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HMRC internal manual

Corporate Finance Manual

Derivative contracts: hedging: regulation 10: examples

This guidance applies to periods of account starting on or after 1 January 2015 where the company has elected for regulation 7 or 8 to apply. 

Examples of regulation 10

Example 1

A company draws up accounts to 30 June. At 1 June 20X0, it expects to make a purchase of wheat, for the purposes of its trade, on 31 May 20X1. In order to hedge the risks relating to this expected purchase, it enters into wheat future contracts maturing on 31 May 20X1, and designates these futures as the hedging instrument in a cash flow hedge of the forecast transaction.

On 31 May 20X1, the fair value of the derivative contracts is (positive) £50,000, and they are cash settled with the company receiving £50,000. The forecast purchase of wheat also occurs on 31 May; the company pays £300,000 for the wheat. The company’s accounting policy is to make a basis adjustment where the forecast transaction results in the purchase of a non-financial asset. (CFM27150 explains this more fully. Rather than the amount sitting in cash flow hedge reserve being recycled to profit or loss, the carrying value of the non-financial asset is adjusted.)

The cumulative fair value profit of £50,000 in reserves is therefore debited to cash flow hedging reserve and credited to stock, so that the initial carrying value of the stock of wheat is £250,000.

Under regulation 8, the fair value profit of £50,000 on the commodity contract, which is credited to the cash flow hedging reserve (though other comprehensive income), is disregarded. Recycling of the fair value change does no more than adjust the carrying value of an asset - in the terms of CTA09/S595(2), nothing is recognised in determining the company’s profit or loss for the period. So there are no tax consequences. (Even if that were not so, the £50,000 debit to reserves when the basis adjustment is made would be disregarded under regulation 10(10)(b)(ii) - see CFM57280.)

However, the £50,000 falls to be brought into account under regulation 10. Since the purchase price of the wheat is deductible in computing the profits of the company’s trade, regulation 10(3) is in point and the amount must be brought into account in the period or periods in which the purchase price is allowed. This end can be achieved by following the basis adjustment in the accounts, in other words by treating the stock as acquired for £250,000 (rather than the cash price of £300,000).

If the company does not make a basis adjustment in its accounts (e.g. under IAS 39), but recycles the £50,000 from the cash flow hedging reserve to profit or loss in the period or periods in which the purchase expenditure affects the company’s profit or loss, the regulation 8 deferred amount should again be brought back into account under regulation 10(3) for the period in which the expenditure affects the company’s taxable profits. In many cases, this will follow the accounting treatment. It should not, however, be assumed that computational adjustments are unnecessary - while the operation of regulation 10 broadly mirrors the effect of a designated cash flow hedge, it will not always give the same result: see example 4 below.

Example 2

The facts are as in example 1, except that the company enters into the hedging contract on 1 June 20x5; it prepares its accounts to 30 June 20x5 under Old UK GAAP (excluding FRS 26), and then adopts IFRS for its period of account ending on 30 June 20x6. At 30 June 20x5, the contract is not shown on the balance sheet; at 1 July 20x5, it is recognised at an initial fair value of £10,000.

The company therefore has a transitional credit of £10,000 under CTA09/S613. This is disregarded under regulation 8, as are the subsequent fair value profits of £40,000 taken to equity. The amount to be brought back into account under regulation 10 when the forecast transaction occurs is the aggregate amount of £50,000.

Example 3

The facts are as in example 1, except that on 1 April 20X1, the company de-designates the cash flow hedge because it no longer regards the forecast transaction as highly probable, although it still expects it to occur. It does not terminate the hedging contract, but for accounting purposes subsequent fair value changes in the contract are taken directly to profit and loss.

It will be a matter of fact whether or not there continues to be a hedging relationship between the derivative and the forecast transaction. It is likely that, if the company does not terminate the contract, it still intends it to act as a hedge, so that the condition in regulation 2(5)(b)(iii) is satisfied. If so, regulation 8 will continue to apply, so that fair value changes - albeit now taken directly to profit or loss - continue to be disregarded.

The discontinuance of hedge accounting (or even the cessation of a hedging relationship, if applicable) is not, however, a ‘termination event’ under regulation 10. If the forecast purchase of wheat occurs on or before 31 May 20X1, the deferred amounts are brought back into account under regulation 10(3), as outlined in example 1. If the contract matures without the forecast purchase having occurred, they are brought into account under regulation 10(1) when the company ceases to be a party to the contract. A trivial interval (for example, a few days) between a company ceasing to be party to a hedging contract and the occurrence of forecast tax-deductible expenditure, can be ignored.

Example 4

The facts are as in example 3, except that on 1 April 20X1 the company decides that the forecast purchase is no longer likely to occur. It therefore discontinues hedge accounting, and immediately recycles the cumulative profit in equity to profit and loss account. This recycling is ignored under regulation 10(10)(b)(i) and 10(11)(b). A ‘termination event’ will occur when the company ceases to be party to the contract (either on 31 May if it is allowed to run its course, or earlier if the company terminates the contract early). The deferred amounts are brought back into account at that point.