HMRC internal manual

Corporate Finance Manual

CFM76100 - Other tax rules on corporate finance: Change of accounting basis: amounts excluded

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SI 2004/3271: regulation 3C

Certain debits and credits arising on a change of accounting policy are not brought into account under the Change of Accounting Practice Regulations, for any period. These are set out in regulation 3C and are in general amounts relating to derivative contracts that are embedded, or are hedging instruments and where there is an interaction with the Disregard Regulations (see CFM57000). Regulation 3C(2) lists certain cases where the transitional adjustments are excluded, detailed below.

The Disregard Regulations also operate to initially exclude certain debits and credits on a change of accounting policy in respect of certain currency, debt and commodity contracts – see CFM57130 and CFM57200.

Derivative contracts in pre-2005 convertible securities (embedded derivatives) - regulations 3C(2)(a) and (aa)

Where a company:

  • has a debtor relationship on a convertible or asset linked security;
  • was previously within FA96/S92A or FA96/S93 immediately before the company’s first period of account beginning on or after 1 January 2005; and
  • adopts a new accounting framework/policy whereby the company ‘bifurcates’ (separates) the loan and the option to convert for accounting purposes,

the company is required for tax purposes to apply the derivative contracts rules to the option. CFM81000 and CFM37500 has more on convertible and hybrid securities.

Debits and credits on the loan will not be brought into account, by virtue of regulation 12 of the Disregard Regulations.

Regulations 3C(2)(a) and (aa) ensure that transitional adjustments on the embedded derivative are also not brought into account.

Derivative contracts that are embedded in a contract that is not a loan relationship - regulation 3C(2)(b)

Derivative contracts that are embedded in a contract that is not a loan relationship are treated as closely related to the host contract for tax purposes.  Such contracts (excluding interest rate contracts within regulation 9 of the Disregard Regulations) are taxable in accordance with CTA09/S616 (CFM50430).

Regulation 3C(2)(b) specifies that debits and credits that arise on the transition to a new accounting framework/policy on such contracts are never brought into account.

Interest rate hedges under regulation 9 of the Disregard Regulations - regulation 3C(2)(c)

Regulation 9 of the Disregard Regulations deals with interest rate derivative contracts used for hedging. In certain circumstances, the fair value movements on the derivative are disregarded, and debits and credits on such contracts are brought in on an accruals basis. In effect, the tax treatment of such contracts under ‘old UK GAAP’ continues where regulation 9 of the Disregard Regulations applies and there are no transitional debits or credits to spread. (See CFM57290)

Regulation 3C(2)(c) therefore specifies that no transitional adjustments arising on such contracts are brought into account.

Loan relationships hedged by interest rate contracts - reg 3C(2)(d)

Regulation 3C(2)(d) applies where a foreign currency loan relationship is hedged by a derivative contract.

Where there is a change to a new accounting framework/policy:

  • From the loan relationship being accounted for at the rate implied in the contract – as a ‘synthetic sterling’ asset or liability; to
  • The derivative being brought onto the balance sheet at fair value and the loan relationship being translated at spot rate,

There will be two adjustments – the first to the derivative contract and the second to the loan relationship.

Where regulation 9 of the Disregard Regulations applies, the adjustment to the derivative contract is ignored, and regulation 3C(2)(d) disregards the loan relationship adjustment as well.

Reversal of previous exchange gains and losses - regulation 3C(2)(ca)/(da)

Very occasionally an issue can arise where transitional adjustments represent the reversal of previous exchange gains and losses, typically where the company treats the loan as an equity instrument. The COAP Regulations (regulation 3C(2)(ca) and regulation 3C(2)(da)) provide that such transitional adjustments are not to be brought into account to the extent that those previous exchange gains or losses had been disregarded for tax under one of the following provisions:

  • CTA09/S328(3) or S606(3) (see CFM60000)
  • Regulations 4 to 11 of SI1994/3227 (see CFM86310)
  • Regulation 3 or 4 of the Disregard Regulations (see CFM62600).

Interest rate hedges under regulation 9A of the Disregard Regulations - regulation 3C(2)(e)

Under regulation 6(5) of the Disregard Regulations a company could previously elect out of regulation 9 of the Disregard Regulations, so that the normal tax treatment of derivative contracts will apply to bring in fair value movements on designated interest rate hedges. Where a company elects out of regulation 9, then regulation 9A will apply to disregard for tax purposes the amounts recognised in other comprehensive income (OCI) (that is, the amount recognised as an effective hedge), until they are recycled to the income statement.

Regulation 3C(2)(e) exempts the spreading on transition amounts that have gone to OCI rather than income. It is aimed at the opening adjustments to the cashflow hedge element of shareholders’ equity reserves. This is because these amounts will subsequently be recycled through the income statement, potentially leading to double counting. Amounts that adjust the opening balance of the income statement or profit and loss can never be recycled and are therefore included in the 10 year spread (CFM76090).

This rule was removed for accounting periods commencing on or after 1 January 2016 following the repeal of regulation 9A from the Disregard Regulations. No transitional adjustment will arise in this scenario for the future as the definition of tax-adjusted carrying value excludes amounts recognised in OCI.

Loan relationship component of pre-2005 convertible securities - regulation 3C(2)(f)

This limb applies where a company:

  • has a debtor relationship on a convertible;
  • was previously within FA96/S92A(4) immediately before the company’s first period of account beginning on or after 1 January 2005; and
  • adopts a new accounting framework/policy whereby the company ‘bifurcates’ (separates) the loan and the option to convert for accounting purposes.

Where this applies, regulation 3C(2)(f) ensures that transitional adjustments on the loan component are not brought into account. 

Substantial modifications of stressed debt - regulation 3C(2)(g)

Under certain accounting standards, where there is a substantial modification to a loan the company may be required to derecognise the loan and recognise a new instrument based on the revised terms of that loan. The new instrument will be recognised at its fair value which can result in a significant gain or loss. Where the fair value of the liability has fallen (for example, where the company is facing distress), this will result in a gain being recognised for the company.

In cases where there has been a substantial modification under an old accounting standard, the impact of this accounting requirement may materialise as part of the transition to a new standard.

Regulation 3C(2)(g) excludes the transitional adjustments that relate to a substantial modification (or a replacement) where the company has been in significant financial distress. In particular, where immediately before the debt restructuring it is reasonable to assume that, without the restructuring, there would be a material risk that within 12 months the company would be unable to pay its debt.

Amounts in other comprehensive income (OCI) pre-2016 - regulation 3C(2)(h)/(i)

An amendment to the COAP Regs was made in 2016 to ensure that the spreading rules interact correctly with the transitional rules that apply to the 2016 legislative changes to the loan relationship and derivative contract rules (F(No.2)A15/SCH7/PARAS115-124).

Following the 2016 legislative changes the tax rules for loans and derivatives now follow the amounts recognised in profit or loss. Transitional rules apply in respect of amounts that had been recognised in OCI prior to 2016 and which, as a result, had been brought into account for tax.

To ensure that these two sets of rules operate correctly, the 10-year spreading rule needs to turn off for periods of account commencing on or after 1 January 2016 for amounts which:

  • have been recognised in OCI in an accounting period that commenced before 1 January 2016; and
  • have not been subsequently transferred to become items of profit or loss in such an accounting period. This ensure that transitional amounts are not brought into account under both the COAP spreading rules and the 2016 transitional rules.