UK and International Tax news
Upper Tribunal Case And Allowable Exchange Losses
Sunday 23rd December 2018
The UT has recently issued its decision in a case involving exchange losses arising following a group reorganisation and a change in functional currency.
This was a decision on the appeal by HMRC against the decision of the FTT in HMRC v Smith & Nephew Overseas Ltd and Others [2018 UKUT 393].
Following a group reorganisation, three Smith & Nephew companies changed their functional currency from sterling to US dollars and claimed in their 2008 tax returns foreign exchange losses totalling approximately £675m. These losses were the results of revaluations included in the statement of recognised gains and losses of each of the companies in their respective 2008 accounts resulting from the fall in value of sterling against the US dollar.
HMRC did not accept that the losses arose for CT purposes and disallowed the losses. The companies appealed to the FTT which allowed the appeals on the grounds that:
- the accounts of each company for the relevant year were drawn up in accordance with UK GAAP;
- the claimed exchange differences gave rise to “exchange losses” within the meaning of the legislation [FA 1996], and
- those exchange losses did “fairly represent” losses within the meaning of the legislation.
The FTT granted permission to appeal on all grounds.
In relation to ‘GAAP compliance’, whilst it was agreed that the S&N companies were obliged to change their functional currency as a result of the group reorganisation, the point at issue was which of the two available accounting methods was appropriate to use – either the foreign operations method [FO] or the single rate method [SR].
Under the FO method, balance sheet amounts are translated at closing exchange rates, while activities during the accounting period are translated at average rates. Gains and losses are likely to arise from the retranslation of balance sheet items and from differences between the results for the period translated at average exchange rates.
With the SR method, all items, balances and results prior to the date of change of the functional currency are converted at the single rate applicable at that date. And no foreign exchange differences will arise.
In this case, the adoption of the FO method gave rise to exchange losses recorded in the STRGL of each S&N company. HMRC argued that the FO method was not GAAP compliant and, in the circumstances, the SR method was the only appropriate choice.
With regard to ‘exchange loss’, HMRC argued that the word “loss” must be interpreted in the statutory context as applying only to a “real economic” loss which is actually suffered by a company. HMRC contended that the S&N companies showed purely arithmetical differences in their accounts, had no exchange rate exposure and realised no currency losses.
The UT dismissed HMRC’s appeals on both these issues.
In relation to ‘fairly represents’, HMRC contended that the exchange losses did not “fairly represent” losses of the companies. In considering this issue, the UT referred to the decisions in the cases of GDF Suez, DCC Holdings and Greene King in examining the requirements of s.84(1) FA 1996.
The UT held that, taking into account all the facts, including but not limited to the absence of a tax avoidance motive, the absence of any material asymmetry, and the absence of an absurd result, the exchange losses did fairly represent losses as required by the legislation, thus affirming the decision of the FTT but for different reasons.
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