Disregard Regulation 9A: Should I elect (deadline 31 December 2005) for it or not?

I make no apology for writing yet again about the Disregard Regulations.  While some may wish the subject would just go away, it is too important to ignore.

Under Regulation 9 of the existing regulations, i.e. “The Loan Relationship and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses) Regulations 2004”, SI 2004/3256 as amended by SI 2005/2012), where there is a hedging relationship between an interest rate contract and any of the risks on a hedged item, and fair value profits on the hedged item are not brought into account for corporation tax purposes, then for tax purposes the interest rate contract must be accounted for on an accruals basis.

This regulation applies irrespective of whether the derivative qualifies as an effective cash flow hedge under IAS 39 or FRS 26.  (Special treatment is not needed for effective fair value hedges, since for such hedges the underlying item will be fair valued for interest rate risk and taxed accordingly).  Those companies which did not want Regulation 9 to apply, e.g. because the record keeping needed was considered burdensome, had until 30 September 2005 to elect out of it.  That deadline is now past.

HM Revenue and Customs (HMRC) are now planning to amend the Disregard Regulations, and to introduce a new Regulation 9A, which companies can elect into.  The election deadline will be 31 December 2005, irrespective of a company’s year end, and the election will be irrevocable.  If a company elects into Regulation 9A then:

1) Regulation 9 will not apply

2) Instead, the company will be taxed in respect of the derivative contract on those debits and credits that are recognised in its profit and loss account (using FRS 26 language) or its income statement (using IFRS language).

To decide, a company must consider its own facts and circumstances, and its goals.  There is no shortcut from that.  When conducting the evaluation, it is worth bearing the following points in mind:

(a) If all of your interest rate hedges are perfectly effective cash flow hedges, properly designated in advance, then the numbers going through your profit and loss account under FRS 26 / IFRS may be prove to be almost the same as the accruals accounting numbers generated by Regulation 9. This may happen this if you are hedging with interest rate swaps that have no initial cost, with the payments aligned with the payments on the underlying item. Conversely, if you are hedging with interest rate options or other instruments where there is an initial cost that is being amortised, you are more likely to have divergences, possibly quite large ones, between the numbers computed under FRS26/IFRS and those computed under Regulation 9.

If HMRC are willing to be pragmatic and ignore any differences as being immaterial and self cancelling over the life of the hedge, then they could agree to accept your accounts figures as being equivalent to accruals accounting numbers under Regulation 9. If so, you don’t need to elect into Regulation 9A. However, if HMRC insist that you actually do the accruals accounting calculations needed by Regulation 9 for your tax return, then you have to consider whether the effort is acceptable. If you think it excessive, then Regulation 9A should be helpful to elect into, as it saves doing the calculations needed under Regulation 9, while leaving the company with what may be essentially the same tax liability (unless your divergences are large.)

However, bear in mind that the Regulation 9A election is irrevocable, and may result in an unwanted tax result on a future transaction.

(b) If you transact interest rate derivatives for hedging purposes that are not recognised as valid hedges under IFRS / FRS 26, then the position may be quite different.  This is best understood with an example.

X plc has issued 15 year fixed interest sterling bonds.  It then hedges them into floating rate debt, by transacting a 15 year pay floating/receive fixed interest rate swap, which is properly designated as a fair value hedge.  Assuming that the hedge is perfectly effective, the accounting under IFRS or FRS 26 should mean that the net cost in the profit and loss account (after one includes fair value movements on the swap and on the bonds in respect of interest rate risk) should equate to the floating rate interest payable on the swap.  So far, so good.

Suppose that X plc now wishes to hedge its synthetic 15 year floating rate bond into fixed interest for the first 5 years, by transacting a 5 year pay fixed/receive floating interest rate swap.  It might do this, for example, if it was in a regulated industry, with a set pricing formula for 5 years.

This 5 year interest rate swap sadly cannot qualify as a hedge under IFRS or FRS 26.  One would want it to be a cash flow hedge, but the accounting rules do not permit a derivative or a synthetic combination of a derivative and a real underlying item to be a hedged item.  Accordingly the 5 year interest rate swap must be fair valued at each year end, with the movements going through profit and loss.

I would however expect the 5 year swap to qualify as having a hedging relationship under Regulation 9, and therefore to be accruals accounted for tax purposes.  This needs some extra calculations, and also means that for Company X the cash tax payable is not simply based upon the profit and loss account, as under Regulation 9 one disregards the fair value movements included in the P&L from the 5 year swap, and instead substitutes accruals accounting.

Conversely, if the company elects under Regulation 9A, then the cash tax will be based upon the accounting P&L.

There is no “a priori” way of deciding which is better.  X plc needs to decide what its goal is, e.g. a goal of minimising cash tax volatility, or a goal of having cash tax follow the accounting profit, since they lead to different decisions on the Regulation 9A election.

Whatever it wants, it needs to conduct the evaluation so that it can reach a decision to elect under Regulation 9A, or to not elect, by 31 December.

(c) Some companies, especially banks, transact large volumes of interest rate derivatives for hedging purposes, as well as transacting trading derivatives. They may find the Regulation 9 calculations for their hedging derivatives burdensome, while being happy to be taxed on their accounting profits. The Regulation 9A election may often be the solution for them.

Once treasurers and tax managers have worked their way through the election decision for their companies, they may feel they have earned their Christmas break.

Mohammed Amin