CFM9416 - Taxing forex: matching under Disregard Regulations: regulation 4(4) - matching extent

Extent of matching - regulation 4(4)

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

This rule prevents the matching of a larger derivative position with the asset. It works by limiting the amount that is matched to the carrying value of the asset when the contract is acquired or, if later, when the asset is acquired. CFM9420 tells you more about what is meant by “carrying value”.

This limitation applies to what the legislation refers to as “the value of the obligation under the derivative contract”. This is defined as the value of the company’s obligation to pay, under the contract, an amount of one currency in return for receiving an amount of a different currency. The following example illustrates how this works.

Example

Using the same facts as in the example at CFM9404, Dopmet Ltd has an investment in €200,000 of shares in an Irish company. The exchange rate at 31 December 2006 is £1:€1.32 whilst the rate at 31 December 2007 is £1:€1.45. On the 31 December 2006 accounting date the investment is worth £151,515. At 31 December 2007 it is only worth £137,931 producing an exchange loss on the asset of £13,584.

Dopmet Ltd takes out a swap on 1 January 2007. It agrees to sell €200,000 in exchange for £151,515 (the spot rate at the outset) in a year’s time.

Therefore the value of its obligation under the derivative contract is €200,000 – the amount of Euro it agrees to sell in exchange for £151,515. The derivative is therefore fully matching the value of the shares.

On 31 December 2007 the contract is in the money. The company could only sell €200,000 for £137,931 on the open market but is contracted to receive £151,515 under the derivative contract. The derivative is settled by a payment to Dopmet of £13,584 representing its profit on the contract. This exchange gain is disregarded under regulation 4(1). It may be taxed as a capital gain when the shares are sold, see CFM9346.

Dopmet may then take out another contract agreeing to swap at the opening rate of £137,931 so that the position is matched for another year.

For periods of account beginning on or after 1 January 2008, an obligation to pay an amount of currency under a derivative is treated as matched with an asset to the extent that the carrying value of the obligation does not exceed the carrying value of the asset at “the relevant time” (see CFM9432).