16 June 2023
Recent years have seen high inflation, with interest rates steadily rising, and considerable volatility in exchange rates and commodity prices. Consequently, there has been a significant increase in the use of derivatives, such as futures and swaps, to mitigate the financial risks associated with certain underlying transactions and reduce companies’ exposure to volatility in financial performance.
There is scope for considerable complexity, and volatility in taxable profits, in the corporation tax treatment of derivative contracts. The introduction of the corporate interest restriction (CIR) has added an additional layer of complexity for many companies. The increase in interest rates, in particular over the past 18 months, means that many companies are beginning to see the CIR rules having a much greater impact than at any time since their introduction.
The use of an election to ‘disregard’ the accounting treatment of certain derivatives and recognise gains or losses for tax purposes on a different basis can help ensure that a ‘dry’ tax cost does not arise as a result of differences between the accounting treatment of the derivative and the underlying ‘hedged’ item. However, this does come with added complexity.
It all starts with the accounting
There is a special tax regime for derivative contracts, but it starts from the straightforward premise that tax follows the accounting. Derivative contracts are normally required to be measured at fair value for accounts purposes, with movements in fair value recognised in the income statement (ie as items of profit and loss).
To illustrate: suppose that a derivative contract such as a floating-to-fixed interest rate swap is used to hedge an interest rate risk on a specific loan. The loan itself is measured on an amortised cost basis. If interest rates are expected to increase, the fair value of the swap may increase significantly, resulting in the recognition of a large gain on the hedging instrument, whereas the movement in the amortised cost of the underlying loan is much smaller. Where the requirements are met and the business elects to adopt ‘hedge accounting’, the income statement recognition of hedging gains and losses will be matched with the movements on the underlying hedged item.
The tax treatment of the hedging instrument
Where hedge accounting is applied the tax position is straightforward and the tax consequences of fair value volatility should be manageable.
Problems can arise, however, where hedge accounting is not used – a large fair value gain can significantly increase the corporation tax liability, without increasing the cash available to fund it; ie a dry tax charge.
An election into the corporation tax regime’s ‘disregard regulations’ in respect of certain derivatives may help companies manage the volatility. The disregard regulations broadly put the company in the same tax position it would have been in if hedge accounting applied, but bring an additional compliance obligation, requiring parallel sets of records to be kept for accounting and tax purposes.
Despite the potential cash flow management advantages of electing to disregard, many affected companies have therefore prioritised keeping their tax affairs simple – but the compliance advantages of not making the election may be a mirage for those affected by the CIR.
The CIR and derivatives
The CIR imposes a cap on interest deductions, broadly linked to net UK earnings of corporate groups (including ‘single company groups’), limited to the group’s net external financing costs. The calculations can be complex and offer the taxpayer a number of optional elections, which may result in improved interest deductibility.
Where a group holds derivative financial instruments, the CIR calculations are complicated by an assumption that disregard elections have been made in respect of all eligible derivatives. This not only means that companies affected by the CIR (broadly members of groups with UK financing expenses of more than £2m) will suffer the compliance burden of preparing parallel records for tax and accounting purposes, even if a disregard election has not been made, it can also result in dry tax charges, even where a disregard election has been made.
In some cases this will be a timing difference, and it will be possible to ‘reactivate’ and deduct the disallowed interest in a later period, but in other cases there may be an absolute tax cost.
Electing to disregard
Companies that hold relevant derivative contracts and are affected by the CIR, or are likely to be in the future, would be wise to consider whether an election into the disregard regulations will be beneficial. However, the regulations are very prescriptive. Unless the company is a ‘new adopter’ (ie it is measuring a relevant derivative contract at fair value for accounting purposes for the first time), the election can only apply to contracts entered into after the date it is made. For new adopters, the deadline for making the election varies depending on the size of the company, but it can easily be missed. If it is, an election cannot affect any hedges entered into broadly in the first three years that the regulations may be relevant.
Making a disregard election in respect of a time after the company is a new adopter may present an additional compliance headache, in that the company will have some derivative contracts that are subject to the regulations and some that are not. However, it could nevertheless help mitigate disallowances under the CIR.
Businesses that are considering hedging financial risks for the first time should consider the accounting and tax implications at an early stage, to ensure that any relevant deadlines for elections are not missed.
Furthermore, in light of the interaction with CIR and the current economic climate, those that are accounting for relevant derivatives at fair value for the first time, or already measure hedging derivatives at fair value but have not elected into the disregard regulations, should consider whether an election may now be appropriate if they are in time to make the election.
For more information, please get in touch with Hannah Lloyd or your usual RSM contact.