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8.6 Hedges of net investments in foreign operations
Publication date: 31 Mar 2024
us Derivatives & hedging guide
The balance sheet of a foreign operation comprises dissimilar assets and liabilities with various maturities. ASC 815 provides an exception to the prohibition against hedging dissimilar assets and liabilities in a single portfolio and allows reporting entities to hedge their net investments in foreign operations. The maturity of the hedging instrument does not have to match the maturity of these dissimilar assets and liabilities, since the investment is viewed as a single unit of account with no maturity.
8.6.1 Qualifying criteria
To qualify for net investment hedge accounting, the qualifying criteria for all other foreign currency hedges, discussed in DH 8.3, must be met. These criteria require that the party to the hedge be either (1) the operating unit that has the foreign currency exposure or (2) another member of the consolidated group that has the same functional currency as the operating unit (provided there are no intervening entities with a different functional currency).
Either a derivative or nonderivative can be the hedging instrument in a net investment hedge.
Question DH 8-11
USA Corp has two subsidiaries: Nikkei Corp (based in Japan) and Aussie Corp (based in Australia). The functional currency of each subsidiary is the local currency in its respective country. Aussie Corp has Japanese yen-denominated debt. Can USA Corp designate Aussie Corp’s Japanese yen-denominated debt as a hedge of USA Corp’s net investment in Nikkei Corp?
USA Corp has two subsidiaries: Nikkei Corp (based in Japan) and Aussie Corp (based in Australia). The functional currency of each subsidiary is the local currency in its respective country. Aussie Corp has Japanese yen-denominated debt. Can USA Corp designate Aussie Corp’s Japanese yen-denominated debt as a hedge of USA Corp’s net investment in Nikkei Corp?
PwC response
No. Since (1) USA Corp (the operating unit with the foreign currency exposure) is not a party to the hedging instrument (i.e., the Japanese yen-denominated debt) and (2) USA Corp and Aussie Corp do not have the same functional currency, the requirements in ASC 815-20-25-30 have not been met.
Question DH 8-12
Can a reporting entity designate a net investment hedge of its investment in a foreign equity method investee?
Can a reporting entity designate a net investment hedge of its investment in a foreign equity method investee?
PwC response
Yes. Although an equity method investment is not eligible to be a hedged item with respect to fair value hedges and cash flow hedges, a reporting entity may hedge the foreign currency risk of its equity method investments.
Question DH 8-13
Reporting entities that do not assert indefinite reinvestment of a net investment must recognize a deferred tax liability for any applicable foreign withholding taxes on historical earnings and profits. Since the withholding tax obligation is typically denominated in the currency of the foreign entity, does this deferred tax liability meet the definition of a financial instrument that is eligible to be designated as a hedge of a net investment in a foreign operation?
Reporting entities that do not assert indefinite reinvestment of a net investment must recognize a deferred tax liability for any applicable foreign withholding taxes on historical earnings and profits. Since the withholding tax obligation is typically denominated in the currency of the foreign entity, does this deferred tax liability meet the definition of a financial instrument that is eligible to be designated as a hedge of a net investment in a foreign operation?
PwC response
No. Only a nonderivative financial instrument can be designated as a hedging instrument in a net investment hedge (provided the qualifying criteria are met). A financial instrument is defined as cash, evidence of an ownership interest in an entity, or a contract that imposes the contractual right/obligation either to (1) receive/deliver cash or another financial instrument or (2) exchange financial instruments on potentially favorable/unfavorable terms.
Because the withholding tax does not meet the definition of a financial instrument it would not qualify to be designated as a hedging instrument in a net investment hedge.
As discussed in DH 9.9, there are two methods a reporting entity can use to assess the effectiveness of a net investment hedge: (1) based on spot rates and (2) based on forward rates. A reporting entity must document the method it chooses and consistently apply it. The forward method may not be used when the hedging instrument is a nonderivative.
Unlike fair value and cash flow hedges, ASC 815 does not prescribe specific documentation criteria for hedges of net investments in foreign operations. However, the hedge designation documentation of a net investment hedge should be prepared with the same detail as other types of hedges, which is discussed in DH 5.7. Additionally, a reporting entity should document the elections specific to net investment hedges, such as (1) how frequently any redesignation will be made pursuant to ASC 815-35-35-27 and Example 1 in ASC 815-35-55-1 and (2) whether hedge effectiveness will be assessed using the spot or forward method.
8.6.1.1 Net investment hedge with a cross-currency interest rate swap
ASC 815-20-25-71(d) clarifies that a reporting entity is not permitted to designate a cross-currency interest rate swap that has one fixed-rate leg and one floating-rate leg as the hedging instrument in a net investment hedge because such a swap includes interest rate risk and ASC 815 generally prohibits a compound derivative that involves an underlying other than foreign currency risk to be designated as the hedging instrument in a net investment hedge. However, fixed-for-fixed and floating-for-floating cross-currency interest rate swaps are permitted. A cross-currency interest rate swap that has either two floating legs or two fixed legs has a fair value that is driven primarily by changes in foreign exchange rates rather than by changes in interest rates. Therefore, foreign currency risk, rather than interest rate risk, is the dominant risk exposure in such a swap.
For a floating-for-floating cross-currency interest rate swap to be an eligible hedging instrument, it also must comply with ASC 815-20-25-67(a), which requires that (1) the interest rates are based on the same currencies contained in the swap and (2) both floating legs of the swap have the same repricing intervals and dates. We understand that these criteria may be more difficult to meet following reference rate reform as the standard interest rate conventions of the IBOR replacement rates may not be the same across different currencies. For instance, SOFR in the United States may not have the same standard repricing intervals and dates as SONIA in the United Kingdom.
8.6.2 Accounting for net investment hedges
ASC 815 requires changes in the fair value of a hedging derivative or the foreign currency transaction gain or loss on a nonderivative hedging instrument to be reported in the same manner as the related translation adjustments (i.e., recorded in CTA), except for any permitted excluded components.
As it pertains to excluded components (i.e., spot-to-forward difference) a reporting entity can elect to record the related cost in one of two ways:
- The initial value attributable to the excluded component is amortized to income over the life of the hedging instrument; any difference between the change in fair value of the hedging instrument attributable to the excluded component and the amounts recognized in earnings is recorded in CTA.
- The change in fair value attributable to the excluded component is included in earnings over the life of the hedging instrument.
If the hedge is discontinued, the unamortized amount remains in CTA until the net investment is disposed of or substantially liquidated. See FX 8.4 for information on the disposition of a foreign entity.
8.6.3 Hedging gains and losses and impairment of net investment
ASC 830-30-45-13 through ASC 830-30-45-15 provide guidance on when a reporting entity should include the CTA account balance attributable to a foreign entity in an impairment assessment. It requires a reporting entity to include the CTA balance related to any gain or loss from an effective hedge of the net investment as part of the carrying amount of the net investment when evaluating that investment for impairment. See FX 8.5 for additional information on impairment calculations that should consider CTA.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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