The Commissioners for HMRC v Smith & Nephew Overseas Ltd & Ors

The loan relationships regime does not permit an undefined requirement of a real-world or genuine economic loss to be added to the statutory treatment of exchange losses. Where the debit fairly represents the exchange loss arising from the loan relationship, and the calculation complies with GAAP, no further economic inquiry is required. Tax avoidance, counterparty asymmetry and manifest absurdity are not universal preconditions for applying the fairly represent requirement in the Finance Act 1996. The leading judgment also held that regulation 13(3) directly mandates inclusion of qualifying STRGL-recognised exchange losses on disposal, although that issue was not necessary to the unanimous dismissal of the appeal.

HMRC appealed against the Upper Tribunal’s decision, reported at [2018] UKUT 0393 (TCC) and [2019] STC 116, which had dismissed HMRC’s appeal from the First-tier Tribunal’s decision at [2017] UKFTT 151 (TC) and [2017] SFTD 678.

The respondents claimed corporation-tax relief for exchange losses arising when their functional currency changed from sterling to US dollars. It was accepted before the Court of Appeal that the accounts complied with GAAP, the amounts were exchange losses under section 103(1A) of the Finance Act 1996, and the losses were recognised in the statement of total recognised gains and losses. The central questions were whether regulation 13 of the Exchange Gains and Losses (Bringing into Account Gains or Losses) Regulations 2002 bypassed the fairly represent requirement, and whether that requirement demanded a real-world economic loss.

Appeal dismissed unanimously. The court held that the respondents’ debits were to be brought into account for corporation-tax purposes.

1. Exchange losses and fair representation. Rose LJ held, and the Chancellor independently agreed, that section 84A(1) expands the reference in section 84(1)(a) to profits, gains and losses so as to include exchange gains and losses. In this context the relevant question is whether the debits fairly represent the exchange losses arising from the companies’ loan relationships. Once GAAP compliance and the identity between the debits and the accepted exchange losses were common ground, the debits satisfied that inquiry.
2. No real-world overlay. Section 103(1A) defines an exchange loss by an arithmetical comparison, at different times, of the currency expression of an asset or liability. The relevant dates are determined by GAAP. The statute does not require proof of a separately realised, genuine or economic loss. The respondents’ hedging arrangements related to a different period, and the intra-group nature of the loans did not exclude them from the regime.
3. Scope of the fairly represent requirement. The court accepted the guidance in GDF Suez that fair representation is separate from GAAP and can override accounting treatment. Its application is not confined to tax-avoidance cases, does not require counterparty asymmetry, and is not subject to a threshold of manifest absurdity. Those observations were alternative guidance because the exchange-loss analysis was determinative.
4. Regulation 13. Rose LJ, with Coulson LJ agreeing, held that regulation 13(3) itself requires the aggregate net gain or loss calculated under regulation 13(4) to be brought into account as a debit or credit in the disposal period. On that view, the regulation directly brings the amount into Chapter 2 without a further section 84 fair-representation test. Vos C of H considered the point unresolved and declined to decide it, since the appeal was already determined under section 84(1)(a).

• Court of Appeal (Civil Division) dismissed HMRC’s appeal and upheld the respondents’ entitlement to bring the relevant debits into account.
• Upper Tribunal (Tax and Chancery Chamber) dismissed HMRC’s appeal from the First-tier Tribunal: [2018] UKUT 0393 (TCC); [2019] STC 116.
• First-tier Tribunal held that the accounts were GAAP-compliant, the amounts were exchange losses, and the losses fairly represented losses for the purposes of the loan relationships regime: [2017] UKFTT 151 (TC); [2017] SFTD 678.