Smith and Nephew Overseas Ltd and Others v Revenue and Customs Commissioners
| Jurisdiction | UK Non-devolved |
| Judgment Date | 29 November 2018 |
| Neutral Citation | [2018] UKUT 393 (TCC) |
| Date | 29 November 2018 |
| Court | Upper Tribunal (Tax and Chancery Chamber) |
[2018] UKUT 0393 (TCC)
Upper Tribunal (Tax and Chancery Chamber)
Mr Justice Fancourt, Judge Thomas Scott
James Rivett and Emma Pearce, instructed by the General Counsel and Solicitor to HM Revenue and Customs, appeared for HMRC
Julian Ghosh QC, Jonathan Bremner QC and Charles Bradley, instructed by Johnson Allen Tax, appeared for the respondents
Corporation tax – Change in functional currency following reorganisation – Whether relevant accounts complied with UK generally accepted accounting practice – Yes – Whether exchange losses arose – Yes – Whether exchange differences fairly represented losses arising to the company under FA 1996, s. 84(1) – Yes – Appeal dismissed.
The Upper Tribunal (UT) upheld the First-tier Tribunal (FTT) decision in Smith & Nephew Overseas Ltd [2017] TC 05644 that foreign exchange differences arising on a change of functional currency were tax deductible.
Following a group reorganisation, the taxpayer companies changed their functional currency from sterling to US dollars. The companies applied the “foreign operations” (FO) method for accounting for the change and as a result recognised significant foreign exchange losses in their accounts for the year ended 31 December 2008. HMRC did not accept that the losses arose for corporation tax purposes and it fell to the FTT to determine three issues:
- whether the companies' accounts complied with UK GAAP;
- whether the losses were exchange losses within FA 1996, s. 103; and
- whether the losses fairly represented a loss arising to the companies as defined in FA 1996, s. 84(1).
The FTT (in Smith & Nephew Overseas Ltd [2017] TC 05644) found for the taxpayer companies on all three issues. HMRC appealed to the UT on the basis that the FTT had erred in law in reaching all three conclusions.
In accounting for the change in functional currency, the companies had preferred the FO method over the “single rate” (SR) method. Had the companies used the SR method, no foreign exchange differences would have arisen. For HMRC, the use of the FO method in these circumstances was not in accordance with GAAP. Before the UT, HMRC argued that the FTT had determined the issue on the flawed bases of a “bald assertion” that they preferred the evidence of the companies' expert; guidance from the manuals of a number of large accountancy firms and the audit opinions to the effect that the companies' accounts gave a true and fair view.
The UT found that the FTT had given adequate reasons for its decision; was entitled to adopt the evidence of the companies' expert witness; gave due weight to the manuals and to the audit opinions and had not made an error in law in assessing whether the FO method was in accordance with GAAP, as opposed to whether it was more appropriate than the SR method. The UT reached the “clear conclusion” that HMRC's appeal on the first issued failed.
On the second issue, HMRC submitted that a loss did not arise for the purposes of s. 103 as the companies had not suffered an actual or economic loss. The UT dismissed HMRC's appeal on this second issue, finding that the definition in the legislation refers specifically to gains and losses “which arise as a result of comparing at different times” the relevant valuations, and not to profits or losses measured by some other criteria, such as exposure.
On the third issue, s. 84(1) stipulates that that the debits and credits to be brought into account for the period are those sums which, when taken together, “fairly represent” the profits, gain and losses for the company for the period. HMRC argued that the losses in this case did not “fairly represent” the losses of the companies as the companies had suffered no economic loss.
The UT referred to GDF Suez Teesside Ltd v R & C Commrs [2018] BTC 36, finding that three propositions of general application could be drawn from GDF Suez:
- the fairly represent rule is intended to act as an override and was introduced to address tax avoidance schemes;
- it is not limited to the attribution or allocation of gains and losses to accounting periods or to loan relationships; and
- the absence of specific statutory guidance is not problematic as the concept of fairness is well suited to application by accountants, lawyers and judges.
The FTT had ruled in favour of the taxpayer companies on this point on the basis that the words “fairly represent” were included in the legislation for an identification and/or timing purpose only. The UT found that the FTT had erred in law in basing its conclusion on this reasoning. However, the UT did not set aside the decision of the FTT, finding that the FTT had reached the correct conclusion on this issue for the following reasons:
- this case does not concern a tax avoidance scheme;
- there is no accounting mismatch of the kind in GDF Suez;
- the application of the override is not required in this case to avoid a result that is contrary to Parliamentary intention; and
- the override is not a mechanism to re-open the status of the accounting method for GAAP purposes.
The appeal in relation to all three issues was dismissed.
This is a significant defeat for HMRC; the foreign exchange losses for the three companies total approximately £675m. The UT drew on the recent GDF Suez case, finding that, in “the absence of a tax avoidance motive, the absence of any material asymmetry, and the absence of an absurd result”, the exchange losses passed the “fairly represent” test.
[1] This is the decision on the appeal by HMRC against the decision of the First-tier Tribunal ( “FTT”) in Smith and Nephew Overseas Ltd. The FTT's decision (“the Decision”) is published at [2017] TC 05644.
[2] Following a company reorganisation, Smith and Nephew Overseas Limited (“SN Overseas”), TP Limited (“TP”) and Smith and Nephew Finance Holdings Limited (“SN Finance”) (together “ the S&N Companies”) changed their functional currency from sterling to US dollars. They claimed in their tax returns for the accounting periods ended on 31 December 2008 that this gave rise to foreign exchange losses. In sterling terms the claimed losses amounted to £445,868,096, £138,188,096 and £90,652,234 respectively.
[3] The companies claimed that the exchange losses arose as a result of revaluations included in the statement of total recognised gains and losses (“STRGL”) of each of the companies in their respective accounts for the period ended 31 December 2008. The losses were said to arise as a result of the fall in the value of sterling against the US dollar.
[4] HMRC did not accept that the losses arose for corporation tax purposes, and on 16 April 2014 issued closure notices under paragraph 34(2) of Schedule 18 to the Finance Act 1998 which disallowed the losses and made consequential amendments to the tax returns of each company.
[5] The companies appealed to the FTT against the closure notices, and the appeals were heard together. The FTT (Judge Brooks and John Agboola) allowed the appeals, and concluded that:
- The accounts of each company for the relevant year were drawn up in accordance with UK Generally Accepted Accounting Practice (GAAP).
- The claimed exchange differences gave rise to exchange losses within the meaning of the legislation.
- Those exchange differences did fairly represent losses within the meaning of the legislation.
[6] On 14 August 2017 HMRC applied for permission to appeal the Decision. The grounds of appeal were that the FTT had erred in law in reaching all three conclusions. In relation to the conclusion that the accounts were drawn up in accordance with GAAP, it was submitted that numerous findings of fact by the FTT gave rise to errors of law under the principles in Edwards (HMIT) v Bairstow (1955) 36 TC 207.
[7] The FTT (Judge Brooks) granted permission to appeal on all grounds.
[8] At the time of hearing the appeal, the Court of Appeal had reserved its judgment in the appeal against the decision of the Upper Tribunal in GDF Suez Teesside Ltd v R & C Commrs [2017] BTC 507. This concerned, amongst other issues, the interpretation of the “fairly represents” requirement in the loan relationships code. We determined that it was appropriate and in accordance with the overriding objective to proceed with hearing the appeal, but to allow each party to make submissions following the release of the Court of Appeal judgment on the effect if any of the decision on the “fairly represents” issue in this appeal. The Court of Appeal judgment was released on 5 October 2018. Further written submissions were received from both parties by 19 October 2018.
[9] In view of HMRC's extensive criticisms of the FTT's findings of fact in relation to the GAAP issue, which HMRC say amount to errors in law, we set out below the lengthy statement of agreed facts recorded in the Decision (at paragraph 5). The only findings of fact made by the FTT related to the issue of GAAP compliance, in particular as to the expert evidence, and we refer to those findings in our discussion of that issue. The statement of agreed facts was as follows:
[5] The parties produced the following Statement of Agreed Facts:
(1) The Smith & Nephew Group is a multinational group engaged in the development, manufacture and marketing of medical devices. The headquarters of the Smith & Nephew Group is in the UK. The ultimate parent of the Smith & Nephew Group is Smith & Nephew PLC.
(2) Smith & Nephew PLC has two main trading groups:
- a trading group which comprises the international operations of the Smith & Nephew Group the entities within which trading group have at all material times prepared their accounts using US dollars as the functional currency and
- a trading group the UK sub-group that comprised the UK trading operations of the Smith & Nephew Group which for periods prior to 23 December 2008 prepared their accounts using sterling as the functional...
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