Is a notional gain from exchange rate changes taxable?

The facts

In 2006 Mr and Mrs Rawlings (R) purchased an apartment in Zermatt partly funded by a mortgage. They sold the property in 2016 and repaid the mortgage. R made a gain from the sale which they reported on their 2016/17 self-assessment returns. Their calculation reflected the change of exchange rates on purchase and sale values and also the mortgage amount. HMRC disagreed with the calculation, started an enquiry and issued an assessment to demand the additional tax it thought was due. R appealed to the First tier Tribunal (FTT).

Foreign exchange

The capital gains tax (CGT) rules require all gains or losses to be worked out in sterling. That’s to say that the purchase price of an asset must be converted to sterling at the time it was made and the sale price converted at the date it occurred. The effect is that fluctuations in exchange rates between the purchase and sale will increase or decrease the taxable amount of gain or loss. HMRC had no issues with the foreign exchange rate changes used by R except where they related to the mortgage repayment.

Mortgages and capital gains

HMRC argued that how R financed the purchase of their property had no bearing on the calculation of the gain, which is simply the difference between the purchase price plus expenses, e.g. legal and agents’ fees, and the sales price less expenses. However, R countered that the position was different for foreign assets because the exchange rate changes resulted in an extra cost and this should be deductible from the gain. This view doesn’t seem unreasonable. In their arguments R referred to HMRC’s advice on how to calculate capital gains and losses.

HMRC guidance

R directed the FTT to HMRC’s published guidance which says CGT is “a tax on the profit when you sell (or dispose of) something (an asset) at an increased value” . They stated that their “profit” was reduced because they had to pay more in sterling to clear the mortgage compared to the value of the mortgage in sterling when they took it out. This was an expense linked to the sale.

The FTT rules

In their ruling the FTT judges went to some length to set out and explain the problems with the tricky calculations submitted by R. We think this unnecessarily complicated the position but they may have done it to help R understand the logic of their decision, which was in favour of HMRC. While accepting that R had incurred an extra cost relating to the mortgage, the legislation precisely sets out what expenses are allowed to be deducted when working out the amount of a gain or loss. Mortgage costs are not an allowable expense and therefore any additional cost, e.g. exchange rate losses, linked to a mortgage are therefore also not deductible.