The tax treatment of many aspects of the loan relationship and derivative contract legislation has many areas of uncertainty at the moment.Not only are we waiting for final regulations from the UK Inland Revenue, but we cannot reasonably expect such regulations to be finalised until the accounting standards on which they rely have stopped moving.
International Financial Reporting Standards (IFRS) have been adopted by the EU with the exception of International Accounting Standards (IAS) 32 and 39 which,broadly,deal with derivative contracts and related matters. The original intention was that all IAS which were finalised by 31 March 2004 would be adopted and become mandatory for the consolidated accounts of listed companies throughout the EU for accounting periods beginning on or after 1 January 2005. However, IAS 32 and 39 have been subject to subsequent revision and indeed a further amendment to IAS 39 is expected in the next few weeks.
Thus,the European Commission is considering either not adopting IAS 32 or 39 in their entirety, or possibly adopting them with deletions to cover the areas of disagreement which remain. Some Member States, including the UK, seem to believe that either of these courses will give a completely unacceptable result and lead to the adoption of an incomplete set of standards which will not give a consistent picture of the financial affairs of reporting entities.The UK Accounting Standards Board in particular has been urging the Commission to adopt all IAS in full, notwithstanding that IAS 39 is unlikely to reach its final state before October 2004.
In the meantime,the UK Accounting Standards Board has been looking to ‘plug the gap’ which may be present in IFRS by an early adoption of FREDs 30 and 33,which cover the same ground as IAS 32 and 39. A further meeting of the UK body was due to be held in September at which final revisions to these exposure drafts may be made, with a view to their being adopted as standards with effect from accounting periods beginning on or after 1 January 2005.The UK standards will be mandatory for not just the consolidated accounts of listed companies but the entity accounts of the parent company as well.
Thus,the issues that we face now are:
- We do not know what the accounting standard for derivative contracts will be next year;
- We do not know if it will be IFRS and applicable just to the consolidated accounts of listed companies or new UK GAAP, applicable to the consolidated and entity accounts of listed companies;
- We do not know what the tax treatment will be if the accounting standards change;
- We do not know if the existing legislation which supposes that companies will change to the whole of IFRS in one go will be modified if IFRS excludes IAS 32 and 39.
The users of financial instruments are thus crying out for the accounting standards setters and European Commission to deal with the accounting treatment as quickly as possible and then will,of course, be looking for a fast reaction from the UK Inland Revenue. The UK Inland Revenue, for its part, has been maintaining a dialogue with the professional firms and representative bodies; has made a number of amendments to the legislation by Finance Act 2004 to deal with the introduction of IFRS; and has produced a set of draft regulations which are available on the web site for consultation purposes. However, there are still many areas where no draft provisions have been published any many others where changes may be required following further amendments (or lack of them) to the accountings standards.
Which LR and DC amounts are taxable?
FA 2004 introduced new s85A FA 1996 and new para.17A Sch.26 FA 2002,which both require amounts taxable under the revised loan relationship (LR) and derivative contract (DC) tax regimes to be those that:
- in accordance with generally accepted accounting practice,are
- amounts recognised in determining the company’s profit or loss for the period.
The two legs of these new requirements are explored further below.
Generally accepted accounting practice is defined in s50 FA 2004;it permits UK GAAP and GAAP based on international accounting standards (IAS). IAS-based GAAP is defined as including only those international standards adopted by the EU, but if a particular international standard has not been adopted, accounts prepared using either the unadopted standard or the equivalent under UK GAAP will be regarded as having been prepared in accordance with IAS-based GAAP.
This means that for accounting periods beginning on or after 1 January 2005,the company’s accounts must be in accordance with either EU adopted IFRS or UK GAAP if they are to form the basis for tax computations under the revised LR and DC tax regimes.
Should the EU not adopt IAS 39,accounts prepared under IFRS will be acceptable whether financial instruments are accounted for under IAS 39 or UK GAAP.It is not entirely clear what the position will be if it is confirmed that the EU has opted for partial adoption of IAS 39.
The ‘tax based on GAAP accounts’ test for LRs in s85A FA 1996 and DCs in para 17A Sch 26,are both subject to the over-riding requirement in s84(1) and para 15(1) respectively that the credits and debits to be brought into account shall be sums which when taken together,fairly represent for the accounting period in question all profits, gains, losses, interest, charges and expenses from its LRs and DCs (and related transactions).
As there is an explicit starting point that tax must be based on GAAP accounts, the previously prescriptive definitions of authorised accounting methods (i.e. ‘accruals’ and ‘mark to market’ based accounting) contained in s85 FA 1996 are no longer required,and so have been abolished.
To the extent that the tax legislation requires the accounting bases of ‘amortised cost’ and ‘fair value’ accounting to be defined (e.g. in the case of connected party transactions),these terms are defined in the LR definitions section (s103 FA 1996). In all material respects, the statutorily defined accounting bases of amortised cost and fair value equate to the similarly named IFRS concepts and to the accruals and mark to market bases hitherto used by the LR and DC legislation.
The expression ‘amounts recognised in determining a company’s profit or loss for the period’ is defined in both s85B and para 17B Sch 26 as amounts recognised for accounting purposes in:
- the company’s P&L;
- the company’s STRGL or statement of changes in equity;or
- any other statement of items brought into account in computing the company’s profits and losses for the period.
This approach, even more strongly than before, binds the tax position to the position adopted for accounting.
The taxable amounts are restricted by s84(A)(3) and para 16(3) Sch 26.These explicitly exclude from tax exchange gains and losses arising from LRs and DCs that are recognised in a company’s STRGL or statement of changes in equity.This generic exclusion will, in particular, maintain the existing concept of ‘mandatory matching’ for certain foreign currency hedging transactions under UK GAAP where fair value accounting has not been used.
At entity level,IFRS will not allow any exchange gains or losses in respect of LRs that form part of an entity’s net investment in foreign operations to be posted to equity. Exchange gains and losses in respect of DCs and LRs (subject to the point made in the next paragraph) will only be posted to equity in respect of cash flow hedges.
It is unclear whether the element of a fair value movement on a LR or DC that is attributable to a movement in exchange rates represents an ‘exchange gain or loss’ as defined in s103(1A) FA 1996 and para 54(2) Sch 26 FA 20.
At present,the Inland Revenue is maintaining that it does on the basis that a foreign exchange gain or loss as defined would arise if a comparison as envisaged by the legislation were to be made,a rather unusual (and unsatisfactory) approach to applying statute.
Tax relief for bad debts
The existing tax regime for bad debts in paras.5 to 6C Sch.9 FA 1996 has been preserved (including the connected party restriction and permitted relaxations), but its terminology has been amended to:
- accommodate the new IFRS concept of ‘impairment loss’ (defined in s103 FA 1996);and
- reflect the fact that the new basis of taxation is to follow accounts based on GAAP rather than applying an ‘authorised accounting method’.
The tests for obtaining bad debt relief for un-connected party debt in s74(j) ICTA 1988 have effectively been replaced by the equivalent IFRS tests for companies that adopt IFRS accounting.The position is less clear (and potentially ‘softer’) for companies that adopt UK GAAP accounting which seek a deduction for an impairment loss on debtor balances.
Connected party transactions
New s.87(2) FA 1996 requires the taxable amounts on LRs between connected parties to be calculated according to an amortised cost basis of accounting.
When a LR moves into or out of the connected party test, and so potentially switches its basis of accounting to or from amortised cost, the new s87(2B) and (2C) FA 1996 prescribe how movements in the accounts carrying value of the LR should be taxed or relieved.
The legislative requirement that all amounts due under a LR must be assumed to be paid when they fall due has caused problems in the arena of connected party loans,where departure from this assumption was not (at least before the relieving provisions) allowed.In the move to reliance on GAAP this requirement has been abolished.Instead,there is a clear statement that a connected party impairment loss may not be recognised except in prescribed circumstances.
Where a debt of damaged creditworthiness is bought in,the GAAP (IFRS and UK) approach would be not to accrue any further value in respect of that debt rather than to accrue value and then provide for an impairment loss. It appears therefore that there is less risk of the acquisition of connected credit worthiness impaired debt leading to the accrual of fictitious income.
Anti-avoidance legislation in s51 FA 2004 is designed to prevent groups obtaining any tax advantage that would otherwise arise if one leg of an intra-group transaction was accounted for under UK GAAP and the other leg was accounted for under IFRS. If s51 applies, both legs will be deemed to be accounted for under UK GAAP.
Debt for equity swaps
The previous exclusion from tax for amounts required to be transferred to share premium account in respect of LRs and DCs (s84(2)(a) FA 1996 and para 15(2) Sch 26) is abolished for accounting periods beginning on or after 1 January 2005. This may be a particular concern in commercially motivated debt for equity swaps where the excess of the face value of the debt over the nominal value of new shares issued is credited to share premium account.
The transition from UK GAAP to IFRS
The following paragraphs represent a summary of the taxation position on a transition to IFRS.A company specific review of a potential transition will require detailed accounting input to assess the full extent of the changes to the carrying values of assets and liabilities – and hence the tax treatment of those changes. For LR, new para.19A Sch.9 FA 1996 brings into charge to tax the difference between the closing accounts carrying value of a LR asset or liability in one accounting period,and the opening carrying value of the same LR in the subsequent accounting period,in circumstances where the company has changed from one acceptable accounting basis to another in successive accounting periods e.g. a move from UK GAAP to IFRS,from IFRS to UK GAAP or a change of accounting policy brought about by changes to UK GAAP (e.g. following the implementation of FRED 30 – see paragraph 2 of Section 1 above).
The difference in value is taxable or deductible as appropriate in the later accounting period.
The equivalent provision for DC (para.50A Sch.26 FA 2002) works in the same way, except that it only applies for a change from UK GAAP to IFRS i.e.not vice versa, and not to any other change between acceptable accounting bases.
This means that differences in the carrying value of a DC that may arise if a company moves from existing UK GAAP to UK GAAP as amended for the provisions of FRED 30,would not appear to be taxed or relieved.
It is understood that the Revenue are considering introducing a spreading provision for the taxable amounts that will otherwise arise under para 19A Sch 11 and para 50A Sch 26 (for both debit and credit amounts), but to date no draft Regulations have been released.
The latest draft of the Disregard and Bringing into Account Regulations reflect the Revenue’s intention that where debits and credits arising on a DC in an accounting period beginning on or after 1 January 2005 are excluded from immediate charge to tax by the Disregard regulations, a transitional adjustment under the taxable ‘change of accounting basis’ tax provisions of para 50A Sch 26 FA 2002 will be similarly disregarded.
An example would be the change in carrying value of a DC acting as a cashflow hedge when a company moves to IFRS (such movements are excluded from tax by draft Regulation 10).
Certain profits or losses associated with DCs that have been closed are spread forward under UK GAAP. There is an associated balance sheet item being deferred income or expense. Paragraph 53 Schedule 26 brings the spread debits and credits into tax under the derivatives regime notwithstanding the absence of a DC.
If these deferred items have their carrying value adjusted that adjustment is not to the carrying value of a DC,as specified in paragraph 50A Sch 26.
The wording of para 53, the phrase ‘debits and credits….. shall continue to be brought into account….. as in the case of a derivative contract to which the company is party’ is clear in its intent and the legislation requires the taxation or relief of such adjustments.
For LRs, adjustments to associated deferred income and expenditure items (not rolled into loan carrying value) do not appear to be relieved.The adjustments do not represent a change in the accounting value of “an asset or liability representing a loan relationship” as specified in paragraph 19A FA1996.There is no explicit override of FA 1996 in Sch.22 FA 2002 and so SBO(5) prevents an adjustment under that legislation (which would,in any event,have only applied to trading items).
Transitional treatment for qualifying convertibles, asset linked securities and index-linked gilts.
With the abolition of s92 and s93 FA 1996, instruments previously recognised within these provisions (convertibles and asset-linked securities) will be subject to a deemed chargeable gains disposal and re-acquisition at market value at the end of the last accounting period beginning before 1 January 2005 (FA 2004 Sch 10 paras 9 and 11 respectively) – which gain or loss is held over in accordance with the provisions of the former s92(8) to (11) FA 1996.
The tax exemption for movements in the value of indexed-linked gilts previously in s94 FA 1996 has been preserved within the new chargeable gains regime introduced for certain embedded derivatives.
N.B.The simple analysis above must only be taken as a general overview. In specific cases, conclusions can only be reached by examining the individual adjustments (or groups of identical adjustments), the specific legislative provisions and considering the impact of the Disregard regulations.
The taxation treatment on the transition to IFRS for other types of instrument is not considered in this short article.
Other difficult areas
The list of difficulties is extensive,but some of the key ones are:
- matching of assets and liabilities for groups under IFRS seems to be limited to shares on the asset side and does not include net investment in branches, nor ships nor aircraft;
- The implication of the draft regulations is that matching can function on a group basis,(or at least with the liability further up a direct chain of ownership) rather than just on a single entity basis;
- The draft regulations imply that matching in future will have the exchange gains and losses on the liability disregarded in the entity subject to the liability and thus potentially brought into account when the company ceases to be subject to that liability,but the bringing into account regulations are largely missing;
- There is different tax treatment for loan relationships and derivative contracts used for hedging foreign investment;
- The tax legislation appears to require the use of functional currencies for the preparation of tax returns, giving problems for UK tax resident companies making up their accounts in non-Sterling currencies and the UK subsidiaries of European Groups which may have the Euro as their functional currency and Sterling as their presentation currency;
- Does the tax definition of fair value necessarily always equate to the accounting definition?
In summary, there remain more questions than answers, but it is essential that a full set of answers is available well before 31 December 2004.
Author Note: Derek Jenkins is a tax partner in PricewaterhouseCoopers and joint author (with David Southern) of “Tolley’s Taxation of Corporate Debt,Foreign Exchange and Derivative Contracts”.