Corporation Tax on Derivative Contracts and Hedging

Introduction

If your company uses derivative contracts (such as interest rate swaps, foreign exchange forwards, or commodity futures) to hedge business risks, the way these are taxed depends on your accounting treatment and whether you elect into special "Disregard Regulations". From 1 January 2015, companies must actively choose how their hedging arrangements are treated for Corporation Tax, with strict election deadlines that can significantly impact your tax position.

What are derivative contracts?

Derivative contracts are financial instruments whose value depends on an underlying asset, rate, or index. Common examples include:

• Interest rate swaps – to manage borrowing costs
• Foreign exchange forwards – to lock in currency exchange rates
• Commodity futures – to fix prices for materials

Companies use these contracts to "hedge" against business risks – protecting themselves from adverse movements in interest rates, exchange rates, or commodity prices that could affect their profits.

Changes to accounting standards

On 1 January 2015, accounting standards changed significantly. Most companies now must use one of the following standards to prepare their financial statements:

• EU-endorsed International Financial Reporting Standards (IFRS)
• FRS 101
• FRS 102

From 1 January 2016, the Financial Reporting Standard for Small Entities (FRSSE) was withdrawn, meaning many small companies also needed to apply section 1A of FRS 102.

Under these new standards, most companies must apply "fair value accounting" for derivative contracts. This means recording derivatives at their current market value in the accounts, which can create significant volatility in reported profits even when the hedging strategy is working effectively.

How derivative hedging is taxed: two main options

There are two fundamental approaches to how hedging relationships are treated for Corporation Tax purposes.

Option 1: Following profit or loss (the default)

The default approach simply follows the amounts recognised in your profit and loss account. If fair value movements on derivatives appear in your profit or loss, you pay Corporation Tax on gains and get relief for losses in the same period.

Under regulation 9A of the Disregard Regulations, amounts taken to a "cash flow hedging reserve" (a separate part of equity) are automatically disregarded for tax purposes.

This approach works well for companies that:

• Use formal hedge accounting in their financial statements
• Have effective hedges with minimal "hedge ineffectiveness"
• Can designate hedging relationships for accounting purposes

However, you will be taxed on any fair value movements that do reach profit or loss, including undesignated hedges or any portion of hedge ineffectiveness.

Option 2: Electing into regulations 7, 8 and 9

Alternatively, you can elect into the detailed computational provisions in regulations 7, 8 and 9 of the Disregard Regulations (Statutory Instrument 2004/3256). These regulations override your accounts and broadly restore the tax treatment that existed under Old UK Generally Accepted Accounting Principles (GAAP) where FRS 26 did not apply.

The effect in most cases is to remove fair value volatility from your Corporation Tax computation where the derivative is part of a hedging relationship. You make adjustments in your tax computation rather than being taxed on accounting movements.

This approach may suit companies that:

• Cannot use hedge accounting in their financial statements
• Choose not to designate hedging relationships
• Have significant hedge ineffectiveness in their accounting

Time limits for making an election

The election deadlines are strict. You must make an election by the later of:

• 6 months from the start of the accounting period where fair value accounting first applies
• 6 months from entering into the first relevant contract
• 12 months from the end of the accounting period (for non-large companies only)

A company is considered "large" if it qualifies for the Senior Accounting Officer rules under Schedule 45 of the Finance Act 2009.

Missing these deadlines means you cannot elect into regulations 7, 8 and 9, and you will default to following your profit or loss treatment.

What happens if you make no election and use no hedge accounting?

Some companies adopt neither hedge accounting nor make an election. In this scenario, your tax treatment follows the amounts in profit or loss, meaning you will be taxed on fair value volatility in your accounts. This is the least common approach and can create significant tax volatility that doesn't reflect your economic position.

Key considerations when deciding

The right approach depends on your specific circumstances. When deciding whether to elect into regulations 7, 8 and 9, consider:

• Whether you can and wish to apply hedge accounting in your financial statements
• How effective your hedges are (the level of hedge ineffectiveness)
• Whether you have undesignated hedges that will show fair value movements in profit or loss
• The administrative burden of making tax adjustments versus accepting accounting-based tax treatment

You can specify which of regulations 7, 8 and 9 apply to your derivative contracts. If you don't specify, the election applies all three regulations automatically.

The Disregard Regulations contain anti-avoidance rules to prevent manipulation, so elections must reflect genuine commercial hedging arrangements.

Who these rules apply to

The Disregard Regulations apply only for Corporation Tax purposes. They do not apply to individuals or other entities that pay Income Tax.

Companies that applied fair value accounting before 1 January 2015 continue with the same treatment without needing to make new elections. The "elect in" requirement only applies to companies moving to fair value accounting from that date onwards.

Getting it right

These rules are complex, and the decision on whether to elect can have significant Corporation Tax consequences for companies with hedging arrangements. The interaction between your accounting policies, hedging strategies, and tax elections requires careful analysis.

HMRC provides worked examples and detailed guidance in the Corporate Finance Manual to help companies understand how the rules apply to common hedging scenarios.

Sources

• Corporation Tax: Disregard Regulations for derivative contracts
• Corporation Tax: derivative contracts, hedging and Disregard Regulations
• Corporation Tax: hedging arrangement examples
• Accounting standards: the UK tax implications of new UK GAAP

This article provides general guidance based on current HMRC rules. For advice specific to your situation, speak to your accountant.