Hedge accounting has been an area of

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1 Volume 9 Issue The Mystery of Hedge Accounting and Its Taxation in Germany By Holger Haeuselmann Holger Haeuselmann discusses the issues involved in reconciliation of a potential conflict between German tax accounting and financial reporting rules applicable to a hedging position. Hedge accounting has been an area of uncertainty in German financial and tax accounting. As of 2010, however, German companies have to apply the amendment to 254 of the Commercial Code that establishes basic criteria for hedge accounting in financial statements. At the end of July 2010, the Institute of Public Auditors in Germany presented a Draft Auditing Standard on this subject. In August 2010, the Federal Ministry of Finance presented its views on the impact of hedge accounting on the determination of taxable income. The views expressed in the Revenue Statement conflict with hp prevalent ent tax accounting practice and may cause eso some difficulties fic in implementation in particular with regard rd to the hedging of shareholdings. The Legal Framework for 2010 With effect from 2010, the German Commercial Code (HGB) was amended by the German Accounting Law Modernisation Act (BilMoG) by introducing the following statutory language on hedge accounting to 254 of the HGB: If assets, liabilities, pending transactions or highly probable forecast transactions are grouped together with financial instruments to compensate opposing changes in values or cash flows deriving from comparable risks (hedging relationship), 249 (1) (regarding provisions for potential losses), 252 (1) Nos. 3 and 4 (principle of item-by-item valuation, imparity principle Holger Haeuselmann is a Partner in the Frankfurt office of the international law firm Freshfields Bruckhaus Deringer LLP. and realisation principle), 253 (1) sentence 1 (historical cost principle) and 256a (principles of currency translation) are not to be applied to the extent that and for the periods in which opposing changes in value and cash flows offset each other. Section 5 (1a), sentence 2 of the Income Tax Act (EStG) requires a taxpayer to adopt such results in its tax accounts: The results from a hedging relationship established in accordance with financial accounting standards and formed to hedge against financial risk are authoritative for the determination of taxable profits. For the sake of completeness it has to be mentioned that the new rules are to be applied by all industry groups including the insurance and banking industry. However, the concept does not apply to financial instruments held in the trading books of a banking institution. Pursuant to 340e(3) of the HGB, financial instruments held by a bank for trading purposes have to be measured at (risk adjusted) fair value. Such valuation is also authoritative for the determination of the taxable profits of a bank. This follows from 6(1) No. 2b EStG. To facilitate the interpretation of 254 of the HGB, the Institute of Public Auditors in Germany (IDW) issued a Draft Auditing Standard on hedge accounting (IDW ERS HFA 35) dated July 23, The German Federal Ministry of Finance (BMF) more or less simultaneously published a letter ruling on the interpretation of the complementary 5(1a) EStG H. Haeuselmann JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 29

2 The Mystery of Hedge Accounting and its Taxation in Germany A Brief Overview of the History of Hedge Accounting in Germany Financial Accounting In the past, hedge accounting had always been an alien element in German financial accounting. Hedge accounting was regarded as contradictory to old-school German accounting principles. German GAAP and, thus, German tax accounting has always been governed by the so-called prudence concept: Assets have to be assessed at the lower of cost or market (historical cost principle). All anticipated risks and losses that arise up to the balance-sheet date have to be taken into account (imparity principle). Gains may only be shown if realised by the balance-sheet date (realisation principle). Assets and liabilities must be measured on an item by item basis (principle of item-by-item valuation). Assets must not be offset against liabilities nor must income be offset against expenses. The discrepancy between these principles and the concept of hedge accounting is obvious. Nevertheless, it had become a common view in the accounting profession that at least the concept of true and fair view as stipulated in 264(2) of the HGB should allow for hedge accounting (whether micro-hedging orm macro-hedging) irrespective re of any restrictive interpretation etation of the prudence principle. To comply with the prudence principle and not to introduce mark-to-market -m ket valuation through the back door, the common view of permitted hedge accounting allowed only an (off-balance sheet) offsetting of unrealised gains and unrealised losses of the hedged item and the hedging instrument. Any excess (unrealised) loss had to be provided for in the accounts whereas net excess (unrealised) gains could not be accounted for due to the realisation principle. Tax Accounting The German tax authorities so far have taken a rather pragmatic approach vis-à-vis hedge accounting. Although official guidance has never been published, the local tax inspectors were prepared to adopt the hedging methodologies as applied for financial accounting purposes. This policy suffered a significant setback in March The German Federal Fiscal Court (BFH) expressed its opinion that at best micro-hedging (item-by-item hedging) would be acceptable for tax purposes. Therefore, in 2006, the legislature felt compelled to amend 5 EStG by introducing subparagraph 1a pursuant to which the results from a hedging relationship established in accordance with financial accounting standards should be adopted for tax purposes. The message was that, whatever the views of the Federal Fiscal Court should be, we the tax authorities are willing to adopt the result for financial accounting purposes also for tax purposes. The amended 5 (1a) EStG did not, however, solve a key problem of hedge accounting in taxes, which is how to deal with the exclusion from the tax base of gains and losses from shareholdings, 2 whereas corresponding gains and losses from hedging instruments are included in the tax base (although potentially being ring-fenced under 15 (4) EStG). Suppose that in 2003 a German corporation invested US $200m in a U.S. subsidiary ( 170m acquisition cost) and entered into a five-year FX-hedge expiring in Suppose further that on expiry the hedging instrument generated an inflow of 40m; correspondingly, the subsequent year end economic assessment of the U.S. investment should reflect a write-down of 40m. The company is commercially flat. But how should the termination of the hedging relationship be reflected in the 2008 financial and tax accounts? More than once auditors have confirmed a recognition without any profit and loss effect: credit cash of 40m, debit participating interests of 40m. It will not come as a surprise that the tax authorities in a number of tax inspections have favoured a different view: the inflow from the expired FX-derivate was treated as generating a fully taxable gain of 40m, while the write-down on the shareholding should not reduce the tax base pursuant to 8b(3) KStG. The IDW Draft Auditing Standard and How It Conflicts with the Newly Issued Revenue Statement on Hedge Accounting Basics of the Hedge Accounting Rules and the Interpretations Thereof Conceptually, the IDW s interpretation of the new 254 HGB is only one opinion amongst others. Practically, however, a company needs to get an auditor s approval of its annual accounts. An auditor on his part will usually apply the IDW s auditing and accounting standards. Thus, the IDW s position CCH. All Rights Reserved.

3 Volume 9 Issue on hedge accounting will have a great impact on standard accounting practice. From a tax perspective, the key consideration is that 5(1a) EStG explicitly requires adoption as far as hedge accounting is concerned of the result recorded in the financial accounts also for tax purposes. That is, 5(1a) EStG precludes the use of tax valuation principles that differ from those used in preparing the financial statements. While this will not force the tax authorities to follow the commercial accounting adopted by the taxpayer in all instances without any consideration of the appropriate application of 254 HGB, it will be difficult for the tax authorities to claim that a taxpayer and its accountant have incorrectly applied the law in preparing the accounts. It is the understanding of the IDW that a company may elect (in its full discretion) whether to apply hedge accounting. If a company is commercially hedged and even if the treasurer of a company has designated a hedging position for commercial reasons, this does not necessarily require the application of theh hedge accounting counting rules. In the opinion of the IDW, even in this case a company may continue to apply ythe concept of item-by-item valuation unless it has explicitly designated a hedging relationship for accounting purposes. In its Revenue Statement of 25 August 2010 the BMF does not address this issue. However, it should be expected that the tax authorities will not accept any right to elect hedge accounting but will simply apply 254 HGB if its criteria are met. On the other hand, it has always been accepted that a company in practice has the choice whether or not to apply hedge accounting, simply by meeting or not meeting the necessary documentation requirements and thus satisfying or failing to satisfy the conditions. The hedge accounting provision of 254 HGB covers balance sheet valuation only. It does not have any impact on the recognition or de-recognition of an item. Thus a realised gain or loss and any income or (effective) expense related to the hedged item or the hedging instrument will be accounted for separately for tax purposes. As a consequence and also not explicitly discussed in the Revenue Statement such inflows and outflows further on should be subject to the same tax The German tax authorities have adopted a rather restrictive attitude. It should not be expected that it is at the taxpayer s option to apply the recently introduced hedge accounting provision. treatment as if the respective balance-sheet item were not part of a hedging relationship. For example, dividend income hedged through a total-return swap (TRS) remains tax-exempt dividendincome within the meaning of 8b(1) KStG whereas the dividend-compensation payment made under the hedging instrument (TRS) constitutes a taxdeductible item pursuant to 8b(3)2 KStG. Suppose that a company has entered into a (payer) liability swap to hedge its floating-rate funding. A perfect hedge may be established and the accountant may have accepted that the company s profit and loss will show only a (netted) fixed-rate interest expense. Nevertheless, for tax purposes the floating-rate interest paid on the funding should be considered when calculating the amount of interest relevant for the interest deduction limitation pursuant to 4h EStG (so-called interest barrier Zinsschranke) or the limited interest deduction for trade tax-purposes ( 8 No. 1 letter a of the Trade Tax Act). Any net inflow under the swap will be fully included in the tax base and, correspondingly, any net outflow would reduce the tax base. The Designation of a Hedging Relationship and Its Consequences The designation n of a hedging relationship firstly requires the identification of the risk to be hedged, whether it is a market risk (e.g., interest rate risk, foreign currency risk, etc.) or a credit risk. Secondly, the hedge must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk. If only a portion of an asset is hedged, the nonhedged portion will have to be measured by applying the general accounting provisions. For example, a German operating company is holding 1,000 shares in a listed German stock corporation. It has entered into 8 single stock-future contracts (contract size 100 shares) to hedge its position. 200 shares have to be measured on an item-by-item basis by applying the general accounting provisions. The hedge accounting rules apply only to the type of risk for which the hedge is designated. Other types of risk changes in value have to be considered by applying the general accounting provisions. JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 31

4 The Mystery of Hedge Accounting and its Taxation in Germany For example, a German operating company is holding a block of shares in a listed U.S. company. It has entered into a US$-denominated single stockfuture contract to hedge its position. On the balance sheet-date the change in value of the shares has to be measured against the future contract. With regard to the share price risk, hedge accounting rules may be applied. However, with regard to foreign-exchange risk (US$against ), the general accounting provisions have to be applied. The application of the hedge accounting rules requires that the hedge is expected to be highly effective (so-called prospective effectiveness). Nevertheless, as in real life, it is unlikely to have a perfect hedge on balance sheet dates, the ineffective part of the hedge (the nonoffsetting changes in value of the hedged item and the hedging instrument) has to be reflected in the accounts. In this respect, the general accounting provisions have to be applied as 254 HGB is applicable only to the extent that opposing changes in value and cash flows offset each other. In the case of micro-hedging, gains and losses can be clearly attributed to the hedged item and to the hedging instrument. Consequently, the ineffective part of the hedged position can be attributed to either of them as well. For example, suppose the amount of ineffectiveness ecti iven on the balance-sheet date is negative because eth the loss from the (derivative) hedging instrument tex exceeds ed the gain from the hedged item. In that case, the eco company must set up papr provision due to the prudence concept. If the negative balance results from a loss in the hedged item exceeding edi the gain in the hedging instrument, t a write down in the hedged-item d should be the consequence. Should the excessamount be positive for whatever reason such amount must not be included in the profit and loss due to the realisation principle according to which gains may only be recorded if and when realised. In case of macro-hedging such attribution is not possible. Therefore a negative balance of ineffectiveness will always have to be reflected by a provision. The negative balance deriving from an ineffective hedging position should in principle be tax-deductible even if not realized. However, if it requires a write-down of an equity position such write-down would not be tax-deductible pursuant to 8b(3) KStG. If the negative balance derives from an excess loss in the hedging instrument, a provision for losses from uncompleted transactions will have to be setup. As an exception to the general rule limiting the tax-deductibility of (unrealised) losses from uncompleted transactions, the respective amount will be tax-deductible pursuant to 5(4a) 2 EStG. However, if the hedged position does not constitute part of the company s core business (so-called ordinary activities) the derivative loss-ring fencing rule ( 15(4)3 EStG) may have to be considered. For example, a German operating company is holding a block of shares in a listed U.S. company. It has entered into a single stock-future contract (SSF) to hedge its position. On the balance sheet-date, the change in value of the shares has to be measured against the future contract. Although a high degree of effectiveness could be expected when designating the hedging relationship the change in value of the shares (hedged item) and the SSF (hedging instrument) on balance-sheet date unsurprisingly does not fully match: Assume the value of the stocks goes down by US$20 whereas the SSF increases by US$19. This requires a write-down of the shares by US$1, which will not be accepted for tax purposes due to 8b(3) KStG. By contrast, assume the market value of the stocks goes up by US$19 whereas the SSF goes down by US$20. The net loss of US$1 will be reflected by a provision. The respective expense item will be taken into account when calculating the company s taxable income due to 5(4a) 2 EStG. However, the tax authorities will claim such loss to be ring-fenced under 15(4)5 EStG according to which losses from other derivates may be offset only against gains from derivatives as e s the hedged instrument is a shareholding that t basically results in tax-exempt capital gains pursuant to 8b(2) KStG. Hedge Accounting on Balance-Sheet Date We finally arrive at the question of all questions: What exact steps are required by the hedge accounting provision (i.e. 254 HGB) on the balance-sheet date with regard to the effective (offsetting) part of a hedging relationship? Two schools of thought exist. And it does not make life easier that (i) the legislator has not provided further guidance on this question, and (ii) the Big-Four accounting firms appear to have different views in this respect: The so-called net method (Einfrierungsmethode). The changes in value of the hedged item and the hedging instrument will be identified. The compensating amounts (effective part of the hedge) will be reflected neither in the accounts nor in CCH. All Rights Reserved.

5 Volume 9 Issue the profit and loss. This would be different for the ineffective part of the hedge (the nonoffsetting amounts). The so-called gross method (Durchbuchungsmethode). The gross method also requires identifying the changes in value of the hedged item and the hedging instrument. However, this method goes one step further: any change in value will be fully reflected at least in the balance-sheet through a parallel write-up and write-down of the hedged item and the hedging instrument, respectively. The IDW also allows such write-downs and write-ups with profit and loss effect. Continuing the above example, the value of the stocks went up by US$19 and the future contract as far as the effective part of the hedge is concerned went down by US$19. Pursuant to the gross method the base of the equity position would be increased by US$19, and correspondingly a provision of US$19 would be set-up with respect to the futures contract. The IDW in its Draft Auditing Standard on hedge accounting ( IDW ERS HFA 35 ) recommends the application of the net method. Commentators consider the gross method as not being in line with 254 HGB. They reason that the gross method would effectively ec result in a mark-to-market valuation. Mark-to-market arket valuation, however, is limited to the eva valuation atio of financial ia instruments held as tradingbook kass assets setss by banks ( 340e (3) HGB). Therefore, the gross method should not comply with the law. 3 In its Revenue Statement of August 25, 2010, 0 the BMF strongly supports the net method and considers it as the only method complying with the spirit and the purpose of 5(1a) sentence 2 EStG, the tax provision addressing hedge accounting. Discontinuation of Hedge Accounting How to deal with an expiring hedging relationship is a somewhat tricky question as well. A hedging relationship may expire if the hedging instrument expires or is sold, terminated or exercised or if the hedge no longer meets the criteria for hedge accounting. Pursuant to the wording of the law, the general accounting provisions (i.e. the prudence concept as explained above) shall be applied if a hedging relationship has expired or terminates. This general statement is supported by the IDW and by the tax authorities. Nevertheless the conclusions and its consequences are very different. According to the IDW, the moment at which the hedging relationship expires constitutes a special cutoff date for valuation purposes. At this cut-off date, the afore-described (hedging) valuation rules shall be applied for the last time before moving back to the general valuation principles. As a result, the supporters of the net method are proposing to roll the gains/ income or losses/expenses resulting from the expired hedging instrument into the basis of the hedged item without triggering a profit and loss effect. Thus, at the end of a hedging relationship the supporters of the net method are adopting the same concept which the supporters of the gross method would already apply at each previous balance sheet date. Continuing the above example (and focusing only on the effective portion of the hedge): the single stock future contract expires. The company has to make a payment of US$19 to the futures exchange. The book entry formula to be applied: credit participating interests US$19, debit cash US$19. Consequently, an immediate disposal of the shares thereafter would result in a profit and loss effect of nil. Contrary to the above, the tax authorities want to apply the general accounting principles right away if a hedging relationship has expired without establishing an additional valuation date. The wording of the law supports this view: 254 HGB deals with valuation only; it does not address recognition or de-recognition. Furthermore, valuation is a balance sheet date issue. Events after balance sheet date are issues of recognition or de-recognition. In cases like the above, the tax authorities would require the taxpayer to include the US$19 inflow from the expired futures contract in the tax base. On the other hand, the company would be required to write down its participation, which would not be deductible for tax purposes as an equity instrument is affected. 4 The Conclusions to be Drawn In its Draft Auditing Standard on Hedge Accounting, 5 the Institute of Public Auditors in Germany (IDW) offers a rather flexible approach. A company may opt for hedge accounting at its full discretion. It may follow the net concept (i.e. compensate gains and losses off-balance sheet) or it may follow the gross concept (i.e. compensate gains and losses on-balance sheet or alternatively also with profit and loss effect). Following IDW upon expiry of a hedging relationship, a company may roll expenses or losses from the hedging instrument into the basis of the hedged item. JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 33

6 The Mystery of Hedge Accounting and its Taxation in Germany The German tax authorities have adopted a rather restrictive attitude. It should not be expected that it is at the taxpayer s option to apply the recently introduced hedge accounting provision. The tax authorities are unwilling to apply the so-called gross method which in essence results in a mark-to-market-valuation on balance sheet dates. Finally, the tax authorities will not accept rolling the results of an expired hedging instrument into the formerly hedged item. The dissenting views of the German tax authorities are particularly crucial with regard to hedged (exempt) equity positions. They may also have an impact on hedged funding positions as far as the application of the interest deduction limitation (so-called interest barrier Zinsschranke) and the limited interest deduction for trade tax-purposes is concerned. ENDNOTES 1 BMF of August 25, 2010, ref. IV C 6 S 2133/07/ b of the Corporation Tax Act (KStG). 3 Same view taken by Scharpf in Küting, Pfitzer and Weber, HANDBUCH DER RECHNUNGSLEGUNG, 5th ed. 2010, 254 HGB note 311. Also preferred view by Förschle and Usinger, in Beck scher, BILANZ-KOMMENTAR, 7th ed. 2010, 254 HGB note b (3) KStG. 5 IDW ERS HFA 35. This article is reprinted with the publisher s permission from the JOURNAL OF TAXATION OF FINANCIAL PRODUCTS, a quarterly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher s permission is prohibited. To subscribe to the JOURNAL OF TAXATION OF FINANCIAL PRODUCTS or other CCH Journals please call or visit All views expressed in the articles and columns are those of the author and not necessarily those of CCH CCH. All Rights Reserved.