Finance and Treasury blog: 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.”

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.

Consider the following example, where Parent Company takes out the borrowing in US dollars on 1 January 2007 to hedge its investment in the shares of Country A Sub.

The currency of Country A is pegged against the dollar, with a currency board that has operated successfully for many years maintaining the peg. Accordingly, the hedge is expected to be highly effective. Parent Company does not bother formally assessing the effectiveness of the hedge at each month end (which it could have done quite easily) as no ineffectiveness is expected. However, in December 2007 Country A experiences a massive economic crisis and devalues by a large amount against the dollar.

As the hedge is ineffective the first time it is measured, which is in December 2007, for the entire period no hedge accounting is allowed under IAS 39. The question is whether this was a designated hedge for the purposes of Condition 1?

There are two alternative interpretations:

(a) Favourable. The argument is that there was a designated hedge. Parent company carried out the prospective analysis required by IAS 39, and then documented the hedge in writing.

(b) Unfavourable. Although Parent Company intended to hedge, at no time during the period of account has hedge accounting actually been applied (because the first time the hedge was tested, it was shown to be ineffective). As no hedge accounting has taken place, how can the shares in Country A Sub have been a hedged item?

I understand that HMRC consider that (b) is the correct interpretation. While the legislation is unclear the point is probably unlikely to be litigated for two reasons:

(i) The act of creating hedging documentation is strong evidence of an intention to reduce economic risk as required by Condition 2.

(ii) It would be relatively unusual for a company not to test the effectiveness of the hedge for almost the entire period of account, as assumed for Parent Company above. If the hedge is tested at the end of each of the first eleven months (say) and found to be effective, then for those months hedge accounting would clearly have been applied.

Under IAS 39, if the hedge then proved ineffective in December, it would only be foreign exchange differences from 1 December 2007 that would be ineligible for hedge accounting. As condition 1 is looking at “the accounting period”, within that period there would have been hedge accounting in respect of the liability and the hedged item, even if not for the whole period. This should be sufficient to cause Condition 1 to be satisfied.

(2) When do “intentions” exist for Condition 2?

Consider a group finance company which is running a balanced dollar foreign exchange position:

As part of group reorganisation, the finance company uses its $100m group receivable to purchase shares in a US group company, so that the structure is now:

If (for whatever reason, e.g. oversight) no hedging documentation is executed, can the Finance Company maintain that its intention in continuing to be subject to the $100m eurobond is to reduce the economic risk of its owning US Sub, as required by Condition 2?

There is no doubt that the effect of owning the eurobond is to reduce the foreign exchange risk of owning the US Sub. However, what was the Finance Company’s intention?

When the Finance Company borrowed the eurobond, its intention was to use the proceeds to make a loan to a US group company, or to raise the cash “for general corporate purposes”. As the shares in US Sub were not acquired until later, (assumed not to be pre-planned), it cannot have been Finance Company’s intention “by entering into” the liability to reduce the foreign exchange risk of owning the US shares.

Accordingly, Condition 2 is likely to be failed in this example, which would leave the foreign exchange differences on the eurobond liability being taxable or deductible.

(3) Compound hedging and Condition 2

It is relatively common to use derivatives to create synthetic currency loans. In the example below, Parent Company wishes to reduce the foreign exchange risk of buying Euro Sub, but for commercial reasons finds it preferable to borrow dollars. Accordingly it enters into a cross currency swap to convert the fixed rate dollar debt into floating rate euro.

(a) Accounting

Under SSAP 20, it would have been possible for Parent Company to look at the dollar eurobond and the $ / € cross currency swap together as a synthetic euro floating rate loan which hedged its equity investment in Euro Sub.

Under IFRS, this is not possible and the financial instruments must be considered separately.

The good news is that IAS 39 para 76 allows a hedging instrument to be “designated as a hedge of more than one type of risk provided that (a) the risks hedged can be identified clearly, (b) the effectiveness of the hedge can be demonstrated, and (c) it is possible to ensure that there is specific designation of the hedging instrument and different risk positions”.

If one looks at the dollar leg and the euro leg of the swap separately, one can see that they have different characteristics, and bear some relationship to the dollar eurobond and the euro denominated investment in the subsidiary. This is easier to see if one pairs each leg of the swap with a notional sterling leg, where the periodical payments are in floating rate sterling. One of these notional sterling legs would be to pay and the other to receive. Clearly the value of these notional sterling legs will always be zero, since they are equal and opposite. I understand this can be done provided the notional additional legs are in the functional currency of the reporting entity, here sterling.

After this is done, one notionally has two swaps, as illustrated below.

Swap A and swap B are notional ways of looking at the real swap the company has entered into. At all times, the fair value of swap A and swap B will be equal in total to the fair value of the real swap.

The combined effect of the fixed dollar eurobond and Swap A is equivalent to a floating rate sterling liability. Accordingly, one immediately sees that Swap A is a fair value hedge of the $ eurobond, hedging both the currency and the interest rate risk and it can be designated as such for IFRS purposes. Accordingly, fair value profits and losses on (notional) Swap A will be included in the profit and loss account. Also included in the profit and loss account will be valuation differences from recomputing the carrying value of the fixed dollar eurobond liability that arise from changes in the sterling / dollar exchange rate and from changes to dollar interest rates. The differences on (notional) Swap A and on the dollar eurobond should be equal and opposite, assuming of course that it is a perfect hedge. i.e. the notional principal amount of the dollar leg of the swap equals the dollar amount of the eurobond, and the cashflows of the fixed dollar interest rate leg of the swap exactly match the fixed interest payable on the eurobond.

Swap B should be capable of designation as a net investment hedge of the investment in Euro Sub. As it is a floating / floating swap, its value will change almost entirely in response to the £ / € exchange rate. However, net investment hedging is only possible in the consolidated accounts of Parent Company, not in its solus accounts. Inability to designate (notional) swap B as a hedge at legal entity level would in turn preclude designating (notional) swap A as a hedge at entity level, since I understand that the entire real swap needs to be designated as a hedge, not just a part of it.

A solution would be to designate, at entity level, (notional) swap B as a fair value hedge of that part of the fair value risk of the carrying amount of the investment in Euro Sub that arises from movements in spot exchange rates. That would mean that fair value differences on (notional) swap B were taken to the profit and loss account, where they would offset exchange differences arising from retranslating the investment in Euro Sub.

Accordingly, Parent Company is not subject to any financial accounting volatility as exchange rates fluctuate or as the dollar yield curve varies. This result follows from the above entity level hedge designations, where the dollar eurobond is hedged with regard to foreign exchange rate risk and interest rate risk by part of the swap, while the shares of Euro Sub are hedged with regard to exchange rate risk by the other part of the swap as a fair value hedge at entity level of the foreign exchange risk.

(b) Taxation

(i) Based upon the actual transaction and accounting discussed above

The result of the above accounting is that in fact all of the fair value changes in the actual swap will be included in the profit and loss account. As the swap is being accounted for as two notional swaps, initially one starts by looking at them separately, although as explained below the tax rules do not permit that when it comes to the matching provisions.

Firstly, fair value changes in (notional) swap A in the profit and loss account. Also included in the profit and loss account will be changes in the value of the dollar eurobond liability arising from exchange rate changes and interest rate changes, since notional swap A is being accounted for as a fair value hedge of the exchange rate risk and interest rate risk in the eurobond.

This accounting complies with International Accounting Standards. Accordingly the above amounts included in the profit and loss account will be taxable/deductible and as explained above, will cancel out numerically.

That leaves the other part of the fair value changes in the actual swap, corresponding to value changes in (notional) swap B. These will also be included in the profit and loss account, as explained above. Are these profit and loss amounts taxable or are they disregarded?

One needs to consider Regulation 4. The text in Regulation 4(1) seems fairly clearly to look at the whole derivative, and does not appear applicable to only part of a derivative contract. One cannot say that the entire derivative contract meets either condition 1 or condition 2. Accordingly, the fair value movements in respect of (notional) swap B when included in the profit and loss account will also be taxable or deductible and do not benefit from the disregard regulations.

To summarise, fair value profits and losses on the entire actual swap contract will be included in the profit and loss account, for both accounting and tax purposes.

That part of the overall swap profit or loss which arises from notional swap A will be offset by equal amounts from restating the liability on the dollar eurobond for exchange rate and interest rate risk. This applies both in the accounts and in computing the taxable profits.

However, that part of the total fair value profit or loss on the swap which arises from notional swap B will give rise to volatility in the taxable income. In the financial accounts, fair value differences on notional swap B will be offset by equal differences from restating the carrying value of Euro Sub for exchange rate movements. However, the exchange differences on the shares of Euro Sub are not taxable/deductible, while the fair value differences on notional swap B are taxable/deductible.

(ii) An alternative way of looking at the swap and the above accounting

To illustrate how difficult the legislation is, I should point out that there is another way of looking at the actual swap, which actually gives rise to possibly even more volatility in the taxable income.

The actual swap appears relatively clearly to fall within the definition of an interest rate contract, as defined by Regulation 9(4) since it is “a swap contract in which payments fall to be made by reference to a rate of interest.”

Furthermore, as Regulation 9(1) (a) requires “there is a hedging relationship between … a portion of the contract and any of the risks arising in respect of an asset… (“the hedged item”).” In this case, the portion of the contract is the euro principal amount of the swap, and the risk being hedged is the foreign exchange risk of Euro Sub.

While the above are pretty clear, what is less certain is whether Regulation 9(1) (b) is also satisfied, which is necessary for Regulation 9 to be operative. This requires that “fair value profits or losses arising … in relation to any of the risks, in relation to which the contract was intended to act as a hedge, arising in respect of the hedged item, or any portion of the hedged item, are not brought into account for the purposes of corporation tax for that period.” The latter half of this test is met, since exchange gains and losses on the Euro Sub shares are not taxable. What I find difficult is the phrase “in relation to which the contract was intended to act as a hedge”, rather than using the phrase “a portion of the contract.” However, I think one must read it to extend to “or a portion of the contract” as otherwise the entire provision would become vacuous, since it is always parts of swap contracts that act as hedges of risks. For example, it is only the fixed dollar payments leg that acts as a hedge of the interest rate risk in the dollar eurobond.

Accordingly, one concludes that the actual contract is within Regulation 9. The consequence is that it is accounted for, for tax purposes, on an accruals basis, although that of course does not preclude retranslation of the dollar and euro legs for exchange rate differences. The end result on the tax return is that:

Exchange differences on the dollar principal leg of the swap are recognised in the accounts and the tax return, where they offset the equal and opposite exchange differences on the dollar amount of the eurobond. This is the same as (i) above.
Exchange differences on the euro leg of the swap are recognised in the accounts and the tax return. Conversely, exchange differences on the Euro Sub shares are recognised in the accounts, but are not taxable. This introduces volatility in taxable income, as in (i) above.
Fair value profits and losses on the fixed dollar interest element of the eurobond are recognised in the accounts, and on the tax return. This is the same as in (i) above. However, even though fair value profits and losses of an equal and opposite amount on the fixed dollar leg of the swap are recognised in the accounts, they are excluded for tax purposes since the mandatory effect of Regulation 9 is to account for the swap on an accruals basis. Hence, additional tax volatility arises from taxing the fair value movements on the fixed dollar interest element of the eurobond, which differs from the answer in (i) above.

While this overall result involves greater volatility in the tax charge than the overall result at (i) above, my somewhat reluctant conclusion is that it is a more accurate reading of the legislation, which shows how many difficulties can arise.

(iii) Splitting the real swap into two

The problems can be solved, prospectively, by replacing the actual original swap with two replacement swaps, corresponding to swap A and swap B. This would of course have a higher cost than a single swap. However, provided the replacement contracts are between the same company and the same bank, with appropriate offset rights the bank’s economic risks do not change from agreeing to split the swap, as long as both new swaps continue to be held by the same company. In that situation the additional cost from splitting should not be excessive.

Once the swaps are split it becomes clear that new actual swap A is a fair value hedge of the dollar eurobond.

Meanwhile new actual swap B can be designated in the entity accounts as a fair value hedge of the exchange rate risk of the carrying amount of the investment in Euro Sub, thus meeting Condition 1. Even without such designation, it is quite clear that the new actual swap B is capable of meeting the requirements of condition 2, though the intention at entity level should be appropriately documented at the outset. This means that fair value movements on the new actual swap B that arise from foreign exchange differences will be disregarded.

As new actual swap B is floating sterling / floating euro, essentially all of its fair value movements should be attributable to movements in spot exchange rates. Accordingly, the complications discussed in my posting “How do you calculate exchange gains and losses when using Fair Value Accounting?” should not arise.

The overall result is that after splitting the swap into two, Parent Company faces no volatility in either its account income or its taxable profits.

Conclusion

As seen from the above examples, even apparently simple situations can give rise to unexpected tax outcomes and real points of difficulty.

Accordingly, it is essential for groups engaging in any kind of hedging to review both the accounting and the tax treatments carefully, and of course prospectively, and to take action where appropriate.