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UK Court of Appeal: group restructuring forex losses tax deductible

Out-Law News | 02 Apr 2020 | 11:38 am | 3 min. read

Foreign exchange losses on an intra-group restructuring qualified for a tax deduction, the UK's Court of Appeal has decided in a case involving medical equipment manufacturer, Smith & Nephew.

"This decision concerns the ‘fairly represent’ provision, which was removed from the loan relationships legislation for accounting periods commencing on or after 1 January 2016. However, the decision is still important as there are a number of other pending cases which may be affected by the decision," said Jake Landman, a tax disputes expert at Pinsent Masons, the law firm behind Out-Law.

The case concerned three Smith & Nephew dormant subsidiaries which had large intercompany balances due to them from their immediate parent company. The group wanted to eliminate the balances but HM Revenue & Customs (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. This resulted in the three companies changing their 'functional currency' from sterling to US dollars at a time when the only asset on their balance sheets was a very substantial inter-company debt owed to them by their parent company.

A company's functional currency is the currency of the primary economic environment in which the company operates. A company must compute its profits for corporation tax purposes in its functional currency.

The debts were disposed of as part of a group restructuring. In their US dollar accounts, as a result of the fall in the value of sterling against the US dollar, the companies recognised foreign exchange adjustments of around £675m through non-distributable reserves in their statements of total recognised gains and losses (STRGL).

Although HMRC accepted that the restructuring had taken place for commercial reasons, it did not accept that the arrangements meant that foreign exchange losses arose for corporation tax purposes.

"HMRC has now lost this case in each of the First-tier Tribunal, the Upper Tribunal and now the Court of Appeal. Although both parties have changed their lines of argument as the case has proceeded and the judges at each stage have found for the taxpayer for different reasons," Jake Landman said.

HMRC originally argued that the accounts did not comply with UK GAAP, that the exchange differences were not 'exchange losses' within the meaning of the legislation and that they did not 'fairly represent' losses. By the Court of Appeal only the 'fairly represent' argument was left.

At the time the transactions took place, the legislation provided that the credits and debits to be brought into account for tax purposes were the sums which when taken together 'fairly represent' all profits, gains and losses of the company arising from its loan relationships.

In the Court of Appeal, HMRC argued that the 'fairly represent' test could only be satisfied if the relevant debits arose because of some 'real world' detriment caused a result of the fluctuation of the dollar/sterling exchange rates and they argued that in this case the exchange loss arose only as a result of the restatement of the accounts in dollars. The debts were always in sterling and were paid off in sterling as part of the restructuring.

The taxpayer argued that the 'fairly represent' test did not apply at all or that in the context of exchange losses, it only required an assessment of whether the debits fairly represented the exchange losses and not whether the exchange losses fairly represented losses.

Lady Justice Rose and Lord Justice Coulson decided that the fairly represent test did not apply where a loan relationship gave rise to exchange gains or losses recognised in the companies STRGL. However, in case they were wrong on this point, they also dismissed HMRC's other arguments.

The third Court of Appeal judge hearing the case, Sir Geoffrey Vos, agreed that HMRC's appeal should be dismissed. However he thought that the fairly represent test did still apply, but that the test was whether the debits fairly represented the exchange losses, which he found they did.

Lady Justice Rose rejected HMRC's arguments that the fairly represent test requires a 'real world' assessment. She said that in the context of foreign exchange gains and losses it required a purely arithmetical exercise carried out to arrive at "a result of comparing at different times the expression in one currency of the whole or some part of the valuation put by the company in another currency on an asset or liability of the company".