CFM9402 - Taxing forex: matching under Disregard Regulations: overview

Overview of matching in periods beginning on or after 1 January 2005

This guidance applies to periods of account beginning on or after 1 January 2005

Listed entities have to adopt International Accounting Standards (or UK equivalents) in their first accounting period to begin on or after 1 January 2005. Any entity using fair value accounting for its financial instruments must adopt these standards for accounting periods beginning on or after 1 January 2006. Other entities may adopt from 2005 or leave it until a later year. UK accounting standards will eventually fully converge with International Accounting Standards but that date has yet to be agreed.

International Accounting Standards and UK equivalents require different accounting treatment for liabilities, assets or derivatives hedging exchange exposure on shareholdings than was the case under SSAP20. As the tax matching treatment under FA96/S84A(3) (for loan relationships) and FA02/SCH26/PARA16(3) (for derivatives) was based upon SSAP20 accounting treatment, new rules were required for those companies using International Accounting Standards (or UK equivalents).

The most straightforward matching situation is where a company holds shares in a subsidiary whose activities are based or conducted in a country or currency other than those of the company itself. (The shares themselves may also be foreign currency denominated). The company is therefore at risk from foreign exchange movements because the value of the investment will fluctuate with exchange rate movements. It takes out a loan in the currency in question or a derivative over the currency to hedge this exposure. It may wish to have the exchange movements on the liability/derivative matched for tax purposes with the opposite movements on the asset.

Example

Dopmet Ltd, a company accounting in sterling, has an investment, €200,000 of shares in an Irish company. The exchange rate at 31 December 2006 is £1:€1.32 whilst the rate at 31 December 2007 is £1:€1.45. On the accounting date at 31 December 2006 the investment is worth £151,515. At 31 December 2007 it is only worth £137,931 producing an exchange loss on the asset of £13,584.

The company can avoid this exposure to exchange rates by taking out a €200,000 loan. This produces an exchange gain to match the exchange loss.

Special tax rules are needed to make this work because shares and loan relationships are normally taxed in a different way. An exchange gain or loss on a loan relationship is taxed each year whilst the exchange gain or loss on the shares is taxed, if at all, on disposal. In practice, many share disposals will not constitute chargeable gains because of the substantial shareholding exemption.

For a company that continues to account in accordance with “old UK GAAP”, SSAP 20 permits the exchange gain or loss on the liability to be taken to reserves to the extent that it can be set off there against the exchange gain or loss on the matched asset. So in the above example, the exchange gain on the loan, £13,584 would be set off against the exchange loss on the asset, £13,584 in reserves in line with SSAP 20. Nothing would be brought into account for tax purposes in respect of these exchange movements until disposal, if at all.

These rules do not work under International Accounting Standards and their UK equivalents.

A foreign operation may take the form of a branch of a company, in which case IAS 39 hedging is permissible in the individual accounts of the company.

But with this exception, hedging of a net investment in a foreign operation is permissible only in consolidated accounts. In the case of a foreign operation that takes the form of a subsidiary, IAS 39 does not allow hedging of the net investment at single entity level (unlike under SSAP 20). Therefore there is no special accounting treatment adopted and no way of seeing from the accounts

• whether matching of assets with liabilities is intended, or
• how much of an exchange difference arising on a liability should be offset against exchange differences on one or more assets.

A company may designate a fair value hedge under IAS 39 of the shares at single entity level. But because the rules for hedge designation are strict this may not always be possible. For more on fair value hedges see CFM16290.

During consultation, companies indicated that, despite the change in accounting treatment, they wanted to continue matching for tax purposes at single entity level in line with their economic intentions. Most companies will wish to hedge in order to avoid an unpredictable impact on their business through foreign exchange movements, and where hedging achieves a “balanced” commercial position, it is reasonable for this to be reflected in the company’s tax position.

The rules to allow this are contained in The Loan Relationships and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses) Regulations 2004 - SI 2004/3256 as amended by SI2005/2012, SI2005/3374, SI2006/3236, SI 2007/948 and SI 2007/3431. These are generally collectively referred to as the “Disregard Regulations”.

Regulation 3 ( CFM9404) deals with loan relationship matching and regulation 4 ( CFM9414) deals with derivative contract matching.

The broad aim is to preserve matching treatment for tax purposes in circumstances where it was permitted under SSAP 20.

For companies still using SSAP 20, FA96/S84A(3) and FA02/SCH26/PARA16(3) continue to operate to provide tax matching. See CFM9300 onwards for those rules. For such companies therefore there is generally no need to apply the Disregard Regulations to match foreign exchange movements – the primary legislation takes priority. CFM9424 gives more detail.

For background on the history of matching for tax purposes see CFM9330 to CFM9340.