CTM76310 - Local currency accounting (FA93 scheme): election: primary economic environment

This paragraph, reproduced here in full for convenience, is reflected in the public statement.

‘One of the primary conditions to be satisfied before a local currency election can be validly made is set out in Regulation 5 (2)(a) SI1994/3230 which requires the currency to be that of the `primary economic environment' in which the trade or part is carried on. Regulation 6 then sets out guidance on how the primary economic environment is to be determined.

All relevant circumstances are to be considered but Regulation 6 sets out a number of factors that have to be considered in particular insofar as they are relevant. The Regulations do not require a majority or any particular number of factors to be present and the relevance and importance of each factor needs to be considered separately for each trade (or part). These may vary with the type of trade and the manner and particular market in which the company operates. This paragraph looks at each of the factors set out in Regulation 6, describes circumstances in which they would be relevant and in which the relative importance of each factor may also be a consideration.

The currency in which the net cash flows of a trade or part are generated or expressed in the relevant accounting records (factor (a)).

SSAP20 describes local currency as the currency of the primary economic environment in which the company operates and generates net cash flows. The Regulations do not just talk about generating cash flows because a company may generate income in a variety of currencies, none of which might represent a majority even of its income let alone its net cash flows. For a company that earned 40% of its income in dollars with the remaining income spread amongst other non-sterling currencies but which paid its administration expenses (including salaries) in sterling, the currency of generation of cash flows would have little relevance.

However despite the mix of currencies contributing to net cash flows the company may well record its transactions in its records by translating them immediately into what it regards as its local currency. If this happens then clearly factor (a) is relevant in terms of the currency in which cash flows are expressed.

A company may adopt multi-currency accounting by which it may mean that transactions are initially recorded in the currency in which they are carried out (in which case there might be separate records for dollar, yen etc transactions). The relevance of factor (a) in this situation would depend on the extent to which net cash flows expressed in the relevant records contributed to overall net cash flows.

Alternatively a company might keep parallel records in both dollars and sterling. In this situation factor (a) would not enable a choice to be made between the two, and other factors would need to be considered.

The currency in which the company manages the profitability of the trade or part so far as it is affected by currency exposure (factor (b)).

This factor is likely to be relevant for all companies and for some companies it may be the only relevant factor or may be so important that it dominates any other relevant factors. Companies will need to know by reference to what currency they are trying to manage their profits for a variety of reasons. For example they may be required by the parent company or the Head Office for a branch to measure their profitability in a particular currency or bonuses or profit-sharing arrangements may be based on profitability in that currency. There is more however to this factor than mere measurement of profit in a particular currency because the factor refers to the management of profitability. Companies will normally have a clear policy on the hedging of exchange risk from which it should be clear by reference to which currency profitability is being managed. This is not to say that all risk would have to be hedged back to, say, the dollar. The company may take the view that the dollar profit would be higher if it left certain transactions unhedged. Most companies preparing their accounts in a particular currency are likely to be managing their profitability by reference to that currency but a company ought if necessary to be able to produce some evidence of what it is actually doing to manage profitability in a particular currency.

For companies resident in the UK the currency in which the company's share capital and its reserves are denominated (factor (c)).

The currency in which share capital is denominated will be a relevant factor for companies (but not branches). It may not however be an important factor where a company is thinly capitalised or it uses hedging transactions to avoid or alter currency exposure on finance raised through the issue of share capital. If a company has $2 share capital but borrowings of £1,000,000 then factor (c) will be relevant but insignificant in terms of its importance.

The currency to which the company or branch is exposed in its long-term capital borrowing (factor (d)).

The currency risk to which a company depending on significant borrowings is exposed will be relevant. Where borrowings in a specific currency hedge currency assets there will normally be no currency exposure and as far as that borrowing is concerned, factor (d) will not be relevant. Similarly, it will not necessarily be the case that the denomination of the original borrowing will determine the relevant currency for the purposes of factor (d). A company may borrow in say dollars but use a currency swap effectively to swap the borrowing into Deutschmarks. In this case the currency exposure would be to Deutschmarks. There is a strong likelihood that the currency for factor (d) would be the same as that for factor (b) - the currency in which the company is managing its profitability. Long-term capital borrowings for the purposes of this factor should be taken to be borrowings for a period of more than one year.

The currency which is the generally recognised currency in which trading in the principal market of the trade or part is carried on (factor (e)).

For certain specialised trades there may be a global market in a particular currency. The most obvious example is oil, which is internationally traded in dollars. This factor is likely to be of importance where other factors do not give a conclusive steer. Not all oil companies for example account in dollars presumably because they consider themselves to be managing their profitability in a different currency (factor (b)).

Cases in which local currency approach adopted pre commencement day.

Inspectors may have accepted a local currency approach to the calculation of basic profits for CT for periods prior to the appointed day. It is anticipated that the tests set out in regulations will be satisfied in such cases to enable a valid election to be made to cover periods following a company's commencement day.'