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The Foreign Currency Clause Trap

07 November 2001 / David Hughes 2
Issue: 3832 / Categories:

DAVID HUGHES BBS (TCD), ACA, AITI, FTII explains how a foreign currency clause could inadvertently turn a loan note into a qualifying corporate bond.

DAVID HUGHES BBS (TCD), ACA, AITI, FTII explains how a foreign currency clause could inadvertently turn a loan note into a qualifying corporate bond.

A DRAFT FOREIGN currency clause was set out in my article 'Qualifying or Not?' (Taxation, 23 August 2001 at page 530), and I explained in outline how such a clause may achieve non qualifying corporate bond status. This short follow up article considers a possible further issue that may affect the percentage chosen to incorporate into the capping provisions of such foreign currency clause. The issue simply stated is whether one should limit the cap by reference to paragraphs 3(3) and (4) of Schedule 13 to the Finance Act 1996 (set out below) so as to avoid falling within section 117(2AA), Taxation of Chargeable Gains Act 1992 which deems relevant discounted securities to be qualifying corporate bonds.

The capping provision is meant to limit the exposure to exchange rate fluctuations inherent in the right to obtain repayment of the loan note in a foreign currency. The draft clause appearing in my earlier article permitted a variation in the sterling equivalent of the redemption monies (paid in dollars) up to a maximum of 0.8 per cent upwards or downwards.


Definition of relevant discounted security


Paragraph 3(1) of Schedule 13 to the Finance Act 1996 sets out the meaning of relevant discounted security as:

'Subject to the following provisions of this paragraph and paragraph 14(1) below … any security which (whenever issued) is such that, taking the security as at the time of its issue, the amount payable on redemption –

(a) on maturity, or

(b) in the case of a security of which there may be a redemption before maturity, on at least one of the occasions on which it may be redeemed,

is or would be an amount involving a deep gain, or might be an amount which would involve a deep gain.'

Subparagraph (2) then enumerates items which are not relevant discounted securities. Subparagraph (3) provides:

'For the purposes of this Schedule the amount payable on redemption of a security involves a deep gain if –

(a) the issue price is less than the amount so payable; and

(b) the amount by which it is less represents more than the relevant percentage of the amount so payable.'

Subparagraph (4) states:

'In this paragraph "the relevant percentage", in relation to the amount payable on redemption of a security, means –

(a) the percentage figure equal, in a case where the period between the date of issue and the date of redemption is less than thirty years, to one half of the number of years between those dates; and

(b) in any other case, 15 per cent;

and for the purposes of this paragraph the fraction of a year to be used for the purposes of paragraph (a) above in a case where the period mentioned in that paragraph is not a number of complete years shall be calculated by treating each complete month, and any remaining part of a month, in that period as one twelfth of a year.'

In practical terms, these provisions work as set out in Examples 1 and 2.

Example 1

Rapids plc issues to Mr Klein a loan note redeemable in 12 months time. The maximum deep gain that may attach to the security, if the security is not to fall to be treated as a relevant discounted security is 0.5 per cent.


Example 2

Palm Ltd issues a loan note redeemable in nine months. The maximum deep gain that may attach to the loan note if it is not to constitute a relevant discounted security is 0.375 per cent, i.e. (0.5 per cent x 9/12).

It is important to note that paragraph 3(1) does not require that the amount payable on redemption involves a deep gain; it merely requires that it might.

In order to determine 'the relevant percentage', it is necessary to determine the security's date of redemption. The basic provision is that the life of the security is determined by reference to the first occasion on which the holder can require it to be redeemed (see Example 3).

Example 3

Wend plc issues on 1 September 2001 £100,000 6 per cent loan notes 2004. The terms of the note provide for redemption after:

    • 12 months at the option of the company;
    • 18 months at the option of the note holder;
    • 36 months (maturity).

For the purposes of determining the relevant percentage, the period to redemption is deemed to be 18 months (the security will be a relevant discounted security if a deep gain may arise either at 18 months or 36 months).


The foreign currency clause effect


It is the author's view that the matter is not free from doubt as to whether a foreign currency clause may inadvertently cause a loan note to constitute a relevant discounted security within the meaning of paragraph 3(1) of Schedule 13.

The Revenue has expressed the view in correspondence that the redemption of the note in a foreign currency would not of itself trigger a deep gain provided that the loan is not treated as extinguished by redemption, but rather by conversion into property, being in these circumstances a foreign currency holding. This is because the meaning of the word redemption has not been extended beyond its normal meaning, other than in the special case of conversion into shares or securities (paragraph 5 of Schedule 13 to the Finance Act 1996.) Thus conversions into other types of property would not constitute redemption and therefore would fall outside the scope of Schedule 13.

There are further arguments that may be made as to why a foreign currency clause should not of itself cause a loan note to fall to be treated as a relevant discounted security. Certain of these are set out in outline below.


Economic substance


From an economic perspective the foreign currency clause described in my earlier article has the following characteristics:

  • it offers the loan note holder the option to receive foreign currency rather than sterling at the redemption date;
  • the quantum of foreign currency received being subject to the risk of a positive or negative exchange rate movement in a thirty day period;
  • the exchange exposure being capped by reference to the mechanism described above.

These features seem to me to be so far removed from a return on money lent that to apply Schedule 13 to the Finance Act 1996 would be contrary to the intention of that legislation.

The point is succinctly put by Sue Davies, technical adviser, Inland Revenue who says that her 'personal view favours the second of the two possibilities, i.e. that the security would not be a relevant discounted security. The purpose of Schedule 13 is to ensure that if a person, chargeable to income tax, receives a return on lending which is functionally equivalent to interest, that return can be taxed as income. In your example, however, the foreign currency clause is not there primarily to provide an income-like return to the investor (indeed, from your Taxation article, its prime purpose is to ensure that the security is not a qualifying corporate bond). The loan note holder is afforded an incidental opportunity to profit from exchange rate movements in the 30 days prior to the note maturing: such a profit strikes me as having the character of a capital gain'. It must be said, however, that this was not given as a definitive view of the Revenue and Sue Davies regards the matter as not being free from doubt.


A narrow interpretation?


There is some doubt in the author's mind as to whether in the absence of an extension of the meaning of the words 'might be an amount which would involve a deep gain' would encompass situations where a contingent gain or loss 'might' only arise if the note holder exercised an option.

Although, if given a broad interpretation, 'might' would be deemed to include gains contingent on the exercise of an option, a narrow interpretation may perhaps be to exclude contingent gains that require the exercise of an option before the contingency may affect the loan note. That there are arguments that the latter interpretation should prevail may be inferred by paragraph 3(1), which requires the matter to be determined by 'taking the security as at the time of its issue'. It would be posited that the security at the time of issue may not produce a deep gain. A gain (or loss) may only arise on the exercise of an option towards the very end of the securities life.


A certain risk


In conclusion, there is certainly risk that foreign currency clauses could, unless suitably capped cause a loan note to fall to be treated as a relevant discounted security and hence a qualifying corporate bond by virtue of section 117(2AA). In all cases therefore a suitable cap not exceeding 0.5 per cent per annum should be inserted, to remove the risk. (Taxpayers should also consider including a fall back provision, e.g. an option to subscribe for additional securities.) It is, however, the author's view that for the reasons stated above the point is not free from doubt. It is hoped that taxpayers will find the response received from the Revenue, although caveated, to be of interest.

David Hughes is a senior tax manager with Levy Gee, part of the Numerica Group, and he can be contacted on 020 7467 4229. The views expressed in this article are those of the author and not necessarily those of Levy Gee.

Issue: 3832 / Categories:
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