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Tax case – functional currency change results in claiming foreign exchange losses

Tax case – functional currency change results

The Commissioners for HM Revenue and Customs v Smith and Nephew Overseas Ltd and Others Upper Tribunal decision.

Mark Eaton - Director, International Tax, KPMG UK

Director, International Tax

KPMG in the UK


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The Upper Tribunal (UT) has dismissed HMRC’s appeal in a case involving a change in the functional currency of three companies from sterling to US dollars as a result of an intra-group company reorganisation near the end of a period which resulted in members of a group claiming significant foreign exchange losses on sterling loan relationship assets. These losses were included in each company’s accounts within the statement of total recognised gains and losses. The First-tier Tribunal (FTT) had found that the accounts were GAAP compliant, the accounting exchange differences were exchange losses and did fairly represent losses for tax purposes. HMRC appealed all three issues.

Were the accounts GAAP compliant?

In principle, there were two possible accounting treatments for the change in functional currency and the one adopted in the statutory accounts gave rise to significant foreign exchange losses whereas the other would not. The FTT had preferred the evidence of the taxpayers’ expert and concluded that the accounts were GAAP compliant. The UT did not accept that HMRC’s preferred accounting was the only GAAP compliant method or that the FTT was wrong to conclude that the method adopted in the statutory accounts was GAAP compliant. Accordingly, HMRC’s appeal was refused.

Were the exchange differences ‘exchange losses’ for the purposes of the loan relationship rules?

The FTT had rejected HMRC’s argument that the accounting exchange differences could not be ‘exchange losses’ because there was no actual economic loss, finding that the legislation only required there to be a comparison at different times of the expression in one currency of the valuation of an asset or liability in another currency. Therefore, as there was a fall in the value of sterling against the US dollar, these exchange differences were indeed exchange losses. The UT agreed, importantly noting that the conclusion applies equally to gains and losses and the outcome is a sensible one in that the taxpayer should not be able to remove a profit from the charge to corporation tax on the basis that it is in some way not a ‘real’ or ‘actual’ profit, or accurately reflective of an exposure.

Do the exchange differences ‘fairly represent’ a loss arising to the taxpayers during the period as required by the loan relationship rules?

HMRC argued that the FTT was wrong to conclude that the losses in this case did ‘fairly represent’ losses of the company because the companies had no underlying foreign exchange exposure and suffered no real economic loss.

Following the Court of Appeal judgment in the GDF Suez case on 5 October 2018, the UT helpfully allowed each party to make submissions on the effect, if any, of the decision on the ‘fairly represents’ issue.

The UT rejected HMRC’s appeal but on different grounds to those of the FTT. Applying the reasoning in GDF Suez, ‘fairly represents’ is an override to the accounting which would not be appropriate here in the absence of a tax avoidance motive, the absence of any material asymmetry in the tax treatment and the absence of an absurd result.

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