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HMRC internal manual

Corporate Finance Manual

Derivative contracts: hedging: regulation 9: just and reasonable adjustments: example

This guidance applies to periods of account starting on or after 1 January 2015 where the company has elected for regulation 9 to apply. 

Example of just and reasonable adjustments

Company A is a group treasury company. Where the group is exposed to interest rate risk because of monetary assets or liabilities held within the group, it will hedge that risk by entering into an appropriate derivative with an external counterparty, such as a bank. In its consolidated accounts, the group will designate the relevant asset or liability as the hedged item, and the derivative as the hedging instrument, in a cash flow (or fair value) hedge.

Company A draws up its balance sheet to 30 June each year. On 1 January 20X0 it enters into a fixed to floating interest rate swap as a cash flow hedge (at consolidated level) of £50 million unquoted floating rate notes (FRNs) held by another company, B, within the group. The notes pay LIBOR in arrears on 30 June and 31 December. The swap is at market rates with no premium payable. The terms of the swap are as follows:

Notional principal amount: £50 million

Fixed rate 8% receivable 30 June and 31 December

Floating rate LIBOR payable 30 June 31 December

Maturity 30 June 20X2 (same as maturity of notes).

Following this, LIBOR reduces to 6% so that company A’s floating payments will be smaller than its fixed receipts. On 30 June 20X0, company A receives a net payment of £500,000 being the excess of the fixed receipt over floating payment. Interest rates are not expected to change again before maturity of the swap so company A anticipates receiving 4 further payments of £500,000, with a combined fair value as at 30 June 20X0 of £1,850,000.

It is assumed that LIBOR does indeed remain at 6%, so that overall the company receives five net payments of £500,000.

What is the tax treatment of this swap by company A?

Year ended 30 June 20X0 - normal derivative contracts rules

Company A has elected for regulation 9 to apply.

Company A draws up a balance sheet at 30 June 20X0 showing the swap at its fair value of £1,850,000. Although the swap functions as a hedge at consolidated level, for tax purposes it is necessary to look only at company A. Since company A does not hold the FRNs it does not have a hedging relationship within regulation 2(5), so regulation 9 will not have effect. Company A will therefore be taxed on normal CTA09/PART7 principles on a total of £2.35 million, made up of the £1.850 million increase in fair value plus the £0.5 million cash receipt on 30 June 20X0.

Year ended 30 June 20x1 - swap comes with regulation 9 for the first time

As a result of a change in group hedging policy, on 31 August 20X0 the FRNs held by company B are transferred to company A. The transfer is tax neutral under the group continuity rules. Company A does not designate this as a cash flow hedge. As the swap now begins to satisfy the conditions of regulation 9(1), and since the company has elected for regulation 9 to apply, it must begin to apply the appropriate accruals basis from that date.

On 31 December 20X0 and on 30 June 20X1, company A receives two further payments each of £500,000 from the swap counterparty. The closing fair value for the swap at 30 June 20X1 is £950,000. The company will therefore show a fair value profit on the swap of £100,000, arrived at as follows:

Swap Asset  
B/f £1,850,000 Cash £1,000,000
Income statement (FV profit) £100,000 C/f £950,000

Now that company A holds the FRNs, it will also show in its income statement the interest accrued on the notes since 1 August - that is, 10/12 x £50 million x 6% = £2,500,000.

Under the appropriate accruals basis, company A will need to exclude the fair value profit of £100,000. It will then calculate its return on the FRNs by combining with the interest the payments due under the swap. The overall effect of the swap is that interest receivable on the notes is fixed at 8%. On this basis, its return is £3,333,333 (that is, 8% x £50m x 10 months) so an addition to accounts profits of £833,333 is needed.

Regulation 9(2A) then requires that such other adjustments shall be made as are just and reasonable and with regard to whether amounts would fall out of account or be taxed more than once. The aim is to ensure that over the life of the swap the aggregate net receipt or payment is brought into account for tax purposes.

Here, there is a danger of double taxation. The appropriate accruals basis will bring in all payments that accrue on the swaps from 31 August 20X0, but not anything that accrues before that date. However, the £1.85 million fair value of the swap at 30 June 20X0 - which has already been taxed - takes into account amounts receivable after 1 August, which are now being taxed again.

To ascertain what adjustments are needed, it is helpful to begin by ascertaining what amounts would have been taxed had the appropriate accruals basis applied from inception of the swap to the date that regulation 9(1) began to apply. To the extent that any amounts already taxed exceed this sum, there will need to be a reduction in taxable profits to ensure that they are not taxed twice.

In this example, if the appropriate accruals basis had always applied the amounts that would have been taxed on the swap up to 31 August 20X0 would be:

Net payment received 30 June 20X0 £500,000
Accrual 1 July 20x0 - 31 August 20X0 of swap receipt £500,000 due on 31 December £166,667 (2/6 x £500,000)
Total taxable on accruals basis £666,667
Amount actually taxed on fair value basis £2,350,000

The difference between these two amounts, £1,683,333, represents the amount that would be taxed twice if no adjustment was made.

In addition, Company A must exclude the fair value profit of £100,000 shown in its accounts. The total adjustments required are therefore:

Disregard of fair value profit (£100,000)
Credit on regulation 9 accruals basis £833,333
Regulation 9(2A) adjustment to eliminate double taxation (£1,683,333)
Total Adjustment (£950,000)

Another way of getting to the same result is to make a deduction from profits of £1.85m in year to 30 June 20X1 (since this value relates to future payments that will in part be taxed under the appropriate accruals basis), but as the appropriate accruals basis will apply only after 31 August 20X0, a further adjustment is then need to pick up £166,667 that accrues on the swap between 1 July and 31 August which would not otherwise be taxed.

Year ended 30 June 20x2 - ceasing to satisfy the conditions

Assume now that the company ceases to hold the FRNs from 31 August 20X1 so the conditions of regulation 9(1) then cease to apply. The appropriate accruals basis will apply up to that date with the result that £166,667 of swap receipts will be combined with interest receipts of £500,000 to give an 8% return for 2 months. There would also then be a regulation 9(2A) credit of £833,333 to ensure no profits fell out of account. A total of £1.5 million is therefore taxed.


Overall, the company has received a net payment of £500,000 under the swap on each of the five payment dates from 30 June 20X0 to 30 June 20X2 inclusive - a total of £2.5 million. It has also held the FRNs for 12 months and brought into account interest credits of £3 million (6% x £50 million).

It has been taxed on the following amounts

30 June 2010 = £2.35 million

30 June 2011 = £1.65 million

30 June 2012 = £1.5 million

Total = £5.5 million

Thus the company A’s commercial profit has been taxed once and only once, which is what the legislation is designed to achieve.