Her Majesty’s Revenue & Customs has developed a practice note which provides an excellent overview of the tax situation.  This article will summarise the salient points.

The practice note is CFM61010 –Foreign Exchange.

Pre-1993 Regime

The pre-1993 tax regime for taxation treatment of foreign exchange gains and losses was determined by reference to the Case into which the gain or loss fell.

• Case I    As part of the ordinary trading profit and loss account if the loss or gain is linked to such activities.

• Capital Gain    Treated as a capital gain or loss if associated with the acquisition or disposal of a fixed asset.

• “Nothings”    In effect, foreign exchange gains and losses were considered to be outside the UK tax system completely.  Accordingly, gains were not taxed nor any relief given for losses.

While the tax treatment provided a fair degree of variation, the accounting treatment was straightforward – all foreign exchange gains and losses were taken straight to the profit and loss, or, in very limited instances, they were taken to reserves.  The old accounting standard was known as Statement of Standard Accounting Practice 20 (SSAP 20).

Clearly, there was a significant divide between the accounting treatment and UK tax treatment of foreign exchange gains and losses.

Finance Act 1993 (FA 93)

FA 93 attempted to bring the tax treatment of forex gains and losses into line with accounting treatment, i.e. gains and losses were taken to the profit and loss and either taxed or allowed as a loss as the case may be.

This only applied to incorporated companies (Ltd and PLC’s) and a different set of rules was applied to unincorporated businesses.

This was a golden opportunity to clear the confusion between tax and accounting treatments, however the UK legislators fudged the issue very badly.  Instead, FA 93 did not directly bring forex gains and losses into the profit and loss but instead introduced a new raft of controversial rules for determining whether a gain was taxable or whether a loss should be granted relief.

In particular, FA 93 introduced the concept of whether a forex gain or loss was “realised” or “unrealised”, i.e. whether the physical monetary foreign exchange conversion had actually taken place or was simply a shuffling of numbers on the accounts.  This has implications for treatment of forex movements as they affected balance sheet items, and especially the taking of gains and losses to capital reserves which bypassed the profit and loss altogether.

Finance Act 2002 (FA 2002)

FA 2002 is the current taxation regime subsisting in the UK today.

Under FA 2002, the taxation of foreign exchange gains and losses are now covered by the tax rules governing loans and derivative contracts, however special rules do apply for non-financial corporations.

A corporation (not unincorporated entity such as a sole trader or partnership) will follow a different set of rules provided they meet two conditions:
1.    They have adopted IAS (International Accounting Standards) since 1 January 2005; and
2.    They use Fair Value Accounting.
These detailed rules are to be found in the HMRC’s CFM manual – CFM611600 (Foreign Exchange Tax Rules on Exchange Gains and Losses).