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HMRC internal manual

Corporate Finance Manual

Derivative contracts: hedging: Regulation 10(5): example

Regulation 10(5): example

A company manufacturing copper tubing has an order which it expects to fulfil on 1 December 20X0. It regards it as highly probable that it will receive £1,200,000 on that date. In order to hedge the risks from the forecast transaction, it enters into a forward contract based on copper prices, of notional principal amount £1,200,000, maturing on 1 December 20X0. It designates the forward contract as a cash flow hedge of the forecast transaction. The derivative has a fair value of nil when the company enters into it.

On 15 November 20X0, it is approached by the customer, who asks that only part of the order is delivered in December, with further instalments in January and March 20X1. The hedge is no longer highly effective, and the company discontinues hedge accounting at that point. When the derivative contract matures on 1 December, the company rolls it over into a further copper derivative, with the same principal amount, maturing on 31 March 20X1. No further hedge is designated, but the company’s intention remains to hedge the forecast sale.

Regulation 8 applies to the hedging relationship, with the result that fair value profits or losses on the copper derivative are deferred. The rolling-over of the derivative contract on 1 December is not treated as a termination event, under Regulation 10(7) - see CFM57270.

In the event, the sale of copper tubing results in the sales receipts shown below. The table also shows the fair value of the hedging contract at each date.

Date Sales proceeds received Fair value of derivative
15 December 20X0 £300,000 + £60,000
30 January 20X1 £500,000 + £85,000
12 March 20X1 £200,000 + £50,000

At 15 December 20X0, the company expects to receive further instalments of £500,000 on 1 February 20X1 and £150,000 on 1 March 20X1. It discounts these future cash flows (a discount factor of 5% is used here for illustration) to arrive at a fair value of £995,240 for the entirety of the forecast transaction.

The fair value of the amount recognised on 15 December is £300,000. Thus under Regulation 10(5), the amount of the £60,000 fair value increase to be brought into account on 15 December is:

£60,000 x 300,000/995,240 = £18,086

At 30 January 20X1, the company revises its expectations and now anticipates receiving £200,000 on 1 March 20X1. The fair value of the remaining cash flows is £699,178, of which £500,000 is recognised on 30 January. Fair value changes in the derivative have been:

Up to 15 December 60,000
Already brought into account (18,086)
Further increase to 30 January 25,000
Cumulative deferred amount 66,914

The amount to be brought into account on 30 January is therefore:

£66,914 x 500,000/699,178 = £47,852

At 12 March 20X1, the forecast transaction is completed with the receipt of £200,000. The ‘proportionate amount’ under Regulation 10(5) is therefore 100%. The amount to be brought into account will be:

Cumulative deferred amount on 30 January 66,914
Amount brought into account on that date (47,852)
Subsequent decrease in fair value (35,000)
Brought into account on 12 March (15,938)

Note that the derivative contract credits and debits to be brought into account for tax purposes will not be equal to the amounts that, having remained in equity after de-designation of the cash flow hedge, are recycled to profit and loss when the cash flows from the forecast transaction occur.

After 12 March 20X1, the forecast transaction has taken place in its entirety, so there can no longer be a ‘hedging relationship’ and Regulation 8 will no longer apply. Further fair value changes between that date and the time when the company ceases to be a party to the contract are brought into account in the normal way.

The question may arise whether the hedging relationship has terminated earlier, for example after receipt of the bulk of the sales proceeds on 30 January. HMRC would take the view that the hedging relationship persists unless there is evidence to the contrary, for example if the derivative is designated as the hedging instrument in a hedge of some other asset, liability or forecast transaction.