The Smith and Nephew Overseas Ltd case: Court of Appeal finds for taxpayer

The Smith and Nephew Overseas Ltd case.

Court of Appeal finds for the taxpayer in a case concerning the availability of exchange losses following a change in functional currency.


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The Court of Appeal has dismissed HMRC’s appeal in a case involving a change in the functional currency of three companies from sterling to US dollar as a result of an intra-group reorganisation near the end of a period which resulted in members of a group claiming significant foreign exchange losses on sterling inter-company loan assets. These losses were included in each company’s accounts within the statement of total recognised gains and losses. The First-tier Tribunal (FTT) and Upper Tribunal (UT) 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 largely on new grounds (”the case has stood on somewhat shifting sands”) and the Court of Appeal has found for the taxpayer in the three issues which were considered.

Key points from the comments of the three judges are summarised as follows:-

Were the exchange differences subject to a ‘fairly represents’ requirement?

The exchange gains and losses on intra-group loan assets were not taxable and allowable when recognised in the statement of total recognised gains and losses. Instead, they were required to be brought into account when the loans were disposed of as part of the intra-group reorganisation. The Court of Appeal found for the taxpayer, deciding that the correct construction of the legislation is that the exchange gains and losses were not subject to a ‘fairly represents’ requirement.

If the fair representation requirement does apply, how is it to be applied to the exchange gains and losses?

The Court of Appeal considered if it is wrong on the first issue, how the ‘fairly represents’ requirement is to be applied to exchange gains and losses. The legislation requires that the debits to be brought into account are those sums which fairly represent the exchange losses and once the accounting was accepted to be GAAP compliant, it followed that the debits did ‘fairly represent’ the exchange losses. Effectively, the ‘fairly represents’ test has no discernible application to GAAP compliant exchange gains and losses from loan relationships. There was no place for a ‘real-world’ overlay to the accounting entries. This was said to support the conclusion on the first issue.

Does the ‘fairly represent’ loss test require that the fluctuations in exchange rates had a real world effect on the company’s finances and, if so, was there such a real world effect?

Notwithstanding the conclusions above, the Court of Appeal did not accept that the application of the ‘fairly represents’ test requires an investigation into the reality of gains and losses as contended by HMRC. In addition, if some real-world consequences are required in order for debits to ‘fairly represent’ exchange losses, it was decided that the consequences of the intra-group reorganisation were sufficient for it to be said that the debits fairly represent exchange losses from loan relationships.

Relevance of the ‘fairly represents’ test

The ‘fairly represents’ test is no longer part of the legislation but it can still be relevant to historic enquiries. The Court of Appeal provides some guidance on when the test is relevant:

  • It is not only applicable in avoidance cases and can operate in favour of a taxpayer to exclude a profit included in GAAP compliant accounts; 
  • It can apply even if there is no asymmetry in the tax treatment; and
  • The Court of Appeal in this case was disinclined to follow the factors which had been identified by the Court of Appeal in GDF Suez as to when the ‘fairly represents’ test is to be applied. Rather, the test is engaged wherever fair representation would not otherwise be achieved (there is no particular hurdle to be passed, such as ‘manifest absurdity’ referred to at the UT).

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