CFM13274 - Taxing derivative contracts: hedging: hedging relationship

What is a hedging relationship?

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

Regulations 7, 8 and 9 all require there to be a “hedging relationship” between a derivative contract and a particular hedged item. Regulation 2(5) defines what is meant by a hedging relationship.

If the derivative and the hedged item are designated by the company as a hedge, there is automatically a hedging relationship for the purposes of the Regulations. “Designated” has the same meaning that it does for accounting purposes. Where a hedging relationship has been designated under IAS 39 or FRS 26, the company will have documented in advance its hedging strategy and the nature and purpose of the particular hedge under consideration, and it will expect the hedge to be highly effective ( CFM16285).

There may, however, be a hedging relationship for tax purposes even where the criteria in IAS 39 or FRS 26 for hedge accounting are not satisfied. The test is whether the hedging instrument is intended to act as a hedge of

• the exposure to changes in fair value of an asset or liability, or an unrecognised firm commitment, which is attributable to a particular risk and could affect the company’s profit or loss
• the exposure to variability in cash flows associated with an asset, liability or forecast transaction, which is attributable to a particular risk and could affect profit or loss; or
• a net investment in a foreign operation of the company.

See CFM16040 for the meaning of “firm commitment” and “forecast transaction”. CFM13275 gives guidance on the interpretation of “intended to act as a hedge”.

Where there is a hedging relationship, application of the Disregard Regulations is mandatory unless the company has elected out of the relevant regulation. A company cannot, for example, apply the Disregard Regulations to designated hedges, but not to “failed hedges” which do not meet the IAS 39 hedging criteria.

A “hedging instrument” may comprise all or only part of a derivative contract. Similarly, the “hedged item” may be all or only part of the overall asset, liability or transaction.