Futures and forwards

Futures contracts

A futures contract is an agreement in terms of which a contracting party contracts with a counterparty to deliver a standard amount of a commodity or a financial instrument, on a specified future date, for an agreed price to be paid by the counterparty.

The features of futures contracts are:

Common futures contracts

Common types of futures contracts are currency futures, interest rate futures, financial futures and commodity futures.

Uses of futures contracts

Futures contracts are entered into for purposes of speculation or trading, arbitrage, or for hedging of risk.

A futures contracts is entered into for speculation or trading where the intention of the contracting party is to earn a profit from the “sale” or assignment of the contract at a future date when its value has increased. Trading in futures contracts enables a contracting party to earn profits from movements in interest rates, exchange rates or share market indices, without having to buy the underlying subject matter of the contract. A trader can utilise one or more of several trading strategies involving futures contracts: position trading, which involves acting on minute by minute fluctuations in market prices, and concluding a large number of purchases and sales with the intention that the net result of all transactions will be a profit; spread trading, which involves the purchase and sale of different contracts for the same month of delivery; or straddle trading, which involves the purchase and sale of one type of contract for settlement in different delivery months. If the price of the underlying security is expected to increase, the dealer goes “long”, that is, he buys financial futures. If the price of the underlying security is expected to fall, the dealer goes “short”, that is, he sells financial futures. The risk involved in these activities is that the price of the underlying security will move in the opposite direction to the direction anticipated by the dealer. A dealer earns two types of income from speculation in financial futures: reward for assuming risk, and the potential profits from taking a correct view of future movements in prices of underlying cash market securities. Financial futures are particularly suitable for trading, because transaction costs are low, there is no requirement to purchase or sell the underlying asset, and the only cash outlay that is required is the initial margin.

Arbitrage is the purchase and sale of a specific futures contract with the object of profiting from temporary differences in the price of the contract in different markets, or between prices in the cash market and prices in the futures market. Those differences are small and they exist for a short time, because as soon as they are noticed, arbitrageurs exploit them in order to earn profit with low risk. If there is a misalignment between the prices of the underlying asset and the futures contract, the arbitrageur may undertake “cash and carry arbitrage” by borrowing funds, purchasing the underlying asset, and selling a futures contract. Arbitraging the differences between the prices of different types of futures contracts or between the delivery dates of futures contracts, is referred to as “spreading”.

Hedging involves the use of futures contracts to reduce or eliminate risks associated with fluctuations in share prices, foreign exchange rates, interest rates or other assets. For example, a trading company may use a future to hedge against interest rate or currency risk, and a pension fund manager may use an index future to protect against a fall in the equities market. Hedging with futures contracts is carried out in the following ways: an anticipated currency receipt or payment is hedged with a currency future, with the object of securing the current exchange rate and avoiding the risk that the value of the foreign currency will weaken or strengthen in relation to sterling, before the underlying transaction occurs. An interest rate is hedged with an interest rate future by a company that wishes to borrow funds in the future and wishes to “lock in” the current interest rate, by purchasing an interest rate future for that date, the effect of the hedge being to fix the company’s interest rate cost by guaranteeing the prevailing interest rate. An asset or liability is hedged with a share index future or an interest rate future by a company that wishes to protect the current value of a share portfolio against an anticipated decline in the equities market, the company purchasing a share index future which has the effect of hedging the value of all shares the price of which forms part of the index.

Forward contracts

A forward contract is an agreement whereby a contracting party undertakes with a counterparty to buy or to sell an agreed quantity of an asset, at a specified future date, at a fixed price. Neither party makes any payment on the date on which the contract is entered into. When the contract matures, that is, when the time for performance arrives, the contracting party renders performance by making a cash payment to the counterparty, while the counterparty renders performance by delivering cash or an asset to the contracting party.

The terms of a forward contract are agreed between the parties pursuant to negotiation. In other words, forward contracts are custom designed for the parties who enter into them. The terms can therefore be structured to meet the specific needs of a party, and can be in respect of any amount and for any delivery date. A forward contract thus has the advantage over a futures contract that it can be tailored precisely to a party’s requirements. Forward contracts are “over the counter” agreements and are normally intended to be cash-settled, with settlement occurring at maturity. Because the objectives of the contract are only achieved when a payment passes between the parties, credit risk in the form of risk that the counterparty will be unable to perform when performance is due, is an issue.

The maturity date of a forward contract is usually more than two days after the date on which the contract is entered into, because a shorter period between conclusion and maturity would result in the contract being a “spot contract” rather than a forward. The spread between the performance required under a forward contract and the performance that would be required under an equivalent spot contract is referred to as a “premium” or “discount”, depending on whether the performance required under the forward contract is more or less than the performance required under the spot contract.

There is no organised market for the trading of forward contracts, nor is there a margin system of credit protection. Because a forward contact is a firm agreement under which contractual performance will definitely be rendered, there is no requirement for any premium to be paid when the contract is entered into, nor for the payment of any margin during the contract term. The contractual relationship of the parties to a forward contract, as purchaser and seller, is a fixed relationship. Forward contract usually reach maturity because there is an underlying commercial reason why the contract was entered into initially. A disadvantage of forward contracts is the inability of a party to assign his contractual rights and obligations to a third party, by “selling the contract”, in order to obtain the benefit of any increase in the value of the contract.

Uses of forward contracts

Forward contracts are used for speculation or trading with the object of earning a profit from movements in the value of the underlying asset, or for hedging against currency, interest rate or other market risks.

The most common applications of forward contracts are “forward foreign exchange contracts” in relation to foreign exchange, and “forward rate agreements” in relation to interest rates.

There are two methods of accounting for forward rate agreements. Under the accruals method, no accounting entry is made until the settlement date, and when the settlement date arrives, the profit or loss on the contract is deferred and amortised over the forward rate agreement period. Under the mark to market method, a value is determined for the forward rate agreement from the contract date onwards, with revaluation profits and losses being taken to the profit and loss account and to the corresponding debtor and creditor account in the balance sheet. On the settlement date, the balance sheet value equals the cumulative profit or loss and is extinguished by the cash settlement.

A forward rate agreement entered into for the purpose of trading or speculation is “marked to market”. Banks usually enter into forward rate agreements for the purpose of hedging future interest rate exposure, in which case the accounting must reflect the reason for holding the instrument and must mirror the accounting for the hedged instrument. A forward rate agreement entered into for the purpose of hedging is accounted for in the same way as the underlying item being hedged. In the case of a hedge of an future interest rate exposure, the exposure is not itself on the balance sheet at the time at which the forward rate agreement is entered into, although it may constitute a commitment for the bank. Because the forward rate agreement is intended as a hedge, it is difficult to conclude that for accounting purposes it should be marked to market, with any gain or loss being taken to the profit and loss account. For such instruments, therefore, treatment as an off balance sheet item is regarded as appropriate. If the forward rate agreement was not entered into for hedging purposes, then the gain or loss at a point in time will not be offset by an off balance sheet exposure. The forward rate agreement would thus be marked to market, and the result discounted back to present value.

Where a forward rate agreement is intended to be a hedge, the holder is required to carefully monitor the reason for the transaction. This is because of the possibility that the future event that the agreement was entered into to hedge against, will change or dissipate, negating the need for the hedge. The holder would then have three options:

If the underlying asset or liability is derecognised or sold, the forward rate agreement is valued at fair value and the resulting profit or loss is recognised immediately in the profit and loss account. Alternatively, the profit or loss is spread over the life of the underlying item that is being hedged.

FA 2002 Schedule 26

The term “future” is defined in FA 2002 Schedule 26 paragraph 12(6) as “a contract for the sale of property under which delivery is to be made – (a) at a future date agreed when the contract is made, and (b) at a price so agreed.”

This definition is based on the definition in the Financial Services and Markets Act 2000 Schedule 2 paragraph 18, where the term “futures” is defined as “Rights under a contract for the sale of a commodity or property of any other description under which delivery is to be made at a future date.” This definition is very wide, and without qualification would include many contracts that are not normally regarded as derivatives. The definition has accordingly been narrowed down by the definitions in the Financial Services and Markets Act 2000 Regulated Activities Order (SI 2001/544), which states:

“Futures 84. - (1) Subject to paragraph (2), rights under a contract for the sale of a commodity or property of any other description under which delivery is to be made at a future date and at a price agreed on when the contract is made. (2) There are excluded from paragraph (1) rights under any contract which is made for commercial and not investment purposes. (3) A contract is to be regarded as made for investment purposes if it is made or traded on a recognised investment exchange, or is made otherwise than on a recognised investment exchange but is expressed to be as traded on such an exchange or on the same terms as those on which an equivalent contract would be made on such an exchange. (4) A contract not falling within paragraph (3) is to be regarded as made for commercial purposes if under the terms of the contract delivery is to be made within seven days, unless it can be shown that there existed an understanding that (notwithstanding the express terms of the contract) delivery would not be made within seven days. (5) The following are indications that a contract not falling within paragraph (3) or (4) is made for commercial purposes and the absence of them is an indication that it is made for investment purposes - (a) one or more of the parties is a producer of the commodity or other property, or uses it in his business; (b) the seller delivers or intends to deliver the property or the purchaser takes or intends to take delivery of it. (6) It is an indication that a contract is made for commercial purposes that the prices, the lot, the delivery date or other terms are determined by the parties for the purposes of the particular contract and not by reference (or not solely by reference) to regularly published prices, to standard lots or delivery dates or to standard terms. (7) The following are indications that a contract is made for investment purposes - (a) it is expressed to be as traded on an investment exchange; (b) performance of the contract is ensured by an investment exchange or a clearing house; (c) there are arrangements for the payment or provision of margin. (8) For the purposes of paragraph (1), a price is to be taken to be agreed on when a contract is made - (a) notwithstanding that it is left to be determined by reference to the price at which a contract is to be entered into on a market or exchange or could be entered into at a time and place specified in the contract; or (b) in a case where the contract is expressed to be by reference to a standard lot and quality, notwithstanding that provision is made for a variation in the price to take account of any variation in quantity or quality on delivery.”

This definition provides that a contract is not a future if it is made for commercial, rather than investment, purposes. A contract that is traded on a recognised exchange, or an over-the-counter contract on the same terms, is presumed to have been entered into for investment purposes. Any other type of contract is regarded as having a commercial purpose if the parties intend that it will result in the delivery of the underlying asset.

The limitations in the Order are thus based on the purpose of the contract – whether the contract was entered into for a “commercial purpose” or an “investment purpose”, or whether a non-financial trading company entered into the contract as a hedge. Because it is 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, however, Schedule 26 provides for another method, which is paragraph 3, which provides (with certain 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, are not derivative contracts for tax purposes. Even if a contract satisfies the accounting test, it must still pass the underlying subject matter test in Schedule 26 paragraph 4, in order to be a derivative contract.

Schedule 26 paragraph 12(7) provides that for the purpose of determining whether a price has been “agreed” for the purposes of the definition of “future” in paragraph 12(6), a price is deemed to have been agreed when the contract is entered into, notwithstanding that the price is left to be determined by reference to a second price at which a contract is to be entered into on a market or exchange, or which could be entered into at a time and place specified in the contract, or where the contract is expressed to be by reference to a standard lot and quality, notwithstanding that provision is made for a variation in the price to take account of any variation in quantity or quality on delivery. A price is thus presumed to have been “agreed” when the contract is entered into, even if the contract does not expressly say that an amount of money will be paid. Consequently, even where the contract is an exchange-traded commodity future or a gilt or US Treasury bond future that provides for the delivery of alternative assets to those specified in the contract, or where the underlying asset referred to in the contract does not exist, or there is provision for the price to be varied, the contract remains a future. If the price of a future is dependent on market value at a specified time and place, paragraph 12(7) deems the contract price to have been agreed when the contract is entered into.

Schedule 26 paragraph 12(10) provides that references to a “future” do not include references to a contract whose terms provide that after setting off their obligations to each other under the contract, a cash payment is to be made by one party to the other in respect of any excess, or that each party is liable to make to the other party a cash payment in respect of all that party’s obligations to the other under the contract, and do not provide for the delivery of any property. Paragraph 12(10) does not, however, have the effect of excluding from references to a “future” a futures contract whose underlying subject matter is currency. In other words, a contract whose terms provide that after setting off their obligations to one another under the contract, a cash payment is to be made by one party to the other in respect of any excess, or that each party is liable to make a cash payment to the other party in respect of all of that party’s obligations under the contract, and does not provide for the delivery of any property is not a “future”, but a future whose underlying subject matter is currency is not disqualified from being a “future” for the purposes of Schedule 26. The Schedule 26 definition of “future” implies therefore that for tax purposes a contract that can only be cash-settled and does not provide for the delivery of any property, is not a “future”, but is a “contract for differences”, unless Schedule 26 paragraph 26(4A) regarding transfers of value to connected companies applies. This limitation does not apply, however, to a contract that provides for a payment of foreign currency. Even with the paragraph 12(10) restriction, the Schedule 26 definition of “future” is very wide, and includes any contract in terms of which the purchase price is agreed when the contract is signed, with delivery to be made at a later date. Thus any contract for the purchase of any assets would fall within the scope of this definition, and is only removed from its scope by the operation of the accounting test in Schedule 26 paragraph 3.

Schedule 26 paragraph 11(3) deems the underlying subject matter of a “future” to be the property which, if the contract was to be performed by delivery, would be delivered on the date and at the price agreed when the contract was entered into, or, where the property to be delivered was another a derivative contract, then the underlying subject matter of the future would be the underlying subject matter of that derivative contract.

If a futures contracts is entered into for the purposes of trade, the contract is marked to market, with the profit or loss on the transaction being recognised immediately, and the asset or liability value being adjusted accordingly in the balance sheet. The rule of accounting practice that provides that open positions should be marked to market at current market value, which implies that unrealised profits and losses are recognised, is regarded by HMRC as being appropriate for tax purposes in relation to futures, firstly, because the market is liquid and it is therefore possible to realise an unrealised profit or loss at any time; secondly, because unrealised profits and losses are reflected in cash payments to and from margin accounts, so that it can be argued that they are in fact “realised” in any case; thirdly, because marking to market removes potential for manipulation of financial statements; and fourthly, because true performance can only be measured by reference to the market value of positions.

As regards margin movements, because a range of margin movements may occur on a single date and because some movements may relate to dealing positions, and others to hedging positions, and some movements may be in respect of initial margins and others variation margins, the margin balance in the company’s books should be analysed into its constituent parts. “Initial margin” is a form of collateral, and is shown as a current asset in the paying company’s balance sheet. If the company marks a futures contract to market and thus pays or receives “variation margin”, the profits and losses represented by movements in variation margin are recognised immediately in the profit and loss account, if the transaction is a “trading” transaction. If the transaction is a “hedging” transaction, then even if mark to market accounting is applied, the resulting profit or loss may be deferred and carried in the balance sheet, until the underlying item or transaction reaches maturity. The background to this treatment is as follows. Because the effects of fluctuations in the market value of futures contracts, reflected in the variation margins, are identified daily, the profit or loss on trading contracts may be regarded as realised. Where a futures contract has been entered into in order to hedge another position, however, any profit of loss at the balance sheet date should be matched with the related change in the value of the other position, in accordance with the “accruals” concept. Where a futures contract has been entered into in order to hedge a commitment which is not reflected in the company’s financial statements, any profit or loss should be deferred until the commitment to which it relates, matures.

The accounting for hedge transactions should match the accounting used for the underlying transaction, otherwise the hedging objective will not be achieved. The criteria for determining whether a hedge exists are, first, intention: the party should intend that the transaction will be a hedge; and second, correlation: the price movement of the hedge should inversely correlate with that of the underlying transaction, and there should be reasonable certainty that the underlying transaction will be fulfilled. Because the matching of profits and losses on a hedge is open to manipulation, hedging and dealing portfolios should be separately identified. If the underlying profit or loss is recognised immediately, then the profit or loss on futures contracts should be recognised on the same basis. If the profit or loss on the underlying position is deferred, then the profit or loss on the hedge should also be deferred. But this can only be done if hedges are clearly differentiated from dealing positions. If there is doubt, losses should be expensed, and only profits carried forward. While the accounting treatment for a hedge where an underlying asset or liability can be identified, follows the accounting treatment of the underlying asset or liability, the underlying item is likely to appear on the balance sheet, although the hedge is not likely to appear. The reason for this is that the hedge transaction is likely to be closed out before maturity of the futures contract, so that the notional amount of the contract should not appear on the balance sheet. The appropriate accounting principles are accordingly regarded as the following:

Current practice for banks is to disclose financial futures and forward contracts with other off balance sheet items, in a note to the accounts. If dealing in futures is a major part of a bank’s business, then there is more extensive disclosure. For companies other than banks, futures transactions are entirely off-balance sheet. Because futures contracts are commonly closed out before delivery, and it is therefore rare for the underlying items to be delivered, the underlying items is not shown in the balance sheet, unless and until delivery of the underlying item occurs.

Outside Schedule 26

Profit and losses on futures transactions entered into prior to 6 April 1985 were taxed under Schedule D Case VI. If the profit on a futures transaction was not liable to income tax because the transaction was an “isolated transaction”, then the profit constituted a capital gain and was taxed under TCGA 1992. Transactions in commodity and financial futures dealt in on recognised futures exchanges entered into on or after 6 April 1985 were liable to capital gains tax and were not taxable under Schedule D Case VI. Any unused Schedule D Case VI losses were not available to be set off against capital gains in subsequent tax years, but they could be carried forward and set off under ICTA 1988 section 392(1) against Schedule D Case VI liabilities that arise in respect of subsequent tax years. Transactions in commodity and financial futures that were dealt in on futures exchanges which were not “recognised” exchanges were liable to tax under Schedule D Case VI. From 29 April 1988 onwards, transactions in over-the-counter futures were liable to capital gains tax, rather than to income tax under Schedule D Case VI.

Profits and losses on futures contracts that are outside the scope of FA 2002 Schedule 26 are currently taxed in accordance with TCGA 1992 section 143, as capital gains or losses. The legislation has two purposes: Section 143(1) ensures that transactions in futures are taxable either under Schedule D Case I or are liable to capital gains tax, and that they are not taxable under Schedule D Case VI. Section 143(1) applies in terms of section 143(2) to commodity and financial futures dealt in on recognised futures exchanges, and to over-the- counter futures as defined in Section 143(3). Section 143(5)-(7) provides a set of rules for computing profits and losses on futures contracts that are either closed out or are completed by the making of a payment in settlement of contractual obligations, with the transaction being deemed to be the acquisition or disposal of an asset. There are no special rules for futures contracts that are settled by delivery of the underlying asset. Over-the-counter futures contracts are not dealt in on recognised futures exchanges, and they therefore do not fall within the scope of the definition in section 143(1); they are, however, brought within the scope of section 143(1) by section 143(3), where one of the contracting parties is an “authorised person”. The “small chattels” exemption provided for by TCGA 1992 section 262(6) does not apply to futures contracts.

Section 143(1) provides that, if apart from ICTA 1988 section 128, gains arising to any person in the course of dealing in commodity or financial futures would constitute profits or gains taxable under Schedule D otherwise than as the “profits of a trade”, then that person’s outstanding obligations under any futures contract entered into in the course of that dealing are deemed to be assets to the disposal of which TCGA 1992 applies. The term “commodity or financial futures” is defined in section 143(2) as “commodity futures or financial futures which are for the time being dealt in on a recognised futures exchange.”

Section 143(3) provides that notwithstanding the definition of “commodity or financial futures”, where, otherwise than in the course of dealing on a recognised futures exchange, an “authorised person” enters into a commodity or financial futures contract with another person, or the outstanding obligations under a commodity or financial futures contract to which an authorised person is a party, are brought to an end by a further contract between the parties to the futures contract, then except for any gain or loss arising to any person from that transaction in the course of a trade, that gain or loss is deemed for the purposes of section 143(1) to arise to that person in the course of dealing in commodity or financial futures.

Section 143(5) provides that for the purposes of TCGA 1992, where in the course of dealing in commodity or financial futures, a person who has entered into a futures contract closes out the contract by entering into another futures contract with obligations that are reciprocal to those of the original futures contract, that transaction is deemed to constitute the disposal of an asset, namely, that person’s outstanding obligations under the original contract, and therefore any money or money’s worth received by him in respect of that deemed disposal is deemed to constitute “consideration” for the disposal, and any money or money’s worth paid or given by him in relation to that transaction is deemed to constitute incidental costs incurred by him in making the disposal. In other words, where a futures contract is closed out by the entering into of a second and reciprocal contract, the holder of the contract is deemed to have disposed of an asset, being the obligations under the first contract. Any money received is deemed to be consideration for the disposal, and any money that is paid is treated as an incidental cost of making the disposal. Those costs constitute expenditure that is allowable under TCGA 1992 section 38(1)(c) and therefore no indexation allowance is available.

For example, if an investor sells a commodity futures contract and subsequently closes out the contract by buying an equivalent contract, and he receives a payment equal to the difference between the values of the two contracts, he will have derived a capital gain equal to the amount of the payment received net of his dealing costs. If a speculator purchases a commodity futures contract and subsequently closes out the contract by selling an equivalent contract, and he makes a payment equal to the difference between the value of the two contracts, he will have incurred a capital loss equal to the amount paid plus his dealing costs. He will not be entitled to any indexation allowance on the amount paid, or on any margin payment, or on the notional value of the underlying contracts.

The tax treatment of a futures contract which is not closed out but runs to completion, depends upon the manner of contractual performance. The same rules apply whether the future is traded on a futures exchange or sold over the counter. In practice, over-the-counter futures contracts are usually held until maturity, while exchange-traded futures contracts are usually closed out.

Section 143(6) provides that where in the course of dealing in commodity or financial futures, a person has entered into a futures contract, and has not closed out the contract, and he becomes entitled to receive or liable to make a payment, whether under the contract or otherwise, in full or partial settlement of any obligations that he has under the contract, then for the purposes of TCGA 1992, he is deemed to have disposed of an asset, namely, the entitlement or the liability, and the payment received or made by him is deemed to constitute “consideration” for the disposal or incidental costs relating to the making of the disposal. Section 143(6) thus provides, with regard to futures contracts that are settled by payment in satisfaction of contractual obligations, that any payment that is received is deemed to be consideration for the disposal of an asset, and that any payment that is made is deemed to be an “incidental cost” of disposing of the asset. No indexation allowance is permitted, as the costs are themselves allowable under TCGA 1992 section 38(1)(c). In relation to futures contracts entered into before 30 November 1993 and settled by payment, section 143(6) only applies to financial futures contracts, and in addition, payment must be made in full settlement of all obligations under the contract. In the case of a futures contract entered into after 30 November 1993 and settled by payment, section 143(6) also applies to commodity futures, and covers payments made during the life of the contract before its maturity.

If a futures contract is settled by delivery of the underlying asset, the normal capital gains tax rules apply. If the underlying asset is held by the taxpayer as a chargeable asset, no chargeable event occurs until the asset is disposed of. The date of acquisition or disposal of the underlying asset is determined in accordance with TCGA 1992 section 28, in the same was as in any other contract.

Futures contracts are usually unconditional, but a futures contract may be conditional where, on the date on which the contract is entered into, there is no certainty as to the identity of the assets that would have to be delivered if the contract was to run to maturity. Examples of conditional futures contracts are contracts that can be settled by the delivery of one or more of a range of assets, such as one of various securities. The date of acquisition and disposal of the assets for capital gains tax purposes is taken to be the date of delivery of the underlying asset, and not the date on which the futures contract is entered into.

Gains arising from the disposal of a futures contract to acquire or dispose of gilt-edged securities or qualifying corporate bonds are exempt from capital gains tax, in terms of TCGA 1992 section 115. Section 143(7) provides that TCGA 1992 section 46, which allows for the reduction of the value of “wasting assets”, is deemed not to apply to obligations under a commodity or financial futures contract which is entered into by a person in the course of dealing in such contracts on a recognised futures exchange, or a commodity or financial futures contract to which an “authorised person” as defined in the Financial Services and Markets Act 2000, is a party. The term “authorised person” is defined in section 143(8) as a person authorised under the Financial Services and Markets Act 2000 to carry on trade in exchange traded futures. The implication of this provision is that the acquisition cost of a futures contract is not reduced for the purposes of the computation of any gain arising when the contract is closed out or settled by way of a cash payment. This provision is, however, of limited application as it is unusual for an up-front payment to be made to acquire a futures contract. Most payments in respect of futures contracts are margin payments which are treated as deposits, and do not constitute consideration for the acquisition of the futures contract. Section 143(7) is most likely to apply to hedging transactions, such as interest rate caps, collars and floors, under which, in return for making an up-front payment, the taxpayer acquires the right to receive automatic payments based upon movements in interest rates. Transactions of this kind are not treated as options, if the payments are made automatically under the terms of the contract and do not depend upon the exercise of any right. HMRC accepts that an interest rate cap, collar or floor is a “financial future”. Consequently, any payment made to acquire such an instrument, where an authorised person is the counterparty, can be deducted in full and is not “wasted” for capital gains tax purposes.

For the purpose of capital gains tax, margin payments are regarded as deposits lodged with a broker to cover any loss that might arise on a futures contract, and do not constitute consideration for the acquisition of an asset. Margin payments do not therefore qualify for indexation allowance or taper relief.

SP 3/02 Tax treatment of transactions in financial futures covers the tax treatment of futures transactions defined in TCGA 1992 section 143, relating to shares, securities, foreign currency and other financial instruments. It applies to UK residents, including unauthorised unit trusts, charities, and other persons including companies, which do not trade, or which do trade but the principal trade of which is not financial trading. SP3/02 does not apply to approved pension schemes, the profits of which from futures are exempt from tax.

SP 3/02 applies for companies accounting periods commencing on or after 1 October 2002, and only in relation to financial futures where the underlying subject matter is shares, a holding in an authorised unit trust, or a security to which FA 1996 sections 92 or 93 applies. The statement says that ICTA 1988 section 128 and TCGA 1992 section 143 provide that transactions in financial futures are to be treated as capital transactions, except where they constitute the profits or losses of a trade.

It was held in HSBC Life (UK) Ltd v Stubbs [2002] STC 9 (SCD), that for this purpose, it was irrelevant whether such trading profits were taxed under Schedule D Case I, or under any other provision of ICTA 1988; if under statute and case law, profits or losses are “trading” profits or losses, then section 128 of ICTA 1988 and section 143 of TCGA 1992 are not applicable to those profits or losses.

As to the question whether a taxpayer’s futures transactions result in “trading” profits or losses, HMRC’s views stated in SP 3/02 is that:

Whether a financial futures or options transaction is “ancillary to another transaction” depends on the following factors:

The question whether a financial futures transaction to buy or sell currency forward is “ancillary to a capital transaction” may depend on the taxpayer’s base currency, which in the case of a UK taxpayer, would probably be sterling.

The rules apply to both long and short positions, and irrespective of whether the futures position is closed out or is held to maturity.

As to whether a financial future is “economically appropriate” to the elimination or reduction of risk, HMRC’s view is that:

SP3/02 states that if the financial futures transaction is entered into in order to eliminate or reduce risk, but the other transaction is terminated or the intention to enter into it is abandoned, then, if the futures transaction is closed out as soon thereafter as is practical, the futures transaction will retain its character. If the futures transaction is not closed out at that time, HMRC reserves the right to argue that any resulting profit or loss will be of a trading nature, although HMRC declares that where the taxpayer is not otherwise trading, it would not pursue this argument.

Whether futures contracts are taxable under Schedule D Case I or as capital gains thus depends on whether the taxpayer’s transactions in futures contracts constitute a “trade”. This is a question of fact, and is subject to the SP3/02 guidelines for determining when a trade in futures is carried on. An individual who enters into commodity futures transactions is unlikely to be regarded by Inland Revenue as trading in futures. Where a person is trading in futures, transactions that are entered into which are ancillary to trading transactions are themselves revenue transactions. Whether profits or losses on futures that are not taxable under Schedule D Case I are taxable under Schedule D Case VI or as capital gains, depends upon when the transactions occurred.

Anti-avoidance

Because futures contracts can be used to generate a guaranteed return which, in economic terms, is equivalent to interest, and because in the absence of specific rules any profits on such transactions would, except where income treatment applies for other reasons, be liable to capital gains tax, capital gains treatment could be beneficial to the holder of a futures contract. The possible benefits of capital gains treatment would be that profits generated by the contract might be reduced by indexation or taper relief in computing any chargeable gain; or chargeable gains might be covered by existing capital losses; or in the case of gilt futures held by individuals and trusts, gains from futures contracts are exempt from tax in terms of TCGA 1992 section 115(1).

ICTA 1988 Schedule 5AA is intended to counter arrangements of this kind. It applies where there is a disposal of a futures contract which is one of two or more related transactions which are designed to produce a guaranteed return, whether the return from that disposal, or a number of disposals of the futures or options taken together. Where these rules apply, any profits on the futures contract are taxed under Schedule D Case VI, rather than as capital gains, and any losses are similarly dealt with as Schedule D Case VI losses. The Schedule 5AA rules apply to commodity or financial futures, and cover a wider range of contracts than those within the scope of TCGA 1992 section 143.