Currency Hedging in Russia: Foreign Trade Legal Guide

 

November 30, 2023

BRACE Law Firm ©

 

Foreign trade activity is inextricably linked to international exchange rates. This is because trade occurs between foreign partners and, often, settlements under international transactions are made in foreign currency. The exchange rate is a volatile value, and predicting the exact rate of a particular currency can be very difficult. To minimize risks arising from exchange rate fluctuations, foreign trade participants use hedging, which involves minimizing exchange rate risk through the use of derivative financial instruments.

In Russian legislation, the concept of hedging is defined in the Tax Code of the Russian Federation. It represents operations with derivative financial instruments performed to reduce adverse consequences for the taxpayer caused by losses, lost profits, decreased revenue, a reduction in the market value of property (including property rights), or an increase in the taxpayer's obligations due to changes in price, interest rates, exchange rates (including the exchange rate of a foreign currency against the currency of the Russian Federation), or other indicators of the hedged item.[1]

Furthermore, the Law recognizes property, property rights of the taxpayer, and the taxpayer's obligations as hedged items. This includes claims and duties of a monetary nature whose performance date as of the date of the hedging transaction has not arrived, including claims and duties whose exercise (performance) is conditional upon a demand by a party to the contract and regarding which the taxpayer has decided to hedge.[2]

At the same time, as early as 1999, the Methodological Recommendations for Evaluating the Efficiency of Investment Projects were developed and approved.[3] (the "Methodological Recommendations for Efficiency Assessment"). These recommendations state that currency risk arises in a direct form if payment amounts (or interest rates) are expressed in a foreign currency while the exchange rate is unstable. In an indirect form, currency risk manifests in cases where the borrower's primary activities are related to foreign trade operations.[4]

Important types of derivative financial instruments include forwards, options, swaps, and futures. Futures and forwards represent a transaction that fixes the currency rate as of the current date for the future. An option is a transaction in which, for a certain fee, a party acquires the right to demand the purchase or sale of currency in the future at a rate agreed upon on the date the transaction is executed. A swap is a transaction for the purchase/sale of currency in which a reverse transaction for the sale/purchase of currency is executed after a certain period. In this case, the difference between the purchase and sale price is fixed at the moment the first transaction is executed and is the subject of trade.

The primary form of currency risk reduction (hedging) is the execution of forward currency contracts, and the acquisition of currency futures and options. A forward contract is an agreement between two parties under which the parties undertake an obligation to exchange a certain amount at a pre-fixed exchange rate on a specific day. Futures and options are market securities providing an obligation or right to exchange at a fixed rate, with the possibility of assigning this obligation or right to another person until their performance period expires.

Forwards, options, and swaps executed with banks represent over-the-counter hedging instruments. Exchange-traded hedging instruments include futures and options executed on specialized trading platforms.

The implementation of any financial project (financial operation) involves risk for the creditor-investor. It is not recommended to consider investment risk solely as the risk of non-repayment.

An investor should pay attention to the following types of risk:

• credit risk, related to the potential failure of a counterparty to a transaction to perform its obligations;
• market risk, related to the potential occurrence of market conditions unfavorable to the investor;
• liquidity risk, related to losses during investment portfolio restructuring arising due to the difference between the purchase and sale prices of securities on financial markets.

To reduce the risk of investing in market securities, derivative securities called futures and options are used. Futures allow for fixing transaction terms prior to their future implementation. Moreover, each party to the transaction can transfer its obligations to any market agent who agrees to this.

An option represents a right (but not an obligation) to conduct a transaction in the future under agreed terms, again with the possibility of assigning this right. It should be emphasized that the right to conduct a transaction arises upon the purchase of an option, while the obligation arises upon its sale. The (primary) sale of an option can potentially lead to large financial losses during sharp changes in market conditions. Futures, like any obligation, must be guaranteed, for which collateral is generally used. Options, like any right, must be paid for by the party acquiring this right.

Hedging Under International Financial Reporting Standards

In accordance with International Financial Reporting Standard (IFRS) 9 Financial Instruments [5] (the "IFRS 9"), the objective of hedge accounting is to reflect in the financial statements of an organization the results of its risk management activities. These activities involve using financial instruments to manage positions for specific risks that could affect profit or loss. To implement hedging, the following instruments are used:

• A derivative instrument measured at fair value through profit or loss may be designated by the organization as a hedging instrument, with the exception of certain written options.
• A non-derivative financial asset or non-derivative financial liability measured at fair value through profit or loss may be designated by the organization as a hedging instrument, unless it is a financial liability designated by the organization as measured at fair value through profit or loss for which the amount of change in its fair value attributable to changes in credit risk for the specified liability is presented in other comprehensive income. Regarding currency risk hedging, an organization may, at its own discretion, designate a component of a non-derivative financial asset or non-derivative financial liability related to currency risk as a hedging instrument, provided that this non-derivative financial instrument is not an investment in an equity instrument whose changes in fair value the organization decided to present in other comprehensive income.

At the same time, a qualifying hedging instrument may be designated by the organization as a hedging instrument only in its entirety. The only permitted exceptions are:

• Separating the value of an option contract into intrinsic value and time value and designating only changes in the intrinsic value of the option as the hedging instrument, excluding changes in its time value.
• Separating the value of a forward contract into a forward element and a spot element and designating, at the organization's discretion, only changes in the value of the spot element of the forward contract as the hedging instrument, but not changes in the value of the forward element; similarly, a foreign currency basis spread may be separated so as not to take it into account when designating a financial instrument as a hedging instrument at the organization's discretion.
• A proportional share of the entire hedging instrument, for example, 50 percent of its nominal value, may be designated by the organization as a hedging instrument in hedging relationships. However, one cannot designate as a hedging instrument a part of the change in its fair value relating only to a part of the term during which this hedging instrument is outstanding.

A hedged item may be a recognized asset or liability, an unrecognized firm commitment, a forecast transaction, or a net investment in a foreign operation. A hedged item may be a single item or a group of items. Furthermore, the hedged item must be capable of being reliably measured.

An organization may, at its own discretion, designate an entire object or its component as the hedged item within a hedging relationship. The entire object encompasses all changes in cash flows or the fair value of the object. A component encompasses not the entire magnitude of the change in fair value or variability of cash flows for the object.

Hedge accounting is allowed to be applied to hedging relationships only if they meet all the following criteria:

1. These hedging relationships include only qualifying hedging instruments and qualifying hedged items.
2. As of the start date of these hedging relationships, the organization has a formalized decision on their designation and prepared documentation for them, as well as a documented risk management objective and strategy for performing hedging. This documentation must specify the hedging instrument, the hedged item, describe the nature of the risk being hedged, and how the organization will assess whether these hedging relationships meet hedge effectiveness requirements (including an analysis of sources of hedge ineffectiveness and approaches to determining the hedge ratio).
3. These hedging relationships meet all the following requirements for hedge effectiveness: 3.1. an economic relationship exists between the hedged item and the hedging instrument; 3.2. the credit risk factor does not exert a dominant influence on changes in value caused by the specified economic relationship; 3.3. the hedge ratio determined for these hedging relationships reflects the ratio between the quantity of the hedged item actually hedged by the organization and the quantity of the hedging instrument actually used by the organization to hedge the specified quantity of the hedged item.

However, when determining these relationships at the organization's discretion, an imbalance between the weighting factors of the hedged item and the hedging instrument should not be taken into account if it would lead to hedge ineffectiveness (regardless of whether it is recognized or not), as a result of which a result inconsistent with the objective of hedge accounting might be reflected in the statements.

Executing Transactions on Exchange and OTC Markets

An exchange is an organizer of trading, plays the role of a central counterparty, and provides a platform for trading—essentially the technical ability for a buyer to find an offer for their demand and for a seller to find demand for their offer. In this regard, the primary function of the central counterparty is the management of credit risks of trading participants; it daily revalues the cost of instruments and requires collateral for a transaction.

Collateral for a transaction is called maintenance margin (the "maintenance margin"), which represents funds blocked in the accounts of contract buyers and sellers for the duration of the contract obligations. The main advantage of exchange-traded contracts over OTC contracts is that when executing an exchange-traded contract, it does not matter whether the second party performs its obligations under the contract or not. In this case, contract obligations may be performed by the exchange as the central counterparty to the transaction.

Another important feature of exchange-traded contracts is their daily revaluation, called variation margin, which represents funds (in rubles only) arising due to the daily revaluation of the contract price and subject to debiting/crediting to the account of the parties to the transaction.

The OTC market is a market where transactions are executed directly between trading participants; meanwhile, to execute OTC transactions, a company can approach a bank, and it is better for such a bank to have a high credit rating. At the same time, given that transactions can be executed directly between participants, the parties can agree on practically any terms.

It is important to note that only professional market participants — legal entities with a special license — can trade directly on the exchange. All other legal entities can trade on the exchange only through brokers who are professional market participants.

To hedge on the OTC market, it is necessary to sign a contract with the counterparty bank — a general agreement, which represents a document in which the parties agree to standard terms that will apply to all derivative transactions executed between the parties.

Accounting for Qualifying Hedging Relationships

An organization applies hedge accounting to hedging relationships that meet the prescribed criteria for applying hedge accounting. There are three types of hedging relationships:

• fair value hedge: a hedge of the potential change in the fair value of a recognized asset or liability, or an unrecognized firm commitment, or a component of such an object, which is caused by a specific risk and can affect profit or loss;
• cash flow hedge: a hedge of the potential change in the magnitude of cash flows caused by a specific risk associated with the entire recognized asset or liability or its component, or with a highly probable forecast transaction, and can affect profit or loss;
• hedge of a net investment in a foreign operation; meanwhile, if the hedged item is an equity instrument for which the organization has chosen the option of presenting changes in fair value in other comprehensive income, then the hedged potential change must relate to changes that can affect other comprehensive income.

In this case, and only in this case, recognized hedge ineffectiveness is presented in other comprehensive income.

Currency risk hedging for a firm commitment can be accounted for either as a fair value hedge or as a cash flow hedge.

If a fair value hedge meets the hedge accounting criteria, these hedging relationships must be accounted for as follows:

• Gains or losses on the hedging instrument must be recognized in profit or loss.
• Hedging gains or losses for the hedged item must adjust the carrying amount of that hedged item and be recognized in profit or loss. If the hedged item is a financial asset accounted for at fair value through other comprehensive income, hedging gains or losses for the hedged item must be recognized in profit or loss. However, if the hedged item is an equity instrument for which the organization decided to present changes in fair value in other comprehensive income, then the organization must continue recognizing the specified amounts in other comprehensive income. When the hedged item is an unrecognized firm commitment, the accumulated magnitude of the change in the fair value of this hedged item after its designation as such at the organization's discretion is recognized as an asset or liability with the recognition of the corresponding amount of gain or loss in profit or loss.

If a cash flow hedge meets the hedge accounting criteria, these hedging relationships must be accounted for as follows:

• A separate component of equity related to the hedged item is adjusted to the lesser of the following magnitudes: — the accumulated magnitude of gain or loss on the hedging instrument since the start of hedging; — the accumulated magnitude of the change in the fair value of the hedged item since the start of hedging.
• That part of the gain or loss on the hedging instrument that is determined as effective hedging must be recognized in other comprehensive income.
• The remaining part of the gain or loss on the hedging instrument represents hedge ineffectiveness, which must be recognized in profit or loss.
• The amount accumulated within the cash flow hedge reserve must be accounted for as follows: — If a hedged forecast transaction subsequently leads to the recognition of a non-financial asset or non-financial liability, or if a hedged forecast transaction regarding a non-financial asset or non-financial liability becomes a firm commitment to which fair value hedge accounting is applied, then the organization must exclude the specified amount from the cash flow hedge reserve and include it directly in the initial cost or other measurement of the carrying amount of the corresponding asset or liability. This adjustment is not a reclassification adjustment and, consequently, does not affect other comprehensive income. — Regarding cases of cash flow hedging, the specified amount must be reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment in the same period or periods in which the hedged expected future cash flows will affect profit or loss. — However, if the specified amount represents a loss and the organization expects that all or part of this loss will not be recovered in one or more future periods, the organization must immediately reclassify the amount whose recovery is not expected to profit or loss as a reclassification adjustment.

A hedge of a net investment in a foreign operation, including a hedge of a monetary item accounted for as part of the net investment, must be accounted for similarly to a cash flow hedge:

• that part of the gain or loss on the hedging instrument that is determined as effective hedging must be recognized in other comprehensive income;
• the ineffective part must be recognized in profit or loss.

Accounting for Hedging Operations for Credit and Non-Credit Organizations

The procedure for reflecting hedging operations on accounting records by credit organizations is determined by Bank of Russia Regulation No. 617-P dated November 21, 2017, On the Procedure for Reflecting Hedging Operations on Accounting Records by Credit Organizations (the "Regulation No. 617-P").

Hedging instruments are used by a credit organization for reflecting hedging operations on accounting records [6] without separating individual parts of such instruments, except for cases provided for by IFRS 9.

A credit organization makes a decision on designating the following as a hedging instrument [7]:

• a derivative financial instrument determined in accordance with Article 2 of Federal Law No. 39-FZ dated April 22, 1996, On the Securities Market, with the exception of a sold option (except for an option sold for the purpose of hedging a purchased option);
• a financial instrument determined in accordance with IFRS 9.

In cases where the hedged item is an asset reflected on balance sheet accounts or an obligation reflected on balance sheet accounts, the change in the fair value of the hedged item is reflected by the credit organization in accounting in accordance with paragraph 6.5.8 (b) of IFRS 9.

In cases where the hedged item is an equity financial instrument whose revaluation in accordance with paragraph 4.1.4 of IFRS 9 is reflected by the credit organization in other comprehensive income, the change in the fair value of the hedged item is reflected by the credit organization in other comprehensive income, and the change in the fair value of the hedging instrument is transferred by the credit organization to other comprehensive income.

In cases where the hedged item is a debt financial instrument classified by the credit organization as a financial asset whose change in fair value is reflected in other comprehensive income, the change in the fair value of the hedged item is reflected by the credit organization in accounting in accordance with paragraph 6.5.8 (b) of IFRS 9.

In cases where the hedged item is a firm commitment, the change in the fair value of the firm commitment is reflected by the credit organization in accounting in accordance with paragraph 6.5.8 (b) of IFRS 9.

The accounting entries reflected above are performed by the credit organization simultaneously with accounting entries reflecting the change in the fair value of the hedging instrument.

Upon initial recognition in accounting of an asset or liability as a result of the performance of a firm commitment, the initial cost of such an asset or liability is adjusted by the credit organization by the change in the fair value of the hedged item.

For non-credit financial organizations, the procedure for the accounting of hedging is determined by Bank of Russia Regulation No. 496-P dated October 5, 2015, Industry Accounting Standard for Hedging by Non-Credit Financial Organizations (the "Regulation No. 496-P"). In accordance with this regulation, the objective of hedge accounting is to reflect in the accounting (financial) statements of a non-credit financial organization the results of its risk management activities involving the use of financial instruments to manage positions for specific risks that may affect profit or loss (or other comprehensive income if it is an investment in equity instruments for which the non-credit financial organization decided to present changes in fair value in other comprehensive income). This approach explains the procedure for using hedging instruments to which hedge accounting is applied to ensure an understanding of their purpose and influence on accounting (financial) statements.

Hedge accounting is performed if a non-credit financial organization has defined hedging relationships between a hedging instrument and a hedged item in internal documents. Hedging relationships are defined at the start of hedging. The start date of hedging is the date the hedging relationships are defined.

A hedging instrument can represent:

• a derivative financial instrument, with the exception of a sold option (except for an option sold for the purpose of hedging a purchased option), determined in accordance with Federal Law No. 39-FZ dated April 22, 1996, On the Securities Market;
• a contract for the purchase and sale of foreign currency, precious metals, or securities that is not a derivative financial instrument, providing for an obligation of one party to transfer foreign currency, precious metals, or securities into the ownership of another party no earlier than the third business day after the date the contract is executed, and an obligation of the other party to accept and pay for the specified property;
• a contract recognized as a derivative financial instrument in accordance with the law of a foreign state, the norms of an international treaty, or business customs, and regarding which judicial protection is provided for by the law of the foreign state or the norms of the international treaty, with the exception of a sold option (except for an option sold for the purpose of hedging a purchased option);
• a non-derivative financial asset or non-derivative financial obligation measured at fair value through profit or loss, with the exception of a financial obligation reflected at fair value through profit or loss for which the amount of fair value change relating to changes in credit risk is accounted for in other comprehensive income;
• other instruments falling under the definition of a hedging instrument in accordance with IFRS 9.

The choice of hedging instruments is performed by a non-credit financial organization in internal documents.

A non-credit financial organization may, at its own discretion, define any combination of the following as a hedging instrument:

• derivative financial instruments or their proportional shares;
• non-derivative financial instruments or their proportional shares.

A hedged item can represent:

• An asset or liability reflected on the accounting records of Chapter A of the Chart of Accounts for Non-Credit Financial Organizations[8].
• A firm commitment not reflected on balance sheet accounts. A firm commitment is understood as a binding agreement to exchange a specific quantity of resources at a specific price on a specific future date or dates.
• A forecast transaction. A forecast transaction is understood as an expected future transaction not formalized by a contract that meets the criteria for a hedged item in accordance with IFRS 9.
• A net investment in a foreign operation. A net investment in a foreign operation is determined in accordance with International Accounting Standard (IAS) 21 The Effects of Changes in Foreign Exchange Rates.[9]

A hedged item can be:

• an individual object;
• a group of objects;
• a component of an individual object or a group of objects.

The choice of hedged items, as well as the determination of a specific list of characteristics (conditions) distinguishing a firm commitment from a forecast transaction, is performed by the non-credit financial organization in internal documents.

Hedging meets all the following hedge effectiveness requirements in cases where:

• an economic relationship exists between the hedged item and the hedging instrument;
• the influence of credit risk does not exert a prevailing influence on the change in value caused by the specified economic relationship;
• the hedge ratio determined for this hedging relationship reflects the ratio between the quantity of the hedged item actually hedged by the organization and the quantity of the hedging instrument actually used by the non-credit financial organization to hedge the specified quantity of the hedged item.

Any foreign trade interaction between partners is caused by diverse risks that can be related to various areas of activity. The primary task of an entrepreneur becomes the minimization of emerging risks, including the minimization of currency risks, for which diverse protection schemes are used. Hedging, as one of the options for minimizing currency risks, allows for reducing adverse consequences caused by losses, lost profits, decreased revenue, a reduction in the market value of property (including property rights), or an increase in the taxpayer's obligations due to changes in price, interest rates, exchange rates (including the exchange rate of a foreign currency against the currency of the Russian Federation), or another indicator of the hedged item.

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References

[1] Clause 5 of Article 301 of the Tax Code of the Russian Federation.

[2] Resolution of the Arbitration Court of the Ural District dated October 31, 2016, No. F09-9165/16 in case No. A76-30784/2015. During the consideration of the case, it was established that the tax authority assessed VAT, corporate profit tax, penalties, and fines due to the non-accounting of revenue from hedging operations for the risk of falling prices for precious metals and operations for the sale/exchange of promissory notes. Having considered the case, the court concluded that the claims should be denied because the disputed operations are not subject to VAT; the failure to account for income from them reduced the specific weight of revenue and the share of expenses attributable to activities not subject to VAT; separate accounting of expenses for operations subject to VAT and not subject to VAT was not maintained; and the rule on calculating the five-percent barrier, at which the right not to distribute input VAT arises, is not applicable.

[3] Approved by the Ministry of Economics, Ministry of Finance, and Gosstroy on June 21, 1999, No. VK 477.

[4] Clause 2.6. of the Methodological Recommendations for Efficiency Assessment.

[5] Put into effect in the territory of the Russian Federation in the 2014 edition by Order of the Ministry of Finance of Russia dated June 27, 2016, No. 98n.

[6] Resolution of the FAS of the Volga District dated May 31, 2013, in case No. A55-22803/2012 On Declaring the Decision of the Tax Authority Invalid. During the consideration of the case, it was established that the tax authority excluded expenses for hedging operations from the composition of profit tax expenses because the acceptance certificates for an agent's services for hedging operations were not presented, and the company's accounting policy lacked a description of planned hedging operations. The court decided to grant the claims because the performance of the contract confirmed the expediency of the accounting policy chosen by the company; as a result of hedging, the company received significant non-operating income from which taxes were calculated and paid to the budget.

[7] Resolution of the Arbitration Court of the Moscow District dated July 24, 2018, No. F05-19311/2016 in case No. A40-94322/2016 On the Recovery of Debt Under a Currency Risk Hedging Agreement. When applying to the court, the Plaintiff argued that the defendant failed to perform the obligation to transfer profit. During the consideration of the case, the court decided to deny the claim because performing hedging operations requires legal entities to have a license to carry out professional activities in the securities market or a license on the basis of which it is possible to execute transactions with derivative financial instruments; however, the parties are not professional participants in the securities market and do not possess these licenses, and therefore the plaintiff's claims arising from the disputed contract are not subject to judicial protection by virtue of the direct instruction of Clause 2 of Article 1062 of the Civil Code of the Russian Federation.

[8] Bank of Russia Regulation No. 486-P dated September 2, 2015, On the Chart of Accounts for Non-Credit Financial Organizations and the Procedure for Its Application.

[9] Put into effect in the territory of the Russian Federation by Order of the Ministry of Finance of Russia No. 160n On Putting into Effect and Terminating the Effect of Documents of International Financial Reporting Standards in the Territory of the Russian Federation.