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BKL Tax consider some tax issues arising from the recent fall in the value of Sterling.

Fair Exchange

Astute readers may have noticed that the rest of the world doesn’t seem to place as much value as it used to on their hard-won £1; which brings into focus the treatment of exchange gains (and losses) on foreign currency.

It might well surprise you to hear that foreign currency is an asset for capital gains tax purposes and exchange gains or losses will be taxed or allowed respectively. So if you’d bought £100 worth of dollars at $1.80 a year or so ago and you sell them today at $1.46, you've made a capital gain of £23.

But does that mean that every time you go abroad on holiday you should be reporting a gain or claiming a loss?

No of course not - the reason is TCGA 1992 s269, which provides that a gain on currency acquired by an individual for the personal expenditure outside the UK of himself and his family is not a chargeable gain. (This includes expenditure on the provision or maintenance of a residence outside the UK).

So what’s the problem? Mainly, it’s that the let-out applies only to currency acquired specifically for personal use. It does not apply to currency acquired as (for example) remuneration, dividends, interest or from sale of assets - even if it is subsequently applied for personal use.

For example, John is resident and domiciled in the UK and works here for a US employer. In 2007 he is paid a bonus of $100,000. He is subject to employment tax on the Sterling equivalent of this at the date it is paid. The rate was £1:$1.80 and he was taxed on £55,555. John decides to keep the bonus in a dollar bank account and some time later withdraws the money to help buy a holiday home in Florida. He does not convert the money to Sterling but the exchange rate at the time he withdraws it is £1: $1.50.

The withdrawal from the bank account is a disposal of dollars despite not being converted to Sterling. (Technically there is a debt due from the bank and the withdrawal is a part-disposal of that debt; non-Sterling debts are not exempt). As a result John has Sterling-equivalent proceeds of £66,666 and a taxable gain of £11,111.

As another example, Jane sells her villa in Spain in 2008 for €2,000,000 and keeps her proceeds in a Spanish bank account. At the time of the sale the exchange rate is £1: €1.40 so the Sterling equivalent is £1,428,571. She pays capital gains tax on the disposal based on these proceeds. In 2009 she buys a new villa and takes the money out the account. Now the exchange rate is £1: €1. She has a capital gain of £571,429.

Each bank account is treated as a separate asset and so every withdrawal is a part disposal. This means that foreign currency accounts need to be constantly monitored for gains or losses.

Although in both these examples the money was used for personal expenditure abroad it was not acquired for this purpose and so the gains are taxed.

Bizarrely, had John or Jane converted the foreign currency they received into Sterling immediately on receipt and then used that Sterling amount to buy foreign currency kept in an account to use for holidays or the provision or maintenance of a residence abroad, exchange gains on that account would not have been taxable.

As so often in tax, its not what you do it’s the way that you do it.

Carry on abroad

The European Commission have recently issued a "reasoned opinion" declaring that the relief from UK IHT afforded by Agricultural Property Relief is incompatible with EU legislation regarding free movement of capital. The EC objection is of course that the relief applies only to property in the UK, Channel Islands and Isle of Man - EU law requires, broadly speaking, that any relief should be available to property situate anywhere in the EU. HMRC have yet to respond to the opinion.

Does this presage a mass flight from the prairies of East Anglia to the orange groves of Seville and the spaghetti bushes of northern Italy? Well, perhaps not: at least not while the Euro trades at its present heady levels, anyway. But it did get us thinking about the tax implications of investing in property overseas.

First, a home overseas may of course be a "residence" for the purposes of CGT main residence exemption. Indeed, it may by election be treated as the main residence. Acquisition (or sale) of an overseas holiday home may therefore trigger an opportunity for making a main residence election. Rent from overseas property may be subject to UK tax (though local tax may also need to be considered) but must for tax purposes be kept separate from any profits of a UK property rental business.

Second, the CGT consequences of owning foreign property can be counter-intuitive. Consider: I buy a property overseas for 500,000 Euro on an interest-only Euro mortgage at a time when £1 = 2 Euro. I subsequently sell it for 500,000 Euro and repay the mortgage, at a time when £1 = 1 Euro. Obviously I have made no gain and would expect to pay no tax.

Er... no.

I will be treated as making a gain of £250,000 on the disposal of the property - remember, acquisitions and disposals must be calculated in sterling terms. But I get no relief for the equivalent loss of £250,000 on the mortgage. In particular the additional cost of repaying the mortgage is not treated as part of the cost of acquiring the asset: a liability isn’t an asset (!) for CGT purposes and a "loss" arising from the increased cost of repaying a foreign currency mortgage isn’t an allowable loss. Of course, where the same thing happens in reverse on a rising pound the "gain" on the mortgage debt isn’t taxable either, though that may be cold comfort to a client who is presented with a tax bill on a wholly notional gain.