Managing tax on Forex

Thu 05 Dec 2019

Sterling has had a bit of a turbulent time ever since the Brexit referendum and this foreign exchange (“forex”) volatility, with sharp falls and rises is not likely to end until there is some certainty over our future trading arrangements with the EU.

Foreign exchange movements can have a significant impact on a company’s tax results. For UK corporation tax purposes, forex on the retranslation of monetary items (i.e. cash, receivables and payables) is generally taxed on an accruals basis as it is reflected in the accounts, and on a realisations basis (e.g. recognised when the item concerned is disposed of) for capital gains items, such as shares). As a result, forex volatility can lead to a number of tax problems, including:

◾Unexpected cash tax bills on unrealised forex gains on long term monetary items that need to be funded before the item creating the forex is realised; and

◾Large forex losses which may not be relieved in full against corresponding gains.

I have had to advise a UK company that made a large forex loss on long term currency debt taken out shortly before the referendum. Despite the company being in a net loss overall over two years, it still had a material tax liability in those years. This was because the company was only allowed a 50% offset of the FY 16 loss against the FY 17 profits generated after 1 April 2017. The case demonstrates that the tax outcome relating to forex can often be different to what you expect and that it is not always possible to rely on losses being available to off-set corresponding gains.

HMRC were aware of the inherent unfairness of being taxed on unrelieved losses and ensured there were a number of relieving measures as set below which can be taken to defer or remove the tax impact on forex differences.

The starting point is to look at the currency in which taxable profits are calculated. The basic rule is that taxable profits should be calculated in the functional currency of UK GAAP compliant accounts (FRS101 or 102). In those circumstances there is no requirement to retranslate the underlying transactions into sterling. Therefore, if your business properly accounts in a non-sterling currency, then there is no retranslation differences on transactions undertaken in that functional currency. The one downside is that the accounting rules don’t let you pick and choose which functional currency you can adopt.

However, there is an election which allows investment companies to elect to use a designated currency instead of the functional currency. In that case, taxable profits are calculated by reference to the designated currency and not the functional currency of the accounts. This is particularly useful if the UK investment company is lending money overseas in a non-sterling currency or borrowing from its overseas parent in the consolidated accounts currency.

The limitations of functional currency accounting and designated currency elections are that they are only useful in dealing with forex differences on one currency. If an investment company is lending in a number of currencies then these techniques have limited usefulness. There is a way in which that can be addressed by using currency denominated preference shares.

The special tax rules relating to net investment hedging can also be used to reduce or eliminate the forex tax exposure on foreign currency loans receivable by issuing preference shares in the same currency. For example, it is possible for a UK company to issue dollar and euro preference shares to hedge dollar and euro exposures in the same entity. This can allow the company to disregard the forex on the loans, potentially indefinitely.

Forex is a fact of life when operating in a global economy with many major currencies. Each tax jurisdiction may tax forex differently, so care is required in determining which jurisdiction should bear the forex exposure. The above techniques are tried and tested ways in which common forex exposures can be managed from a UK tax perspective. If there is a post-Brexit resolution bounce or collapse in sterling, then your company can therefore use these to obtain a degree of protection from the tax effects.

If you want to find out more, please get in touch with Ludovic Black who has over 15 years’ experience advising companies on the tax consequences of financing and treasury matters.