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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Derivative contracts: hedging: pre-2015: regulations 7 and 8 election: example

This guidance applies to periods of account starting before 1 January 2015.  

Electing out of regulation 7 or 8: example

The facts are as in example 1 of CFM57220 - the company has used a commodity contract to hedge commodity price risk in a forecast purchase of wheat, and has used cash flow hedge accounting. Fair value profits of £50,000 arise on the derivative, and are initially taken to equity; when the forecast purchase occurs, they are recycled to inventory, so the purchase of the wheat is recorded at the contracted price (£250,000) rather than the cash price of £300,000.

When the basis adjustment is made, the book-keeping will be:

Dr Cash flow hedge reserve 50,000
     
Cr Stock 50,000

Company elects under regulation 6(3)

The basic rules of CTA09/PART7, unmodified by the Disregard Regulations, will apply to the commodity contract. The initial credit of £50,000 to cash flow hedge reserve will therefore be taxable.

The subsequent debit to cash flow hedge reserve, and credit to stock, does not result in any amount being recognised in determining the company’s profit or loss, and so does not have any tax consequences.

In its accounts, the company will recognise the £50,000 ‘profit’ it has made by hedging the purchase when it sells the wheat - by treating it as having been bought for £250,000, rather than £300,000. But for tax purposes, the £50,000 has already been brought into account under the derivative contracts rules. Under CTA09/S699(1), it cannot be brought into account for CT purposes in any other way. So the company will need to make an adjustment in its trading CT computation to exclude any profit (or loss) that has already been taxed.

The same principle applies to prevent double counting of any profit or loss, which has already been taxed or relieved under CTA09/PART7, under any other statutory provisions (for example, capital gains or capital allowances rules).

If the company does not make a basis adjustment, but recycles the fair value change to profit and loss account, the CTA09/PART7 rules will impose a timing difference from the accounts - initial credits or debits to cash flow hedge reserve are taxed or relieved, but not their subsequent recycling.

Company elects under regulation 6(3A)

Regulation 9A will apply to the currency contract. The initial credit of £50,000 to cash flow hedge reserve is disregarded, under regulation 9A(1). As above, the recycling has no effect for the purposes of CTA09/PART7. The wheat is treated as having been acquired for £250,000. No computational adjustment is required - for tax purposes, as for accounting, the £50,000 is brought into account as part of the profit on selling the wheat.

If the company does not make a basis adjustment, but recycles the £50,000 to profit or loss account, the £50,000 credit to profit or loss will not be disregarded (regulation 9A(2)), but the corresponding debit to equity will (regulation 9A(3)). Again, no computational adjustment will be required.

The table below summarises the treatment of anticipatory cash flow hedges, where an adjustment to the carrying value of an asset or liability (a basis adjustment) is made:

Company makes Credits or debits to cash flow hedge reserve. Recycling to the carrying value of asset or liability. Disposal (or revaluation etc) of asset or liability.
       
No election - reg 7 or 8 applies Disregarded - no computational adjustment. No profit or loss within CTA09/S595(2) - no computational adjustment. Asset or liability treated as acquired for ‘cash price’ - disregarded profit or loss on derivative brought into account under reg 10. Computational adjustment needed.
Election under Reg 6(3) - normal Sch 26 rules apply Brought into account. Computational adjustment to amounts in profit or loss needed. As above. CTA09/S699(1) mandates no double counting of derivative contracts profits or losses, so asset or liability treated as acquired for ‘cash price’. Computational adjustment needed.
Election under Reg 6(3A) - Reg 9A applies Disregarded - no computational adjustment. As above. Asset or liability treated as acquired for ‘contracted price’ - no computational adjustment (except where asset within capital gains or capital allowances rules, when acquisition cost will likewise be contracted price).