CFM62935 – Corporate Finance Manual – HMRC Internal Manual

REG 5ZA(4)(a) and REG 5ZA(6) SI 2004/3256

The amounts resulting from the derivative contract during an accounting period that can be ignored vary depending on the type of derivative contract entered into by the company.

Relevant amount

When the company enters into a forward contract conditional on a transaction or option, the entire fair value gain or loss to the company resulting from the derivative contract is the relevant amount to ignore. This includes foreign exchange gains or losses and premiums or fees.

For any other derivative contract, only the foreign exchange gain or loss is the relevant amount to ignore. The Company will generally be required to adopt fair value accounting for derivative contracts. Therefore, the enterprise will have to separate the exchange gain or loss attributable to movements in the spot exchange rate (see CFM61160).

When several derivatives can be used for the same transaction, for example when an option is initially entered into to hedge foreign exchange risk and is then transformed into an ordinary forward contract, the changes in fair value resulting from the derivative contracts must be separated to ensure that the correct relevant amounts are not taken into account.

Fair and reasonable rule

A derivative contract can hedge more than one economic risk. For example, a company may enter into an option that may hedge an anticipated stock trade and other risks associated with the same currency.

Under REG 5ZA(1)(b), a hedging relationship exists only to the extent that it relates to the forecast transaction being hedged. Similarly, under REG 5ZA(2), there is a relevant hedging relationship if and to the extent that the contract, or part of the contract, is intended to hedge the relevant economic risk attributable to fluctuations in exchange rates. REG 5ZA(6) is a fair and reasonable rule that ensures that the disregarded amount (excluded amount) is an amount proportional to the relevant hedging relationship under REG 5ZA relative to the total amounts arising from the derivative contract.

Share transactions that don’t complete

If a derivative contract is entered into to hedge the economic risk associated with an anticipated transaction or a firm commitment relating to an anticipated future acquisition or disposal of shares, and the proposed share transaction fails (or the share transactions become unlikely such as the intention to cover the downsides), any relevant amount arising from the derivative contract must still be disregarded under REG 5ZA until the date the trade fails. For early share transfers, the EGLBAGL Regulation may still apply to take into account these amounts not taken into account, in the event of a transfer of the shares (see CFM62950).

Hedge accounting

If the company adopts cash flow hedge accounting, changes in fair value (or foreign exchange gains and losses) may initially be recognized in a cash flow hedge reserve and therefore not be recognized at tax purposes in the accounting period in which the amounts arise.

Instead, the relevant amounts are recognized in the cash flow hedge reserve and are then recycled to the income statement so taken into account for tax purposes at that later time (see CFM27160). These amounts may be disregarded under REG 5ZA, provided the conditions were met at the time the amounts were recognized in a cash flow hedge reserve.

If, when cash flow hedge accounting is applied to a highly probable acquisition of shares, changes in fair value (or foreign exchange gains and losses) initially recognized in other comprehensive income are treated as adjustments to the carrying amount of a relevant investment, once acquired, applying the treatment for acquisitions of non-financial assets, see CFM27160, amounts that would otherwise be recognized for tax at that time, under CTA09/S604(2) can be ignored.

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