Debt cap: calculating the disallowance of financing expense amounts: derivatives
Derivative contracts debits are not included
TIOPA10/S313(2)(b) refers to debits that are brought into account ‘in respect of a loan relationship’. This does not include debits relating to derivative contracts that hedge a loan relationship. Although credits or debits on derivative contracts are brought into account under CTA09/PT3 if the contract is held for trading purposes, or CTA09/PT5 otherwise - in the same way as loan relationships credits or debits - they arise in respect of a derivative contract, and not a loan relationship.
This means that where the figure for financing costs in a company’s accounts takes into account the effect of hedging derivatives, the company must identify loan relationships debits separately from debits (or credits) relating to derivative contracts, when computing financing expense amounts.
A UK company has issued fixed rate bonds, but uses an interest rate swap (under which it pays floating rate and receives fixed rate) to hedge its interest rate exposure. The company accounts under FRS 26, and designates the interest rate swap as the hedging instrument in a fair value hedge of interest rate risk. The derivative is measured at fair value.
The interest rate swap is a derivative contract, and fair value changes in the swap give rise to credits or debits under the rules in CTA09/PT7. But these are not debits (or credits) in respect of a loan relationship, and are not taken into account when computing the company’s finance expense amounts (or financing income amounts). However, fair value losses or profits on the hedged item - the bonds - are brought into account for tax purposes and arise ‘in respect of a loan relationship’. Such debits or credits will be, respectively, financing expense amounts or financing income amounts.
The facts are as in example 1, except that the hedge is not sufficiently effective to be designated as a fair value hedge. In consequence, although the interest rate swap is still measured at fair value, the bond liability is measured at amortised cost.
There is nonetheless a hedging relationship between the bonds and the interest rate swap, and Regulation 9 of the Disregard Regulations (SI 2004/3256 - see CFM57290) applies. (It did not apply in example 1, since fair value profits or losses on the hedged item were brought into account for CT, and thus the condition at Regulation 9(1)(b) is not met). As a result, the derivative contract is accounted for on an ‘appropriate accruals’ basis, under Regulation 9(4). Fair value changes are disregarded and, under this basis, the credits or debits to be brought into account from the derivative contract must, when aggregated with interest debits from the bonds, represent the debits that would be given by GAAP, ‘in relation to a … liability representing a loan relationship whose terms include those of both the hedged item and the interest rate contract.’
The aggregation referred to in Regulation 9(4) is, however, purely notional. The effect of Regulation 9 is to disregard the credits and debits shown by the accounts in respect of the interest rate contract, and to substitute credits or debits computed on a statutory basis. It does not alter the fact that there are, for tax purposes, separate ‘loan relationships debits’ and ‘derivative contract debits (or credits)’. When applying section 313, the company must take into account the former but not the latter.
Regulation 9 of SI 2004/3256 aims to replicate the accounting method frequently adopted under UK GAAP where FRS 26 does not apply. The derivative is off balance sheet, and the interest expense shown in the profit and loss account is modified to take account of the effect of the derivative.
For debt cap purposes, the same principle applies where a company actually accounts in this way under ‘old UK GAAP’. It is necessary to unpick the interest expense shown by the accounts, so that only the real interest cost is included as a financing expense amount.