The institution holds interest rate swap (IRS) derivatives designated as hedging instruments in a cash flow hedge accounting relationship to hedge interest rate risk. Over a short period of time the interest rates subject to the hedge accounting relationship increased significantly. This caused in a decrease in the valuation of the IRSs designated in the cash flow hedge accounting relationship. The institution applies IFRS and elected to continue to apply IAS 39 for hedge accounting. Therefore, the decrease in the valuation of the IRSs resulted in a negative (debit) cash flow hedge reserve in equity. [IAS 39.95]

The IRSs designated as hedging instruments in a cash flow hedge accounting relationship by the institution are subject to the ‘settled-to-market’ convention. [e.g. see LCH Rulebook General Regulations, Regulation 23] Under this convention, the margin exchanged legally settles the daily changes in the market value of the IRSs, resulting in the fair value of the IRSs to be close to zero every day. Due to this convention the tax treatment under the applicable national tax code is different. Instead of the IRSs’ interest rate payments affecting taxable profits, the daily settlement of the market value of the IRSs affect taxable profits. Therefore, when the IRSs decrease in value, the margin exchanged to settle the decrease in market value actually reduce taxable profit in the current period. In the case of the institution, the decrease in the valuation of the IRSs designated in the cash flow hedge accounting relationship was so significant that the taxable profit turned negative, resulting in a tax loss. Under the applicable national tax code this resulted in a tax loss carry forward, which was recognized as a deferred tax asset (DTA) on the institution’s balance sheet. [IAS 12.34]

Regulation (EU) No 575/2013, as amended (CRR) article 33(1)(a) requires that cash flow hedge reserves related to financial instruments is filtered from own funds. Q&A 2014_720 has clarified that this filter must be applied net of tax. In addition, Q&A 2015_1887 states that “[i]n order to properly neutralise the impact of the cash flow hedge on own funds, the fiscal effect has to be neutralised as well.” The Q&A further notes―seemingly in order to clarify how this general rule is to be applied in the specific fact pattern outlined in the question posted by the submitter―“[t]herefore, any gains or losses arising from the changes in value of the cash flow hedges, and their associated deferred tax assets (DTAs) or deferred tax liabilities (DTLs) should be filtered from the own funds calculation under Article 33(1)(a).” What is not entirely clear is to what extent and how the general rule stated by the EBA (“to properly neutralise the impact of the cash flow hedge on own funds, the fiscal effect has to be neutralised as well”) is to be applied in case the daily settlement of the market value of IRSs subject to the ‘settled-to-market’ convention affect taxable profits, and this tax treatment results in a DTA for losses carry forward. More specifically, must this DTA also be filtered from own funds?