Derivative contracts: hedging: Regulation 7A: hedging proceeds from certain share issues: example
This guidance applies to certain derivative contracts entered into on or after 1 January 2009
On 1 March 2010 it is announced that there will be a rights issue of shares on 1 June 2010. The shares are to be issued in sterling and the price of the shares is pre-announced at £10 per share with 1 billion shares to be issued. The company has a functional currency of US$ and on 1 March 2010 the £/$ spot rate is 1:1.5. The company will, therefore, hope to raise $15 billion. However as the £/$ exchange rate fluctuates between 1 March 2010 and 1 June 2010, the value of the shares in US$ will also fluctuate.
In order to deal with this problem, the company enters into a derivative contract that hedges this currency exposure. This involves entering into a forward contract on 1 March 2010 to purchase $15 billion on 1 June 2010 at a price of £10 billion payable on that date to settle the contract.
On 1 June 2010 the £/$ spot rate is 1:1.
So, on 1 June 2010, if the company had not entered into the forward contract, the company would only have been able to convert the £10 billion raised into $10 billion - a shortfall of $5 billion from expectation.
When closed out on 1 June 2010, the forward purchase contract has made a profit of $5 billion (i.e. $15 billion that the contract has purchased for £10 billion as compared to the $10 billion that £10 billion would have purchased on 1 June 2010).
Reg 7A will ensure that this $5 billion profit on the derivative contract is excluded from being brought into account for corporation tax purposes.