INTM432135 - TIOPA10 Part 4: how it works - FOREX: matching loans
Introduction
Tax treatment of foreign exchange gains and losses on “matching” loans
Interest free loans
Loans on which interest is charged
Tax treatment of foreign exchange gains and losses on “matching” currency contracts
Application of CTA09/S694
Overall effect
Introduction
Where one UK company (“the acquiring company”) in a group acquires a foreign currency asset which is a non-monetary asset such as shares in another group company, it may hedge the foreign exchange risk by taking out a matching loan in the same currency.
In a group, however, the matching loan may be taken out by another group company (“the external borrower”), e.g. a group treasury company, which then on-lends the money borrowed to the acquiring company. Where such lending is on non-arm’s length terms, it may be caught by the provisions of TIOPA10/Part 4 (though before the advent of UK-UK transfer pricing on 1 April 2004, this would have been so only if the external borrower or other party to the contract was outside the charge to UK corporation tax which was not the usual set up).
As an alternative to a loan, a company might hedge the foreign exchange risk from the asset by entering into a currency contract, such as a forward currency contract or a currency swap. The counterparty to the contract may be an unconnected provider such as a bank, but in some instances it may be a related company. In such cases TIOPA10/Part 4 potentially applies to the derivative contract.
This guidance deals with the tax treatment of foreign exchange gains and losses on loans or currency contracts that are matched, at individual company level, with a company's net investment in a foreign operation, and which are not on arm's length terms.
Tax treatment of foreign exchange gains and losses on “matching” loans
The provisions of CTA09/S328 onwards govern the tax treatment of foreign exchange gains and losses (FEGLs) on loans. They do not affect the application of, or the amount of any adjustment made under, Schedule 28AA.
CFM62600 has more on matching and foreign exchanges gains and losses under the loan relationships and derivative contracts rules, and in particular describes the application of the “Disregard Regulations” (SI2004/3256). CFM62830 has an example of matching by a thinly capitalised company.
Interest free loans
Where a loan between related parties is interest-free, there may be a charge on the lender (the external borrower) under TIOPA10/S147. It is to be expected that there would be a compensating adjustment on the borrower (the company holding the matched asset) under TIOPA10/S174. The currency of the loan will be relevant in ascertaining the arm's length rate of interest for this purpose. But transfer pricing adjustments to impute interest will not affect the tax treatment of FEGLs for either the debtor or creditor companies. This is because
- for the debtor (the company holding the matched asset), CTA09/S328(3) operates to leave FEGLs on the loan out of account to the extent that are matched and can be set off by FEGLs on the asset. Where the loan hedges shares and FEGLs are taken to profit and loss account, Regulation 3 of The Loan Relationships and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses) Regulations 2004 ("the Disregard Regulations") will apply to the same effect (CFM62630); and
- for the creditor, CTA09/S328(1) brings FEGLs on the loan (and also the FEGLs on its external borrowing) within CTA09/S307(3) and, provided there is a corresponding debtor relationship (as there will be if interest is imputed under Sch 28AA), CTA09/S449 will not apply even if the amount of the loan is greater than it would have been if the parties were dealing at arm’s length.
Loans on which interest is charged
If interest is charged on an intra-group loan made in the circumstances described above, the tax treatment of the FEGLs of the debtor (the company holding the matched asset) is exactly the same as in the case of an interest free loan; and this is so whether or not the interest is below, at or above an arm’s length rate and whether or not the amount of the loan is less than, equal to or bigger than an arm’s length amount. This is because the matching rules will apply to disregard the FEGL whatever the provisions of CTA09/S447 provide.
In the case of the creditor (external borrower), if the amount of interest accruing on the loan is equal to or less than an arm’s length amount, having regard both to the rate of interest and the amount of the loan that would have been made at arm’s length, the position is exactly the same as for an interest free loan - this is because there would have been a corresponding debtor relationship had the debtor not matched, and so the condition in CTA09/S449 and CTA09/S451 is not met.
But if the amount of interest accruing on the loan is more than an arm’s length amount, having regard both to the rate of interest and the amount of the loan that would, in the absence of matching, be disregarded for the debtor (by operation of CTA09/S447), then the condition in CTA09/S449 and CTA09/S451 is met, i.e. there would not have been a corresponding debtor relationship and the corresponding amount of FEGL is left out of account for the creditor. This would then mean that the creditor does not have a symmetrical position as far as its FEGL on its lending and borrowing are concerned. However, where the loan to the debtor is supported by a guarantee, then the guarantor may be able to make a claim under TIOPA10/S192 to be treated for all purposes of the Taxes Acts as if it had taken out the loan.
So, for example, provided another UK group member has sufficient assets and income to support the loan, it should be possible for it to guarantee the loan to ensure that any FEGL disregarded for the debtor are still brought into account for the group, through making a claim for a compensating adjustment for the guarantor company (see separate guidance on Thin Capitalisation for further guidance on guarantees).
To preserve matching with FEGL on the debtor’s assets, Regulation 3(3) of the Disregard Regulations treats the FEGL on that part of the loan attributed to the guarantor by virtue of a claim under TIOPA10/S192 as matched for the purposes of FA96/S84A if the FEGLs accruing to the original debtor are also matched under that section. This regulation applies for accounting periods beginning on or after 1 January 2005.
Tax treatment of foreign exchange gains and losses on “matching” currency contracts
The provisions of CTA09/S606 govern the tax treatment of FEGLs on currency contracts. They do not affect the application of, or the amount of any adjustment made under, TIOPA10/Part4.
It is convenient to consider currency contracts under two headings - currency futures and forwards, and currency swaps.
Currency futures and forwards
In most cases the only taxable or relievable amounts arising on a currency forward or future (apart from any associated fees or expenses) will be foreign exchange gains or losses. Since CTA09/S694(8) excludes FEGLs from the provisions of the TIOPA10/Part4, there are no amounts in relation to such contracts to which transfer pricing can apply.
This is the case even where the notional amount of a contract between related parties is greater than would have been the case had the contracting parties been at arm's length. Thus it is unnecessary to consider the respective credit ratings of the parties, or the presence or absence of collateral or guarantees that might have been required in an arm's length situation.
A company using currency forwards or futures to hedge exchange risk from shares in an overseas subsidiary may, under SSAP 20, offset FEGLs on the currency contract in reserves against exchange differences on the asset. Such FEGLs on the contract are disregarded under CTA09/S606(3). Nothing in TIOPA10/Part4 affects this treatment. The same applies where, in an accounting period beginning on or after 1 January 2005, a FEGL on a derivative contract is disregarded under CTA09/S606(3) or regulation 4 of the Disregard Regulations (CFM62680).
The exchange rate implied by a forward currency contract will normally be the appropriate forward rate, so that at the inception of the contract the net present value of the rights and obligations assumed by each party is zero. It is, however, possible that related parties might enter into a currency contract at an "off market" rate of exchange. In such a case, one party would - at arm's length - receive a premium from the other in consideration of entering into the contract. CTA09/S694(8) does not prevent such a premium from being imputed. Similarly, the transfer pricing provisions will apply to any non-arm's length arrangements between related companies to assign, terminate or vary a currency contract.
- Swaps where “interest” payments are exchanged
- Where related companies enter into a cross-currency swap
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- the profit and loss account of each company will show receipts and/or payments relating to the obligation to exchange periodic payments, and
- exchange gains and losses may (depending on the accounting method used) also arise.
The guidance above on FEGLs arising on currency forwards or futures applies equally to FEGLs arising on a currency swap as a result of periodic retranslation of the obligation to exchange amounts of currency at maturity of the swap. TIOPA10/Part4 does not apply to such amounts, by virtue of CTA09/S694(8).
The transfer pricing provisions may, however, apply where the periodic payments are not on arm's length terms, for example where the interest rate applying to one or both legs of the swap is not a market rate, having regard to the currency or currencies concerned.
Application of CTA09/S694
Where
- TIOPA10/Part 4 applies to make an adjustment to an amount payable under a derivative contract (including, but not confined to, a currency contract)
- that amount is denominated in a foreign currency, and
- the amount is retranslated at a later date, so that FEGLs arise,
CTA09/S694 ensures that the effect of making the transfer pricing adjustment follows through to the consequential FEGLs. It will be seen from the above that the occasions on which S694 applies are quite limited.
Example
Y Ltd (whose functional currency is sterling) has external borrowing denominated in US dollars. In order to hedge its interest payments, it purchases a 3-year interest rate cap from Z plc, a company in the same group. A premium of $3 million is payable for the cap. In its accounts, Y Ltd treats the $3 million as a prepayment, releasing the amount to profit and loss over the period of contract. In each accounting period, the debtor balance is retranslated at the closing rate, giving rise to FEGLs.
At arm's length, however, a premium of only $2 million would be payable for the interest rate cap. When it prepares its tax computations, Y Ltd applies TIOPA10/S147 to adjust the debits in respect of the premium to the arm's length amount. It also applies CTA09/S694(5) so that the FEGLs brought into account for tax purposes are no more than they would have been had the company paid a premium of $2 million.
If, at arm's length, the interest rate cap contract would not have been entered into at all, CTA09/S694(3) applies to leave out of account all of the consequential FEGLs.
FEGLs may arise on a currency contract in this way, for example where a company pays a foreign currency denominated premium to enter into a currency option. But it would be unusual for such exchange differences to be taken to the company's statement of recognised gains and losses, or statement of changes in equity. Should this occur, however, the FEGLs will be disregarded under CTA09/S606(3). In such a case, S694 will not apply, because no amounts are being brought into account for the purposes of CTA09/PART7/CHAPTER11.
Overall effect
The overall effect is that the extension of transfer pricing should not change the tax treatment of foreign exchange gains and losses on an interest free intra group foreign currency loan or swap matching foreign exchange gains and losses on an asset. So, transfer pricing requirements will not disturb such foreign exchange hedging arrangements. Nor will there be any effect on a loan or swap on which interest or deemed interest is charged in an amount which does not exceed an arm's length amount. In the case of a loan (but not a swap) there will be an effect if the amount of interest exceeds an arm’s length amount (in which case arranging an intra-group guarantee may be helpful).
