Satisfying hedge accounting compliance is 9/10th of the law for TOFA
Retirees and hedge accounting have probably never been mentioned in the same sentence before so sit back and strap yourself in, you are about to read something more original than a pair of Air Jordan 1’s!
To provide some context, imagine you are a fund manager of an Australian fund that invests in assets from outside of Australia i.e. an International Managed Fund.
As a result, the fund is naturally exposed to fluctuations in foreign exchange rates which can negatively impact the performance of the fund.
Some of your investor base are retirees who have little to no alternative income except for the income distributions received from this fund. They rely on this income to fund their regular living expenses.
To mitigate this risk, the fund chooses to hedge foreign currency exposure by deploying currency overlay strategies, further explained here.
However, hedging the fund performance with the use of derivatives can increase the volatility of the income distributions due to a tax timings mismatch, further explained below.
For the retiree, this is not ideal, as they want to have consistent income distributions to pay for their everyday expenses!
The mismatch occurs because the underlying asset that is being hedged is held for a number of years and changes in the value of this asset will only be distributable when they are finally realised.
Whereas the derivatives (typically FX Forward Contracts with maturity in 90 days) are realised on a much more frequent basis with the gains/losses on these instruments impacting the fund’s distributable income immediately, generating the added volatility mentioned above.
The trustee of the fund is effectively forced to distribute all the realised income for the year, as failing to do so would create a tax liability for the trustee on the undistributed income at the top marginal tax rate (currently 47% including the Medicare Levy)!
TOFA hedging election
To help investors, like retirees, achieve consistent distributions more aligned to the economic fund performance, the taxation policy setters have made available a tax hedging election under their TOFA (Taxation of Financial Arrangements) regime. The election, if validly made, will allow funds special accounting treatment to match the gains/losses on the derivatives with the gains/losses on the underlying assets.
For anyone familiar with hedge accounting, the overriding principle of the TOFA hedging election (to better align the tax treatment of derivative gains and losses with the tax treatment of the underlying hedged item) should sound familiar. The intention of IFRS 9 for hedge accounting is also to improve mismatching caused by derivative gains or losses.
Hedge accounting requirements
The overarching principle for IFRS 9 is to align hedge accounting more closely with risk management activities, resulting in more useful information to users of financial statements.
By applying hedge accounting, an entity will be able to match the gains or losses on the derivatives with the underlying exposures.
Applying hedge accounting is not a formality and there are strict criteria that must be met to qualify for hedge accounting and satisfy the auditor before the special accounting treatment can be used.
Some of the criteria include formal documentation of the hedge relationship and the effectiveness testing at inception and throughout the term of the hedge relationship.
This can be achieved only if entities have appropriate systems and procedures and internal expertise to monitor each hedging relationship. Outsourcing this to a treasury professional is often the optimal commercial outcome.
Confirming eligibility for the TOFA hedging election is a strict and important process and it can be time-consuming. It should be done in conjunction with your tax advisor and hedge accountant expert to avoid an unsatisfactory outcome and any surprises. The benefit is of course that your fund’s distributions are not likely to be impacted by foreign exchange risk or the risk management strategies. And retirees will have one less thing to worry about.
For more information, please reach out via email at firstname.lastname@example.org or call +61 2 8916 6115.
The information contained in this report is provided by Rochford Capital Pty Limited – ACN 143 601 594, AFSL 361276. This report is provided for general information purposes and is solely intended for use by persons who are Australian wholesale clients. To the extent that any recommendations or statements of opinion constitute financial product advice, they constitute general financial product advice only. As such, any advice contained in this report does not take into account your objectives, financial situation or needs. You should consider whether this advice is appropriate for you and seek independent professional advice before making any investment decision.