Contracts for differences

The Financial Services and Market Act 2000 Schedule 2 paragraph 19 defines the term “contracts for differences” as:

“Rights under- (a) a contract for differences; or (b) any other contract the purpose or pretended purpose of which is to secure a profit or avoid a loss by reference to fluctuations in- (i) the value or price of property of any description; or (ii) an index or other factor designated for that purpose in the contract.”

The definition in the Financial Services and Markets Act is limited by the Financial Services and Markets Act 2000 Regulated Activities Order (SI 2001/544), which states:

“Contracts for differences etc. 85. - (1) Subject to paragraph (2), rights under - (a) a contract for differences; or (b) any other contract the purpose or pretended purpose of which is to secure a profit or avoid a loss by reference to fluctuations in - (i) the value or price of property of any description; or (ii) an index or other factor designated for that purpose in the contract. (2) There are excluded from paragraph (1) - (a) rights under a contract if the parties intend that the profit is to be secured or the loss is to be avoided by one or more of the parties taking delivery of any property to which the contract relates; (b) rights under a contract under which money is received by way of deposit on terms that any interest or other return to be paid on the sum deposited will be calculated by reference to fluctuations in an index or other factor; (c) rights under any contract under which - (i) money is received by the Director of Savings as deposits or otherwise in connection with the business of the National Savings Bank; or (ii) money is raised under the National Loans Act 1968 under the auspices of the Director of Savings or treated as so raised by virtue of section 11(3) of the National Debt Act 1972; (d) rights under a qualifying contract of insurance.”

The term “contracts for differences” is also used in a narrower sense than the definition in the Financial Services and Markets Act, to describe derivatives sold to individual investors, based on price movements of specific shares, bonds, stock market indices, or futures contracts, under which the customer agrees with the seller of the contract that that for each day of the contract term, the customer will pay or receive an amount based on the movement in the underlying asset.

FA 2002 Schedule 26

The definition of the term “contract for differences” in Schedule 26 paragraph 12 is based on the definition in the Financial Services and Markets Act 2000. That definition is very wide, and without qualification would include many contracts that are not normally thought of as derivatives. The definition in the Financial Services and Markets Act is limited by the definitions in the Regulated Activities Order 2001. The limitations in the Order are based on the purpose of the contract whether the contract was entered into for a commercial or an investment purpose, or whether a non-financial trading company entered into the contract as a hedge.

It would, however, be impractical to determine the purpose of every one of a company’s derivative contracts before it could be determined how the contract should be taxed. Schedule 26 therefore uses another method, referred to in paragraph 3, which provides (with some exceptions) that a “relevant contract” cannot be a “derivative contract” unless it is treated as a derivative contract for accounting purposes.

The result is that most ordinary commercial contracts, such as purchase agreements with a later delivery date, do not qualify as derivative contracts for tax purposes. Even if a contract satisfies the accounting test, it must still pass the underlying subject matter test, in paragraph 4, in order to be a derivative contract. In most cases, it will not matter in which order the two tests are applied, so that if the underlying subject matter disqualifies the contract from being a derivative contract, then there is no need for the accounting test to be applied.

The term “contract for differences” is defined in FA 2002 Schedule 26 paragraph 12(3) as “a contract the purpose or pretended purpose of which is to make a profit or avoid a loss by reference to fluctuations in (a) the value of price of property described in the contract, or (b) an index or other factor designated in the contract”.

The reference to “pretended purpose” means aimed for, and does not imply fraud or deception.

Paragraph 12(4) provides that for the purposes of sub-paragraph (b), “an index or factor may be determined by reference to any matter and, for those purposes, a numerical value may be attributed to any variation in a matter”. This definition includes swaps as well as futures and options. For tax purposes, the scope of the definition is limited by excluding contracts that are not treated as derivatives in a company’s accounts, in terms of Schedule 26 paragraph 3.

Paragraph 12(5) provides that the following contracts are expressly excluded from being “contracts for differences”:

Consequently, contracts that are intended to result in delivery of an underlying asset, contracts that are intended to result in the depositing of money, and insurance contracts, are not “contracts for differences”. Many of these would in case fail the accounting test in Schedule 26 paragraph 3.

Paragraph 11(4) provides that the underlying subject matter of a “contract for differences” is, where the contract for differences relates to fluctuations in the value or price of property described to in the contract, the property so described, or where an index or factor is designated in the contract for differences, the matter by reference to which the index or factor is determined. The index need not be an existing index (such as the FTSE-100 index) and can be an index custom created for the purposes of the specific contract.

Paragraph 11(5) provides that the underlying subject matter of a contract for differences may include interest rates, weather conditions, or creditworthiness.

CFDs and wagering

It has been held that a debt that arises from a wagering contract is enforceable, provided that the wagering contract was entered into by way of business.

It was held in Morgan Grenfell & Co Ltd v Welwyn Hatfield District Council [1995] 1 AER 1, that while a contract for differences can be entered into for speculation, and may be a wager, this is not necessarily the case, and whether it is a wager depends on the intention of the parties.

Because a company would usually conclude a derivative contract to hedge against risk or to invest, rather than to wager its shareholders’ money, it would be unusual for a contract for differences entered into by a company to be a wager.

Where a contract falls within the FA 2002 Schedule 26 rules, it is irrelevant whether the contract is a wager or not.