The TMI Tax Doctor: Achieving Your Hedging Objectives

Welcome to the third column of Tax Doctor. In this issue I look at two questions around the management of cash tax volatility as a result of hedging foreign exchange exposures.

Q1: We are a UK headed group and our primary reporting currency is USD. Our overseas entities have predominantly USD revenues and we hedge their local currency denominated costs of sales out of our central UK treasury company. This is resulting in significant cash tax volatility in both the treasury company (due to mark to market movements on currency forward contracts) and the overseas entities (due to FX gains and losses on revenues reported in their local currencies). What strategies could we consider to manage this tax exposure?

This is a common problem for groups when hedging currency exposures across multiple entities in various jurisdictions. Although you maybe hedged on a pre-tax basis when looking at the group’s consolidated position, the impact of local tax payable can result in an un-hedged post-tax position.

An effective post-tax hedging strategy could be to push down the exposures being hedged by your group treasury company to the various legal entities with the non-USD costs by entering into back-to-back forward contracts. Your UK treasury company would have off-setting positions in its single entity accounts which should then be followed for tax purposes (eliminating its cash-tax volatility). FX movements in the local currency reported earnings of your overseas entities would also be hedged at the single entity level, minimising local tax volatility.

Such a strategy does raise some practical challenges, particularly where your treasury company is hedging on a portfolio basis, so separately indentifying the necessary back-to-back contracts can be complex and time-consuming. However a suitable treasury management system will offer this functionality, from enabling the group treasury company to calculate an appropriate ‘offer’ rate for the internal contracts entered into with group entities (based on the external portfolio position) to producing the necessary transaction documentation.

Although the upfront cost of implementing such a system or upgrading existing systems could be significant, the cash-tax savings on offer can be substantial, as well as the commercial benefits of accurately tracking the group’s FX exposures (avoiding the extensive use of spreadsheets that can undermine the control environment). This will provide greater transparency around allocation of appropriate costs to the entities benefiting from an efficient post-tax hedging strategy, supporting your group’s transfer pricing policies.

Q2: Our group has a policy of hedging local transaction exposures into the local reporting currency of each group entity. As a consequence we then look to hedge the group’s consolidated net cashflow exposure to our main reporting currency. What are the key tax considerations associated with such a strategy?

Although such a hedging strategy generally results in the least local tax volatility (on the assumption local taxation of transactions is calculated on the basis of the reporting currency of the relevant legal entity), the key point to consider is whether such an approach results in a hedged post-tax position. For example, if you are hedging returns to shareholders in the form of dividends then these may well be tax exempt in the parent jurisdiction while the P&L impact of the hedging instrument is taxable, as a consequence an over-hedged position maybe appropriate based on the prevailing corporation tax rate at the parent level. Another consideration would be hedging taxable foreign exchange exposures on intra-group loans denominated in the local currency of the borrowing entity through some form of tax matching, as well as managing any consolidated accounting impact of such exposures. Whichever hedging strategy you choose to adopt, a comprehensive review of the tax implications is essential in order to mitigate post-tax volatility and resulting cashflow costs to the group.

If you have any questions regarding any of the issues discussed in this column, please contact Leo Humphries (details below) in the Deloitte Treasury Tax team.