Can you still account in foreign currency?

This is one of the most important issues currently confronting clients and colleagues.

(1) Why you might want to do it

(a)  The problem

This is best illustrated by a simple example.

Probably the most common situation once a group expands overseas is to have a wholly owned foreign subsidiary to which you have made a loan.  The reasons for lending money to the subsidiary rather than contributing additional equity include:

• Repaying the loan if the subsidiary builds up some cash is much simpler than trying to repay equity capital.
• The interest deduction will be at the local corporate tax rate (here Eurocountry) which may be higher than the UK tax rate at which the interest is charged.

The key question is what currency do you use to denominate the loan?  If the loan is denominated in sterling, the Eurocountry subsidiary faces the risk of extra taxable income if the euro strengthens against sterling, since it must prepare its Eurocountry accounts and tax returns in euro.  This represents a wholly unwanted increase in the group’s tax liabilities, since there is no economic gain to the group from this foreign exchange (FX) movement.  (You cannot make an FX gain on money that you effectively owe yourself!)

Of course, if the euro weakens against sterling, the Eurocountry subsidiary would have a welcome tax deduction from the FX loss.  However, you cannot tell in advance which will occur.

The same issues arise if the UK parent lends to the subsidiary in euro, since the parent will be accounting in sterling.

(b) The solution

The simple solution is for the UK parent to setup an equity capitalised UK subsidiary to make the loan.

The UK subsidiary, “UK Finco” issues euro denominated share capital to UK Parent, and then lends the euro it receives to the Eurocountry subsidiary as a euro denominated loan.  Having euro share capital and a euro loan asset, UK Finco makes the natural decision to prepare its accounts in euro.  Preparing accounts in euro, UK Finco never has exchange gains or losses on its euro loan asset, regardless of how the sterling/euro exchange rate moves.  Similarly, the Eurocountry subsidiary also faces no FX differences on its euro loan liability since it too is accounting in euro.

UK parent would normally carry its equity investment in UK Finco at a fixed sterling number, being set by the exchange rate on the day it invested in the euro denominated share capital of UK Finco.  However, even if UK Parent chooses to revalue its equity investment in UK Finco as exchange rates move, such FX differences from revaluating an equity investment are not taxable until UK Parent actually disposes of the UK Finco shares.

Of course, this solution only works if the euro accounting (where applicable) of UK Finco is respected for tax purposes, i.e. if UK Finco can use the euro accounting numbers when preparing its UK corporation tax return.  Prior to FA 2000, this would not have been possible, as UK tax law requires tax returns to be prepared in sterling.  The only exception was for trading companies which satisfied the requirements for making a “local currency” election under FA 1993 s 92-94 and SI 1994/3230, and which made such an election.  They were able to prepare their accounts in the local (i.e. foreign) currency and base their tax return on that local currency accounting profit.

However, a company like UK Finco would not be a trading company, and would be unable to make a local currency election.

FA 2000 s105 revised FA 1993 s93 to permit any company that accounted in foreign currency in accordance with generally accepted accounting practice to base its tax return on those accounts.  The crucial point was that the foreign currency accounting rules were no longer limited to trading companies.  Accordingly, a company such as UK Finco above could account in euro and therefore avoid the risk of taxable FX differences.

(2) Recent Accounting Developments

Under International Financial Reporting Standards (IFRS), foreign currency is dealt with by International Accounting Standard (IAS) 21 “The effects of changes in Foreign Exchange Rates”.  Under the UK Accounting Standards Board’s programme for convergence with IFRS, the UK Standard FRS 23 mirrors IAS 21, so closely indeed that it has the identical title “The Effects of Changes in Foreign Exchange Rates”.  There are two key concepts to understand:

(a) Presentation Currency

This is the currency that the financial statements are actually printed in, e.g. if a set of accounts for a UK company is in sterling, then obviously the presentation currency is sterling.  To change the presentation currency into dollars, all that one needs to do is multiply every balance sheet figure in the accounts by the spot sterling/dollar exchange rate (1.7529 at close of business on 1 March 2006) and the income statement figures by the average rate and put a “$” sign in front of the figures.

Under IAS 21, a company is free to select any presentation currency that it wants, subject of course to any local legal constraints or shareholder objections.

(b) Functional Currency

The functional currency is the currency of the primary economic environment in which the company operates.  This is a question of fact, to be determined by looking at what the company itself does and, if it is part of a group, the role that it plays in the group.  IAS 21 contains a set of rules for determining the functional currency, in paragraph 9-13 reproduced below:

9. The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining its functional currency:

(a) the currency:

(i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and

(ii) of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services.

(b) the currency that mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled).

10. The following factors may also provide evidence of an entity's functional currency:

(a) the currency in which funds from financing activities (i.e. issuing debt and equity instruments) are generated.

(b) the currency in which receipts from operating activities are usually retained.

11. The following additional factors are considered in determining the functional currency of a foreign operation, and whether its functional currency is the same as that of the reporting entity (the reporting entity, in this context, being the entity that has the foreign operation as its subsidiary, branch, associate or joint venture):

(a) whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy. An example of the former is when the foreign operation only sells goods imported from the reporting entity and remits the proceeds to it. An example of the latter is when the operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all substantially in its local currency.

(b) whether transactions with the reporting entity are a high or a low proportion of the foreign operation's activities.

(c) whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it.

(d) whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity.

12. When the above indicators are mixed and the functional currency is not obvious, management uses its judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions. As part of this approach, management gives priority to the primary indicators in paragraph 9 before considering the indicators in paragraphs 10 and 11, which are designed to provide additional supporting evidence to determine an entity's functional currency.

13. An entity's functional currency reflects the underlying transactions, events and conditions that are relevant to it. Accordingly, once determined, the functional currency is not changed unless there is a change in those underlying transactions, events and conditions.

(3) Implications of the new accounting approach

The functional currency of any real company can only be determined from its actual facts and circumstances.  However, it is likely that most accountants would look at UK Finco above, and conclude that it was acting non autonomously and was merely a conduit for UK Parent to lend to Eurocountry subsidiary.  From this, they would most likely conclude that the functional currency of UK Finco was sterling.

This means that for each accounting year, UK Finco needs to consider the sterling equivalent of its euro loan to Eurocountry subsidiary at the start and end of the year.  Any difference between those sterling amounts gives rise to an exchange gain or loss.  As the accounts are still to be presented in euro, the sterling figure for the exchange gain or loss is simply multiplied by the average/appropriate exchange rate to arrive at a euro number to present in the euro profit and loss account.

The key point is that, despite all of its assets and liabilities being denominated in euro, UK Finco will have FX differences to report since its functional currency is sterling.  These FX differences are then converted to euro numbers for presentation purposes.

(4) Corresponding tax law changes

To keep tax law responsive to the accounting standards, FA 2004 s52 and Sch 10 para 77 revised FA 1993 by replacing the former sections 92-94AB with new sections 92-92E.  They apply for periods of account beginning on or after 1 January 2005.  Although they look confusing these sections actually contain some very clear rules.

(a) If a company’s functional currency is sterling, and its presentation currency is sterling, then the tax return is based on those figures.

(b) If a company’s functional currency is sterling, and it uses a foreign presentation currency, then its tax return must be computed as if the company had prepared its accounts in sterling.  In practice this need not entail much extra work.  If the foreign presentation currency figures have been properly computed, you may need to do little more than reverse the currency conversion that was used to convert the sterling functional currency figures into the foreign presentation currency.

(c) If a company prepares its accounts in a foreign currency, and neither rule (b) nor rule (d) applies then the accounts figures are used as the basis for its tax return.  Of course the foreign currency amounts need to be converted into sterling using either the average exchange rate for the period or the spot exchange rate, as appropriate.  Implicit in this rule is the assumption that the accounts have been properly prepared in accordance with generally accepted accounting practice, which tax law elsewhere defines as being IFRS or UK GAAP.

(d) If a company has a foreign functional currency (currency A), but presents its accounts in another currency (currency B, irrespective of whether currency B is sterling or foreign) then its tax return must be computed as if it had prepared its accounts in currency A.  Of course the currency A numbers must then be converted into sterling to put on the tax return.

The overall consequence for UK Finco is that if it prepares its accounts under IFRS with IAS 21 or under “new” UK GAAP using FRS 23, then it will identify sterling as its functional currency and produce accounts in euro presentation currency with FX differences that will be taxable, applying rule (b) above.

For the moment, if UK Finco can prepare its accounts under “old” UK GAAP with SSAP 20, then it can continue to prepare its accounts in euro without FX differences.  Under SSAP 20 most accountants would consider that the “local currency” (as defined in the standard) of UK Finco would be euro, so no FX differences could arise on a euro loan. 

In passing, some accountants have argued that the rules for determining functional currency contained in FRS 23/IAS 21 should be applied for determining local currency under SSAP 20, but I consider that to be illogical as they are different definitions albeit using similar language.  However, when UK Finco has to account under FRS 23 once its use by all UK companies becomes mandatory (subject to the ASB’s convergence plans), it will have to determine its functional currency, and as mentioned above is likely to determine it as being sterling.

Using a non-UK registered company for UK Finco might be contemplated, if it was incorporated in a jurisdiction that did not require it to account under IFRS or UK GAAP.  However, this will not succeed.  Due to the combined effects of FA 1993 s.92C(3) and FA 1996 s.85A, the profits and losses on the loan must be computed in accordance with generally accepted accounting practice, which FA 2004 s.50 stipulates to be UK GAAP or IFRS.

(5) What next?

This problem, namely that IFRS and new UK GAAP make it much more difficult to account in foreign currency in straightforward situations, has been raised by our firm with HM Revenue & Customs.  As the mandatory implementation of FRS 23 is still some months away, only a limited amount of attention has so far been given to this problem.  However, the problem will become urgent if the ASB adheres to the original deadline of FRS 23 being mandatory for all UK companies for accounting periods commencing on or after 1 January 2007.

Mohammed Amin

Comments

[Nik Hanes 7 Jul 2006 16:40:35]

Regarding your para 3.

Does your comment take into account BC9 where para 9 are the primary indicators and 10 and 11 are only secondary. As the interest flows in UK Finco are EUR denominated, a para 9 item.

The secondary considerations are para 10 will imply EUR and para 11 relates to foreign operations, when UK Finco is not the foreign operation but the reporting entity. UK Finco can count as a foreign operation per definition of a foreign operation (para 8), but para 11 has defined the UK Finco as the reporting entity for para 11.

The tax implications aren't an area I'm familiar with, but presumably the continuation of the old functional currency for UK Finco results in no new tax issue.

Nik