Finance Bill 2002: EXPLANATORY NOTE
CLAUSE 69: FORWARD PREMIUMS AND DISCOUNTS UNDER CURRENCY CONTRACTS
SUMMARY
1. This clause amends the rules for recognising forward premiums and discounts on currency contracts under the financial instrument rules in Chapter 2 Part 4 Finance Act 1994. It stops attempts to exploit the old rules where a premium or discount recognised in the accounts of a company might be disregarded for the purposes of the Chapter.
2. The clause applies for accounting periods ending on or after 26th July 2001, the date it was announced. The rules are replaced with effect for periods beginning on or after 1 October 2002 by the derivative contracts rules in Schedule 26.
DETAILS OF THE CLAUSE
3. Subsection (1) substitutes new subsections (5) to (13) of section 153 Finance Act 1994 for the existing sections 153(4) and (5). Those two subsections purported to deal with cases where a premium or discount arose in relation to a currency contract, and made such premiums and discounts qualifying payments for the purposes of the financial instruments rules in FA 1994. It has become clear that they do not work in all cases, and have been exploited to create circumstances in which there appears to be a relievable premium but a non-taxable discount.
New section 153(5) now provides that any forward discount is a qualifying payment received by the company, and that any forward premium is a qualifying payment made by it.
New section 153(6)(a) addresses the situation where one of the currencies exchanged under a currency contract is the company's reporting currency in which case new subsections (7) to (9) apply.
New section 153(7) describes the case where a forward discount arises and new section 153(8) the case where a forward premium arises. In both cases they arise where there is a difference between the contract price of a currency contract and the spot price.
New section 153(9) gives definitions, for the purpose of subsections (7) and (8) of spot price and contract price, both for acquisitions and sales of currency.
New section 153(6)(b) together with new section 153(10) addresses the situation where neither of the two currencies involved in the currency contract is the company's reporting currency. In such a case, where generally accepted accounting practice requires the company to bring into its accounts amounts equivalent to a forward premium or discount section 153(10) ensures that any such credits in the accounts are treated for tax purposes as qualifying payments received, and any such debits in the accounts are treated as qualifying payments made.
New section 153(11) ensures that section 153(5) applies subject to new section 153(12). A company which marks to market a currency contract, or which accounts for the contract at forward rates or at the rate implied by the contract will not show any forward discount or premium in its accounts. New section 153(12) ensures that any difference between the spot price and the contract price, on acquisition or sale of the currency, is not treated as a forward discount or premium in such cases. New section 153(12)(a) provides for the mark to market case, where any such difference is included in the valuation of the contract, and new section 153(12)(b) deals with the cases where the contract is accounted for at forward rates, or the implied rate.
New section 153(13) defines ?the reporting currency? as sterling, except in cases where the company prepares accounts for all or part of its business in a foreign currency and section 93 FA 1993 applies. The reporting currency is then the foreign currency in which the company accounts.
4. Subsection (2) gives the commencement - this is for accounting periods ending on or after 26 July 2001, unless the company has ceased to be a party to the contract before that date.
BACKGROUND
5. A company may choose to account for a currency contract it holds in more than one way. One method recognised by generally accepted accounting practice (GAAP) gives rise to accounting entries described as forward premiums and discounts. This occurs whenever a company accounts for currency contracts using an exchange rate that differs from the spot rate for that currency at the time the contract is entered into.
6. Such a premium (loss) or discount (profit) is usually spread forward over the life of the currency contract. Section 153(4) and (5) of Finance Act 1994 are intended to treat all such premiums and discounts as payments and receipts within the financial instruments rules. The two subsections do not however operate directly by reference to the accounting entries in the company's books. Rather, they seek to describe the circumstances in which such a premium or discount will arise. Some companies have attempted to argue that although a premium or discount is recognised in the accounts it does not fall within the precise wording of the two subsections. Other companies have argued that a premium which is not obviously recognised in the accounts (because it has been set off against an equal and opposite discount) should be recognised as giving rise to a loss for the purposes of the financial instruments rules, while the discount is not brought into tax.
7. An example will illustrate how a forward premium or discount arises when a company accounts for a currency contract at spot rates.
8. Suppose that on 1 January in year 1 the company enters into a forward contract to acquire $100 for £55 in 2 years? time. Spot values of $100 are
| 1 January Year 1 | £52 |
| 31 December Year 1 | £60 |
| 31 December Year 2 | £75 |
9. On 31 December Year 2, the company pays £55 for $100 which, if bought in the spot market on that day, are worth £75. It has therefore made a profit of £20.
10. The ?acquisition contract price?, as defined by new section 153(9), is £55 - it is the amount which under the contract the company will pay for the $100. The ?acquisition spot price? - the value of the currency to be acquired, translated at the exchange rate prevailing when the company enters into the contract - is £52.
11. The acquisition contract price exceeds the acquisition spot price, so under new section 153(8)(a), a forward premium of £3 (£55 - £52) arises.
12. The company would, in accordance with generally accepted accounting practice, spread this forward premium over the period of the contract. It would therefore debit £1.50 to profit and loss account in each of the two years. Its accounts would show
| Year 1: | Exchange gain: £60 - £52 = | £8 |
| Less forward premium = | (£1.50) | |
| Net credit to profit and loss = | £6.50 | |
| Year 2: | Exchange gain: £75 - £60 = | £15 |
| Less forward premium = | (£1.50) |
|
| Net credit to profit and loss = | £13.50 |
13. Thus the overall profit of £20 is recognised.
14. An overall profit of £20 will also be recognised for tax purposes. For accounting periods beginning before 1 October 2002, the exchange gains will be recognised under the FA 1993 forex legislation, and the forward premium will be relieved by virtue of section 153(5)(b) FA 1994.
15. In many cases, companies will not account for a currency contract at spot rates in this way. For example, Standard Statement of Accounting Practice 20 (SSAP 20) allows the use of the rate implied in a contract to value a trading transaction related to that forward contract. Suppose in the above example that the company had borrowings of $100 which it repaid on 31 December Year 2. Following SSAP 20, it could book the borrowing at the contract rate of £55 throughout. The currency contract would not be specifically recognised in the accounts. On repayment of the debt, the necessary dollars cost the company £55. No profit or loss on either the currency contract or the related borrowing appears in the accounts. Section 153(12)(b) ensures that in this case the company cannot claim relief for any forward premium.
16. The new rules ensure that where a premium or discount is, or should be, recognised in accounts in accordance with GAAP then it will also be taken into account for tax under the financial instruments legislation as amended. This means that the new rules will not require recognition of a premium or discount on a contract where the method of accounting for the contract, applied in accordance with GAAP, does not require it.
17. The new rules take effect for accounting periods ending on or after 26 July 2001, the date they were announced.