CFM96080 - Interest restriction: group-interest: derivative contracts: application of the Disregard Regulations

TIOPA10/S420-S421

In calculating the amounts of both group-interest and group-EBITDA, any amounts of fair value movements arising on derivative contracts that have a hedging function are to be removed. Instead, the amounts from those derivative contracts should be recognised in line with the hedged item.

This provision is intended to limit the potential mismatch between amounts taken into account in computing a UK group company’s tax-interest amounts or tax-EBITDA and the corresponding amounts taken into account in computing the worldwide group’s net group-interest expense or group-EBITDA. It is also intended to reduce the potentially distortive effects of fair value movements from the calculation of the group ratio arising from derivatives that fulfil a hedging function.

Volatility in tax computations

A UK group company might seek to limit volatility in two ways. First, it might apply hedge accounting at a single entity level and designate derivatives as hedges of specific risks. In the case of a cash flow hedge, most of the fair value movements will not be taxed when initially recognised as an item of other comprehensive income, and amounts will normally be transferred to profit or loss as the hedged item affects profit or loss or on de-designation, maturity or early settlement of early settlement.

However, this approach is not always effective - the hedge and hedged item may be in different companies, hedge effectiveness tests may be failed, preventing hedge accounting or the fair value adjustments may not be taxable. To address these issues, the company may elect to apply some or all of regulations 7, 8 and 9 of the Disregard Regulations (SI2004/3256).

Application of S420

Whichever approach is applied, the notional application of the Disregard Regulations in computing group-interest and group-EBITDA should reduce any mismatch between the tax-based measures, tax-interest amounts or tax-EBITDA, and the accounting-based measures, group-interest and group-EBITDA.

So, in particular, for the purposes of calculating net group-interest expense and group-EBITDA:

  • Excluded derivative contract amounts, as defined in S420(4), are to be left out of the group-EBITDA calculation. These are the amounts recognised in the group’s financial statements in respect of derivative contracts that would not be taken into account for tax purposes, that is to say, prescribed for the purposes of CTA09/S598(1)(a), as a result of the operation of regulations 7, 8 and 9 of the Disregard Regulations (SI2004/3256).
  • Replacement derivative contract amounts are to be included in the group-EBITDA calculation. These are the amounts that would be brought into account in respect of those derivative contract under regulations 9 and 10 of the Disregard Regulations.

In applying regulations 7, 8, 9 and 10 of the Disregard Regulations, the following assumptions are made:

  • All members of the group are within the charge to corporation tax;
  • Elections under regulation 6A of the Disregard Regulations have effect in relation to each derivative contract of each member of the group; and
  • Paragraph (5) of regulation 7 of the Disregard Regulations has no effect.

Where a derivative contract taken out by one group company is hedging a risk arising in another group company, the derivative and the hedged item are treated as being in the company that has taken out the derivative.

The financial statements of the company holding the derivative deal with the derivative contract and the hedged item in the same way as they are dealt with in the group’s financial statements.

Practical application

S420 applies whether or not the derivative contract concerned is entered into by a UK group company. So, it also includes derivatives entered into by overseas companies which are reflected in the group’s consolidated accounts. In these cases, the data required to compute the adjustment may not be readily available. It may be sufficient to apply a high level approach to identifying amounts subject to S420. It is a matter of identifying the fair value movement which arises in respect of derivative contracts recognised in the group accounts which can be reasonably expected to have a hedging function and which is recognised in profit or loss, even though the derivative contract serves a hedging function. Recognition in profit or loss may arise because of, say, a lack of hedge designation or failure to pass effectiveness tests.