UK: Too Important to Disregard - Securities and Banking Update May 2005

Last Updated: 11 May 2005
Article by David Ireland

Most Read Contributor in UK, August 2017

The tax Disregard Regulations, developed as a foil to the volatility in tax cash flow requirements based on IAS 39 fair value results, will require companies to keep a vast amount of information on which transactions should be treated as hedges for tax purposes. So much so that many companies are electing to opt out of them. It’s a complex assessment and either way, companies have only one chance to decide – and most have to do it by 1 July 2005.

Decisions over highly complex tax matters are often left to in-house tax specialists or external tax advisers to wrestle with. They come up with a straightforward choice – more tax or less tax – and any necessary approvals are given with minimal effort from treasurer or finance director. When the matter is highly complex and yet only affects the timing of cash payments of tax, even the tax specialists may have better things to occupy them.

When the issue at stake relates to IAS 39 (Financial Instruments: Recognition & Measurement), however, alarm bells ring and suddenly the issue gets a much higher profile. Or at least it should. For many organisations, the accounting implications of IAS 39 are hard enough to deal with, and the task of dealing with the tax implications are firmly within the "too hard" category.

Unfortunately, there is a vital choice to consider, it is a choice that can be made once and once only, and it is a choice that must be made before 1 July 2005 for most listed entities.

The old way

UK corporation tax takes as its starting point a company’s reported profit before tax. For pre-IFRS periods, some further adjustments were required for financial instruments, such as bringing into account deductions for interest charged to reserves or to fixed assets. The majority of hedging transactions were taxed in line with the accounts, such that foreign exchange movements taken to reserves were only taxed on realisation (if at all).

The arrival of IAS 39

As has been widely, and often sensationally, reported, accounting under IAS 39 means lots of big fair value movements creating wild swings in reported profits that bear little relation to a company’s underlying trading result. Whatever one’s view of that statement, and calming announcements accompanying many results reports so far this year may expose it as somewhat melodramatic, the Inland Revenue listened to taxpayers telling it that basing taxable profits on results affected by IAS 39 was unacceptable.

The result is a set of rules known as the Disregard Regulations. The broad objective of these regulations is to disregard, naturally, much of the volatility introduced by IAS 39. Broadly, the regulations attempt to recreate the taxable result under "old" UK GAAP (i.e. that applying before FRS 26 Financial Instruments: Measurement) for arrangements that would have been accepted as hedges under UK GAAP, but fall short of the prescriptive requirements of IAS 39. They apply in three specific areas: investments in overseas shares, currency and commodity contracts hedging anticipated transactions, and interest rates. In essence this is achieved by stripping out the fair value movement required by IAS 39.

The choice

Given the task set of them, the Disregard Regulations are not a bad result. However, in order to work out their effect, someone has to keep a vast amount of information about what transactions should be treated as hedges for tax, notwithstanding their treatment under IAS 39. Such record keeping may bring a cost well beyond any benefit that the regulations may confer, and in recognition of this the Inland Revenue have allowed taxpayers to opt out of the regulations.

Choosing to opt out puts the taxpayer back at square one: computing taxable profits based on accounting profits. This means that any volatility in the profit and loss account extends into the tax computation. A further problem is that one of the ways in which some organisations have sought to reduce volatility in the reported profit is by designating cash flow hedges, which transfer some of the volatility to equity. As the calculation of taxable profits will pick up these equity movements, the current tax charge may be even more volatile than accounting profits, if the opt out election is made.

However, making the opt out election does reduce the compliance burden which could be a mountainous record keeping requirement for, say, a large bank. It sounds like a difficult choice, and one that should be given due consideration.

But here’s the rub. The election can only be made before 1 July 2005 in many cases (although a later date may apply in some circumstances and companies should check their position). And, if made, it can only be revoked in respect of new contracts entered after the revocation – that is, it sticks to current contracts for ever.

Making a decision

It may be possible now to judge the relative balance between the costs and benefits of the election for the year just reported. The starting point of this article, however, was of course that IAS 39 made accounts less predictable and more susceptible to market movements around the balance sheet date. Thus the impact of IAS 39 on the tax computation is inherently difficult to predict, and thus the cost/benefit analysis of the opt out election is almost impossible to complete.

The effect of making the election would be felt in tax cash flows (whilst the cash cost of tax is directly related to the tax computation, the accounting cost is likely to end up very similar as a result of the equalisation effect of deferred tax). Thus the tax side effectively becomes a treasury decision – is it acceptable to have a volatile tax cash flow requirement based on IAS 39 fair value results, or is the arguably more predictable result of a wider application of hedge accounting preferable?

The effect that can more easily be measured, or at least envisaged, is the cost of creating and maintaining records, just for tax purposes, to allow the appropriate financial instruments to be treated as hedges and accounted for as such for tax purposes. Perhaps because this cost seems more real, many organisations that have formed a view so far have been led by the compliance cost of living with the Disregard Regulations and have opted out of them.

Too hard?

Ultimately then, this highly complex matter is of sufficient importance to be considered outside the tax department. Treasurers need to have a say on the cash flow implications, and financial controllers need to explain whether systems can manage the record keeping requirements. Opting out is right for many, but will not be right for all. Either way a decision is made: doing nothing means choosing the record keeping burden. What is clear is that the issue has to come out of the "too hard" pile and go on to the "too important to disregard" pile.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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