Exchange differences in international taxation: the UK

1. Exchange differences in international taxation: the UK Roger Muray Ernst & Young LLP Vimal Tilakapala Allen & Overy LLP

2. Agenda • The General Reporters’ directive • Outline of UK taxation regime • UK taxation of exchange differences – outline • Typical transactions • Hedging foreign exchange risk and tax • Foreign exchange and foreign branches • Historical development of UK system for taxing exchange differences • Concluding remarks FX in international taxation: the UK

3. The directive

4. Background • Subject 2, IFA Congress 2009, Vancouver • Foreign exchange issues in international taxation • Last covered New York Congress 1986 • General reporters: • Nick Pantaleo, PwC Canada • Scott Wilkie, Osler • Brief assumed that other countries would have issues similar to those in Canada • Reminiscent of UK before 1993 FX in international taxation: the UK

5. Suggested contents (1) • Very comprehensive, potentially repetitive • Brief outline of domestic tax system • Foreign exchange controls (RIP 1979) • Taxation of exchange gains and losses, general considerations • Accounting principles • Recognition principles (timing) • Character of FX gains and losses • Currencies in which taxable profits may be calculated • Hyperinflationary currency adjustment? • Source of exchange gains and losses • Transfer pricing FX in international taxation: the UK

6. Suggested contents (2) • Typical transactions • Purchase and sale of goods • Measuring cost of plant or machinery, tax depreciation • Measuring cost of real estate • Measuring cost of securities • Intangible property • Borrowing and lending • Hedging and derivatives – expanded to a separate section in UK report • Foreign currency issues related to foreign branches and PEs • Measuring profits, intra-company dealings FX in international taxation: the UK

7. Suggested contents (3) • Foreign currency issues related to foreign PEs • Measuring branch profits • Impact of hedging • Intra-company dealings • Foreign currency issues related to CFCs • Two sections not directly addressed in UK Report: • Other FX issues, mainly related to Canadian tax cases • Instead ground covered by describing historical development of UK system • FX and tax treaties FX in international taxation: the UK

8. Outline of UK domestic tax regime

9. Characteristics of UK tax system • Credit system for foreign profits • Divergence between companies and individuals • Individuals still on pre-1993 system • Only large businesses affected professional advisory firms? • UK Report covers companies only • Schedules and Cases (almost RIP) • The concept of “trading” • Accounts-based statutory codes • Loan Relationships • Derivative Contracts • Intangible Fixed Assets • Capital gains FX in international taxation: the UK

10. Loan relationships • Money debt • Transaction for lending of money • Or deemed lending – issue instrument representing rights of lender • Profits, gains, losses, interest, expenses and charges on loan relationships and related transactions • Debits and credits in GAAP accounts • No distinction between income and capital FX in international taxation: the UK

11. Derivative contracts • Complex definitions • Futures options and contracts for differences • Normally accounting test, depending on underlying subject matter • Accounted for as derivative, or would be, were initial investment zero or small • Profits, losses and expenses and charges on derivative contracts and related transactions • Debits and credits in GAAP accounts • No distinction between income and capital FX in international taxation: the UK

12. UK taxation of exchange differences- outline

13. UK taxation of exchange differences – key points • There is no universal rule or set of principles • Though the report shows that a clear pattern arises • Exchange differences are not taxed in their own right, as separate items • Instead, they are an element of taxing some subject matter: • A loan relationship or derivative contract • The profits of a trade • Capital allowances on plant or machinery • Computation of a capital gain or loss FX in international taxation: the UK

14. UK taxation of exchange differences – key points • Pervasive influence of accounting treatment and principles • Not for pure income and capital gains • Distinction between monetary and non-monetary items • All-income approach for most monetary items • Resolves most historic problems with FX • Sophisticated business-friendly tax regime for hedging • Aligning characterisation and timing of taxation of the hedge with that of the hedged item • As regards FX, UK well-adapted to globalisation • Beneficial effects of consultation process FX in international taxation: the UK

15. Applicable accounting standards • In the context of trading, loan relationships, derivative contracts • IFRS, if applied in single entity accounts • Otherwise UK GAAP • Two versions of UK GAAP: • “New UK GAAP” aligned to IFRS as regards: • Financial instruments, measurement, IAS 39, FRS 26 • Foreign exchange, IAS 21, FRS 23 FX in international taxation: the UK

16. Which companies apply “New UK GAAP” EU-listed shares IFRS in consolidated accounts, 2005 IFRS or New UK GAAP in single-entity accounts Holdings PLC EU-listed debt IFRS or New UK GAAP 2005 Treasury plc IFRS or New UK GAAP 2006 Investment Ltd Trading Ltd True and Fair Ltd Optional Mark to market accounting under old GAAP Optional FX in international taxation: the UK

17. Monetary items • According to IAS 21 • “units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency” • A payment or payments become due or can be demanded • There is a mechanism for determining the amount payable • Will include cash, debt and derivatives • Excludes real property, chattels, IP, most shares FX in international taxation: the UK

18. Monetary items and UK tax on exchange differences • Loan relationships and derivative contracts will be monetary items • Measurement and timing of taxable amounts determined by debits and credits in IFRS or UK GAAP accounts • Will include exchange differences • Either on amortised cost basis (retranslation) • Or fair value basis • FX an economic component of fair value profit or loss • All characterised as income for tax • Unless matching rules apply • This is key to overcoming the pre-1993 problems FX in international taxation: the UK

19. Amortised cost basis • A method used under IFRS and New UK GAAP • Essentially the same as accruals basis under old UK GAAP • Also briefly described in loan relationships provisions • In essence spread payments over lifetime of item on an effective interest rate method • Where in foreign currency, translate carrying value to sterling at spot rate • Differences on retranslation to profit and loss • Except foreign operations and some hedging scenarios • Exchange differences to equity not taxed e.g, s84A(3) FA 1996 FX in international taxation: the UK

20. Fair value accounting • Carry items at fair value in accounts • Establish by reference to market transactions or by discounting anticipated future cash flows • Fair value profit and loss to income statement • Apply to all derivatives, to financial assets designated as held at fair value • Also apply to available for sale financial assets • But then fair value profit and loss to equity; recycle to income statement such that get same answer as under amortised cost • Similar approach for designated effective cash flow hedges • Tax Regulations define exchange difference component of fair value profit and loss FX in international taxation: the UK

21. Non-monetary items • Treatment of economic exchange difference depends on tax treatment of item • May be circulating capital of a trade, such as inventory • Follow accounting treatment, s42 FA 1998 • May be wrapped up in pure income received (e.g, dividends) • Translate amount received to sterling at spot • May be capital expenditure of a trade • May impact cost for capital allowances • May simply be capital gains item • Compute by reference to sterling proceeds and base cost FX in international taxation: the UK

22. Currency in which taxable profits are calculated (1) • Superficially simple rules in s92A – 92C FA 1993 • Default is apply sterling • Even where foreign branch, see later • Currency accounts drawn up in (presentation currency) not sterling and differs from functional currency (s92B) • Use functional currency, then translate to sterling • UK-resident, single non-sterling presentation and functional currency • Apply that foreign currency (s92C) FX in international taxation: the UK

23. Currency in which taxable profits are calculated (2) • Non-resident company, UK branch • Use currency of branch accounts used as basis for tax filing (s92C) • Other non-resident company (e.g. CFC) • Use presentation currency • Potential conflict with “correct accounts” requirement under loan relationships provisions • Might have different functional currency under UK GAAP FX in international taxation: the UK

24. Transfer pricing • OECD principles embedded in interpretation of Schedule 28AA ICTA 1988 • Normally respect currency of debt but expect appropriate interest rate for that currency. • In cases of thin capitalisation do not tax FX on excess debt • May deem actual or implied guarantor to have issued excess debt • Expect FX to move to guarantor • But what if functional currency different? FX in international taxation: the UK

25. INSTRUCTIONS • This template is designed for onscreen presentations and printed handouts only. • The template provides the option of either a grey or white background. • How to change colour palette: • Format menu > Slide Design… > Color Schemes • Choose the desired colour scheme and use the dropdown option to select Apply to All Slides. • Guidance on formatting the beam is available in the notes pages of this document. Typical transactions

26. Purchase and sale of goods • Almost certainly an incident in carrying on a trade • Follow accounts, s 42 FA 1998 • Book at historic cost at spot rate • (unless hedged, dealt with later) • Non-monetary asset so do not retranslate • No FX effects until inventory sold, • Then an economic component of profit or loss on sale FX in international taxation: the UK

27. Plant and machinery • Capital allowances regime applies • Uncertain how to establish sterling base cost • Probably use spot rate at date on which obligation to pay became unconditional • UK does not have a fully-joined up tax system • Disallow depreciation in accounts • Substitute capital allowances based on sterling cost FX in international taxation: the UK

28. Real estate • Normally within capital gains regime • Calculate gain by reference to sterling base cost and disposal proceeds • Bentley v Pike 51 TC 580 • Compute sale proceeds by reference to spot rate on date on which contract to sell became unconditional • FX on unpaid consideration in loan relationships regime • Section 100 FA 1996 • Likewise base cost FX in international taxation: the UK

29. Securities • Debt securities and shares radically different • Debt securities • Loan relationships • Accounts-based all income regime • FX on retranslation • or as economic element of fair value profit or loss • Shares • Normally capital gains, realisations basis • Sterling disposal proceeds and base cost • Substantial shareholdings regime may apply FX in international taxation: the UK

30. Intangible property • Intangible Fixed Assets rules may apply • Assets acquired or created since October 2002 with complex transitional rules • Complex accounts-based all-income regime • Accounting even defines what is taxable • FX determined by accounting • Will not be monetary items, so no retranslation • But revaluations or impairment may lead to tax of FX that is an economic component FX in international taxation: the UK

31. INSTRUCTIONS • This template is designed for onscreen presentations and printed handouts only. • The template provides the option of either a grey or white background. • How to change colour palette: • Format menu > Slide Design… > Color Schemes • Choose the desired colour scheme and use the dropdown option to select Apply to All Slides. • Guidance on formatting the beam is available in the notes pages of this document. Hedging foreign exchange risk and tax

32. Hedging FX risk – the UK approach • Very sophisticated – international comparisons will be interesting • Sometimes can simply follow the accounts • Otherwise mismatches possible between hedge and hedged item • Timing • Characterisation FX in international taxation: the UK

33. Hedging and taxing FX - objectives • Where hedge accounting possible under GAAP • Ensure timing aligned • Where hedging intended but not possible under IFRS or New UK GAAP • Permit hedge accounting for tax, if it is possible under Old UK GAAP • Do not penalise companies forced to apply new GAAP • Ensure timing aligned • Deal with mismatches of characterisation • Where hedge accounting possible, or hedging intention FX in international taxation: the UK

34. FX hedges of monetary items • IFRS or New UK GAAP • A natural hedge will often apply without any need for hedge designation • If use floating / floating currency swap • Fair value profit and loss on swap • Approximates to • Exchange differences on loan (amortised cost basis) FX in international taxation: the UK

35. Cross currency swap, floating rate legs only Swap • Within definition of interest-rate contract • But predominantly a hedge of exchange risk • Fair value movements mimic retranslation of $ principal • Some interest rate “noise” where interest rate reset not at year-end $ LIBOR $ principal on maturity $ LIBOR $ principal on maturity PLC $ floating rate borrowing £ LIBOR £ principal on maturity FX in international taxation: the UK

36. FX hedge of anticipated transactions • Disregard Regulations 7 and 10 • Mimic IFRS accounting of cash flow hedge of FX risk • Fair value profit and loss on hedge not taxed before maturity • If purchasing inventory for trade • Fair value profit and loss on hedge not taxed until inventory sold • If hedges effective in accounting terms • Can elect to follow income statement, Regulation 9A • If intend to hedge, but cannot satisfy stringent hedge effectiveness tests • Do not elect to apply Regulation 9A FX in international taxation: the UK

37. FX hedges of anticipated transaction – example • 1 October 2008 • Expect to buy inventory for €100 1 April • Buy €100 6 months forward £81 • 31 December 2008 • End of accounting period, €100 = £84, 3 months forward • Fair value of forward = (£84 - £81) discounted 3 months • Say £2.95, profit not taxed • 1 April 2009 • Buy inventory, €100 = £83, profit on hedge £2 • Still do not tax it FX in international taxation: the UK

38. FX hedges of anticipated transaction – example (continued) • 31 December 2009 • Inventory unsold; no profit on inventory • So hedged item does not affect company’s profits • No tax on hedge profit or inventory • 1 February 2010 • Sells inventory for £90 • FX is irrelevant, it is a non-monetary asset • Profit on sale is £7 • £90 less £83 (cost of inventory 1 April 2009 at spot rate) • Now also tax profit on hedge £2 , tax £9 FX in international taxation: the UK

39. Matching • Company hedges FX risk on underlying assets of subsidiary • Use foreign currency swap or borrowing UK Parent Euro loan Or swap, short € Long £ Floating rate periodic payments Euro Sub € net assets FX in international taxation: the UK

40. Matching • Potential tax mismatch • Shareholding is non-monetary asset • Capital gain on sale on realisations basis • Or substantial shareholdings exemption • Hedge is monetary item • Exchange difference on hedging loan taxed on retranslation • On swap fair value profit and loss approximates to FX and is taxed as income FX in international taxation: the UK

41. Matching: Old UK GAAP • If old GAAP applies • Can carry shares at foreign currency amount • FX on retranslation of shares taken to reserves • FX on hedge offset in reserves • SSAP 20 “cover method” • As FX goes to equity, it is not taxed • s84A(3) FA 1996, Para 16(3) Sch 26 FA 2002 • Accounting approach extended by established practice to more complex scenarios FX in international taxation: the UK

42. Matching: the problem under new GAAP • If IFRS or new GAAP applies • Cannot carry shares at foreign currency amount • They are not monetary items • Usually carry at historic sterling cost • Cannot take FX on hedge to equity • Net investment hedge treatment denied • As no “foreign operation in single entity accounts • So s84A / Para 16(3) cannot solve the mismatch FX in international taxation: the UK

43. Matching: New GAAP fair value hedge approach • Applying IFRS or New UK GAAP in single entity accounts • Designate borrowing a fair value hedge of FX risk on shareholding • Make fair value adjustments to carrying value of shares • This does not help directly as shares are capital gains assets taxed on realisations basis, or not at all • But Disregard Regulations allow FX or fair value profit or loss on swap disregarded and not taxed • To the extent it relates to FX • Regulations to work out the FX element FX in international taxation: the UK

44. Matching: intention approach • IFRS or New UK GAAP • Borrowing or swap • Intended to hedge FX risk on shareholding; and • Is economically suitable • FX on hedge or fair value profit and loss on swap relating to FX disregarded • Limit normally carrying value of shares • But may elect for underlying net asset value • Figures usually derived from parent’s consolidated accounts FX in international taxation: the UK

45. Matching – when is FX on hedge taxed? • Repaying loan or settling swap has no effect on past exchange differences • Selling shares is a trigger • If substantial shareholding regime applies • Still no tax • Matches timing and characterisation • If the SSE does not apply • Past FX treated as a capital gain or loss • Matches timing and characterisation FX in international taxation: the UK

46. Foreign exchange and foreign branches

47. FX and foreign branches • Normally the context is trading • Thus tax is based on the profit and loss account • S42 FA 1998 (plus some inferences e.g. s472A ICTA) • Foreign branch with a different functional currency is a “foreign operation” under IAS 21 FRS 23 • Transactions measured at transaction date, so profits computed in effect at weighted average exchange rate • Exchange differences by reference to functional currency of foreign operation to profit and loss • Exchange differences by reference to presentation currency to equity FX in international taxation: the UK

48. Foreign branches: exchange differences in equity • Can see them as having two main causes: • Retranslation of opening net investment in branch to closing rate • Retranslation of net assets derived from the profits of the year to the closing rate • Also applied under Old UK GAAP, SSAP 20 • Known as closing rate / net investment method • Exchange differences taken to equity not taxed • S42 FA 1998, or s84A(3) FA 1996 FX in international taxation: the UK

49. FX on internal transactions – the grin on the Cheshire cat • Internal transactions can give rise to FX • For instance US branch of UK bank “deposits” dollars with head office of GBP company • Prepare separate statements and consolidate • Internal balance disappears. • But FX to income statement in head office • No FX in branch but deposit is part of net assets, so equal and opposite FX to equity • Is it taxable? • No real loan relationship • But FX in p/l does exist in GAAP accounts, s42 FA 1998 FX in international taxation: the UK

50. CFCs • Current regime works company by company • Escape via exempt activities and motive tests • Relevant profits, compute on modified UK CT principles • Normally compute in currency in which the company draws up its accounts – s93C FA 1993 • Possible loan relationships issue • If company would have different functional currency in UK GAAP “correct accounts” FX in international taxation: the UK