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How do you calculate exchange gains and losses when using Fair Value Accounting?

21 July 2006

As explained in my previous posting in May 2006 “The Tax Law on Foreign Exchange Net Investment Hedging”. mandatory “matching treatment” applies to exchange gains and losses arising on loan liabilities and derivatives that are hedging an investment in a foreign subsidiary.  However, this leaves open the question of how you compute the exchange gain or loss.

This question will be topical for many tax professionals who are currently preparing corporate tax returns for the year ended 31 December 2005 for companies that have applied fair value accounting for derivatives or loan relationships that are hedging foreign currency investments.  As discussed below, although there is a statutory instrument that sets out the tax law, there appears to be no guidance on how to perform the calculations.  Accordingly I have considered that issue from first principles.

(1) Illustrative Example

Consider the following fact pattern.

PLC has invested, say, $100 million purchasing the US subsidiary, paid for out of existing sterling cash resources.  On the day of purchase, £1=$1.80.  To protect itself against translation risk (discussed in “Should companies hedge against translation risk” .)  PLC transacts the following derivative with a bank:

- In 5 years time PLC will deliver $100 million to the bank, and will receive £55.5 million (i.e. the swap is at the current spot exchange rate.)

- Netting will apply to this exchange, so that on the swap closeout date, the parties will calculate a net amount to be paid by PLC or Bank, depending on the spot exchange rate prevailing on the day of closeout.

- As PLC wants to have fixed rate obligations, the swap requires it to pay interest at A% on $100 million, in dollars, every twelve months to Bank.  At the same time Bank will pay interest to PLC every twelve months, calculated at B% on £55.5 million.  Again netting will apply to these twelve monthly periodical swap payments.  A% and B% will be fixed in the swap contract based upon prevailing five year fixed interest rates in dollars and sterling respectively.

Very briefly, what we have here is a fixed/fixed cross currency swap.

(2) Accounting

The basic accounting rule in IAS 39 is that derivatives are always carried on the balance sheet at fair value.  On the day the swap is transacted, its fair value is likely to be zero, if the $/£ exchange ratio and the periodical payment rates A and B have all been set at market rates.

By the time the balance sheet date arrives, the value at which the swap is included on the balance sheet will be £X, where X may be positive (the swap is in the money and an asset), negative (the swap is out of the money) or, possibly zero.

The main factors that cause the fair value of the swap to vary from its assumed initial zero value are:

(a) The spot £/$ exchange rate on the balance sheet date will probably differ from the spot exchange rate prevailing on the day the swap was transacted.

(b) Time will have elapsed from the inception of the swap to the balance sheet date.  With the assumed swap terms, by the first balance sheet date no swap payments will have been made, but the periodical payments will be nearer in time.  By the second balance sheet date, only four periodical payments will remain.  The fair value of the swap always takes into account all future periodical payments, appropriately discounted.

(c) The sterling and dollar yield curves on the balance sheet date will probably differ from the yield curves prevailing on the swap inception date.  These yield curves are used to compute the net present values of the future swap cashflows as part of determining its market value.

(d) The credit worthiness of Bank or PLC may have altered, and this could affect the fair value of the swap, especially if the swap contract does not provide for margining.

In the solus accounts of PLC, the whole of the fair value movement of £X will go to the profit and loss account, as IAS 39 does not allow net investment hedging at a solus level.  (Even if the swap is designated as a fair value hedge of the foreign exchange risk of owning the US subsidiary, the fair value movement on the swap will still go to the profit and loss account.)

The Disregard Regulations require the exchange gain or loss to be disregarded.  One possible view would be to say that none of the profit and loss account movements is an exchange gain or loss, since it is a fair value movement. This apparent conundrum actually caused some difficulty when tax law was being revised to accommodate IFRS.

Historically, tax law has taken a very prescriptive approach in telling corporate taxpayers how to compute exchange gains or losses.  For example, FA 1993 s.94 specified in some detail how to convert foreign currency amounts into sterling, and FA 1993 s.126 then told you how to compute foreign exchange differences on currency contracts.

Accordingly, when the fair value accounting issue described above was first identified, one possible approach would have been a detailed prescription for calculating exchange gains and losses.  However, given the complexity of many modern derivatives, a prescriptive approach would have created a significant risk of the legislation failing to work properly.  Instead, a much simpler approach was taken in “The Loan Relationships and Derivative Contracts (Exchange Gains and Losses using Fair Value Accounting) Regulations 2005, SI 2005 No 3422 .

(4) What the Regulations say

The Regulations apply to both loan relationships and derivative contracts.  In relation to derivatives, Regulation 7(3) specifies that “the exchange gain or loss for any accounting period is the change in fair value between the earlier and later time in that period that is attributable only to fluctuations in the spot rate of exchange between the currency or currencies and the base currency”.

Regulation 8 then states that Regulation 9 applies when there is a fair value profit which is not wholly an exchange gain or loss.

Regulation 9 explains at some length that the “residual profit” is calculated by subtracting the exchange gain from the fair value profit, with appropriate adaptations when there are losses instead of profits.

(5) Potential points of difficulty

(a) How do you apply Regulation 7(3) in practice?

(i)  Version 1

In the example above, at the “earlier time” the fair value of the currency swap is zero.  At the later time (the closing balance sheet date) the fair value is £X, assumed for simplicity to be positive.  Accordingly, how much of the fair value profit of £X is an exchange profit?

One possible approach would be to take the valuation formula for the derivative at the closing balance sheet date, and in that formula replace the closing spot rate with the spot rate on the earlier date (the inception date).  This would output a number, £Y.  One would then treat (X-Y) as the exchange profit.

In most cases, I believe this will be an excessive simplification.  In particular, it fails to address cash transactions (such as periodical swap payments) that have taken place during the accounting period.  Those cash transactions will have contributed to the overall fair value profit or loss in respect of the contract, and their quantum will have been affected by spot exchange rate movements during the accounting period.  In my view, at the very least it appears necessary to proceed as follows:

a) Compute the fair value of the derivative, £X at the closing balance sheet date, using the current spot exchange rate and current market data such as the yield curve.

b) Recompute the fair value of the derivative, £Y, using the opening spot exchange rate, but otherwise using market data at the closing balance sheet date.

c) £X — £Y represents part of the exchange gain or loss for the year.  The other part relates to transactions during the year.

d) For each cash flow during the year in respect of the derivative, compute what the cash flow would hypothetically have been if the prevailing spot exchange rate had actually been the same as the opening spot rate for the period.  The difference between the actual cash flow and the hypothetical one is an exchange gain or loss.  These exchange gains or losses need to be added to the amount calculated at (c) to give the aggregate exchange gain or loss for the year.

In my view, these calculations at (d) risk not complying with the strict words of Regulation 7(3) as they can reflect changes in fair value arising from factors other than exchange rate movements. 

For example if the cross currency swap is at floating interest rates, then the dollar amounts payable/receivable, on which exchange differences can arise, are themselves dependent on market interest rate changes during the year.  As a simple example, if PLC’s swap had been at floating rates, in the first year it might be paying $4m on the dollar leg of the swap, if floating dollar interest rates averaged 4% during the first twelve months.  Accordingly, one would then consider what sterling amounts the $4 million would equal, using the opening and actual spot rates, and treat the difference as the exchange gain or loss on the swap payment.  However, if dollar interest rates had averaged only 2%, there would have been only a $2 million payment to recalculate in sterling, and the calculated exchange gain or loss half that in the previous sentence.  Hence my contention that this approach to the calculations risks including factors other than movements in spot exchange rates, conflicting with the wording of Regulation 7(3).

(ii) Version 2

In my view, the most appropriate way to perform the Regulation 7(3) calculation is as follows:

(1) Compute fair value of the swap at the start of the accounting period, or at inception if later.  Obviously, if the swap was owned during the previous year, the company will have both a monetary figure and a valuation model used to compute the fair value for the previous year’s balance sheet.

(2) Recompute the fair value using market conditions at the opening balance sheet date, but using exchange rates determined as follows.  For cash flows that will arise after the closing balance sheet date, use the closing spot rate in the valuation formula.  For cash flows that took place during the year, use the spot rate on the cash flow date.  The critical point is that one is applying these exchange rates in the valuation formula at the opening balance sheet date, to the originally forecast amounts of these cash flows, and not to the actual cash flows.

(3) The difference between (1) and (2) is the exchange gain or loss during the year, being the change in fair value for that accounting period that is attributable only to changes in spot exchange rates.  All the rest of the fair value profit for the year is attributable to other factors such as changes in market interest rates or the effluxion of time.

To aid my thought process, I built a simple spreadsheet model for a fixed/fixed cross currency swap which you can find at the end of this posting.  This brings out the point, since the exchange gains calculated under the two approaches are different, and the difference arises because during the year the fair value of the swap is changing because the discount on the swap payments is unwinding.  In my view the Regulation 7(3) calculation of the exchange gain needs to exclude the impact of the unwinding discount, which is the reason I prefer the calculation on the spreadsheet tab labelled “version 2”.

(b) What if the fair value profit or loss is zero?

Regulation 8 states that Regulation 9 applies “where there is a fair value profit or loss” which is not wholly an exchange gain or loss.  If the fair value profit or loss is nil, it could be argued that there is not a fair value profit or loss, but in my view, Regulation 9 can be applied perfectly naturally if the fair value profit (or loss) is zero.

However, an alternative reading is to say that the plain words of Regulation 8 require a non-zero fair value profit or loss whereas a nil amount is neither a fair value profit nor a fair value loss.  Consider the following scenario:

Regulation 7(3) will identify an exchange loss of £2m which may be disregarded if the Disregard Regulations are applicable.  Regulation 9 applied naturally will leave a residual profit of £2m which is taxable.

Can the company argue that since there is no fair value profit, Regulation 9 cannot apply?  The scenario is unlikely to arise in practice, since to argue the point the fair value profit would need to be exactly zero, but if the amounts were material I would not be surprised if some company chose to argue the point.

This article was originally written and published by Mohammed Amin.