Hedging financial arrangements method
Entities enter into various hedging arrangements to manage their exposure to risks such as interest rate and currency exchange rate fluctuations. For example, a foreign currency hedge can protect an entity against the foreign currency exchange risk that arises from the purchase of machinery in a foreign currency at a future date.
For income tax purposes, gains and losses on arrangements may be taxed on a different basis (for example, realisation and accruals). Where a financial arrangement is used to hedge the risk in relation to another arrangement, and each are taxed on a different basis, the effectiveness of the hedge, in a post-tax sense, is reduced.
Tax mismatches could also occur where gains or losses made on an underlying hedged item are taxed on capital account, whereas the gains or losses made on the hedging financial arrangement are brought to account on revenue account.
Although the outcomes under the hedging financial arrangements method will not necessarily align with accounting principles, this method broadly reduces post-tax mismatches ensuring that gains and losses from hedging financial arrangements are included in taxable income at the same time as those made from the hedged items are recognised for tax purposes. This method also matches the tax classification or status of a hedging financial arrangement gain or loss with that of the hedged item.
To be eligible to make the hedging financial arrangements method election in an income year, an entity must meet the common requirements. If the hedging method election is not made, an entity cannot use the hedging financial arrangements method for tax purposes, irrespective of whether a financial arrangement is a hedge for accounting purposes.
Once made, the hedging financial arrangements election cannot be revoked.