U.K. Tax Rules on Functional Currency Significantly Liberalized

New rules were recently introduced in the United Kingdom (U.K.) on the use of a functional currency other than the Pound Sterling (sterling) for calculating taxable income. For example, passive affiliates of U.S. companies may wish to use the U.S. dollar as their functional currency; under the new rules this may be possible, although previously it frequently was not. In general, the rules apply retroactively for tax years beginning after 1999 and ending on or after March 31, 2000. It may be possible in limited circumstances to defer implementation of these rules until the first tax year beginning on or after July 1, 2000.

Previous Rules

Under previous rules, it was only possible for a U.K. resident company or U.K. branch of a nonresident company to elect to use a nonsterling functional currency (such as the U.S. dollar) in relation to its trading profits; thus, foreign exchange differences would arise for tax purposes on any nontrading dollar-denominated monetary balances. Under U.K. rules, "trading" activity is analogous to the U.S. concept of an active trade or business, as distinguished from passive investment activities.

While many financial services companies may fulfill the trading requirement, a pure cash management or treasury function may not be a trading company and an investment or holding company would not, under the old rules, have been able to calculate its taxable income in dollars. For example, a U.K. branch of a U.S. investment management company would generally not be a trading company for these purposes; under prior rules, the branch would be obligated to use sterling as its functional currency and to compute taxable income in sterling.

Other than the trading condition, a company seeking to elect a different currency had to meet various other conditions concerning the primary economic environment of the company's business and had to prepare its financial statements in dollars. Further, an election, which generally was only prospective, had to have been made to the U.K. tax authorities (Inland Revenue) if a company wished to calculate its trading profits or losses in dollars.

New Rules

Under the new rules, companies can have a nonsterling functional currency for all profits (with the exception of capital gains, which are still calculated in sterling), provided they meet two conditions—the U.K. company (or U.K. branch of a nonresident company) must carry on a business and the financial accounts must be prepared in the nonsterling functional currency.

Under U.K. principles, "carrying on a business" is a much lower threshold of activity than "carrying on a trade." The process is no longer elective; the currency used for financial accounting purposes will generally be followed for tax purposes. It is likely that most companies should be able to fulfill the criteria, with the possible exception of dormant companies and some holding companies.

Whether the accounts can be prepared in nonsterling functional currency is clearly a U.K. accounting issue (dependent on U.K. GAAP) and will ultimately depend on the directors and auditors of the companies concerned. There are no strict guidelines for determining when a company can or cannot prepare foreign currency accounts. The factors to be taken into account would most likely include denomination of share capital, denomination of loans made, denomination of loans borrowed, denomination of any income flows and expenses and, when relevant, the currency generally accepted as the principal currency for that market. (Note: using dollars in accounts must be in accordance with normal accounting practice to be effective for tax purposes.)

Effect of the New Rules

The effect of these changes is that many U.K. holding companies, U.K. group treasury companies or other nontrading U.K. companies can use dollars or euros (the two most likely) as their functional currency for tax purposes and not be concerned with dollar-hedging techniques for accounting or tax purposes. The change in the functional currency rules should also allow more flexibility for U.K. companies and U.K. branches to use dollars as their currency for tax purposes for all profits (rather than only trading profits).

Often, companies following GAAP would already have been preparing their financials in U.S. dollars if appropriate; therefore, the impact of these provisions for a U.S. parent is likely to be confined to the elimination of book/tax foreign exchange differences. It is possible that companies will focus on accounting treatment more closely when an activity may benefit from the new tax rules.

From Robert Moncrieff, New York, NY