Derivative contracts and hedging

Produced by Tolley
Derivative contracts and hedging

The following Corporation Tax guidance note Produced by Tolley provides comprehensive and up to date tax information covering:

  • Derivative contracts and hedging
  • Hedging interest expense
  • New UK GAAP and IFRS
  • Hedge accounting ― cash flow hedges
  • Hedge accounting ― fair value hedges
  • Hedging overseas investments
  • Commercial scenario
  • Accounting treatment
  • Corporation tax treatment
  • The Disregard Regulations

This guidance note provides assistance with the rules governing the taxation of derivative contracts that are used to hedge monetary assets and liabilities and net investments in overseas operations. See the Derivative contracts guidance note for more general information on the taxation of derivative contracts.

See also Simon’s Taxes D1.852 onwards for a more detailed discussion of derivative contracts and hedging.

Hedging interest expense

New UK GAAP and IFRS

Under new UK GAAP and IFRS, derivative contracts must be shown on the balance sheet at their fair value and changes in the market value reflected in the income statement, unless hedge accounting is adopted.

Market value movements in interest rate hedges reflect changes in market interest rates and counter-party risk. The former risk in particular can fluctuate considerably. Although the fluctuations typically reverse over the life of a contract, such movements can cause volatility in the annual financing expense. Hedge accounting is designed to reduce this volatility.

See Example 1.

Hedge accounting ― cash flow hedges

Corporate treasurers will typically use a hedging instrument, such as an interest rate swap, to mitigate the effect of a future rise in interest rates on variable rate borrowings of the company, or on variable rate bonds issued by the company. Most corporate debt is borrowed on ‘floating rate’ terms and then ‘swapped’ into fixed rate debt. Due to the laws of comparative advantage, it is typically beneficial in reducing financing costs for both parties entering into a swap. A financial institution will sit in the middle between the two counter-parties and take a share of the profits, although they may also charge an arrangement fee.

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