Practical difficulties with net investment hedging

My colleagues in the PwC Finance & Treasury network have recently spent a significant amount of time advising clients on net investment hedging. In this regard Neil Edwards, who is based in London, has identified a number of areas where very real practical difficulties can arise when undertaking net investment hedging and seeking to apply the Disregard Regulations, more fully The Loan Relationships and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses) Regulations 2004.

The issues are best understood by considering some examples, which show that relatively straightforward situations can cause difficulties. In all cases, the company is assumed to be accounting under IFRS, so UK GAAP accounting using SSAP 20 is not in point.

(1) When does Condition 1 apply?

Regulation 3 (for loan relationship liabilities) and Regulation 4 (for derivative contracts) prescribe (i.e. exclude from taxation in the current period) fair value movements in respect of foreign exchange arising on hedging instruments provided one of two conditions is met, as set out below.

For convenience, to avoid having to repeatedly refer to liabilities and to derivative contracts, the text below is from Regulation 3 dealing with liabilities.

1. “…for the accounting period, the shares, ships or aircraft are a hedged item under a designated hedge of exchange rate risk in which the liability is the hedging instrument.”

or

2. “…the currency in which the liability is expressed is such that the company intends, by entering into and continuing to be subject to that liability, to eliminate or substantially reduce the economic risk of holding the asset, or part of the asset, which is attributable to fluctuations in exchange rates.”

The word “designated” in Condition 1 is defined by Regulation 2(2) to “have the same meaning as for accounting purposes.”  Also from Regulation 2(2) “for accounting purposes” means for the purposes of accounts drawn up in accordance with generally accepted accounting practice, which in turn is defined via FA 2004 s50 to mean “in relation to the affairs of a company or other entity that prepares accounts in accordance with international accounting standards (“IAS accounts”), generally accepted accounting practice with respect to such accounts.”

Accordingly, one needs to look at International Accounting Standard 39. IAS 39 para 88 stipulates a set of strict criteria that must be satisfied before hedge accounting can be used.  As an initial step, these require that the hedge relationship is designated and formally documented at inception.

IAS 39 para 88(a) requires that there must be formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.  That documentation must include identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged and how the entity will assess the hedging instrument's effectiveness in offsetting the exposure to changes in the hedged item's fair value or cash flows attributable to the hedged risk.  Paragraph 88(b) requires that, prospectively, the hedge is expected to be “highly effective”.

Once hedging has commenced, para 88(e) requires that “the hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated.” If it is not determined to have been highly effective, then hedge accounting cannot be applied.