VAT – Further clarification of the treatment of foreign exchange transactions (forex) and transactions in other financial instruments

Business Brief 21/05 explained HMRC's position following the tribunal decision in Willis Pension Fund Trustees Limited (Willis)) [VTD 19183] and the implications of the decision for other businesses conducting forex transactions. The Tribunal found that the forex transactions Willis entered into were not supplies for VAT purposes.

This Brief article sets out HMRC's view on when forex transactions are supplies for VAT purposes and the implications this has for VAT recovery. It also outlines HMRC's view on any wider application of the decision to transactions in other financial instruments.

Determining if your forex transactions are supplies for VAT purposes

The tribunal decision in Willis applied to a very specific set of circumstances and, whilst some general principles can be drawn from the decision, care needs to be taken when seeking to give it wider application. The European Court of Justice (ECJ) judgment in First National Bank of Chicago (FNBC) [C-172/96] is the leading authority on the VAT treatment of forex transactions.

In Willis, forex deals were entered into for the purposes of hedging’. This is a term that is variously defined, but hedging’ is about reducing exposure to risk of loss resulting from fluctuations in some commodity or financial market. What is relevant for VAT purposes is whether any underlying trade is performed to achieve that objective. Hedging’ is not in itself a test for determining whether or not there is a supply for VAT purposes.

In general, forex transactions are supplies for VAT purposes if you adopt a spread position over a period of time when buying and selling currency. This applies whether this is being done for your own account, in support of other areas of your business, or to reduce any exposure position in forex that you hold. A spread position means a difference between a bid price and a sell price from which you would expect to derive a profit. These forex transactions would include both ‘spot’ and ‘forward’ transactions, as envisaged by the FNBC judgment.

Most businesses actively involved in forex trading should readily be able to identify whether their forex transactions fall under the FNBC principle of adopting a spread position. If uncertainties remain, you should consider whether, in selling a currency, you are in a position to set the selling price. If so, you are able to determine the consideration you receive by setting a spread, even if only mimicking market movements, and your forex transactions are likely to be supplies for VAT purposes.

Where your forex transactions are supplies, the consideration will be the net result of all your forex transactions over a period of time and would be exempt under VATA 1994, Sch. 9, Group 5, Item 1. Any forex transactions, for which you charge an attributable fee or commission, would also be exempt supplies under Item 1.

The following are examples of circumstances when it is unlikely that your forex transactions would be seen as supplies for VAT purposes:

• a business simply exchanging one currency for another to realise foreign earnings into sterling, for example, or to acquire currency to settle liabilities incurred outside the UK, is unlikely to be seen as making supplies for VAT purposes provided such transactions are not part of a wider economic activity being carried out for an identifiable consideration
• a business entering into forward forex deals in order to limit its exposure to forex fluctuations in respect of future obligations is unlikely to be seen as making supplies for VAT purposes provided such transactions are not part of a wider economic activity being carried out for an identifiable consideration.

Businesses with a corporate treasury operation active in the financial markets may need to look carefully at their forex transactions. If no spread position is being taken and no profit being actively sought, it is unlikely that any forex transactions would be regarded as supplies. However, a number of larger businesses have corporate treasury operations that are much more proactive, either externally or internally, within their commercial groups. For example, a business might typically run a ‘forex desk’ in a similar manner to any other financial institution or market maker more traditionally associated with forex dealing. Such businesses are likely to be taking a spread position and would be making supplies. All their forex transactions, whether spot or forward and whether proprietary or in support of other activities or areas of the business, should be treated as forex supplies.

Intermediaries acting in relation to a forex transaction can exempt their intermediary services under item 5, Group 5 of Schedule 9. This applies whether or not the underlying forex transaction is a supply for VAT purposes.

How your input tax recovery will be affected

The normal input tax recovery rules will apply. Businesses making exempt financial supplies cannot normally recover the VAT attributable to those supplies unless the recipient of those supplies is located outside the EU (in which case recovery is allowed under the VAT (Input Tax)(Specified Supplies) Order 1999). Businesses involved in forex transactions which are not seen as supplies for VAT purposes are able to recover the VAT attributable to those transactions as residual input tax, subject to the partial exemption method used. However, there is no right of recovery under the Specified Supplies Order for such transactions.

Supplies by financial intermediaries can attract recovery under the Specified Supplies Order if the recipient of the intermediaries’ supply is based outside the EU, or if the underlying forex transaction is itself a supply which is made outside the EU. There is no right of recovery under the Specified Supplies Order, however, where the recipient of an intermediary's supply is based in the UK or elsewhere in the EU but the underlying transaction is not a supply for VAT purposes. Intermediaries arranging non-EU forex transactions will therefore need to determine whether the underlying transaction is a supply.

Businesses may wish to seek clarification on their present partial exemption methods, and some methods may need to be revised. There are provisions for excluding, in certain circumstances, incidental financial transactions from values-based calculations in partial exemption methods and the provisions of Regulation 106 of the VAT Regulations 1995 allows for de minimis levels of exempt input tax to be treated as attributable to taxable supplies. For further information on this, please refer to VAT Notice 706 Partial exemption. Whilst HMRC would wish to avoid disproportionate changes, any proposed changes will need to result in a fair and reasonable method.

Wider application in respect of transactions in other financial instruments

The Willis Tribunal made reference in its decision to interest rate swaps. It suggested that, in its view, there would only be a supply when it was possible to identify the consideration being obtained by a party entering into the contract.

There would appear to be nothing arising directly out of Willis that indicates a shortfall in HMRC's current approach to the VAT treatment of other financial instruments and it is, therefore, not intended to revise existing published policy. HMRC do, however, recognise that there may be particular circumstances where Willis principles could apply to transactions in other financial instrument transactions and HMRC would consider such cases on an individual basis.

Further information

For further information and advice, please contact HM Revenue & Customs’ National Advice Service 0845 010 9000.