Derivative contracts: hedging: historical overview
Development of the Disregard Regulations
As explained at CFM57010, companies adopting IFRS, New UK GAAP, or Old UK GAAP (including FRS 26) are potentially exposed to two main problems concerning the tax treatment of hedging arrangements.
First, where a company is economically hedged but is unable to use hedge accounting (perhaps because the hedge is not sufficiently effective) or chooses not to designate a hedge, the derivative must be accounted for at fair value through profit and loss. This may create a mismatch between the accounting treatment of the hedging derivative and that of the hedged item. Such a mismatch (the ‘undesignated hedge problem’) would - in the absence of any special tax rules - follow through to the tax treatment.
Second, because the derivative contracts legislation normally taxes amounts taken to reserves as well as those credits or debits appearing in the profit and loss account, there would - again, in the absence of special rules - be a disparity between the accounting and tax treatments of cash flow hedges (the ‘cash flow hedge problem’).
When companies began to prepare for the adoption of fair value accounting on 1 January 2005, many companies and their advisers were particularly concerned about the first of these problems - the ‘undesignated hedge problem’. The Disregard Regulations, as originally laid in 2004, tackled this problem by ensuring that in defined circumstances, undesignated hedges could (broadly) be taxed as if Old UK GAAP (excluding FRS 26) accounting continued to be used. This applied to currency contracts or commodity or debt contracts hedging forecast transactions (regulations 7 and 8) and to interest rate contracts (regulation 9).
Regulations 7, 8 and 9 also applied to designated cash flow hedges, thus also addressing the second, ‘cash flow hedge problem’. It was recognised from the outset, however, that the computational adjustments required to implement these regulations would be burdensome to companies (such as banks) with scores or hundreds of cash flow hedges. So the original Regulations incorporated the ability to elect out of regulations 7 and 8, and separately out of regulation 9.
Increasing experience of IAS 39 suggested that for many companies the ‘designated cash flow hedge problem’ was considerably more significant than the ‘undesignated hedge problem’. In particular, HMRC received representations that for banks and other companies with large numbers of interest rate contracts, electing out of regulation 9 would also impose an unacceptable compliance burden because the company would still need to make computational adjustments in respect of designated cash flow hedges.
In response to these representations, SI 2005/3374, laid in December 2005, introduced regulation 9A. This meant that, where a company elected for regulation 9A rather than regulation 9 to apply, most cash flow hedges involving interest rate contracts were taxed on the basis of what went through the profit and loss account, ignoring credits or debits to the cash flow hedging reserves (although there was an exception for cash flow hedges of connected party debt). Most (although not all) undesignated hedges were taken out of regulation 9 by the election, so that fair value changes on interest rate contracts were taxed or relieved as they were recognised to profit or loss. Thus the regulation 9A treatment substantially reduced the compliance burden, albeit at the expense of some tax volatility in respect of undesignated hedges and hedge ineffectiveness. This amendment applied to periods of account beginning on or after 1 January 2005, provided the period finished after 29 December 2005.
It also became apparent that similar problems arose where currency, commodity or debt contracts, to which regulations 7 or 8 would apply, were designated as hedging instruments in cash flow hedges. In 2006, it was decided that regulation 9A could also be applied to designated cash flow hedges that would otherwise come within regulation 7 or 8. SI 2006/3236 therefore introduced an election (under regulation 6(3A)) to this effect. This applies for periods of account beginning on or after 1 January 2006 and ending on or after 27 December 2006.
A further change introduced by SI 2006/3236 affected interest rate contracts. It offered companies an alternative election into regulation 9A, the difference being in the scope of those situations in which regulation 9 continues to apply (see CFM57400).
In 2013, the government launched a consultation on modernising the tax rules of corporate debt and derivative contracts. As part of this, it proposed to align the tax treatment closer to the amounts recognised in the income statement (i.e. items of profit or loss). As a preliminary stage of this, SI 2014/3188 made certain changes to the operation of the Disregard Regulations. In particular, it makes ‘following the profit or loss’ the default position (invoking regulation 9A where appropriate). There is now a single election that companies can make to apply regulations 7, 8 and 9 to relevant contracts.
Guidance on elections is at CFM57360 onwards.
The Disregard Regulations also provide particular provision in respect of exchange gains and losses. Guidance on these aspects is at CFM60010+ onwards.