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Context: Multinational corporations whose global subsidiaries need to hedge foreign currency exposure frequently engage in so-called back-to-back derivative trades. That’s typically where the parent trades with a bank and then, back-to-back, trades with the sub, a strategy often motivated by lower trading costs, greater efficiency and tax and accounting considerations. It can help keep subsidiaries accountable for their hedge results. Back-to-back hedges are a common strategy used by companies for both balance sheet and cash flow hedges.
Member question: “Does anyone execute back-to-back intercompany hedges? We’re trying to figure out how to hedge our EUR balance sheet exposure between two different subsidiaries and the parent. From discussing internally and with our banks, it sounds like we should be doing a back-to-back intercompany hedge. Does anyone else do something similar, and are there any tax or legal implications that we should be considering?
- “Hypothetical example: Parent executes an even swap with a bank to buy €1 on the far leg then enters into an intercompany trade with Sub A.
- “Sub A has a €2 liability on balance sheet; enters into intercompany trade with the parent.
- “Sub B has a €1 asset on balance sheet that is unhedged.”
The member told NeuGroup Insights, “The issue arose because we learned that there could potentially be tax issues with one of our foreign entities if they did not have a direct hedge (we currently only hedge from our parent entity).”
- They added the company is primarily working through any “downstream” tax and accounting issues internally. “We’ll likely be doing back-to-back intercompany balance sheet hedges starting in December or January,” they added.
Peer answer 1: “We do back-to-back intercompany hedges, or maybe a variation of what you are referring to. Essentially, we face the market as the parent, execute the hedge, and then execute an internal trade between the parent and the sub to move the hedge to the sub. That puts the hedge on the same legal entity as the exposure which is what you want from a tax standpoint.
- “Otherwise, you risk having gains and losses on different legal entities in different tax jurisdictions which can lead to tax whipsaws and an unintended tax consequence. In your scenario above, you could execute two internals, between the two subs, to hedge the liability and asset exposures accordingly.”
Peer answer 2: “We do the intercompany back-to-back, and we do work closely with the tax and accounting teams to stay in line.”
Peer answer 3: “We do back-to-back hedges for our intercompany loan hedges and our cash flow hedging program. We use Chatham which helps us with that.”
NeuGroup Insights reached out to Chatham Financial for more insights on back-to-back hedges and received this valuable primer:
“What are back-to-back hedges? A back-to-back hedge is when a company executes a derivative trade with their external counterparty (usually a banking partner). Usually the company does that at either the top of their entity structure or at a large entity designed to do the external trading.
- “At the same time the external derivative is executed, the company books a derivative with a subsidiary mirroring the terms of the external trade for the subsidiary. So, if the parent entity does an external trade to sell EUR and buy USD, they will do an internal trade with their subsidiary to buy EUR and sell USD (and the subsidiary’s version of that trade will be sell EUR and buy USD).
- “The net result of this is the parent entity is neutral, their external and internal trades offset, and the subsidiary has a trade on their books that should offset their exposure.
“Why do companies use back-to-back hedges? First, it limits trading to the parent entity which eliminates the need to set up ISDA and trading relationships for multiple legal entities. Additionally, the parent entity usually has the best credit and likely can get the best pricing in the execution. Also, it centralizes trading in one entity, ensuring that everyone trading has the necessary training and experience, plus allows the parent to net trades where possible to save costs.
“How does it help cash flow hedging specifically? To apply cash flow hedge accounting, the derivative must reside at the entity that has the exposure. Using back-to-back hedges allows the company to get the derivative at the right entity while also reaping the benefits of hedging from a central parent entity.
“How does it help balance sheet hedging specifically? For balance sheet hedging, usually you want the hedge and the exposure to reside at the same entity so that they receive the same tax treatment. If the hedge were at the parent but the exposure was at the subsidiary, the hedge would be taxed differently than the remeasurement of the exposure, leading to inefficiency in the program.
“Overall, back-to-back hedging strategies are very common because they provide significant benefits to companies for hedging both balance sheet and cash flow risk. One suggestion for organizations implementing back-to-back hedging is you really need a technology partner that can automate the process for you because managing large programs this way manually will likely lead to inefficiencies and errors where a technology solution can streamline this process in seconds.”
