CFM9140 - Taxing forex: definition of exchange gains: fair value accounting - derivative contracts

Derivative contracts accounted for at fair value

This guidance applies to periods of account beginning on or after 1 January 2005

Regulation 7 of SI 2005/3422 makes similar provision for derivative contracts. It applies in either of two circumstances.

The first of these is where the company

• is party to a derivative contract whose underlying subject matter consists of, or includes, one or more currencies that are not the “base currency” (see CFM9125) of the company, and
• it brings into account, through the profit and loss account or income statement, amounts that arise from comparing the fair value of the contract at different times,
• so that the fair value change is attributable, to a greater or lesser extent, to fluctuations in the exchange rate between the company’s base currency and the other currency or currencies concerned.

For example, suppose that a company with a sterling functional currency (which will also be its “base currency”) enters into a sterling/US dollar cross-currency interest rate swap. Currency – specifically US dollars – is an underlying subject matter of the contract. If the derivative is accounted for at fair value through profit and loss (FVTPL), regulation 7 will apply.

Similarly, the provision would apply to a US dollar/Euro swap, since fluctuations in both the USD/GBP and the EUR/GBP exchange rates will affect the fair value of the swap.

The second circumstance is where currency is not an underlying subject matter of the derivative, but an exchange exposure nevertheless arises because payments fall to be made or received in a currency that is not the company’s base currency. An example would be if a company, with a sterling functional currency, entered into a cash-settled option over commodities where the premium payable, and any amount receivable on exercise, were denominated in US dollars. If the company accounted for the option at FVTPL, the fair value profit or loss would contain an “exchange difference” component, although in practice it is unlikely that the company would ever need to identify separately the exchange gain or loss.

In either of these circumstances, the exchange gain or loss for the accounting period is the change in fair value arising between the earlier and the later time that it attributable only to fluctuations in the spot rate of exchange between the currency or currencies concerned, and the company’s base currency.

HMRC staff should accept any reasonable method of computing this amount. In particular, some companies may simply compute the exchange gain or loss arising on the company’s obligation to pay, or right to receive, foreign currency under the contract. Thus if, for example, a company with a sterling/US dollar swap, under which it will receive $100 million on maturity (in exchange for sterling) may translate $100 million into sterling at the spot rates applicable at the beginning and end of the period, and take the difference between these figures as the exchange gain or loss on the derivative contract. This replicates the approach previously adopted by FA93/S126.

Strictly, this does not comply with the legislation. The fair value of a swap at any time will not just reflect the present value of what will be received or paid on maturity, but also the present value of periodical payments to be made or received, and exchange gains or losses will also arise as a result of these obligations or rights, where they relate to foreign currency amounts. However, HMRC staff should not object to the use of a “simple” method where it is employed consistently, and employed by both parties to the instrument in an intra-group situation, and gives a result that is not materially different from that produced by a more elaborate computation – as is likely to be the case for all but the largest corporates.

Where a more elaborate method is appropriate HMRC staff should ensure that the method used is one that strips out the fair value movements on the instrument that are attributable to things other than changes in spot exchange rates. One way of achieving this would be to apply the spot exchange rates at the closing balance sheet date to the fair value calculation of the instrument at the opening balance sheet date, or inception of the instrument if later.

This may need to be further refined where there are cashflows on the instrument during the period (i.e. to use the spot exchange rates for the dates of the cashflows instead of the closing balance sheet date).

HMRC staff should contact their local advisory accountant where it is unclear whether a method adopted properly identifies the exchange gain or loss element of the fair value movement on a derivative contract.