CFM5159a - Taxing loan relationships: IAS accounts: Para 6D example

Fair value hedge example

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

A company holds bonds that pay interest at a fixed rate. In order to hedge the risk arising from fluctuations in interest rates, it enters into an interest rate swap, effectively converting the debt from fixed to floating rate. It designates a fair value hedge of interest rate risk, with the bonds as the hedged item and the swap as the hedging instrument.

The effect of using hedge accounting is that changes in the fair value of the bonds, in so far as they relate to interest rate changes, are taken to profit and loss account. But no adjustment is made to the fair value of the bonds for any other reason, for example if the credit status of the issuer changes.

Arguably, the carrying value of the bonds in the company’s balance sheet is not “fair value” as defined in FA96/S103. HMRC take the view, however, that company is using fair value accounting for the bonds. If interest rates rise and amounts are debited to profit and loss as the fair value of the bonds decreases, FA96/SCH9/PARA6D does not preclude the company from obtaining relief.