CFM57073 | Derivative contracts: hedging: regulation 9A treatment: example

This guidance applies to periods of account starting before 1 January 2016 and where no election is made under regulation 6A.

Regulation 9A treatment

Example

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 accounts for the interest rate swap as a cash flow hedge in its 2015 accounts. The company has not made an election for regulation 9 to apply. Regulation 9A will therefore apply to the swap since as a result of designation, fair value changes on the swap are taken to a cash flow hedging reserve (recognised through other comprehensive income (OCI)).

Accounting treatment

For accounting purposes:

• the loan is carried at amortised cost, with the floating rate interest payments recognised in profit or loss;

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

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

• amounts are ‘recycled’ from OCI to profit or loss 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) subject to any ineffectiveness under point three above.

Tax treatment

Under regulation 9A, the fair value changes taken to, and from, OCI, will be disregarded. All entries in profit or loss will be taxed.

Suppose, for example, the 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. It pays interest of £300,000 on the borrowing.

It will credit £240,000 to OCI (the fair value increase of £200,000 plus the net cash flow of £40,000 on the swap). However, £40,000 is recycled to profit or loss, where it offsets the £300,000 interest debit, resulting in a net debit of £260,000. Thus for tax purposes:

• the credit of £240,000 to OCI is disregarded;

• the debit of £40,000 to OCI is also disregarded; and

• the credit of £40,000 to profit or loss is taxed.

(Note that in the accounts this may also be presented as a £200,000 credit to OCI and £40,000 taken directly to the income statement. This gives the same result, and is an equally acceptable accounting treatment.)