In international groups, purchasing and sales activities are often centralized in certain companies of the group in order to manage foreign currency risks in a uniform manner. This means that the foreign currency risk is concentrated in so-called procurement or sales companies to obtain a complete overview of the foreign currency exposure centrally and to exploit netting potentials. For the purpose of managing foreign currency exposure, the company then enters into derivative financial instruments, primarily to hedge the foreign currency risks arising from planned sales and procurement transactions. However, given that most value added is not generated in the sales or distribution companies, but elsewhere in the Group, this may result not only in (external) sales and procurement transactions, but also, for example, in internal license payments by the subsidiary to other companies in the Group denominated in foreign currency.1 Whereas hedging the foreign currency risk of internal transactions is plausible from an economic risk management perspective, this approach poses certain challenges for the transfer to hedge accounting relationships.
This article aims to explain in more detail the criteria for designating intragroup hedged items and how intragroup transactions can still be included in hedge accounting relationships under IFRS 9.
The application of hedge accounting rules under IFRS (International Financial Reporting Standards) is subject to specific requirements for the designation of hedge accounting relationships. This includes, among other things, the requirement that hedged items in principle must be with a counterparty outside the Group (cf. IFRS 9.6.3.5). Intra-group transactions, such as foreign currency exposures resulting from administrative or royalty payments between subsidiaries, would normally not be eligible for hedge accounting. But in addition to the principle, IFRS 9.6.3.5f. also allows intragroup transactions to be designated as hedged items provided specific conditions are met.2 With a view to a possible designation, the following intragroup transactions can be designated in hedge accounting:
- Transactions between entities of the same group in the consolidated financial statements of an investment entity in accordance with IFRS 10 measured at fair value through profit or loss;
- foreign currency risk of intragroup monetary items (which is not eliminated on consolidation in accordance with IAS 21)3;
- Foreign currency risk of highly probable intragroup transactions that (will) affect the Group's net income.
It is worth mentioning in this context that hedge accounting can be applied independently at the level of both the consolidated financial statements and the single-entity financial statements. Within a group, as long as hedge accounting is designated at group level, the entity exposed to the hedged risk does not have to be a direct counterparty to the hedging instruments. In addition, hedge accounting can also be applied at the level of the single-entity financial statements if external derivatives linked by the treasury department are passed on to the relevant (subsidiary) company as mirror-image internal derivatives. During preparation of the consolidated financial statements, the hedged item designated in hedge accounting at the single-entity level can also be transferred to a hedge accounting relationship at the group level, provided that the external derivative is designated as the hedging instrument instead of the internal derivative (cf. KPMG Insights into IFRS (2022/2023), point 7.9.1150.20-30.).
Further, the focus is on hedging foreign currency risk arising from highly probable forecast intragroup transactions in cash flow hedge accounting relationships. To the extent that the transaction involves a foreign currency risk for the entity entering into the transaction and the foreign currency risk will affect consolidated profit or loss, such transactions may qualify as a hedged item. Generally, expected intragroup transactions, such as royalty and interest payments or management fees, do not affect consolidated profit or loss. However, intragroup transactions may affect consolidated profit or loss if there is a related external transaction. This means, for example, that internal license payments may qualify as a possible hedged item if there is a corresponding, related external transaction.
These requirements would be considered to be satisfied, for instance, if the expected sale or purchase of inventories between two companies with different functional currencies were to take place with subsequent resale to a party outside the Group, thus affecting consolidated profit or loss. Another example is a planned intra-group sale of assets or equipment between subsidiaries, whereby the assets and equipment are used in the course of operations and may have an impact on consolidated profit or loss as a result of depreciation ( cf. IFRS 9.B6.3.5).
Below, we will now specify the requirements for the structuring of license payments:
A subsidiary pays (internal) royalties to the parent company in the latter's functional currency, which differs from the subsidiary's functional currency. The subsidiary directly or indirectly enters into forward exchange contracts with mirror characteristics of the hedged item via internal transfers in order to hedge the foreign currency risk at the level of the subsidiary.
This raises the question of whether this hedging relationship can also be designated as a hedging relationship for accounting purposes.
In order for the license payments to qualify as a possible hedged item as defined by IFRS 9.6.3.6, they must be related to an (external) transaction. Examples include the parent company's development of a manufacturing process or the use of a technology patented by the parent company. This means that it is necessary for external costs to be incurred at the level of the parent company, which must be related to the internal transaction. Alongside the external link with respect to the underlying transaction, the internal transaction in particular must also have an impact on the Group's income in the further course of the transaction. Under certain circumstances, this may be the case if the goods and/or services are resold to a third party outside the Group. The requirement that the hedged item must be reliably measurable (cf. IFRS 9.6.3.2) means that, in principle, there must be a fixed relationship between the internal transaction and the downstream external transaction. This requirement could for instance be satisfied by offsetting the internal license payment against the license fee on the basis of a fixed foreign currency amount per unit sold and also invoicing the customer for the license fee. Or, as an alternative, the royalty could be invoiced as a fixed (explicit) percentage of the external selling price in foreign currency per unit sold.
Regardless of the specific rules regarding the designation of intragroup planned transactions, the further prerequisite for planned transactions that they must be considered highly probable at inception and over the term of the transaction must be taken into account (see IFRS 9.6.3.3 in conjunction with IFRS 9.B6.5.27(b)). IFRS does not provide a conclusive definition of “highly probable” but does imply that a probability of occurrence of 50% (more likely than not) is not sufficient. According to published literature, there must be a probability of occurrence of at least 90% for the transaction to be considered highly probable (cf. KPMG Insights into IFRS (2022/2023), point 7.9.430.20).
Provided all the above conditions are met, the effective changes in the value of the hedging instrument are recognized in other comprehensive income in accordance with the cash flow hedge accounting rules (cf. IFRS 9.6.5.11). In the context of a reclassification of the amounts accumulated in the cash flow hedge reserve and, if applicable, in the cost of hedging reserve, it must be taken into account that this only has to be carried out when the hedged transaction's foreign currency risk has an impact on the Group's profit or loss. This means that, in contrast to the intra-group netting of services between the parent company and the subsidiary, the intra-group resale only takes place at a later date, which must be taken into account in the reclassification routine and therefore regularly results in a delayed reclassification (cf. IFRS 9.B6.3.6).
In conclusion, it is entirely possible, despite the restrictive rules on the designation of internal transactions, to designate, for example, internal license payments under specific contractual constellations in hedge accounting relationships. Here, each case must be considered on its own merits in order to assess whether it is eligible for designation in hedge accounting. The Finance and Treasury Management team would be pleased to assist you should you be interested in evaluating the possibilities of using hedge accounting for comparable cases.
Source: KPMG Corporate Treasury News, Edition 131, April 2023
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Björn Beckmann, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
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1 In terms of procurement and/or sales transactions in foreign currencies, attention must be paid to ensuring that the rules on the possible separation of embedded foreign currency derivatives as per IFRS 9.B4.3.8(e) are taken into account.
2 In any case, the general application requirements for hedge accounting (documentation and designation as well as effectiveness criteria, cf. IFRS 9.6.4.1) must be met.
3 In accordance with IAS 21, gains and losses arising from the foreign exchange translation of intragroup monetary items are not eliminated on consolidation when the intragroup monetary item is transacted between two entities of the Group with different functional currencies.
