CFM62935 - Foreign exchange: matching: derivative contracts used to hedge share transactions: relevant amounts

REG 5ZA(4)(a) and REG 5ZA(6) S.I. 2004/3256

The amounts that arise on the derivative contract in an accounting period which can be disregarded varies depending on the type of derivative contract the company enters into.

Relevant amount

Where the company enters into a deal-contingent forward contract or an option, the entire fair value profit or loss arising to the company in relation to the derivative contract is the relevant amount to disregard. This includes exchange gains or losses and any premiums or fees.

For any other derivative contract, it is only the exchange gain or loss which is the relevant amount to disregard. The company will typically be required to adopt fair value accounting in respect of derivative contracts. Therefore, the company will need to separate out the exchange gain or loss that is attributable to movements in the spot exchange rate (see CFM61160).

Where multiple derivatives may be used for the same transaction, for example where an option is initially entered into to hedge the foreign currency risk and it is later rolled into an ordinary forward contract, the fair value movements arising on the derivative contracts must be separated to ensure the correct relevant amounts are disregarded.

Just and reasonable rule

A derivative contract may hedge more than one economic risk. For example, a company may enter into an option which may cover an anticipated share transaction and other risks in relation to the same currency.

Under REG 5ZA(1)(b), there is a hedging relationship only to the extent that it is in respect of the anticipated transaction that is being hedged. Similarly, under REG 5ZA(2) there is a relevant hedging relationship if and to the extent that the contract, or a part of the contract, is intended to hedge the relevant economic risk attributable to fluctuations in exchange rates. REG 5ZA(6) is a just and reasonable rule which ensures the disregarded amount (excluded amount) is an amount in proportion to the relevant hedging relationship under REG 5ZA to the total amounts arising on the derivative contract.

Share transactions that do not complete

If a derivative contract is entered into to hedge the economic risk in relation to a forecast transaction or firm commitment relating to an anticipated future acquisition or disposal of shares, and the proposed share transaction falls through (or the share transactions becomes improbably such that the intention to hedge drops away), any relevant amounts arising on the derivative contract should still be disregarded under REG 5ZA up to the date the transaction falls through. For anticipated share disposals, the EGLBAGL Regulations may still apply to bring these disregarded amounts back into account, should there eventually be a disposal of the shares (see CFM62950).

Hedge accounting

If the company adopts cash flow hedge accounting, then the fair value movements (or exchange gains and losses) may initially be recognised in a cash flow hedge reserve and hence not be brought into account for tax purposes in the accounting period the amounts arise.

Instead, the relevant amounts are recognised in the cash flow hedge reserve and are later recycled to the income statement so brought into account for tax purposes at that later time (see CFM27160). These amounts may be disregarded under REG 5ZA, providing the conditions were met at the time the amounts were recognised in a cash flow hedge reserve.

If, where cash flow hedge accounting applies in relation to a highly probable acquisition of shares, the fair value movements (or exchange gains and losses) initially recognised in other comprehensive income are treated as adjustments to the carrying value of a relevant shareholding, once it is acquired, applying the treatment for acquisitions of non-financial assets, see CFM27160, amounts that would otherwise be recognised for tax at that point, under CTA09/S604(2) may be disregarded.