Using financial derivatives to hedge against foreign exchange risk

HMRC have published draft regulations for consultation that, if enacted, would align the corporation tax treatment of certain gains and losses on derivative contracts hedging currency risk on anticipated future acquisitions or disposals of shares with the corporation tax treatment of the underlying hedged risk. Thus, removing certain tax mismatches that can arise under the existing rules. These draft regulations are welcome and should help to address tax issues and uncertainties that can currently arise where anticipated future share transactions are being hedged. 

Example: forward currency contract hedging a forecast share acquisition 

To provide an example of one scenario potentially assisted by the new rules, assume a UK company with a GBP functional currency anticipates that it will acquire a 100 percent shareholding in a US company for consideration of USD 10 million in six months’ time. To hedge the exchange risk from this forecast transaction, the UK company enters into a deal contingent forward currency contract to buy USD 10 million for GBP 7.5 million in six months’ time. As the forward currency contract is ‘deal contingent’ it will expire if the share acquisition does not complete.

Under the existing tax rules:

• Fair value profits and losses in respect of the forward currency contract may be taxed or relieved as income items over the life of the contract;
• By contrast, any offsetting losses or gains reflected in the cost of the shares to be acquired are effectively taxed or relieved as capital items if and when the shares are disposed of (and may be exempted from tax at that time, applying the substantial shareholding exemption or the proposed new asset holding company rules); and
• Therefore, a tax mismatch may arise between the hedging instrument (the forward currency contract) and the hedged item (the shares forecast to be acquired).

Broadly speaking, the new rules may require fair value profits and losses in respect of the forward currency contract to be disregarded for tax purposes, with any net disregarded amounts adjusting the gain or loss on a future disposal of the shares to be acquired. If the forward currency contract was not ‘deal contingent’ then only exchange gains and losses would be disregarded and brought back into account in this way.

Some other key points to note

• The new regulations will only apply to derivative contracts entered into on or after 1 April 2022;
• The new rules will only apply where the anticipated acquisition or disposal is with a third party and is in respect of a ‘substantial shareholding’ (broadly, a 10 percent plus shareholding). If further shares are issued during the life of the contract diluting the shareholding to be acquired/sold below 10 percent, the benefit of the disregard treatment may therefore be lost from that time;
• Where the hedging derivative is a ‘deal contingent forward contract’ (or an option) to which the new rules apply, as the whole fair value gain or loss is disregarded, tax relief as an income deduction will no longer be obtained for any fee paid to the counterparty;
• As well as addressing cases where the currency in which a forecast share sale or purchase is denominated differs from the company’s functional currency, the new rules are also intended to apply where:

o the currency of a forecast share acquisition differs from the currency of the anticipated debt or equity financing for the acquisition, or

o the currency of an exempt dividend paid prior to an anticipated share disposal (i.e. a pre-sale dividend) differs from that of the recipient’s functional currency.

• The new rules will apply automatically if the relevant conditions are met within the same company. However, where a parent company enters into a derivative hedging exchange risk on an anticipated sale or purchase of shares by its subsidiary, an election must be made to apply the new regulations on or before the date the derivative is entered into;
• The new regulations can only apply to a derivative entered into with a connected person if that connected person has entered into an equivalent derivative with a third party; and
• Any representations regarding the draft regulations should be sent to HMRC by 24 January 2022.

For further information please contact:

• Paul Freeman