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Revenue and Customs Brief 22/07

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HM Revenue and Customs -Tax Authorities

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Issued March 12 2007

Elections under regulation 6(3A) of the Disregard Regulations: some guidance for companies

Companies which have adopted "fair value accounting" under Financial Reporting Standard (FRS) 26 or International Accounting Standard (IAS) 39 in respect of their financial instruments may hold currency, commodity or debt derivatives that have been designated as hedging instruments in cash flow hedges of forecast transactions.

For such companies, a new Corporation Tax election - under regulation 6(3A) of the Disregard Regulations (SI 2004/3256) - is likely to be relevant. The deadline for making the election to H M Revenue and Customs is, for many companies, 31 March 2007. The purpose of this article is to provide guidance for companies that may be considering whether or not to make such an election.

Background

Many companies use derivative contracts to hedge risks arising from future events, where it is highly probable that these will occur, or where there is an existing contractual commitment (an "anticipatory hedge"). For example, a company committed to paying for raw materials in a foreign currency at a future date may want to hedge the foreign exchange risk that arises. A company using FRS 26 or IAS 39 may designate such a hedge as a cash flow hedge or (less commonly) a fair value hedge. Alternatively it may be unable to, or choose not to, use hedge accounting in respect of the arrangement, even though it is economically hedged (an undesignated hedge).

The Disregard Regulations, which have effect for periods of account beginning on or after 1 January 2005, were in part intended to help companies reduce the volatility in taxable profits that may result from such hedging arrangements. Where the underlying subject matter of the derivative contract is currency, commodities, or bonds or similar debt, regulation 7 or regulation 8 will in most cases apply to anticipatory hedges. The general effect of the regulations is to initially ignore fair value changes in the derivative for tax purposes. Regulation 10 then provides statutory rules for bringing these profits or losses back into account - broadly, when the forecast transaction happens, or when it affects the company’s taxable profit.

From the outset, companies have been able to make an election under regulation 6(3) of the Disregard Regulations, to disapply regulations 7 and 8, so that the "normal" tax treatment applies to the derivative contracts in question. The Regulations were, however, amended in December 2006 by SI 2006/3236: these changes have effect for periods of account beginning on or after 1 January 2006 and ending on or after 27 December 2006.

One of the changes made was to introduce a new election, under regulation 6(3A). Where a company makes this election, a different tax treatment applies to contracts, which would otherwise be within regulation 7 or regulation 8, and for which cash flow hedge accounting is used. That different tax treatment is given by regulation 9A.

Under cash flow hedge accounting, changes in the fair value of the hedging derivative, which are attributable to the risk being hedged, are initially credited or debited to reserves. When the cash flow that is being hedged affects the company’s profit or loss, amounts in reserves are released ("recycled") to profit and loss account, off-setting the changes. Under the "normal" tax rules in Schedule 26 FA 2002, such fair value profits or losses are taxed when they taken to reserves. The effect of regulation 9A is to tax only the "recycled" amounts that are credited or debited to profit and loss account, so that the tax treatment follows what is in profit and loss.

Where contracts are hedging instruments in fair value or undesignated hedges, changes in their fair value will be reflected in profit and loss account. The effect of a regulation 6(3A) election is to remove such contracts from regulations 7 or 8, so that the normal tax treatment of Schedule 26 FA 2002 applies: such fair value changes are fully taxable or relievable.

Thus the overall effect of the election is that, regardless of the type of hedge, contracts that meet the regulation 7 or 8 conditions are taxed on the basis of the profit or loss account or income statement.

Time limits and election procedure

A company wishing to make an election under regulation 6(3A) in respect of its "regulation 7" and "regulation 8" contracts must make the election before 1 April 2007, unless a later time limit applies.

A later limit will apply in either of two circumstances.

  • The company adopts "fair value accounting" in relation to its derivative contracts for the first time, and has existing contracts to which regulations 7 or 8 would apply. It must make the election before the start of the first period of account for which it uses fair value accounting.
  • The company is not a party to any contracts to which regulations 7 or 8 would apply in the first period in which it is subject to the Disregard Regulations, but it subsequently acquires such contracts. It must elect within 90 days of entering into the first such contract. "The first period in which it is subject to the Disregard Regulations" will be the first period in which the company uses fair value accounting - which, for a newly-incorporated company, may be its first period of account.

An election under regulation 6(3A) cannot be revoked, even if the company’s circumstances later change (for example, if it is acquired by a different group).

The election must be made in writing to H M Revenue and Customs. Each company within a group can decide independently whether or not to make the election (although there is no objection to elections by a number of group companies being submitted in a single letter). The existing rules in regulation 6 about intra-group transfers of contracts apply where the transferor or transferee company has made a regulation 6(3A) election.

Regulation 6(3) and regulation 6(3A) are alternatives

Election under regulation 6(3) and election under regulation 6(3A) are alternatives. Paragraph (9B) of regulation 6 provides that, where a company makes an election under 6(3A), any earlier election it has made under 6(3) is revoked.

Subject to the approval of Ministers, HMRC intends to make a minor amendment to the Disregard Regulations, to make it clear that no company can have a regulation 6(3) and regulation 6(3A) election in force at the same time.

Guidance on the effects of regulation 6(3) and regulation 6(3A) elections

Guidance on the Disregard Regulations generally, including the effect of regulation 6(3A), will be incorporated into HMRC’s Corporate Finance Manual. In the meantime, an updated version of the draft guidance on the Disregard Regulations which appears on International Accounting Standards section of the HMRC web-site will be published shortly.

Some of the points made in that updated guidance relating to regulation 6(3) or 6(3A) elections are given here for convenience.

If a company makes an election under regulation 6(3A), regulation 9A will apply to all of its currency, commodity or debt contracts that would otherwise come within regulation 7 or 8 - regardless of whether cash flow, fair value or undesignated hedges are involved. But only contracts forming part of designated cash flow hedges will meet the statutory conditions in regulation 9A(1). Thus it is only for these contracts that the disregard of fair value profits or losses taken to equity, and their subsequent recognition for tax purposes when recycled to profit and loss account, operates. In all other cases, regulation 9A has no tax effect, and the normal derivative contracts rules in Schedule 26 FA 2002 will apply.

It is intended, again as part of minor amendments to the Disregard Regulations, to clarify that an election under regulation 6(3A) "switches off" regulations 7 and 8 in all cases.

The table below summarises the tax treatment of cash flow hedges, fair value hedges and undesignated hedges where the company either makes no election at all; elects under regulation 6(3); or elects under regulation 6(3A). In considering cash flow hedges, it is assumed that amounts initially taken to reserves are recycled to the profit and loss account.

 
Company makes ... Designated cash flow hedge of a forecast transaction or firm commitment Undesignated hedge of a forecast transaction or firm commitment Designated fair value hedge of a firm commitment
No election Reg 7 or 8 applies. Both amounts initially taken to reserves, and their recycling to P&L, are disregarded; the amounts are brought back into account under reg 10. A computational adjustment is needed where the timing of credits or debits under reg 10 differs from the accounts treatment. Reg 7 or 8 applies. For accounting purposes, fair value changes on the contract will go through P&L. For tax purposes, these are disregarded and brought into account under reg 10. A computational adjustment will be needed in all cases. Reg 7 or 8 will apply if, but only if, changes to the fair value of the firm commitment (which will be reflected in the accounts) are not taxed. Where the regs apply, the tax treatment is as for undesignated hedges.
Regulation 6(3) election The unmodified rules of Sch 26 apply. Amounts are taxed when they are taken to reserves; when recycling occurs, it gives rise to self-cancelling debits and credits and has no tax effect. A computational adjustment to the P&L account figure is therefore needed. The unmodified rules of Sch 26 apply. Fair value changes in the contract are taxed or relieved as they occur. No computational adjustment is needed (unless it is required under any Sch 26 rule). As for undesignated hedges.
Regulation 6(3A) election Regulation 9A applies. Amounts that are initially taken to reserves are disregarded: they are brought into account when they are recycled to P&L. No computational adjustment to the P&L profit is therefore needed (except if required under any Sch 26 rule). The unmodified rules of Sch 26 apply. The position is the same as where a reg 6(3) election is made. No computational adjustment is needed. The unmodified rules of Sch 26 apply. The position is the same as where a reg 6(3) election is made. No computational adjustment is needed.

Accounting standards allow an alternative treatment for cash flow hedges, where the forecast transaction results in a non-financial asset or liability being acquired (for example, where a purchase of trading stock is being hedged). Instead of recycling fair value changes on the derivative to profit and loss account, a company may include the gain or loss in the initial cost or carrying value of the asset or liability. For example, if a company pays £100 for trading stock, but has also realised a profit of £10 on a derivative that hedged that purchase, it may record the initial cost of the trading stock as £90. Its £10 profit is brought into account when the stock is sold, or revalued. Accountants refer to this as a "basis adjustment".

Where the company makes a basis adjustment, the question arises whether the profit or loss is brought into account under the derivative contracts regime, or under some other regime (such as Schedule D Case I). The table below summarises HMRC’s views on the effect of regulation 6(3) or 6(3A) elections on cash flow hedges, where a basis adjustment is made.

 
Company makes ... Credits or debits to cash flow hedge reserve Recycling to the carrying value of asset or liability Disposal (or revaluation etc) of asset or liability
No election - reg 7 or 8 applies Disregarded - no computational adjustment is needed. No computational adjustment is needed. The accounting entries do not give rise to any profit or loss of the company with para 17A(1) Sch 26; there is no tax effect and therefore nothing to disregard. The asset or liability is treated as acquired for the "cash price". The disregarded profit or loss on the derivative is brought into account under reg 10. Computational adjustment needed.
Regulation 6(3) election - unmodified Sch 26 rules apply Brought into account - computational adjustment to P&L profit needed. As above.
The profit or loss on the contract has already been brought into account under Sch 26. Para 1(2) Sch 26 prevents it from being taxed or relieved again. The asset or liability is therefore treated as acquired for the "cash price". Computational adjustment needed.
Regulation 6(3A) election - reg 9A applies Disregarded - no computational adjustment is needed. As above

Asset or liability treated as acquired for "adjusted price" for all tax purposes - no computational adjustment needed.

Where the tax treatment of an existing contract changes as a result of a regulation 6(3A) elections, regulation 9A(3A) provides that a one-off credit or debit is brought into account, on the first day of the company’s first accounting period beginning on or after 1 January 2006, to eliminate any double taxation or double relief.

Further information

CT & VAT Financial and Insurance Team
100 Parliament Street
London SW1A 2BQ

By email: Sue Davies
Telephone: 020 7147 2565

By email: Josephine Crimmin
Telephone: 020 7147 2543


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© Crown Copyright 2007.

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Article Published/Sorted/Amended on Scopulus 2007-03-12 22:35:50 in Tax Articles

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