FASB Embedded Derivatives Application of Paragraph 15(a) regarding Substantial Party to a Contract

FASB: Embedded Derivatives: Application of Paragraph 15(a) regarding Substantial Party to a Contract

Derivatives Implementation Group

Statement 133 Implementation Issue No. B32

Title: Embedded Derivatives: Application of Paragraph 15(a) regarding Substantial Party to a Contract
Paragraph references: 15(a), 311, Implementation Issue B21
Date cleared by Board: March 21, 2001
Date posted to website: April 10, 2001
Date revision posted to website: May 1, 2003
Affected by: FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
(Revised March 26, 2003)

QUESTION

How should an entity determine what constitutes a "substantial party" to an international construction contract in the context of paragraphs 15(a) and 311? Specifically, how does one evaluate the role of a parent company that may not be a legal party to the contract but who provides the majority of resources required under the contract on the behalf of the subsidiary who is the legal party to the contract?

BACKGROUND

Paragraph 15(a), as amended, states that an embedded foreign currency derivative instrument shall not be separated from the host contract and considered a derivative instrument under paragraph 12 if the host contract is not a financial instrument and it requires payment(s) denominated in the functional currency of any substantial party to that contract.

Paragraph 311 states, in part, that "the Board decided that it was important that the payments be denominated in the functional currency of at least one substantial party to the transaction to ensure that the foreign currency is integral to the arrangement."

It is a common practice in the international construction industry to enter into contracts in foreign countries via local subsidiaries to meet the local tax and political requirements. In fact, this is sometimes a requirement to the contractor, especially when the contract is entered into with a foreign government as a customer. However, the customer will typically "look through" the contracting subsidiary to its parent company to provide the experience, management, knowledge, financial resources, infrastructure, and other services under the construction contract and bear the responsibility for the contract management and execution. This responsibility may or may not be evidenced legally through a financial guarantee or other credit comfort provided by the parent company to the customer.

The following fact pattern further illustrates this issue.

A US-based construction company (the Parent) pursues business in a foreign country on a major construction contract. The Parent has an operating subsidiary (the Subsidiary) in that foreign country. The Subsidiary's functional currency is determined to be the local currency (because of business activities unrelated to the construction contract), which is also the functional currency of the customer under the contract. The Parent's functional currency is the US dollar.

Primarily for tax and political reasons, the Parent causes its Subsidiary to enter into a contract with the customer (that is, the contract is legally between the Subsidiary and the customer). The contract requires payments by the customer in US dollars. The payments are in US dollars to facilitate the compensation of the Parent for its significant involvement in and management of the contract entered into by the Subsidiary.

The Subsidiary, by itself, does not possess the requisite financial, human, and other resources, technology, and knowledge to execute the construction contract on its own. The Parent provides the majority of the resources required under the contract, including direct involvement in negotiating the terms of the contract, managing and executing the contract throughout its duration, and maintaining all contract supporting functions, such as legal, tax, insurance, and risk management. Because it is controlled by the Parent, the Subsidiary does not have a choice of subcontractor for these resources and services and will always integrate the Parent into all phases of the contract. Without the Parent, the Subsidiary and the customer would have probably never have entered into the construction contract because the Subsidiary could not perform under this contract without the help of Parent.

RESPONSE

The Parent should be considered a substantial party to the contract. When determining who is a substantial party to the contract for purposes of applying paragraph 15(a), the entity needs to consider all facts and circumstances pertaining to that contract (including whether the contracting party possesses the requisite knowledge, resources, and technology to fulfill the contract without relying on related parties), and look through the legal form to evaluate the substance of the underlying relationships. In the illustration above, the Parent is a substantial party to the construction contract entered into by the Subsidiary for the purposes of applying paragraph 15(a) of Statement 133 because the Parent will be providing the majority of resources required under the contract on the behalf of the Subsidiary, who is the legal party to the contract.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.