SPECIAL FEATURE: THE CITY’S BEST KEPT SECRET Some of the best things in life you stumble on by chance. I certainly feel that way about the financial arrangements that are the subject of this article. At the risk of sounding like one of those mail shots (which I suspect most of us take with a pinch of salt) that we all get tumbling through our letter boxes, where can you find an ‘investment’ that, on the basis of past performance, would return something like 300% a year, probably tax-free and with no effort or hassle on your part? Here’s another question, which, perhaps surprisingly, has the same ultimate answer: if you have borrowing, how can you tap into the lower-interest rates (in some cases very much lower) that apply to borrowing in foreign currencies? This article explains how. Or rather, it gives a basic outline of the arrangements so that readers who are interested in finding out more have a point from which to start. How not to do it: currency mortgages Many of us who have substantial borrowings, perhaps home mortgages or business loans, have dallied with the idea of borrowing in foreign currencies rather than in sterling. (Before all those who have no major borrowings switch off at this point, I would emphasise that this article is by no means just aimed at those with substantial loans.) For example, the Japanese yen has been supported to a great extent in recent years by those borrowing to take advantage of its staggeringly low, approximately 0.5%, interest rate. But of course, there’s one major drawback with borrowing in yen or other non-sterling currencies if the property you are borrowing against is in the UK. The problem is that it’s a very high-risk strategy. If the yen moves significantly in the wrong direction against sterling, you could end up with a major decrease in your overall personal wealth, and even end up without the means to pay back the loan. You can’t always rely on the property market to continue going up and up like a rocket! So currency mortgages have always been seen in the past as the preserve of the specialist few. Multi-currency loans Then, a few years ago, someone came up with a marketed product that is aimed at overcoming this problem of major downside risk. This product is infinitely more sophisticated than the single currency loan and, as the name suggests, involves transacting in more than one foreign currency. The theory runs that, by borrowing in more than one currency at a time and/or switching currencies in accordance with perceived trends (basically, entrusting the management of the currency to experts), you can be much surer of being one of the winners rather than one of the losers. Of course, no one’s pretending that multi-currency loans are free from risk. But the product that has been put on the market addresses this issue. If the currency you are in moves by more than a certain percentage (typically 15%) against sterling, you automatically get switched out of that currency and back into sterling. Hence, while your upside is potentially unlimited, your downside is strictly controlled. More winners than losers? In my view, the foreign-currency market is uniquely favourable, as markets go, to those entering it with a view to making a gain. For a start, it is an incredibly liquid market with literally trillions of dollars equivalent being traded every day in markets round the world. So you are unlikely to be left holding the currency baby. Secondly and probably more importantly, a huge amount of currency changes hands every day between people who simply aren’t trying to make a gain by doing it. Central banks in various countries, for example, trade in foreign currency in order to bolster up their own country’s economy. Multi-national companies quite simply need to exchange currency to trade between different nations and so on. So I wouldn’t be surprised to be told that the activity of those trading in currencies to make a profit out of them was a tiny minority of the total amount changing hands. In this way, the currency market is very different from the stock market, for example. Basically, everyone who is in the stock market is trying to make a profit out of everyone else. To a lesser extent, the same could be said of the property market: while there are obviously a lot of people in this market simply because they need somewhere to live, there is an awful lot of money invested in property by those who are looking to get rich by it. Tax (or lack of it) This is where, especially for readers of Schmidt Tax Report, the whole subject of currency gets even more interesting. Consider what it would be like to have a source of tax-free income or gains. Let’s take the example of somebody with a £1 million mortgage. Even for those in the rare situation of being able to claim tax relief for interest paid on their mortgage (perhaps because the loan was taken out to put money into a business), there is still the immense problem of paying back the capital. Repayment of capital on loans is never going to be a tax-deductible item. So for your average higher-rate taxpayer, which, let’s face it, you probably have to be to get a substantial mortgage in the first place, this £1 million has to be paid back out of income that has suffered income tax of 40%. If you do the calculations, you will see that that means you will need something like £1.67 million of gross income over the years, on which tax at 40% is about £670,000, leaving you with your £1 million to apply against the capital of your loan. When you add that frightening figure to the compounding effect of the interest, it’s little wonder that a large number of people consume most of their substance in paying off mortgages over their lifetimes. With tax-free gains on currency, by contrast, all you need to make is £1 million. If the currency whizz-kids manage to make a 5% annual gain on average, your mortgage is paid off in 20 years without your having to put a penny of your own income into it. Incidentally, I sometimes wonder whether there isn’t another mortgages crisis coming along very like the recent endowments crisis. You will remember that everyone was taking out endowment mortgages 20 or 30 years ago, in the hope that the endowment (which is a type of insurance policy) would grow in value by suitable investment in the stock market and pay off the capital of the loan at the end of the term. Lots of readers of this column will also know, to their disadvantage, that a lot of endowments have failed signally to do this. On a similar basis, is the current spate of ‘interest only’ mortgages, that the mortgage lenders are coming up with hand over fist, going to precipitate a similar crisis in the future? This is precisely where multi-currency loans may be coming to the rescue. If the trading on the markets is successful, this is a very good way to provide for repayment of the capital. So are the currency gains tax-free? In my view, the answer, unless you are a limited company, is a resounding yes. Your average punter, converting his mortgage into a foreign currency, could not be described as a foreign-currency trader by any stretch of the imagination. Any gains that are made in my view are incidental to his ownership of the property and do not result from a trade. Capital gains tax (CGT) only applies to the disposal of assets, and what we are talking about here is not assets but liabilities. So I think the currency mortgage gets over the CGT hurdle as well the income-tax hurdle. Needless to say no one can put their hand on heart and guarantee that the Revenue won’t change things: but that’s how I think matters stand at the moment, and have stood for a very long time. If you are a limited company, there is a special tax regime that applies to your currency gains and losses, and to take these out of tax you would probably be well advised to restructure things so that borrowing is either in your personal name or in the name of an LLP. The next evolutionary stage All that’s very well, but I said early on in this piece that it wasn’t just aimed at those with substantial mortgages. Also, it’s undoubtedly true to say that there are hurdles to overcome to get in on the game. For example, there is the panoply of arrangement fees, valuation fees and possibly also early-redemption penalties on your current sterling mortgage. Secondly, the lenders who support multi-currency loans tend to look for a much greater margin of safety in terms of equity value in the property (i.e. value over and above the amount of the loan). So if you are already geared up as much as you can be, or nearly as much, you will find that your application for a foreign-currency loan is turned down because the lender has to take into account the fact that the ‘real’ (i.e. sterling equivalent) liability may increase if the currency dealing goes wrong. There are a lot of very clever men in the City, and one of them has recently come up with what seems to me to be a quite brilliant idea to get round these difficulties, and also to admit into the game those whose mortgages are small or non-existent. This is the so-called ‘simulated currency mortgage’. In stylised and simplified form, what happens could be described as follows. Alongside your actual sterling mortgage, you take out what are in effect a foreign-currency liability and a matching sterling deposit. (The actual mechanics of how this is done are different, but the overall effect is the same.) So if you regard the sterling mortgage and the sterling ‘deposit’ as cancelling each other out, what you are left with is an asset in the form of the property and a liability in a foreign currency. Because this arrangement sits alongside your current loan rather than replacing it, you don’t need to change lenders, and you avoid all of the expense of paying fees etc. What’s more, questions of ‘loan to value’ become irrelevant. Leveraged gains Because the simulated mortgage isn’t secured against your property as such, the devisers of the simulated currency loan had to come up with some other method of providing a buffer against risk. So what they did was to require a (comparatively) small cash deposit to be put down so that, in the worst-case scenario, this could be drawn down to neutralise the losses. To take an example from an actual instance, a punter puts down £25,000 as a deposit. On top of this, he guarantees, should the need arise, a further £25,000. Therefore his maximum loss is £50,000. On the strength of this, the currency experts enter into a simulated currency mortgage of £1 million, on the basis that, if things go wrong by more than 5%, the arrangements will come to an end. On average, the providers of this product have shown gains, after costs, of something like 9% a year on their currency dealing since 1998. This includes one freak year, where the gain was more than 20%, so if you (unfairly in my view) ignore that year, you come up with an average still of about 7% after costs. So, if you make an average gain in the future as well, you are talking about a gain of £70,000 on your ‘£1 million’ simulated mortgage. Not bad when all you have actually shelled out to get the ball rolling is £25,000. The tax treatment of simulated mortgages It seems to me that the tax situation with simulated mortgages is perhaps a bit muddier than physical mortgages. Readers will already have spotted, probably, that to go in for this simulated arrangement you don’t actually have to have a mortgage at all. So to my mind this looks a lot more like trading in currency than the physical mortgage does. However, the current orthodoxy is that these profits and gains are tax-free, and I am not looking a gift horse in the mouth. Who will this appeal to? We at Schmidt Tax Report have taken a long, hard look at this idea, and we have to say that we like it very much. But it won’t appeal to everybody, of course. Who are the most likely people to enter into this sort of arrangement? First of all, we think the idea of a physical mortgage will attract those who are currently struggling with high interest rates on their loans, and would like, if possible, to take advantage of the lower interest rates available in other currencies. It should be borne in mind, though, that the main motivation for the traders to choose a particular currency is that of aiming to make a gain on the capital amount by switching it at the right time. But, of course, if they succeed in making gains, that’s just as good as, and can be even better than, taking a reduction in your interest rate. We also think this will have great appeal to those who have a certain amount of cash lying around and not doing very much at the moment. A prudent approach, in my personal opinion, would be to set out an amount of money that, if worst came to worst, one could afford to lose without it completely ruining one’s life, and put that into the arrangements. The leveraging effect, as we have seen, can result in you standing to gain (or lose) money on the basis of a figure 40 times greater than you are actually putting down in cash, and 20 times greater than the total you are imperilling. So if the downside is manageable, the upside makes the decision almost a no-brainer, it seems to us. All the traders have to do is continue to perform as they have done in the past, and you are in a situation that certainly beats working for a living! Alan Pink FCA ATII, as well as being the technical editor of Schmidt Tax Report, is also a specialist tax consultant with QED Tax Consulting. Based at their Tunbridge Wells office, Alan advises on a wide range of tax issues and regularly writes for the professional press. Alan has experience in both major international plcs and small local businesses and is recognised for his proactive approach to taxation and solving tax problems. Alan can be contacted on (01892) 530200 or email: alan.pink@qedtaxconsulting.com.