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.