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A rare taxpayer win in the tax tribunal on ‘fairly represent’

Out-Law Legal Update | 11 Apr 2017 | 3:11 pm | 2 min. read

Speed read: In a tax case involving Smith & Nephew, the First-tier Tribunal decided that losses incurred as a result of a change in functional currency were allowable. The case is a rare example of a UK corporate taxpayer succeeding in an argument about loan relationships or financial instruments against HMRC. 

Three Smith & Nephew dormant subsidiaries had large intercompany balances due to them from their immediate parent company. The group wanted to tidy up the position. HMRC declined to give clearance that the balance sheets could be tidied up on a tax neutral basis.

The group therefore entered into a series of complex arrangements to eliminate the balances. The ultimate parent bought the shares of the three subsidiaries from the immediate parent for cash. After various other transactions, the intercompany receivables were eliminated by virtue of a distribution by another group company.

The Smith & Nephew group had two main trading groups: the international operations, which had a US dollar functional currency; and the UK sub-group, which comprised the UK trading operations and which had a sterling functional currency. The result of the transactions was that the companies changed their position within the group, and acquired a dollar functional currency.

The accounts of the three companies recognised exchange differences arising from the revaluation of the intercompany balances. The companies claimed that the exchange differences gave rise to an ‘exchange loss’ and claimed a tax deduction for in excess of $1bn in total. HMRC refused to allow the deduction and the companies appealed.

The First-tier Tribunal (FTT) had to decide:

  • whether the  accounts complied with UK GAAP;
  • whether the exchange differences were ‘exchange losses’ within s 103 FA 1996; and
  • whether the exchange differences could be said to ‘fairly represent’ a loss arising to the companies in the relevant period

The FTT concluded that the accounts did comply with UK GAAP. It is notable that, even in cases (unlike this one) which involve an avoidance scheme, HMRC has rarely succeededin overturning the accounting method used by the taxpayer.

The tribunal found that an exchange loss must, in essence, be an arithmetical exercise. As there was a fall in value of the assets in UK GAAP compliant accounts, it must follow that the exchange differences were exchange losses within s103.

The most interesting part of the case was the argument as to whether the exchange differences ‘fairly represent’ a loss. HMRC argued that the ‘fairly represent’ requirement was an additional obligation, beyond that of requiring a ‘true and fair’ view in the accounts. The FTT dismissed this argument.

Fairly represent has now been removed from the legislation but is still relevant for many open disputes.

Just a week after the Smith & Nephew decision, the Upper Tribunal's decision in GDF Suez Teesside Ltd ([2017] UKUT 68) was released. In that case, a contingent claim was transferred to a third party in exchange for shares. The recipient recognised the asset at market value, but the transferor did not recognise a profit on the transfer. The Upper Tribunal (UT) said that the transferor had attempted to exploit accounting rules, "generating a mismatch between economic reality and the accounting treatment of it". It held that the profit must be recognised in the transferor's accounts.

It seems likely that HMRC will appeal the Smith & Nephew decision, and will rely on the ‘fairly represents’ argument as its main grounds for doing so. The GDF decision in the UT means that HMRC must have some basis for optimism; however, as the Smith & Nephew case did not relate to an avoidance scheme, the courts may be rather more sympathetic to the taxpayers’ arguments.

For more details see the article Smith & Nephew: a rare taxpayer win on ‘fairly represent’ by Heather Self which was published in Tax Journal on 31 March 2017.

Heather Self is a corporate tax expert at Pinsent Masons, the law firm behind Out-law.com.