Recent changes in the U.S. tax laws have created interest from companies to consider repatriating dividends from foreign subsidiaries to the U.S. If cash is held in foreign currency in foreign subsidiaries that use the local currency as their functional currency, the USD-equivalent value of these cash flows are at risk to changes in FX rates.
Without applying special hedge accounting, the change in fair value of derivatives impacts earnings each accounting period, thus creating the potential for income statement volatility. Unfortunately, forecasted intercompany dividend payments fail one of the most basic criteria for an exposure to qualify as a cash flow hedge under ASC 815 — the transactions have no impact on consolidated earnings.
Are there accounting friendly alternatives for hedging forecasted intercompany dividends?
For companies seeking economic protection with either a zero or a limited impact to a company’s earnings — an alternative designation would be as a net investment hedge.
Gains and losses on qualifying net investment hedges are reported in the cumulative translation adjustment section of other comprehensive income (CTA/OCI) to the extent it is effective as a hedge. A net investment hedge is a hedge of existing net equity, so the net investment hedge is simply a hedge of that capital before it is repatriated.
How would the hedge work in relation to the dividend?
- Assume a company forecasts an FX-denominated dividend in six months.
- A hedge is transacted and designated as a net investment hedge either under the Spot or Forward Method. Prospectively, changes in the derivative’s fair value are recorded in CTA/OCI in a manner consistent with its designation.
- When the dividend is declared, the net investment hedge would be dedesignated from the hedge relationship.
- If the declaration of the dividend results in an FX-denominated intercompany payable/receivable, the hedge’s prospective gains/losses recorded in earnings will help offset the remeasurement losses and gains on the intercompany balance.
- When the dividend is paid and converted to USD, then unwind the hedge at the same time.
What happens if the dividend is delayed? Or occurs earlier than expected?
If the dividend is delayed, the hedge can be rolled forward and the hedge relationship can continue. If the dividend occurs earlier, the hedge can be rolled in to an earlier maturity. Net investment hedges can be for any tenor with no impact on the hedge’s effectiveness, so the hedge’s initial maturity date is up to the company and facts and circumstances related to the timing of the dividend.
What if the dividend does not occur at all?
The hedge can be simply unwound and the hedge gain or loss would remain in CTA/OCI. There will be a cash settlement on the hedge resulting in a cash gain or loss that, unfortunately, would not be offset by a cash loss or gain on a dividend cash flow.
In all cases, unwinding the net investment hedge or rolling it forward does not result in an earnings impact. Accumulated gains/losses recorded in CTA/OCI stay there and are only reclassified to earnings in circumstances when the net investment is sold or substantially liquidated.
Under the Forward Method, the entire change in fair value of the derivative is recorded in CTA/OCI. Under the Spot Method, the spot-to-spot change in fair value of the derivative is recorded in CTA/OCI and the change in fair value from all other factors is recorded in earnings. The new ASU 2017-12 will impact the accounting for net investment hedges under the Spot Method and entities will also have the ability under the new rules to switch their designations from the Spot Method to the Forward Method, and vice versa, as an improved method. Companies will also need to determine whether they want to designate the hedge relationship on a before- or after-tax basis.
Qualifying derivative hedging instruments for net investment hedges include FX forwards, purchased or net purchased options, fixed-fixed cross currency swaps or floating-floating swaps.
If you wish to hedge the FX risk related to forecasted FX-denominated dividend payments, be aware that an accounting solution exists to manage what could be a potentially significant cash flow risk.