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HMRC internal manual

Corporate Finance Manual

Foreign exchange: matching under the Disregard Regulations: condition 2: examples

The ‘intention’ test under condition 2

Example 1

Eckburn plc wishes to acquire 100% of the shares in a target company, whose assets and liabilities are denominated in Hong Kong dollars. To finance the purchase of the shares, it borrows in US dollars, since the Hong Kong dollar is pegged against the US dollar.

There is a clear link in this case between the borrowing and the acquisition of the shares, and - as a matter of fact - the currency in which the loan is denominated will provide an economic hedge of exchange risk from the shareholding (there is no requirement in regulation 3 for liability and the shareholding to be in the same currency). Assuming that this actually was the company’s intention (which seems likely), then condition 2 is satisfied. HMRC staff may wish to look more closely at cases where there is a clear objective correlation of this nature, but it is claimed that the company’s intention was not to hedge.

Example 2

Foxgull (Holdings) Ltd has a net investment in a US dollar subsidiary. Its parent company, Foxgull plc, has bank borrowings denominated in US dollars. At 1 January 2005, when the group adopts IAS (at both consolidated and single entity level), the net investment in the subsidiary is worth $10 million. Foxgull plc designates $10 million of the bank borrowing as a hedge, at consolidated accounts level, of the group’s net investment in the US operation.

During year ended 31 December 2005, Foxgull (Holdings) Ltd itself borrows $4 million from a bank.

The shares held by Foxgull (Holdings) Ltd are not matched under either condition 1 or condition 2 with Foxgull plc’s liability under either condition, because the asset and liability are in different companies.

Is the $4 million borrowed by Foxgull (Holdings) Ltd matched with part of the shareholding? This will be a question of fact. If the value of the shareholding remains at $10 million in the parent company’s accounts, the currency risk will remain fully hedged by the parent company’s borrowing, and it would be unlikely that Foxgull (Holdings) Ltd’s borrowing was undertaken with the intention of hedging the net investment. On the other hand, if the value of the net investment has increased, the group may feel the need to adapt its hedging strategy. Such changes will be documented (particularly if redesignation of the hedge at consolidated level is involved), and it should be apparent from the documentation whether the borrowing by Foxgull (Holdings) Ltd is part of the re-hedging, or whether it was undertaken with some different intention.

It is important to note however that this exercise is purely undertaken to establish the intention of Foxgull (Holding) Ltd’s borrowing. Matching extent, in year ended 31 December 2005, will normally be restricted to the cost of the shareholding in Foxgull (Holdings) Ltd’s accounts even if the net investment has a higher value in its parent’s accounts. But in periods beginning on or after 1 January 2008, a company may elect to match at the higher figure. See CFM62730 for more on this.

Example 3

The facts are as in the first paragraph of example 2 above, but Foxgull plc on-lends $10 million of its external borrowing to Foxgull (Holdings) Ltd. Provided that the intention of the on-lending is to hedge the asset at single entity level, and to allow Foxgull (Holdings) Ltd to match for tax purposes, condition 2 is satisfied. HMRC would not seek in such a case to argue that the asset is already matched by the parent company’s external borrowing.

Example 4 - upstream loans

Another common situation arises where a foreign subsidiary lends money to its UK parent.

For example, UK Co has a wholly owned US subsidiary, US Sub.

US Sub decides to invest part of its available US Dollar cash resources in an upstream loan to UK Co. It makes an upstream loan of $50 million out of total assets of $100 million.

It is necessary to decide whether UK Co intends to reduce the economic risk of holding its investment in US Sub. Some commentators have expressed concern that economic risk is measured at group level because this is the economic entity. Any calculation of risk would therefore exclude intra-group balances such as the upstream loan. This strict interpretation of ‘economic risk’ is not intended. In this case HMRC would look at the intention of the company entering into the liability at an entity level. In UK Co the intention is likely to include a desire to hedge the value of the investment in US Sub. Therefore companies can continue to regard upstream loans as matched with shares in the subsidiary company.