MTT21170 | Calculating the effective tax rate: Adjusted profits: Asymmetric foreign currency gain or loss

Adjustments to the underlying profits may be required where a member’s accounting functional currency and local tax currency are different, for example if a UK company makes an election to change their functional currency.

Where a gain or loss arises from fluctuations in the exchange rate between those currencies, or between either of those currencies and a third currency, and that gain or loss is not reflected to the same extent in the underlying profits and taxable income, an adjustment will be required.

This adjustment is set out in section 144 of Finance (No.2) Act 2023.

Meaning of ‘accounting currency’, ‘tax currency’, and ‘third currency’

The accounting currency is the currency of the main economic environment in which a member operates. This may be referred to as the "functional currency" in accounting terminology.

The tax currency is the currency in which the profits of a member are determined for the purposes of determining its liability to covered taxes in the territory where it is located.

A third currency is a currency which is neither the accounting nor the tax currency of the member.

Fluctuation between accounting currency and tax currency

Where a member has a gain or loss because of fluctuations in the exchange rate between the accounting and tax currencies, and that gain or loss is reflected differently in the underlying profits and its taxable income (including where it is not reflected at all in one of these), the gain or loss is to be reflected in the member’s adjusted profits on the same basis as it is reflected in the taxable income.

Fluctuation between accounting currency and a third currency

Where a gain or loss arises for a member because of fluctuations in the exchange rate between the accounting currency and a third currency, that gain or loss is reflected in its underlying profits, and it is not reflected in its taxable income, or is reflected to a different extent, the gain or loss is to be excluded from the member’s adjusted profits.

Fluctuation between tax currency and third currency

Where a gain or loss arises for a member because of fluctuations in the exchange rate between the tax currency and a third currency, and it is not reflected in the underlying profits, or is reflected to a different extent, the gain or loss is to be fully reflected in the adjusted profits.

Example 1

Company A prepares its individual financial statements with the Euro as its presentational and functional currency. It has made an election to change its functional currency for UK tax purposes to sterling and therefore calculates its taxable profit or loss by reference to sterling. This example assumes a EUR:GBP exchange rate of 1.2:1.

Company A has a foreign exchange loss relating to a sterling-denominated asset in its accounts.

The 260 loss in the accounts is a fluctuation between the accounting currency (Euro) and sterling investments. The 260 loss is excluded from the member’s adjusted profits if it is also excluded from taxable profit/(loss). As the investment is denominated in the same currency as the tax functional currency, no exchange gain or loss arises for tax purposes. The amount is therefore also excluded from adjusted profits.

Example 2

Company A also has a foreign exchange loss relating to a US dollar denominated asset. During the accounting period the US dollar has fluctuated against the Euro and sterling to different degrees. In this example the foreign exchange loss in the ‘Accounts’ and the ‘UK Tax Computation’ in the table below, has been calculated with reference to prevailing Euro/USD and GBP/USD exchange rates respectively.

The 260 foreign exchange loss on revaluation of sterling investments is dealt with as per Example 1.

The 200 loss in the accounts is a fluctuation between the accounting currency, Euro, and a third currency, US dollar. It is therefore excluded from the member’s adjusted profits.

The 180 loss in the UK tax computation is a fluctuation between the tax currency, sterling, and a third currency, US dollar. It is therefore fully reflected in the member’s adjusted profits but will be translated into Euros to provide a 216 loss in the adjusted profits.