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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Derivative contracts: hedging: pre-2015: regulation 9 elections: mandatory treatment

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

Contracts where regulation 9 treatment remained mandatory

Regulation 6(5) elections

Regulation 6(5A)(a) provides that an election under regulation 6(5) shall not have effect in relation to interest rate contracts where the following conditions are met:

  • The contract, or a portion of it, is designated as a hedge in respect of risks arising in respect of an asset, liability, receipt or expense.
  • Fair value profits and losses on the hedged item are not brought into account for CT purposes.
  • Fair value changes on the hedging instrument are not brought into account in the company’s statement of changes in equity.

This rule aims to keep within regulation 9 designated fair value hedges where changes in fair value of the hedged item corresponding to the changes in fair value of the hedging instrument are not brought into account for CT purposes. This may happen for example if the hedged item is a fixed rate preference share or connected party debt (since fair value changes on the hedged item will not be brought into account for CT purposes).

Regulation 6(5A)(b) goes further than 6(5A)(a) by providing that all other interest rate contracts that act as hedges of connected party loan relationships must also stay within regulation 9.

The rationale for this is that since connected party debt has to be taxed on an amortised cost basis then any fair value changes to the carrying value of the loan resulting from designation of the hedge as a fair value hedge would have to be reversed for tax purposes. Following the accounts would not in this circumstance be an option, so the legislation aims to mandate the regulation 9 basis that reproduces the economic object of the hedge.

Regulation 6(5B) elections

It was, however, recognised that for some companies - particularly banks - that had large numbers of interest rate contracts, it would be unduly burdensome to have to identify those hedging connected party loan relationships. SI 2006/3236 therefore amended the Disregard Regulations to introduce an alternative election under regulation 6(5B). This has effect for periods of account beginning on or after 1 January 2006 and ending after 27 December 2006 - the effect of the election cannot be backdated to 2005 accounting periods.

Where a company elects under regulation 6(5B), its interest rate contracts remaining within regulation 9 are limited to

  • Those hedges meeting the conditions of regulation 6(5A), in other words fair value hedges of connected party debt, or of other assets or liabilities (such as preference shares) on which no fair value gains or losses are brought in for tax purposes; and
  • Other cases where the interest rate contract hedges connected party debt, and the company uses fair value accounting for the debt. For example, this would include a case where no hedge has been accounted for, but there is a ‘hedging relationship’ between a bond issued by a connected company, which is accounted for at fair value through profit and loss, and an interest rate contract. For accounting purposes, there would be a natural offset in profit and loss between fair value changes on the bond and those on the contract. But for tax purposes, the company must use amortised cost accounting for the loan relationship. Regulation 9 will apply to the derivative contract, thus eliminating the mismatch.

Designated cash flow hedges of connected party debt will, however, come within regulation 9A.

A company cannot have both a regulation 6(5) and a regulation 6(5B) election in force. Making the latter election automatically revokes any previous election under regulation 6(5).