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Tax deduction available for losses from change in functional currency

A tax deduction was available for losses arising as a result of a change in functional currency, the UK's upper tribunal (UT) has decided upholding a previous decision by the First-tier tax tribunal (FTT) in a case involving medical equipment manufacturer, Smith & Nephew.07 Dec 2018

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, because the companies changed their position in the group.

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. 

As a result of the fall in the value of sterling against the US dollar, the companies claimed that the change of currency gave rise to foreign exchange losses.

HMRC did not accept that the arrangements meant that foreign exchange losses arose for corporation tax purposes. It 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. The FTT dismissed HMRC's arguments on all these points.

The UT dismissed HMRC's appeal against the FTT's decision on all grounds, although on the 'fairly represents' ground it found for the taxpayer but it disagreed with the FTT's reasoning.

"The case is interesting as it is rare for the taxpayer to win on a 'fairly represents' argument," said Jake Landman, a tax disputes expert at Pinsent Masons, the law firm behind

Although the UT hearing was held before the Court of Appeal handed down its judgment in a case concerning energy company GDF Suez and the meaning of 'fairly represent', the judgment took into account the Court of Appeal decision.

In the GDF Suez case the Court of Appeal decided that an accounting mismatch which arose as part of a tax avoidance scheme did not 'fairly represent' a loss.

In the Smith & Nephew case, the judges said:  "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, we have concluded that the exchange losses in this case did fairly represent losses as required by the legislation".

Appeals are only allowed from the FTT to the UT on a point of law. There is no appeal on a pure question of fact which has been decided by the FTT, but case law provides that a finding of fact can be challenged if there is no evidence to support the finding or where the evidence contradicts the finding.

HMRC challenged the FTT's findings on the technical accounting expert evidence that the accounting treatment complied with UK GAAP. The UT found that, contrary to what HMRC argued,  the FTT's reasons for accepting the taxpayer's expert advice in preference to HMRC's were not based on inappropriate factors or evidence, or any misunderstanding of the issue.

“HMRC faced an uphill struggle on its first ground of appeal. It was not surprising that HMRC failed to persuade the UT that the FTT had made a serious error in dealing with the expert evidence or had failed to give proper reasons for its decision,” said Landman.

The UT also dismissed HMRC's arguments that the losses were not 'exchange losses' for the purpose of the legislation, because they were not 'real economic' losses. The judges said the wording of the definition was "clear and unambiguous".

"It is plain that the definition requires, and in our opinion only requires, a comparison to be made at two different times. Whether the product of that comparison is or is not a “purely arithmetical difference” is irrelevant to this question. If the comparison produces a loss (or gain), then it is an exchange loss (or gain), because it “arises as a result of” the comparison mandated by the statute," the judgment said.

“In dealing with HMRC’s second ground the UT endorsed the approach of the FTT which had looked at the meaning of exchange losses in the context of this specific statutory code, and identified that the meaning given in the loan relationships code was irrelevant to this interpretation,” Landman said.