The Tax Law on Foreign Exchange Net Investment Hedging

After a period covering other topics, I am reverting to a regular subject in previous postings, The Loan Relationships and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses) Regulations 2004.

Before doing so, I would like to mention that I am always keen on meeting readers needs, so if there is a topic that you would like me to write about within the ambit of this blog, please email me.

1. Net Investment Hedging: The concept

Ever since the UK first introduced specific legislation on foreign exchange differences, net investment hedging has raised difficult issues.  Consider a UK company which spends $100m on acquiring a US trading subsidiary, and for simplicity assume that the net assets of the US subsidiary are also $100m.

In the consolidated accounts of UK Parent, the $100m net assets of US Sub must be translated into sterling for inclusion in the balance sheet.  Year to year foreign exchange differences in this translated sterling value are taken to reserves.  As a result, the group’s consolidated shareholders funds will fluctuate up and down as exchange rates move.

Does this matter? For some groups, the issue may be critical, e.g. if they have given a banking net worth covenant that would be breached if foreign exchange fluctuations reduced group reserves below some trigger point.  Apart from such situations, there is no easy answer, and some groups choose to hedge this translation risk whilst others don’t.  I propose to consider whether or not to hedge in a future posting.

If a group does choose to hedge translation risk, it normally does so by acquiring a matching foreign exchange liability, either by taking on actual debt or by transacting derivatives.  The simplest example is for UK Parent to take on a $100m loan, using the cash borrowed to either repay sterling debt or for other corporate purposes.

Under UK GAAP, SSAP 20 would permit UK Parent to take foreign exchange differences on the $100m loan liability and the $100m US net assets to reserves in its consolidated accounts.  As the foreign exchange differences on these two amounts will always be equal and opposite, group reserves will now be fully hedged against exchange differences from the retranslation of the US net assets and the dollar loan liability.

IAS 39 has the same treatment for such net investment hedges in the consolidated accounts, except that, unlike SSAP 20, the foreign exchange movements taken to reserves are recycled to the income statement on disposal of the hedged subsidiary, as part of the gain or loss on disposal.

As far as the solus accounts of UK Parent are concerned, SSAP 20 permits the shareholding in US Sub, which UK Parent is carrying at cost (normally a fixed cost equal to the sterling equivalent of the price paid) to be carried at a dollar amount and retranslated each year end.  Similarly, the loan liability is retranslated each year end.  SSAP 20 then permits foreign exchange differences on the hedging loan liability to be taken to the reserves, to the extent that there are equal and opposite foreign exchange differences on the investment in US Sub also taken to reserves. I.e. the foreign exchange differences in the solus accounts are treated in a similar way as in  the consolidated accounts.

IFRS differs in its treatment of the solus accounts.  Net investment hedging in IAS 39 is only a concept for the consolidated accounts.  In the solus accounts of UK Parent, the investment in US Sub would be carried at the historic sterling equivalent of the price paid on acquisition.  Meanwhile, foreign exchange differences on the loan liability would be taken to the profit and loss in the solus accounts of UK Parent. Alternatively, UK Parent could designate the liability as a fair value hedge of foreign exchange risk arising on its shares in US Sub, as discussed below.

2.  Historic tax law

Prior to FA 1993, the retranslation of the $100m hedging loan liability would have been on capital account, and indeed would be a “tax nothing” as it relates to a liability. See the case of Beauchamp (HM Inspector of Taxes) v FW Woolworth plc.

When FA 1993 was planned, it was recognised that taxing companies on the retranslation of such hedging loans would produce enormous volatility in corporation tax payments, and could bankrupt some companies.  Accordingly, companies hedging translation risk were permitted to make “matching elections”, provided they were using SSAP 20 and taking exchange differences on the asset and the hedging liability to reserves.  The matching election allowed an element of retrospection, as it could be made up to 92 days after acquiring the asset.

If a matching election was made, foreign exchange differences on retranslating the hedging liability were not taxed on a current basis.  Instead they were computed and held in suspense until the asset was disposed of, when they were included in the computation of the overall capital gain or loss.  This is often referred to as “matching treatment” by tax advisors.

After some experience of the application of the FA 1993 rules, the tax authorities concluded that an elective matching regime, especially with an election that could sometimes be retrospective, was unduly favourable to companies.  Accordingly, when the law was revised in FA 2002, “matching treatment” for tax purposes was made compulsory if the company was using SSAP 20 accounting to take foreign exchange differences on the asset and on the hedging liability to reserves.

3. Current tax law

With the advent of IFRS, any tax regime for translation hedging that operated by reference to whether exchange differences on the asset and the hedge were being taken to reserves could no longer work.  As mentioned above, IAS 39 does not permit net investment hedging treatment in the accounts of individual companies, only in the consolidated accounts.

After extensive consultation, the Disregard Regulations give relief in the following manner.

Under Regulation3, the “matching treatment” mentioned above applies, mandatorily, if either one of two conditions is satisfied.

Condition 1

The shares held as an asset (or ships or aircraft since these are also eligible assets) are a hedged item under a designated hedge of exchange rate risk in which the liability is the hedging instrument.

One would expect this to cover a company using UK GAAP SSAP 20 hedge accounting.  However, the accounting concept of a “designated hedge” is primarily one of IFRS and UK GAAP as amended to harmonise with IFRS, and is not found in SSAP 20. Nevertheless, the point is somewhat academic under current tax law, as FA 1996 s.84A(3) will apply to exclude the foreign exchange differences on the hedging liability from taxation.

Condition 1 is also not very helpful for groups accounting under IFRS, as illustrated below.

Under IAS 39, the group can be expected to designate the $100m loan as a net investment hedge of the net assets of US Sub.  However, that is not the same as designating the loan as a hedge of Parent’s shareholding in the shares of US Sub.  Condition 1 specifically requires that the US Sub shares be the hedged item under the designated hedge.

While IAS 39 does not permit net investment hedging at legal entity level, there is however one way for UK Parent to be able to formally specify its $100m liability as a designated hedge of its shareholding in US Sub. That is to designate the liability as a fair value hedge of the foreign exchange risk of the shareholding. If this designation is made, the dollar carrying value of US Sub would be retranslated into sterling at each year end, with the exchange differences taken to the profit and loss account. Similarly, the dollar loan would be retranslated into sterling at each year end, with the exchange differences also taken to the profit and loss account where they should be equal and opposite to the exchange differences on US Sub. This hedge designation would allow Condition 1 to apply.

It is relatively unusual for companies to proceed in this manner by designating the liability as a fair value hedge. However, it can be useful. For example, if the investment in US Sub is carried at a fixed historic sterling value, foreign exchange losses on the hedging liability may have the effect of depleting UK Parent’s distributable reserves.

In any event, “Matching treatment” is available even in the absence of a designated hedge, due the alternative condition 2.

Condition 2

This condition is satisfied if the currency of the liability is such that the company intends by entering into and continuing to be subject to the liability, to eliminate or substantially reduce the economic risk of holding the asset which is attributable to fluctuations in exchange rates.

There are several quite interesting points to note about this condition.

(a) Intention

Its operation depends upon the intention of the company.  It is good practice to record that contemporaneously.  Consider for example the following fact pattern.

Has UK Parent borrowed the $10m because it wants to hedge the translation risk of its investment in Sub A?  If that was its intention, then “matching treatment” applies to the bank loan.  Meanwhile, translation differences on the $10m loan to US Sub B will be fully taxable.

Conversely, if UK Parent’s intention when incurring the bank loan was to make the onward loan to US Sub B, then translation differences on the bank loan would be fully taxable, and be equal and opposite to the translation differences on the onward loan, leaving UK Parent in a tax neutral position.

Merely observing the facts will not tell you what UK Parent’s intention was.  Instead, the intention in the minds of UK Parent’s management should be recorded in writing contemporaneously.

(b) Dual intentions

An interesting conundrum is whether UK Parent can have different intentions for the purpose of its consolidated accounts and for its solus accounts?  For example, in (a) above, could UK Parent intend the $10m bank loan to be a net investment hedge of the assets of US Sub A in its consolidated accounts, while at the same time in its solus accounts regard the bank loan as intended to facilitate the loan to US Sub B and not as reducing the risk of owning the shares of US Sub A. 

I would argue that these dual intentions are possible.  In particular, for the consolidated accounts intention UK Parent can never have any regard to the loan to US Sub B, since that loan disappears on consolidation. 

(c) Upstream loans

Upstream loans represent an interesting intellectual challenge. Consider the following:

At first sight, one might argue that UK Parent has borrowed the $10m upstream loan to hedge, at least in part, its $100m investment in US Sub.  Indeed, the upstream loan has genuinely reduced UK Parent’s exposure to the dollar, since the dollar operating assets are now only $90m, whereas before the upstream loan there was $100m at risk from dollar exchange rate fluctuations, namely $90m of operating assets and $10m of cash in US Sub’s bank account assumed to be held in dollars.

However, does the currency in which the upstream loan is denominated reduce UK Parent’s risk from owning US Sub?  I would argue that it does not.  Even if the upstream loan was denominated in sterling, or euro or any other currency, it would be just as efficacious at reducing UK Parent’s real economic risk from owning US Sub.  The risk reduction is achieved by taking $10m out of US Sub’s bank account and transferring that cash to UK Parent; the currency of the upstream loan is irrelevant.

As upstream loans were often used with “matching treatment” prior to the Disregard Regulations, we have asked HM Revenue & Customs for their views on this point.

4. Effective Date

The Disregard Regulations have been applicable to all periods of account starting on or after 1 January 2005.  Accordingly, by now they apply to virtually all UK companies.  Despite being first published in 2004, they were only finalised by amendment late in 2005.

HMRC is currently consulting regarding further revisions to be made during 2006 which will be retrospective to 1 January 2006.

If you would like to receive an email alert each time I update my blog, click here to let me know.

Mohammed Amin

Comments

[HARI NAIR 13 Jun 2006 12:47:50]

Can I get a simple explanation of usage of SSAP 20. How i can implement SSAP 20