CFM96500 - Interest restriction: group-EBITDA: derivative contracts
TIOPA10/S420 and S421
In calculating the amounts of net group-interest expense and group-EBITDA any amounts of fair value movements arising on derivative contracts that have a hedging function are to be removed. Instead, the amounts from those derivative contracts should be recognised in line with the hedged item. This is achieved through the application of the Disregard Regulations to the group’s financial statements.
In practice, these provisions are more likely to impact the calculation of group-interest rather than group-EBITDA. More guidance can be found at CFM96080.
S420 applies whether or not the derivative contract concerned is entered into by a UK group company. So, it also includes derivatives entered into by overseas companies which are reflected in the group’s consolidated accounts. In some cases, the data required to compute the adjustment may not be readily available. It may be sufficient to apply a high level approach to identifying amounts subject to S420. It is a matter of identifying the fair value movement which arises in respect of derivative contracts recognised in the group accounts which can be reasonably expected to have a hedging function and which is recognised in profit or loss, even though the derivative contract serves a hedging function.
Recognition in profit or loss may arise because of, say, a lack of hedge designation or failure to pass effectiveness tests. Separate amounts may need to be calculated for contracts that are not relevant contracts and so impact group-EBITDA. Contracts that are relevant contracts may affect the computation of net group-interest expense. A calculation along these lines would not be regarded as an estimate for the purposes of SCH7A/PARA 27.
In the following example, the underlying subject matter of the derivative contract is such that it does not give rise to amounts that would be taken into account in computing group-interest - the derivative contract is not relevant, as defined in S412(2).
Example
XY plc operates a fleet of buses on which it incurs substantial fuel costs. It therefore enters into a series of fuel swaps to effectively fix the price it pays for the fuel. The fuel swaps are not designated as a hedge in the group accounts.
Consolidated financial statements: operating costs
| Actual cost of fuel | £70m |
|---|---|
| Net settlement of fuel swaps in the period | £(5)m |
| Fair value movement on fuel swap | £8m |
| £73m |
The application of the Disregard Regulation to the group financial statements would be as follows:
Regulation 8 would apply as there is a commodity contract that is hedging risks arising in respect of the costs of purchasing fuel (the hedged item) and the fair value profits and losses in respect of the hedged item are not recognised in the group accounts.
As a result, all of the profits and losses on the swap are disregarded for the period. Instead, the amounts are brought into account when the hedged item affects the profit or loss. This is likely to follow the net settlement of the swaps in the period.
The group will therefore have overall fuel costs of £65m for the period included in the calculation of group-EBITDA. This is calculated by excluding the ‘clean’ fair value movement in the swap of £8m for the period.