CFM62240 - Foreign exchange: matching under SSAP 20: use of currency contracts

Matching using forward currency contracts

Where a company accounts for a derivative contract on an amortised cost basis, exchange gains or losses are defined by CTA09/S705 in terms of the profits or losses that arise when comparing the currency valuations placed on the derivative at two different times. There is no explicit requirement in the legislation that the same exchange rate should be used at both the earlier and the later time.

This means that exchange gains or losses on a forward currency contract will fall within the S705 definition regardless of whether they are computed on a ‘spot to spot’ or a ‘forward to spot’ basis.

Example

On 1 March 2010, a company (‘company X’) enters into a 6-month forward currency contract giving it the right and the obligation to buy €1 million for £870,000 on 1 September 2010. At 1 March 2010, €1 million is worth £780,000 at spot rates of exchange; at 1 September 2010 it is worth £900,000.

Overall the company makes a profit of £30,000 on the contract - at 1 September, it is able to buy for £870,000 the euros that would cost £900,000 in the spot market. But this profit is made up of two elements. If the spot price of the euros is compared at 1 March and 1 September, an exchange gain of £120,000 arises (£900,000 - £780,000). Additionally, there is a loss of £90,000 (£870,000 - £780,000) resulting from the difference between the spot price of €1 million at the start of the contract, and the 6-month forward price. This loss is unaffected by any subsequent movement in the spot rate of exchange between the euro and sterling, and depends only on the interest rate differential between the two currencies. The loss is referred to as a forward premium (a profit will be a forward discount - and the term ‘forward points’ is used for a difference in either direction between spot and forward rates).

If the company is using the forward currency contract as a hedge, it may - depending on the risks that it wants to hedge - use hedge accounting only for the forex component (the ‘spot to spot’ exchange gain of £120,000), and debit the forward premium of £90,000 to P&L over the life of the forward contract. Alternatively, it may include the forward points in the hedge.

Tax treatment

In the example above, the ‘spot to spot’ exchange profit of £120,000 falls within the CTA09/S705 of an exchange gain. But so does the ‘forward to spot’ profit of £30,000, since it arises from comparing the value of €1 million at 1 March 2010 (translated at the 6-month forward rate, and therefore giving a sterling value of £870,000) with its value at 1 September (translated at the spot rate, giving £900,000). This meant that, before 22 April 2009, the company could use either figure for forex matching purposes.

This was not the policy intention. It implied that, from 1 October 2002, there was a difference in tax treatment from the previous rules which taxed any forward premium or forward discount on a forward currency contract under the FA 1994 financial instruments rules, so such amounts were not available for matching under the FA 1993 forex provisions. It also meant that forex matching potentially applied differently according to whether forward currency contracts or cross-currency swaps were used as the hedging instrument, since on a swap there is no doubt that the interest rate differential component - represented by the periodic payments - cannot be used to match.

Furthermore, the ambiguity opened up avoidance possibilities. Suppose, in the example above, the counterparty to the currency contract (‘company Y’) is in the same group as X. Company Y’s economic position is the reverse of X’s - it has an overall loss on the forward contract of £30,000, comprising a ‘spot to spot’ exchange loss of £120,000, but a forward discount (a profit) of £90,000.

Company Y (assumed to account under SSAP 20) might hold shares in an overseas subsidiary, and take the loss of £30,000 to reserves in accordance with the cover method. It therefore does not bring any profits or losses into account for tax - in essence, the forward discount of £90,000 is sheltered by the forex matching rules. Company X, on the other hand, might have borrowed €1 million from a bank - at consolidated level, this is what hedges the net assets of the overseas subsidiary. Over the 6-month period of the currency contract, it sustains an exchange loss of £120,000 on the external borrowing. This is exactly matched by the £120,000 forex gain on the currency contract. However, it gets tax relief for the £90,000 forward premium on the contract.

The overall effect is therefore that the group has a tax deduction of £90,000 on an arrangement that, at consolidated level, is flat.

In order to counter schemes of this sort, FA 2009 amended CTA09/S606 so that only exchange differences computed on a ‘spot to spot’ basis can be matched - see CFM62250. The change applies from 22 April 2009.