by Sandra Koch
If your Company’s subsidiaries are local currency functional, and your tax department has executed a cost-plus tax strategy, and you hedge this intercompany exposure—your hedge program may be uneconomic.
A cost plus strategy is typically executed as follows:
- Local subsidiary bills US Parent for all of their operating costs plus some pre-determined markup. Generally the sub invoices in local currency, but could be in dollars at invoice date.
- The US Parent, not wanting to send any more cash outside the US than necessary, will send only the amount of cash the subsidiary needs to handle working capital needs.
- Result is a growing foreign currency liability on the US Parent’s books that is not typically going to be cleared—or when cleared will be returned to parent.
- Non-functional currency assets and liabilities, including intercompanies*, are required to be remeasured with the currency change impact recorded in income each period. Most companies with active hedge programs will execute F/X hedges to offset the risk.
Typically, management is happy with the earnings impact because income volatility is averted. However, when you look through the transactions, the growing “plus” is not an economic exposure. So when the treasury department is executing trades and putting cash at risk for an accounting effect, it is speculating with cash. As “cost-plus” strategies proliferate, the trend in uneconomic hedging is growing. We recommend that companies facing these exposures engage the tax department and start with non-derivative solutions to mitigating these exposures. Hedge Trackers, LLC has worked with a number of companies caught in the uneconomic hedge cycle to align their hedge program with the economics and protect their earnings. To learn more please contact one of our professional consultants.
*Hedge Trackers, LLC does not believe that a Parent’s intercompany payables would qualify as being “of a long-term-investment-nature” (ASC830-20-35-3&4), with the gains and losses accumulating in equity.