funded by the liability.

Example

A QAHC has a GBP base currency. It is funded by a £1,000 profit participating loan (PPL) which it invests in a portfolio of loan receivables. The QAHC acquires EUR-denominated receivables of €650 (worth £600 at that time) and USD-denominated receivables of $425 (worth £400 at that time). The loan payable and loan receivables are all recognised at fair value through profit or loss in the accounts.

At the end of year one the QAHC needs to calculate the fair value of its financial instruments. The return on the loan payable is determined by the profits of the loan receivables so it will need to calculate the fair value of the receivables first.

The fair value of the EUR receivables is now £800 resulting in a profit of £200 (£800 – £600). This profit reflects both a weakening of GBP relative to EUR (exchange gain) and an increase in the credit rating of the debt (fair value profit).

The fair value of the USD receivables is now only £300 resulting in a loss of £100 (£400 – £300). This loss reflects both a weakening of GBP relative to USD (exchange gain) and a large decrease in the credit rating of the debt (fair value loss).

The Loan Relationships and Derivative Contracts (Exchange Gains and Losses using Fair Value Accounting) Regulations 2005 (SI 2005/3422) allow the QAHC to calculate the exchange gain or loss element of the composite £200 profit and £100 loss. SI 2005/3422/REG5(2)(b) is in point because part of the fair value change is attributable to fluctuations in the spot rate of exchange between the currencies in which the assets are denominated (EUR and USD) and the base currency of the company (GBP). Per SI 2005/3422/REG5(3), the exchange gain or loss is the amount of the fair value change that can be attributed to fluctuations in the spot rate of exchange between the currency in which the asset is denominated and the base currency of the company.

When the EUR receivables were acquired, €650 was worth £600. €650 is now worth £630 so the exchange gain is £30 (£630 – £600). The £170 balance of the £200 composite gain (£200 – £30) is therefore the fair value profit.

When the USD receivables were acquired, $425 was worth £400. $425 is now worth £410 so there is an exchange gain of £10 included in the fair value loss (£410 - £400). The fair value movement must therefore be a loss of £110 (-100 – 10). The exchange gain of £10 and the fair value loss of £110 result in the composite £100 loss.

The fair value of the PPL will be £1,100 because the return on the PPL will track the profits or losses of the underlying investments. The underlying investments have made a net £100 profit for the year resulting in a corresponding £100 loss on the PPL. Again, this is a composite figure including both fair value and exchange rate movements. SI2005/3422 cannot engage here to identify the exchange loss because none of the change in the fair value is attributable to fluctuations in the spot rate of exchange between the currency in which the liability is denominated (GBP) and the base currency of the company (GBP).

PARA38 supplements SI2005/3422 to provide for situations where the change in the fair value of an asset or liability held by a QAHC is partly attributable to fluctuations in the spot rate of exchange between the base currency of the QAHC and other currencies which are relevant to the value of the asset or liability. The exchange gain or loss is calculated as the change in fair value that is attributable to fluctuations in the spot rate of exchange between that currency (or currencies) and the base currency of the QAHC.

Here, the £100 fair value loss on the PPL is partly attributable to fluctuations in the exchange rate between both GBP (base currency of the QAHC) and EUR/USD (denomination of the investments). The value of the investments are clearly relevant to the value of the PPL because its terms stipulate that any profit on the investments must be returned to investors. £40 of the fair value change can be attributed to fluctuations in the spot rate between the currencies of the investments and the base currency of the QAHC. This £40 exchange loss is comprised of an exchange loss of £30 (GBP to EUR) and an exchange loss of £10 (GBP to USD). The £60 balance (£100 – £40) is therefore a fair value loss that is not attributable to movements in spot rates.

For CIR purposes, the QAHC will have relevant loan relationship debits of £170 (a £60 fair value loss on the PPL and a £110 fair value loss on the USD receivables) and relevant loan relationship credits of £170 (fair value gain on the EUR receivables). It therefore has a net tax-interest expense amount of nil.

PPL	Foreign exchange loss	(£40)
	Fair value loss	(£60)
	-	(£100)
EUR receivables	Foreign exchange gain	£30
	Fair value gain	£170
	-	£200
USD receivables	Foreign exchange gain	£10
	Fair value loss	(£110)
	-	(£100)