Technical Note on overhedging and underhedging
In the 2009 Budget it was announced that:
'The Government is aware of certain structured arrangements (often described as overhedging or underhedging) which, although not normally undertaken for tax avoidance, involve fragmenting transactions across group companies to ensure the Exchequer bears the full economic risk to the group. The Government believes that the economic risks should be shared between the Exchequer and business as Parliament intended. HMRC will publish a Technical Note in the summer setting out these issues and potential approaches in more detail.'
The Government is clear that it wants to remove Exchequer risk arising from volatility from exchange movements and other indices
- where there are rules in place to allow businesses to hedge those risks on a tax neutral basis but
- groups deliberately choose instead to offset their risks (either existing or newly created) under structured financial arrangements that leave the Exchequer fully exposed to the risk in question.
This Technical Note sets out proposals for how the risk to the Exchequer from these arrangements can be removed in a targeted manner.
These proposals do not seek to disturb in any way the treatment of trading gains and losses on unhedged speculative positions taken by financial traders and others in financial instruments that are not part of such arrangements.
- sets out the background and framework for the present tax rules on hedging: explaining how those rules provide for effective post tax hedging in many circumstances;
- outlines the Government's concerns with those overhedging and underhedging arrangements which sidestep or exploit the rules to obtain returns or levels of financing costs commensurate with exposure to certain economic risks whilst effectively passing those risks on to the Exchequer;
- sets out HMRC's proposals for stopping these arrangements; and
• includes draft legislative clauses and guidance on how these rules would operate in various scenarios.
We welcome the views of all stakeholders on the proposals set out in this note together with any other points or suggestions you wish to make on alternative approaches. We have set out some particular issues on which we would welcome your views at the end of this note, together with where to address your responses. We would welcome your written responses by 30 September 2009.
We will be holding an open day on 18 September 2009 from 2 pm to 4.30 pm at 100 Parliament Street. Please email Karin McHardy - to register your interest in attending.
Present tax rules on hedging
The Government's approach to the taxation of hedging transactions is to ensure that, as far as possible, legitimate commercial hedging transactions can be carried out on a tax neutral basis. In other words, where a company undertakes a commercial transaction and also enters into a hedging transaction to offset an economic risk from that commercial transaction, the tax rules aim to provide for that hedge to be as effective after tax as it was before the tax treatment of the hedged item and hedging instrument are taken into account.
The present tax rules on hedging are as follows:
Net Investment Hedging
In 2002, as part of the changes to the loan relationships regime and the introduction of the derivative contracts regime, the so-called mandatory matching regime was introduced. It applied to exchange gains and losses on loan relationships and derivative contracts where those exchange gains and losses were accounted for, in accordance with Paragraph 51 of SSAP20, under the 'cover' method. Therefore where the opposite exchange movements on the hedging loan relationship or derivative contract and the foreign investment were offset in the reserves of the company, the exchange gains and losses on the hedging instrument would be left out of account and only brought back into account (in certain circumstances) as a capital gain or loss when the asset was disposed of.
Where a company invested in a foreign operation in the form of debt as opposed to equity and the accounting treatment provided that the exchange gains and losses on the loan were taken to reserves, the exchange gains and losses were left out of account until the loan was terminated or disposed of, and then brought back into account as an exchange gain or loss on the loan relationship.
These accounting-based provisions still apply for companies that account under old UKGAAP.
In 2005 the introduction of International Financial Reporting Standards as well as new UKGAAP accounting standards FRS23 and FRS26 required further legislative intervention to ensure that hedging could be effective after tax for companies using these standards.
The new accounting rules do not allow net investment hedging at entity-level, although it may be possible in some circumstances to designate a fair value or cash flow hedge of the exchange risk. Consequently, the tax rules tied to the former accounting treatment were no longer effective in most circumstances in preventing tax mismatches. The Disregard Regulations were therefore introduced. Regulations 3 and 4 deal with hedging the exchange risk on certain assets - shareholdings, ships and aircraft - and with loan relationships and derivative contracts respectively. The rules apply where there is a designated hedge of the exchange risk for accounting purposes, or otherwise, where there is a hedging intention and have the effect of disregarding the exchange gain or loss on the loan relationship or derivative contract. But that disregarded exchange gain or loss is brought back into account in certain circumstances as a chargeable gain or loss on disposal of the asset in question.
There are also provisions that allow the tax neutral hedging of a company's own share capital in certain circumstances.
Fair value and cash flow hedges
The new rules on accounting for derivatives introduced in 2005 meant that new tax provisions were required to prevent tax mismatches from fair value and cash flow hedges. The potential for mismatches arose from the requirements under the accounting rules that the derivative contracts be fair valued (and thus generally taxed on this basis) whereas the item being hedged was either accounted for and taxed on a different basis or was a future transaction with no present tax consequences.
Again the driver for the new tax regulations was to ensure that hedges using currency contracts (regulation 7), interest rate contracts (regulation 9) and commodity contracts (regulation 8) were effective after tax. They do this in a number of different ways to cater for different circumstances, but the fundamental intention is to provide for symmetrical taxation treatment for the profits or losses for the hedged item and the hedging instrument in respect of the risk being hedged.
Hedging Rights Issues
On 10 March 2009 the Financial Secretary to the Treasury announced the Government's intention to extend the Disregard Regulations to allow for the effective post tax hedging of the economic risk to the capital raised from a future rights issue due to exchange movements. These rules apply where the shares are being issued in a currency other than the issuing company's functional currency and where the company wishes to fix the functional currency value of the capital raised under the rights issue. Regulations introducing these rules came into force on 5 August 2009.
So, there are a number of provisions on the statute book that allow companies to enter into commercial hedging transactions on a tax neutral basis. These rules, in the case of foreign exchange, remove the tax risk from volatility in exchange movements for both business and the Exchequer.
Risk is priced into transactions in a number of ways. Interest rates are tied to credit rating, so the higher the credit risk a lender is exposed to the higher the interest rate he will require to bear that risk, (that is, higher returns are available under investment strategies which expose the investor to higher risks). There is also a theoretical correlation between the relative exchange rates of currencies and their interest rates (so-called interest rate parity), such that borrowing in one currency and investing in another should yield a return on translation into the first currency just sufficient to repay the borrowing and accumulated interest.
Overhedging and underhedging transactions seek to obtain a higher return or lower borrowing cost without actually bearing the risk that is priced into that financial outcome. Instead that risk is borne by the Exchequer.
These transactions are structured to create a mix of assets and liabilities whose values are subject to opposing movements, normally across a number of group entities. These movements arise from fluctuations in rates, prices or reference indices (for instance foreign exchange movements between two currencies) where the changes in value on one side are taxed or relieved as income and the opposing changes in value on the other side are either non-taxable or taxable as a chargeable gain or allowable loss, but only where (and when) there is a disposal of the asset. In relation to the instruments hedging the exposure on the assets, the arrangements are normally structured to ensure that the tax neutral hedging rules do not apply and that these instruments are fully tax exposed with regard to the fluctuations in question.
The relative values of the assets and liabilities are such that, regardless of the movement of the rates etc., the group (or the particular group entities concerned) as a whole will be economically flat, once the opposing movements in the values of the assets and liabilities together with the corporation tax on the instruments (that is, those instruments whose movements in value are taxed as income) is taken into account.
This allows the group to make the returns or benefit from funding costs corresponding to exposure to the fluctuations in question, but without actually having the exposure.
It may be the case that the group has an existing foreign investment for which it wants to hedge the exchange risk, but due to the interest rates prevailing for the currency in question, also sees an opportunity to further benefit from the cheaper foreign borrowing Or it may be that the whole structure is created as a risk free carry trade. See the examples below:
Example 1 - Existing Net Investment
Company A is a member of X Group. It invests £100m in yen-denominated shares in a subsidiary.
X wishes to protect the group from the foreign exchange risk from yen depreciating against sterling.
If A borrowed £100m equivalent yen to hedge the shares such that regulation 3 of the Disregard Regulations applied the foreign exchange movement on the borrowing would not be taxed (if at all) until the shares were disposed of due to the tax matching provisions.
However (for the purposes of this example) yen interest rates are significantly lower than sterling so X sees a chance of benefiting from the lower borrowing rate whilst not being exposed to the risk of the yen appreciating against sterling (which would increase the sterling equivalent amount to be repaid) by passing the risk on to the Exchequer. The group has a real commercial need for the funds in question which would otherwise have been borrowed in sterling.
So company B, another member of X, and an affiliate of A, undertakes the borrowing.
Instead of borrowing £100m sterling equivalent yen needed to hedge the shareholding it borrows £139m equivalent. The quantum of the borrowing in excess of that required to hedge the shareholding (the 'overhedge') is determined by grossing-up the £100m by the corporation tax rate (CT rate is 28%. £100m net of CT = £72m. Gross-up = £100m x 100m/72m = £139m)
So what is the effect?
If sterling depreciates by 10% against the yen:
Shareholding is worth £110m equivalent = £10m gain (no immediate
Borrowing now is equivalent to £152.9m = £13.9m loss (£139m + 10%), but tax relief of £3.9m (13.9 x 28%) = £10m net loss
So X Group is economically neutral overall.
If sterling appreciates by 10% against the yen:
Shareholding is worth £90m = £10m loss (no immediate tax effect)
Borrowing now is equivalent to £125.1m = £13.9m gain (£139m - 10%), but tax due of £3.9m = £10m net gain
So X Group is economically neutral overall but the Exchequer bears the risk of foregoing tax as a result of losses on the hedge (or benefits from taxing any gains).
Irrespective of the movement in exchange rates, X Group benefits by being able to borrow a higher amount at lower interest rates.
Example 2 - Wholly Structured Transaction
Bank group Y wishes to benefit from the interest differential between Japanese Yen (JPY) and sterling without being exposed to the JPY:sterling exchange rate fluctuations.
The above structure allows it to sell JPY forward in return for sterling. It sells at the JPY:sterling spot rate and receives the differential between JPY and higher sterling interest rates on the principal.
Holdco invests in a Limited Partnership (LP) that then invests in JPY bonds.
Holdco's LP interest which represents its interest in the underlying bonds is £100.
It has a JPY:sterling cross-currency swap ('XCS') with BankCo with a notional principal of £100.
It also enters into a forward contract ('FWD') for £39 with bank under which it will sell yen for sterling with a settlement date when XCS unwinds.
BankCo has mirror positions out to the market.
Holdco is accounting under old UKGAAP and is treating the XCS as a hedge of the LP interest which is being contract rate accounted. It will be brought into account on unwind.
The principal on the forwards are treated as a hedge of the tax on the XCS and will be brought into account when the tax on the XCS is brought into account.
LP has a JPY functional currency and so will not recognise any exchange gain or loss on the bonds.
The outcome is as follows:
If JPY depreciates by 10%:
Loss on JPY bonds is £10 (reflected in values of Holdco's LP interest).
LP does not itself have an exchange loss as it has a JPY functional currency.
Holdco has a gain of £10 on its XCS. Holdco has a gain of £3.9 on its FWD. Tax thereon is £3.9.
BankCo has matching gains and losses of £13.9.
So the Y as a whole is economically flat (£10 loss on bonds matched by £10 after-tax gain) but has obtained a higher return than investing in sterling.
If FC appreciates by 10%:
Gain on JPY bonds is £10 (reflected in values of Holdco's LP interest).
LP does not itself have an exchange gain as it has a JPY functional currency.
Holdco has a loss of £10 on its XCS. Holdco has a loss of £3.9 on its FWD. Tax relief thereon is £3.9.
BankCo has matching gains and losses of £13.9.
So Y as a whole is economically flat (£10 gain on bonds matched by £10 tax charge) but has obtained a higher return than investing in sterling.
In both these scenarios the volatility risk to the Exchequer is the same, and in both instances the motivation for the groups creating the pre-tax volatility is to gain financial advantage with the risk effectively underwritten by the Exchequer.
The examples focus on foreign exchange arrangements, but HMRC is aware of these arrangements being used in relation to other risks. The proposed provisions will therefore apply more widely than just foreign exchange.
The Government recognises that there will be situations where groups are seeking to undertake commercial hedging transactions not covered by the present tax neutral hedging provisions. Where such situations arise there is no intention to prevent groups from undertaking overhedging or underhedging transactions where this is the only realistic way to provide an effective post tax hedge of the risk in question.
Concerns with these arrangements
The principle concern with these arrangements is that they expose the Exchequer to significant tax risk from volatility in exchange rates and other indices.
In addition, since these transactions would not be economically viable for the business if the risks could not be passed on to the Exchequer, they allow groups to enter into arrangements that are intrinsically non-commercial, distort activity and provide groups that are prepared to undertake these transactions with an unfair advantage over others.
Proposals to address the risk
This note includes draft clauses (PDF 72K) setting out the proposed approach to remove the Exchequer risk from these transactions.
The main features of the proposed approach:
The arrangements that these proposals seek to address must have a main purpose of obtaining the financial advantage (higher return or lower borrowing costs). Therefore the rules will not apply:
- where there is no other way of obtaining a tax neutral hedge,
- where there are accidental or serendipitous positions across a group with respect to a certain risk that would otherwise meet the conditions, or
- where an overhedged position within the ambit of these rules occurs purely due to an error or a mistake.
The risk transfer scheme:
The relevant arrangements are those which meet the above purpose test and where all of conditions A to C are met.
- condition A is that the financial advantage would only have been obtained by exposure to the 'risk' (see below) or by taking out a commercial hedge to offset the risk;
- condition B is that as a result of the scheme the group is not exposed to the risk or only a negligible proportion of the risk;
- condition C is that pre-tax the group is exposed to the risk
In determining whether the conditions are met one must look to group members that are party to the arrangements. The 'risk' in question is taken to be where those group members together will make a combined net economic loss from the relevant fluctuations in exchange rates or other indices or prices.
Meaning of group:
For the purposes of these provisions Company A's fellow 'group' members are:
• companies whose financial results are required to be consolidated
with Company A under section 399 Companies Act 2006 into the same group
consolidated accounts (or would have been required to do so if the exemptions
under subsection (3) had not applied),
• companies in which Company A or a company in the above bullet has a major interest,
• companies that are connected with Company A (under the section 466 Corporation Tax Act 2009 (loan relationships) definition) and companies in which they have a major interest
Operative Provisions - Disallowance of certain losses
Where a company is party to a risk transfer scheme in any accounting period the loss on a loan relationship or derivative contract arising from fluctuations in the rate of exchange, prices or index in question that is part of the risk transfer scheme will be left out of account in determining the debits to be brought into account by that company in that accounting period to the extent that:
- it does not from part of the overall pre-tax net economic loss to the group companies that are party to the arrangements from the fluctuations in question over the relevant period, and
- there is no corresponding profit from a loan relationship or derivative contract that is part of the arrangements
Applying these rules to the examples 1 and 2 above, you would get the following outcome.
Where Yen appreciates by 10% Company A has a £13.9m loss from fluctuation in the yen:sterling exchange rate.
Company B is also party to the risk transfer scheme. So the 'body' that is party to the scheme is Companies A and B.
The pre-tax net ecomomic loss is:
Company A economic loss (£13.9m)
Company B economic profit £10m
Net economic loss to the body (£3.9m)
So company A's loan relationship loss to be brought into account will be restricted to £3.9m.
Where Yen appreciates by 10% Holdco has a £13.9 pre-tax loss.
Bank economic position 0
Holdco economic loss on derivatives (£13.9)
Holdco economic gain on LP interest £10
Net economic loss to the body (£3.9)
So Holdco's loss to be brought into account on the on the XCS and the FWDs will be restricted on a combined basis to £3.9.
As noted above we will be having an open day at 100 Parliament Street on 18 September 2009 to discuss these proposals in more detail, but we would also welcome any written views by 30 September 2009. Your views on all aspects of these proposals would be welcome, but in particular:
- whether the present draft clauses achieve the aim of removing Exchequer risk from these arrangements,
- whether they are properly targeted at the relevant arrangements,
- it is possible that banks and other financial traders could use tax relief from trading transactions involving instruments other than loan relationships or derivative contracts as part of a risk transfer scheme, therefore do you agree that, in the case of financial traders, the rules should be extended beyond loan relationships and derivative contracts to overhedging and underhedging schemes that rely on tax relief on any relevant Case I deductions, and if not, why not?
- any particular areas of concern with the rules as presently drafted,
- any areas of concern with the overlap and interaction of these rules with other provisions.