Derivatives hedging foreign exchange risk on a share sale or purchase
New regulations designed to prevent tax mismatches arising where derivatives are used to hedge currency risk on anticipated future share transactions.
New regulations designed to prevent tax mismatches arising where derivatives are used
We previously reported on welcome draft regulations that should help to address various corporation tax issues and uncertainties that can currently arise where derivatives are used to hedge foreign exchange (FX) risk on an anticipated future sale or purchase of shares. These regulations have now been enacted (and take effect for qualifying derivatives entered into on or after 1 April 2022). The final version contains several important changes to the original draft.
Please see our previous article of 10 January 2022 for:
- An overview of the original draft regulations published by HMRC on 16 December 2021; and
- A worked example of one scenario potentially assisted by the new rules involving a deal contingent forward currency contract hedging an anticipated future share acquisition.
Key changes made to the final version of the regulations (as compared to the original draft regulations) include the following:
- Although the new regulations will still only generally apply where the anticipated acquisition or disposal is in respect of a ‘substantial shareholding’ (broadly, a 10 percent or more shareholding):
- The final regulations make clear that whether the relevant shareholding is ‘substantial’, will be tested solely when the derivative is entered into (so if further shares are issued during the life of the contract diluting the shareholding to be acquired/sold below 10 percent, this should not cause the benefit of disregard treatment to be lost from that time); and
- Where the company entering into the hedge is a ‘qualifying asset holding company (within the new special regime that is also being introduced from 1 April 2022), the final regulations will also extend to derivatives hedging an anticipated future acquisition or disposal of any ‘qualifying shares’ under that new regime (regardless of whether or not it is ‘substantial’).
- Where a UK parent company enters into a derivative hedging exchange risk relating to an anticipated sale or purchase of shares by its subsidiary, this will no longer be subject to an election regime. Instead, the new regulations can apply to the derivative automatically in certain cases where the parent is providing debt or equity funding to its subsidiary to fund an anticipated acquisition and the derivative is intended to hedge FX in relation to the provision of that new funding. This can apply in relation to a direct or indirect subsidiary, and in circumstances where the company making the anticipated acquisition is not a subsidiary at the time the derivative is entered into, but will become so before the anticipated acquisition (e.g. it has not yet been incorporated);
- The final regulations will not apply if the hedge is entered into as part of a trade that consists of (or includes) dealing in shares or advancing loans; and
- The rules determining if (and, if so, when) any disregarded profits or losses from the hedging derivative might increase or reduce the capital gains disposal value on a future disposal of shares are now more complicated, and can depend on: (i) the specific type of risk being hedged; and (ii) whether the anticipated transaction completes.
UK companies entering into derivatives hedging FX risk relating to an anticipated future acquisition or sale of shares (whether directly by the UK company or by a subsidiary) on or after 1 April 2022 should carefully review the new regulations to determine to what extent their particular transaction will (or will not) benefit from these new regulations.
Given the new regulations will only apply where a company can demonstrate that it ’intends’ to hedge FX risk (of a prescribed nature), it will be important to ensure that contemporaneous documentary evidence of that hedging intention is produced and retained to support any position taken in the UK tax return.