CFM57020 | Derivative contracts: hedging: why special rules are needed

Treatment of a cash flow hedge under ‘basic tax rules’

A company borrows at a floating rate of interest and uses an interest rate swap to convert the floating rate interest payments into fixed rate. It designates the interest rate swap as a cash flow hedge (see CFM27160) of the interest rate risk arising from the borrowing. Without the Disregard Regulations the tax treatment would be given by the basic CTA09/S595(2) rule.

For accounting purposes:

• the loan is carried at amortised cost, with the floating rate interest payments debited to profit and loss account;

• fair value changes in the effective portion of the interest rate swap are taken to equity;

• fair value changes in any ineffective portion are taken to profit and loss account;

• amounts are ‘recycled’ from equity to profit and loss account each year, to offset cash flows on the borrowing. The result is that the amount recognised in profit and loss each year represents a fixed interest cost on the borrowing (plus associated fees and expenses, spread over the life of the loan).

Assume that the Disregard Regulations do not apply. For tax purposes the credit or debit brought into account on the interest rate swaps will include both amounts recognised in profit and loss, and amounts recognised in equity.

For example, a company enters into the swap in year 1. The swap has a fair value of nil at inception, and a fair value of £200,000 at the end of year 1. During the period, the company makes fixed rate payments of £260,000 under the swap, and receives floating rate payments of £300,000, so it receives a net £40,000. It pays interest of £300,000 on the borrowing.

It will initially credit the net cash flow of £40,000 on the swap to equity. When interest is paid on the borrowing, the £40,000 is recycled to profit and loss, where it offsets the £300,000 interest debit, resulting in a net debit of £260,000. In addition, the fair value increase of £200,000 on the swap is credited to equity, making total credits of £240,000. Thus three amounts would enter into the computation for tax purposes:

• a credit of £240,000 to equity;

• a debit of £40,000 to equity as a result of the recycling; and

• a corresponding credit of £40,000 to profit and loss.

The last two of these amounts are self-cancelling. The overall result is a credit of £240,000. In other words, the whole of the profit on the swap would be recognised for tax purposes. Thus, although the swap is an effective hedge of the borrowing in accounting terms, it is not an effective post-tax hedge.

(Note that the company could also present this as a £200,000 credit to equity, and a £40,000 credit taken directly to the income statement. This approach would be equally valid and the overall effect would be the same.)

Regulation 9 of the Disregard Regulations applies to the facts in this example and would substantially reduce the tax volatility resulting from taxing fair value movements taken to equity. If the company elected out of Regulation 9, Regulation 9A would then apply instead (see CFM57420).