CFM62720 - Foreign exchange: matching under the Disregard Regulations: relevant value: example

Example to demonstrate the extent of matching

Gambone Ltd holds shares in a German subsidiary that were acquired in 2004 for €15 million. Gambone Ltd has a sterling functional currency. In order to hedge the shareholding, it also entered into a 5-year cross currency swap, at the end of which Gambone Ltd is obliged to pay €15 million and receive £10,050,000 in exchange.

On 1 January 2005, Gambone Ltd adopts IAS 39. It continues to show the shares in the subsidiary at cost, because they are unquoted equity instruments whose fair value cannot reliably be measured. The cross-currency swap is accounted for at fair value through profit and loss.

In year ended 31 December 2006, the German subsidiary shows poor trading results, and at the year end Gambone Ltd reviews the asset for impairment and makes an impairment provision of €3 million, i.e. it writes down the shareholding to €12 million. IAS 39 does not permit this impairment provision to be reversed. Although this leaves the company over-hedged, it judges that the transaction costs involved in varying the derivative contract (or entering into second contract to partially reverse the effect of the first) would be disproportionate. It therefore leaves the cross-currency swap unaltered.

Tax treatment

Although the asset was acquired before the adoption of IAS it was accounted for at cost of €15m (£10,050,000) under SSAP20. As the value shown in the IAS accounts is historic cost the carrying value of the asset will be £10,050,000.

The sterling cost of complying with the contractual obligation at is £10,050,000. Therefore the derivative and the asset (the shareholding) are fully tax matched.

On entering the derivative contract:

The spot rate when the contract was entered is €1/£0.67.

The sterling cost of complying with the contractual obligation was £10,050,000 (€15m x 0.67).

At 31 December 2004:

The exchange rate is €1/£0.70.

The sterling cost of complying with the contractual obligation is £10,500,000 (€15m x 0.7)

The sterling equivalent on entry was £10,050,000. Therefore the exchange loss is £450,000.

As this loss was taken to reserves under SSAP 20 and matched with the opposite exchange gain on the shareholding it is disregarded for tax under FA02/SCH26/PARA16(3).

At 31 December 2005:

The exchange rate is €1/£0.65.

The sterling cost of complying with the contractual obligation is £9,750,000 (€15m x 0.65).

The sterling equivalent at 31 December 2004 was £10,500,000. Therefore the exchange gain, for the purposes of this example, is £750,000. (Strictly, the company would need to extract the exchange gain element from the fair value profit on the derivative - see CFM61130)

As the derivative is fully matched with the asset this exchange gain is disregarded under regulation 4(1). The exchange gain may be brought into account under the Exchange Gains and Losses (Bringing into Account Gains or Losses) regulations when the shareholding is disposed.

At 31 December 2006:

The exchange rate is €1/£0.72.

The sterling cost of complying with the contractual obligation is £10,800,000 (€15m x 0.72).

The sterling equivalent at 31/12/05 was £9,750,000. Therefore the exchange loss, for the purposes of this example, is £1,050,000.

The share value has been written-down to €12 million. However, nothing in the legislation entitles us to take the write-down into account for year ended 31 December 2006. The derivative remains fully matched to the shareholding, and the whole of the exchange loss is disregarded.

Year ended 31 December 2007

Again, the time at which the asset is to be valued remains the time at which it was acquired. However, the company now has a derivative with nominal principal amount €15 million, and an asset of book value €12 million. It will be a question of fact whether the company’s intention, in continuing to be party to the contract, is to reduce its exchange exposure on the asset. It is likely that the company only has a “hedging intention” with respect to €12 million of the contract, so that only 80% of the contract would be regarded as matched.