Derivative contracts: hedging: Regulation 7A: hedging proceeds from certain share issues
This guidance applies to certain derivative contracts entered into on or after 1 January 2009
When a company announces a rights issue or open offer of shares it will announce at that time the amount of capital it is expecting to raise from the issue. The number of shares to be issued and their price will reflect this aim. On the date of the share issue the company will be aiming to receive a set amount of funding. Where the shares are issued in a different currency from the functional currency of the company (for instance if the shares are issued in sterling but the company prepares its accounts in dollars) its capital requirements will be based upon its functional currency and thus it will want to issue sufficient sterling denominated shares to meet its dollar capital requirement.
In determining the number and price of the shares in sterling that it wishes to issue it will therefore look to the exchange rate between the currency in which the shares are denominated and the company’s accounts currency around the date of the rights issue announcement. However the exchange rate between the currencies will almost certainly be different by the date that the share proceeds are actually received.
Consequently, there will be currency exposure between the date of announcement and the date that the share issue proceeds are received which will impact on the amount of funding received. In order to deal with this problem, a company may choose to enter into a derivative contract that hedges this currency exposure (in other words to fix the exchange rate between the currencies by reference to that used in determining the amount and price of the shares to be issued).
Regulation 7A operates to ensure that the profits and losses on the derivative contract are excluded from being brought into account. If the exchange movements on the derivative contract were taxed it would render the hedge ineffective after tax. There is an example at CFM57150.
There are limited circumstances in which certain amounts can be brought back into account:
In order to fall within Regulation 7A, the derivative contract must have an underlying subject matter that is wholly currency.
There must also be a hedging relationship between the derivative contract and the anticipated or future proceeds of an announced or proposed ‘rights issue or open offer of shares’ where the derivative contract is intended to hedge the economic risk to the future capital raised under the share issue and that economic risk relates to foreign exchange exposure.
‘Rights issue or open offer of shares’ is defined at Regulation 7A(8)(b) as meaning an offer or invitation to existing shareholders to subscribe for or purchase further shares in proportion to (or as nearly as may be in proportion to) their current holdings.
Regulation 7A(3) operates to ensure that the amount of profit or loss that is excluded from being brought into account is limited to the extent that the derivative contract has the relevant hedging relationship. It is therefore possible to have contracts where only a proportion is excluded under this Regulation; it all depends on the specific circumstances.