Options

An option contract is an agreement entered into between the grantor or “writer” of an option and the grantee or “holder” of an option, that gives the holder the right, without any obligation, to buy or sell a predetermined amount of a commodity, currency, future, or other financial instrument, at a predetermined price, at or up to a set date in the future, called the expiry date. A call option is an option that gives the holder a right to buy the underlying asset; a put option is an option that gives the holder a right to sell the underlying asset.

FRS 13 states that a put option or call option to exchange financial instruments gives the holder a right to obtain potential future economic benefits associated with changes in the fair value of the financial instruments underlying the contract. Conversely, the writer of an option assumes an obligation to forego potential future economic benefits or bear potential losses of economic benefits associated with changes in the fair value of the underlying financial instruments. The contractual right of the holder constitutes a “financial asset” and the contractual obligation of the grantor constitutes a “financial liability”.

The term “options” is defined in the Financial Services and Markets Act 2000 Schedule 2 paragraph 17 as: “Options to acquire or dispose of property.” The Financial Services and Markets Act 2000 Regulated Activities Order (SI 2001/544) defines “option” as follows: “Options 83. Options to acquire or dispose of - (a) a security or contractually based investment (other than one of a kind specified by this article); (b) currency of the United Kingdom or any other country or territory; (c) palladium, platinum, gold or silver; or (d) an option to acquire or dispose of an investment of the kind specified by this article by virtue of paragraph (a), (b) or (c).” Options are thus limited under this definition to contracts that relate to financial assets, currency or precious metals. Options to acquire land, for example, are excluded from the scope of the definition.

Underlying asset

The underlying asset of an option contract is either the property that would be delivered if the option was to be exercised, or if the property that would be delivered is itself a derivative contract, the underlying subject matter of that derivative contract. The underlying asset of an option contract may be a notional asset, such as a share index, in which case, the contract will be “cash-settled”, with the cash payment being equal to the difference between the amount specified in the option contract, and the value of the underlying asset at the settlement date.

Option premium

Because the right to exercise an option has a value, an amount that is referred to as a “premium” is paid by the holder of the option to the grantor for the grant of the option. The premium may be paid on the date on which the option is granted, or in instalments over the option period, or the premium may be “rolled up” and paid on the expiry date of the option. From the grantor’s perspective, the premium is the amount required to compensate him for the risks associated with the price movements in the underlying instrument during the period in which the option may be exercised. The premium can thus be regarded either as payment by the holder of the option for the right to exercise the option, or as fee income received by the grantor to recompense him for providing the holder with an obligation which he may have to meet in the future.

Option contracts

Option contracts can be categorised according to the manner in which the contract is entered into, the manner in which the option may be exercised, the entitlement of the holder to either buy or to sell the underlying asset, or the type of asset that constitutes the underlying subject matter. Option contracts can be entered into in three ways:

Option contracts categorised according to the manner in which they can be exercised are the European option, under which exercise of the option is permitted only on the expiry date of the option, American option under which exercise is permitted on any date between the issue date and the expiry date, and Bermudan option, that may be exercised on any one of a number of fixed dates falling between the issue date and the expiry date.

Option contracts categorised on the basis of whether they entitle the holder to purchase or sell the underlying asset, are called call options where the holder has the right to purchase the underlying asset, or put options, where the holder has the right to sell the underlying asset.

Option contracts categorised according to the nature of their underlying assets are grouped into two types: options on futures, and options on physical cash or commodities. Options on futures give the purchaser the right to enter into a long or short position in a futures contract. Options on physical assets give the purchaser the right to purchase or sell a physical currency, commodity or financial instrument. The most common physical options are currency options and interest rate options.

Uses of options

Option contracts can be used for trading or speculation, or for hedging.

A person who trades in options does so for the purpose of earning profits from fluctuations in the option price, which are caused in turn by fluctuations in the price or value of the underlying asset. The trader’s objective is to eaarn a profit from movements in the prices at which he can purchase or sell option contracts.

A person enters into an option contract for the purpose of hedging when he is faced with a risk exposure. He can deal with this exposure either by covering it forward, or by transacting the exposure “spot” when it materialises, or he can hedge against it with options. The option removes the risk of an adverse movement in prices, exchange rates or interest rates, while leaving the holder able to benefit from favourable movements.

For example, an option can be used to hedge the contingent exposure that arises where a trading company has made a tender that is denominated in foreign currency, but in the event that it does not win the tender, the company will not require the foreign currency, and will therefore only exercise the option if it is “in the money”, so that the exercising of it will result in a profit. Alternatively, the company may use options if it anticipates a future foreign currency liability, which it is unable at present to quantify, for example, because it does not know what domestic demand there will be for the goods that it intends to import, or what volume of raw materials it will require. The company can then use options to hedge against the resulting foreign currency risk. An option contract thus functions in a similar way to a contract of insurance, with the option premium fulfilling the same role as the policy premium, and the insured risk being the risk of an adverse movement in the value of the underlying asset, with the holder of the option receiving the entire benefit of a favourable movement in that value.

Valuation

The value of an option has two elements: intrinsic value, which represents the profit that would be made by the holder of the option if he exercised it immediately, and time value, which is the amount that is required to compensate the writer of the option for the risks associated with movements in the price of the underlying asset until the option expires. In practice, an option always has a positive time value until it expires, at which date its time value will be nil. The time value reflects the potential that the option’s intrinsic value will increase over the remainder of the option’s life.

When an option has a positive intrinsic value, it is referred to as being “in the money”. If the strike price of a put option is less than the current spot price, then the option is referred to as being “out of the money”. A call option is “out of the money” if the strike price is greater than the market price. If the strike price is equal to the spot price, the option is “at the money”.

The time value of an option is at its maximum for a given expiry date, when the option is “at the money”, and tends to zero for an option that is “deeply out of the money” or “deeply in the money”.

In the case of an option that is “clearly out of the money”, the further away the option is from the strike price, the less likely it is that the option will be exercised. Both the value to the holder and the risk to the writer are reduced, as are the premiums that are required for taking on the risk.

Where an option is “in the money”, it has an intrinsic value and there is a risk to the holder that if there are adverse movements in the spot price of the underlying asset, this value will be reduced, but for the writer of the option, such adverse movement will represent a gain. The higher the intrinsic value, the greater the risk that it will fall. The premium, therefore, compensates the holder of the option with a reduced time value in the premium, so that the writer of the option will be willing to agree to a lower premium because of the reduced risk.

For a call option, the intrinsic value is the excess of the spot price of the underlying asset over the exercise price of the option. This is the gain that would be made by exercising the option and selling the underlying asset in the cash market.

For a put option, the intrinsic value is the excess of the exercise price over the spot price, which constitutes the profit that would be derived from buying the underlying asset in the cash market and exercising the option to sell the asset at the “strike price”, which is the price at which the option could be exercised, in terms of the option contract.

The market value of the option is effectively equal to the premium on the date on which the option is written. The value of an option in the ensuing option period, is calculated using option pricing models.

The value of an option also depends on the value of the underlying asset. The higher the price of the underlying asset, the higher the probability that the option, if a call option, can be exercised at a profit. If the price of the underlying asset increases, however, the time value of the option falls. An option can never have a negative intrinsic value, because the purchaser always has the right not to exercise it. If on a particular date during the option period, an option has no intrinsic value, it will still have a positive market value, because an option always has a time value, which reflects the fact that there is always a possibility, no matter how small, that at some time before it expires, it will increase in value and acquire intrinsic value.

Risk and reward

Options differ from other financial instruments, because they produce different elements of risk. The reason for this is that the holder has the right but not the obligation to exercise the option, and secondly, because the pay-off profile for the holder is not linear, but has a one sided risk and return profile. This means that for the holder, a gain can only be realised if the market price of the underlying asset exceeds the “strike price” of the option.

The maximum loss that the holder of an option can incur is the amount of the premium that has been paid by him. He cannot lose any more, because the option does not have to be exercised.

For the grantor of the option, on the other hand, his profit is limited to the amount of the premium received, while his losses are potentially unlimited. The grantor hopes that the option will not be exercised and that the premium that he has received will represent income for him. If the market moves against him, the more likely it becomes that the holder will exercise the option.

If the underlying asset can be purchased by the holder in the cash market at price below the option strike price, he will not exercise the option. As the market price moves above the strike price, the value of the option will increase and the holder’s potential profit will be unlimited. For the writer of the option, the maximum profit that can be made is equal to the option premium, and this would be earned when the price of the underlying asset falls below the strike price. But if this was to occur, the option would not be exercised. If the price of the underlying asset increased above the strike price, the option would be likely to be exercised and the grantor’s loss potential would be unlimited.

The holder’s potential loss is limited to the premium paid, because he would not exercise the option if the price of the underlying asset increased above the strike price. In the case of a call option, if the price of the underlying instrument fell below the strike price, the holder’s profit would be equal to the strike price received, less the premium paid, less the market price of the instrument sold. For a put option, the position of the grantor would be that if the price of the underlying asset exceeded the strike price, the option would not be exercised and so the grantor’s gain would be equal to the premium received. If the price of the underlying asset fell below the strike price, and the option was exercised, the grantor would incur a loss equal to the strike price paid to the holder, less the value of the underlying asset, less the premium received.

Accounting

There is no UK accounting standard that deals specifically with options contracts. FRS 5 Reporting the substance of transactionsstates that an option to acquire an item of property in the future represents a different asset from ownership of the property itself. For example, when an option to purchase shares at a future date is acquired, the only asset is the option itself; the asset ‘shares’ will only be acquired on exercise of the option. Disclosure of options contracts is governed by FRS 13, which states that there must be numerical disclosure of interest rate and currency risk, including separate disclosure of the terms of “optional derivatives” such as caps and floors.

If an option is held as part of a trading portfolio, it should be “marked to market”. The writer of an option values the option at an amount that does not exceed the option premium that is received or is receivable. Purchased options should not be valued at a negative amount, because the most that can be lost on a purchased option is the premium, and at worst, the option will be allowed to expire without being exercised. “Variation margins” paid on exchange-traded options received or paid are either deferred or are recognised in the profit and loss account. The “matching” principle applies, so that if the option is acquired for the purpose of dealing, the profit is recognised in the profit and loss account, and the “margin” is similarly recognised; if the option was acquired for the purpose of hedging, the margin is deferred until the profit on the hedged item is recognised.

As regards the valuation of open positions, therefore, the main issue is the time when they are recognised. An open position is marked to market, subject to the rules of hedge accounting. The difference between the total value derived from this calculation, and the total value of the positions at the prices at which the contracts were concluded, is the profit or loss on the open contracts at the valuation date. When an option position is marked to market, changes in both the time value and the intrinsic value of the option contract are taken into account.

With regard to the recognition of profit and loss, once the profit or loss from the option contract has been computed, a decision must be taken as to the accounting period in which it should be recognised. This depends on whether the transaction is a “trading” transaction or a “hedging” transaction. A profit or loss that relates to a trading transaction is determined by marking to market and is recognised immediately, because the Companies Act 1985 requires such profits to be included in the profit and loss account under the heading “dealing profits”. The profit or loss on a hedging transactions is recognised over the same period as the income or expense that is generated by the hedged transaction.

Options that are contracted for the purpose of hedging assets, liabilities or future cash flows should be accounted for in the same way as the underlying instrument. If this is not done, the objective of the hedge is not reflected in its accounting treatment. In the case of an option, the identification of a particular transaction as being a hedge may not be obvious. If a transaction is identified as a hedge, it should only be marked to market if the underlying instrument is marked to market. If the purpose of the hedge is to offset a future cash flow, the option premium should be deferred and set off against the profit on the underlying transaction in the period in which that profit is recognised. If the purpose of the hedge is to cover a cash flow or profit flow which is itself expected to be realised over a period of time, then the premium may be amortised over that same period.

In determining whether an option has been contracted for the purpose of hedging, three hedge criteria are applied:

In determining whether these criteria have been met, supporting documentation should be available and should refer to similar instances that occurred in the holder’s business in which hedging was necessary.

An option contract that was not entered into for the purposes of trade is not required to be disclosed in the balance sheet of the holder. The contract is off-balance sheet, with only the premium and any margins which represent cash movements appearing on the balance sheet.

An option entered into for purposes of trade is marked to market and is included at market value with the company’s trading assets and liabilities in its balance sheet. The underlying item to which the option relates is not shown in the balance sheet of the option holder.

Because initial margin constitutes collateral, it is shown in the balance sheet of the option holder under the heading “Other assets”. Variation margin constitutes the profit and loss on open contracts and must be met daily, if the options holder is a dealer in traded options. The use of mark to market valuation results in the immediate recognition of this profit or loss. In the case of hedging transactions, the resulting profits or losses may be carried in the balance sheet under the heading “Other assets” or “Other liabilities”.

FA 2002 Schedule 26

The term “option” is defined in FA 2002 Schedule 26 paragraph 12(8) only as including a warrant.

Paragraph 12(10) provides that 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 the excess if any, or that it provides that each party is liable to make a cash payment to the other party in respect of the entire obligations of that party to the other under the contract, and does not provide for the delivery of any property, is not an option. Schedule 26 paragraph 12(10) thus defines the term “option” in such a way that for tax purposes a contract that can only be cash-settled and does not provide for the delivery of any property, is not an option, but is a “contract for differences” (unless paragraph 26(4A) regarding transfers of value to connected companies applies).

Paragraph 12(10) adds, however, that an option whose underlying subject matter is currency is not excluded by the paragraph from the scope of the Schedule 26 “option” provisions. For tax purposes, the scope of the Schedule 26 definition is further limited by the exclusion of contracts that are not treated as derivatives in a company’s accounts, in terms of Schedule 26 paragraph 3. Paragraph 12(5) provides specifically that a contract that is an option cannot also be a contract for differences. Paragraph 11(2) provides that the underlying subject matter of an option is the property that would be delivered if the option was exercised, or where the property that would be delivered is a derivative contact, then the underlying subject matter of the option is the underlying subject matter of that derivative contract. Paragraph 11(6) provides that interest rates are deemed not to be the underlying subject matter of a “relevant contract”, if the terms of that contract provide that a party to the contract is liable to an obligation to make a payment on a date that is variable, the amount of the payment to be made varies according to the date of the payment, and the terms of the contract refer to an interest rate only for the purpose of establishing the amount of that payment.

Outside FA 2002 Schedule 26

TCGA 1992 section 143(1) provides: “If, apart from section 128 of the Taxes Act, gains arising to any person in the course of dealing in . . . qualifying options would constitute, for the purposes of the Tax Acts, profits or gains chargeable to tax under Schedule D otherwise than as the profits of a trade, then his outstanding obligations under . . . any qualifying option granted or acquired in the course of that dealing shall be regarded as assets to the disposal of which this Act applies.” Section 143(2)(b) defines the term “qualifying option” as “a traded option or financial option as defined in section 144(8)&rdquoo.

Whether transactions in options amount to “trade” is a question of fact. HMRC assumes that individuals are unlikely to be carrying on the trade of dealing in options. Where options transactions are “ancillary” to trading transactions that are of a revenue nature for tax purposes, they are governed by the rules laid down in SP 3/02. Section 143 was originally inserted in TCGA 1992 for the purpose of negating the argument that if Schedule D Case I was not applicable to option transactions, then Schedule D Case VI applied instead; in such cases, however, section 143 now applies, notwithstanding that Case VI and not capital gains would be a natural alternative to Schedule D Case I.

The main difference between options generally and quoted options to subscribe for shares, traded options and financial options, is that abandonment of the option is deemed to be a disposal, with the result that under section 144(4), if the holder allows the option to expire, he will be entitled to an allowable capital loss as at the date of the abandonment of the option, computed as the premium paid less indexation allowance, where applicable.

Section 146 provides that quoted options to subscribe for shares, traded options and financial options are not “wasting assets”, with the result that the holder is entitled to a deduction for the full amount of the premium paid, in the event that the option is sold or abandoned.

SP 3/02 Tax treatment of transactions in financial futures and options covers the tax treatment of option transactions as defined in TCGA 1992 section 143, that relate to shares, securities, foreign currency and other financial instruments. The statement applies to UK residents, including unauthorised unit trusts, charities, and other persons including companies, which do not trade, or which do trade but have a principal trade which is not financial trading.

SP3/02 does not apply to approved pension schemes, the profits of which from options are exempt from tax.

SP3/02 applies for companies’ accounting periods commencing on or after 1 October 2002, and only in relation to options the underlying subject matter of which is shares, a holding in an authorised unit trust, or a security to which FA 1996 sections 92 or 93 applies.

The statement defines “options” as including both exchange traded options and over the counter options; and it covers both options that are to be cash-settled as well as those that provide for delivery; and it includes warrants.

As to whether the holder of an option contract is “trading”, ICTA 1988 section 128 and TCGA 1992 section 143 provide that transactions in options are deemed to be capital transactions, except where they constitute the profits or losses of a trade. For this purpose, it is irrelevant whether such trading profits are taxed under Schedule D Case I, or under any other provision of the ICTA 1988: HSBC Life (UK) Ltd v Stubbs [2002] STC 9 (SCD).

If under statute and case law, profits or losses are “trading” profits or losses, then ICTA 1988 section 128 and TCGA 1992 section 143 are not applicable to those profits or losses.

The basic issue is therefore whether the taxpayer’s option transactions generate “trading” profits or losses. The view of HMRC is that an individual is unlikely to be “trading” as a result of speculative transactions in options, but that a company’s transactions may be either “trading” or capital in nature.

An option transaction which is “ancillary” to a current trading transaction will generate trading profits or losses. On the other hand, an option transaction which is not a current trading transaction will be capital. But an option transaction that is not “ancillary” to a trading transaction may itself still be a “trading” transaction, if it meets the “badges of trade” tests, including frequency and intention.

Whether an options transaction is “ancillary to another transaction&rdquo: depends on the following factors:

It may be necessary to terminate or enter into new option transactions in order to take account of changes in the value of assets or liabilities resulting from other transactions.

The rules apply to both “long” and “short” positions, and irrespective of whether the option is closed out, exercised or held to expiry.

As to whether the option transaction is “economically appropriate” to the elimination or reduction of risk, the view of HMRC is that the option transaction must be such that, taking into account the relationship between fluctuations in its price and in the fluctuations in the value of the other transaction, the option transaction is reasonably appropriate for the elimination or reduction of risk, and while the use of an option transaction based on an index does not preclude such reasonableness, the principal on which the option transaction is based should not exceed the principal of the other transaction.

SP 3/02 states that if the option 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 option transaction is closed out as soon as is practical thereafter, the option transaction will retain its tax character. If the option 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 it has declared that where the taxpayer is not otherwise trading, this argument would not be pursued by it.

TCGA 1992 section 21(1)(a) provides: “All forms of property shall be assets for the purposes of this Act, whether situated in the United Kingdom or not, including – (a) options . . .” This section accordingly deems an option to be a “chargeable asset” for capital gains tax purposes. Rules governing the capital gains tax treatment of options and option premiums are contained in TCGA 1992 sections 144 – 148.

Where a grantor grants an option over a chargeable asset, he is deemed to create an interest over that asset. The granting of the option constitutes the part disposal of the asset, under TCGA 1992 section 21(2)(b), which provides that “for the purposes of (TCGA 1992) there is a part disposal of an asset where an interest or right in or over the asset is created by the disposal, as well as where it subsists before the disposal, and generally, there is a part disposal of an asset where, on a person making a disposal, any description of property derived from the asset remains undisposed of.”

TCGA 1992 section 144 applies to options generally, including quoted, traded and financial options. The differences between the tax rules relating to options generally and to the tax rules relating to quoted, traded and financial options, are that in the case of the latter rules, the grantee of the option derives an allowable capital loss if he permits the option to expire, and the “wasting asset” rules do not apply to the acquisition costs of quoted, traded and financial options.

Section 144(1) provides that, without prejudice to section 21 of the Act, the grant of an option is deemed to constitute the disposal of an asset, namely, the option, and that this rule applies where the grantor of the option contracts to sell assets that are not owned by him and that never become owned by him because the option is abandoned, as well as where the grantor contracts to purchase assets that are never ultimately purchased by him because the option is abandoned. Section 144(1) thus provides that the grant of an option is deemed to be the disposal of an asset, namely, the option itself, and is not a part disposal of the underlying asset or an interest in that asset. Section 144(1) also applies to options granted over assets not owned by the grantor. The effect of these provisions is that the grant of an option constitutes a “disposal” by the grantor, and in computing the gain or loss accruing to the grantor, the only allowable expenditure is the cost, if any, of granting, the option.

Section 144(6) provides that, for the purposes of section 144, the term “option” includes an option to grant a lease for a premium, or to enter into any transaction that is not a sale.

Section 144(7) provides that section 144 applies in relation to a forfeited deposit of purchase money or other consideration money for an intended purchase or other transaction that is abandoned, in the same way as it applies to the consideration for an option that requires the grantor to sell an asset but is not exercised.

Section 144(2) provides that if an option is exercised, the grant of the option and the transaction that results from the exercise of the option are deemed to be a single transaction, and that if the option requires the grantor to sell an asset, the consideration for the option is deemed to form part of the sale consideration. If the option requires the grantor to purchase an asset, the consideration for the option is deducted from the purchase price incurred by the grantor in purchasing the asset pursuant to the option.

Section 144(3) provides that the exercise of an option by the holder does not constitute the disposal of an asset by him, but if the option is exercised, then the acquisition of the option and the transaction that results from the exercise of the option are deemed to be a single transaction.

If the option requires the grantor to sell assets, the cost of the option to the holder is deemed to be part of the consideration for the sale of the assets, and if the option requires the grantor to purchase assets, the cost of the option is deemed to be an incidental cost incurred by the holder in relation to the disposal of the assets purchased by the grantor. In other words, if the holder of the option exercises it, the exercise is not treated as the disposal by the holder of the option. If the option is exercised, the grant of the option and the transfer of the underlying subject matter of the option are deemed to be a single transaction, which is deemed to occur on the date on which the transfer of the underlying subject matter occurs.

If the deemed single transaction is a sale by the grantor of the underlying subject matter (as would be the case in a call option), then the consideration for the disposal and the cost of acquisition of the underlying subject matter by the holder is taken to be the sum of the consideration given by the holder for the call option, plus the consideration for the transfer of the underlying asset.

If the deemed single transaction is a sale by the holder (which would be the case if the option was a put option), then the acquisition cost to the grantor is the consideration for the transfer of the underlying subject matter less the consideration given for the put option. In the hands of the holder, the consideration for the disposal is the full consideration given for the transfer of the underlying subject matter, and the consideration given by the holder for the acquisition of the put option is treated as an incidental cost of disposing of the option. Once the option has been exercised, the grant of the option ceases retrospectively to be a chargeable event, and any capital gains tax paid in respect of the grant of the option is either set off against any capital gains tax that is due on the exercise, or is repaid to the taxpayer.

Section 144(4) provides that the abandonment of an option by the holder does not constitute the disposal of an asset by him, except where the option is a quoted option to subscribe for shares, a traded option, a financial option, or an option to acquire assets to be used for the purpose of a trade.

Section 144(8) defines the term “quoted option” as an option that is quoted on a recognised stock exchange on the date of abandonment or disposal. The term “traded option” is defined as an option that is listed on the date of abandonment or disposal on a recognised stock exchange or a recognised futures exchange. The term “financial option” is defined as an option, other than a traded option, that:

Therefore, if an option is abandoned by the person entitled to exercise it, the abandonment of the option is not deemed to be a disposal for capital gains tax purposes, and consequently no allowable capital loss results from the abandonment.

Different results follow the abandonment of an option to acquire assets to be used for purposes of trade or quoted options to subscribe for shares in a company, traded options and financial options. The term “abandonment” includes surrender for consideration: Golding v Kaufman 58 TC 296; Powlson v Welbeck Securities Ltd 60 TC 269.

The receipt of the premium constitutes a “disposal”, as a capital sum derived from the asset, pursuant to TCGA 1992 section 22(1). The abandonment of an option to purchase assets intended to be used for the purposes of a trade carried on by the option holder, is deemed by TCGA 1992 section 144(4)(c) to constitute a disposal, and therefore to give rise to an allowable loss. Section 146(1)(c) provides that an option of this kind is not treated as a wasting asset.

Although section 144(4)(c) does not refer explicitly to “a trade carried on by” the taxpayer, HMRC accepts that the provision covers cases in which a trade was commenced shortly after the abandonment of the option, as well as cases where there is clear evidence that the option was contracted for the purpose of acquiring assets with the intention of using them, in the event that they were indeed acquired, for the purposes of that trade.

Section 144(5) provides that section 144 applies to an option that obliges the grantor both to sell and to purchase the underlying asset, as if the option was two separate options with one half of the option consideration being attributed to each of the separate options.

Section 145 provides that, for the purpose of computing any indexation allowance that may be due, the option consideration and the underlying asset transfer consideration are regarded as separate items of expenditure, incurred on the date on which the option was acquired and the date on which the asset sale occurred, respectively. For disposals made on or after 6 April 1998, indexation allowance is frozen, except for disposals made by companies within the charge to corporation tax. This implies that section 145 is only relevant to acquisitions of options after 31 March 1998 where the acquisition was made by a company.

Section 144A provides that if an option is exercised, and the terms of the option, or the terms under which the option is exercised, impose a liability on the grantor and an entitlement on the holder to make and to receive, respectively, a payment in full settlement of all obligations under the option, then section 144A(2) and (3) are to apply instead of section 144(2) and (3).

Section 144A(2) provides that the grantor of the option is deemed to have disposed of an asset, namely, his liability to make the payment, and the payment made by him is deemed to constitute an incidental cost incurred by him in making the disposal. The grant of the option and the disposal are deemed to be a single transaction, and the consideration for the option is deemed to be the consideration for the disposal. The holder of the option, or the person exercising it, is deemed to have disposed of an asset, namely, his entitlement to receive the payment, and the payment is deemed to constitute consideration for the disposal.

Whether or not the option was acquired directly from the grantor, its acquisition and disposal are deemed, from the perspective of the holder, to be a single transaction, and the cost of the option is deemed to constitute expenditure that is deductible under TCGA 1992 section 38(1)(a) from the consideration for the disposal.

For the purpose of computing any indexation allowance that may be due on the disposal by the holder of the option, the cost of the option is deemed to have been incurred when the option was acquired.

Section 144A(4) extends the scope of section 144A to options that are partially settled by way of payment.

The implications of section 144A are that if an option is to be cash settled, that is, if the grantor is required by the terms of the option to make a cash payment to the holder in full settlement of the grantor’s obligations under the option contract, then TCGA 1992 section 144A applies. The grantor is deemed to have disposed of an asset, namely, the liability to make the payment, and the payment is treated as an incidental cost of the disposal. The grant of the option and the subsequent disposal are deemed to be a single transaction, that is deemed to occur on the date of the later disposal, and the consideration received for the grant of the option is deemed to be the consideration for the disposal. The holder who exercised the option will have received the cash payment, and is deemed to have disposed of an asset, namely, the right to receive the cash payment, and the payment is deemed to constitute consideration for the disposal. The acquisition of the option by the holder and the disposal are deemed to be a single transaction, and the option acquisition costs are deducted from the consideration given for the disposal, under TCGA 1992 section 38(1)(a). In the event that indexation allowance is available on the disposal, the cost of the option is deemed to have been incurred on the date on which the option was acquired. TCGA 1992 section 144A also applies to options that are partially cash-settled. The remainder of the option consideration falls within the scope of section 144(2) and (3). Amounts that are received or paid are apportioned on a just and reasonable basis.

Section 146(1) provides that TCGA 1992 section 46, which relates to the straightline restriction of allowable expenditure in relation to wasting assets, does not apply to a quoted option to subscribe for shares, a traded option, a financial option, or an option to acquire assets to be used for the purposes of a trade. The implication of this provision is that if an option contract that satisfies the conditions of TCGA 1992 section 44 qualifies as a “wasting asset” in terms of that section, any gain or loss that accrues on its disposal during the option period takes wasted cost into account, except that the straightline restriction of allowable expenditure provided for by TCGA 1992 section 46 does not apply to any option referred to in section 146(1).

Section 146(2) provides that, in relation to the disposal by transfer of an option, other than a quoted option to subscribe for shares, a traded option or a financial option, that obligates the grantor of the option to buy or sell quoted shares or securities, the option is to be regarded as a “wasting asset”, the life of which ends when the right to exercise the option ends, or when the option becomes valueless, whichever occurs earlier.

TCGA 1992 section 18(5) provides that where a person acquires an asset and the person making the disposal of the asset is a connected person on relating to the acquiror, and the asset is an option to enter into a sale or other transaction granted by the person making the disposal, then any loss incurred by the acquiror is not an allowable loss, unless the loss is incurred on the disposal of the option at arm’s length to a person who is not connected with him. This means that where a person grants an option to a “connected person”, and the connected person disposes of the option at a loss, then the loss is not allowable for capital gains tax purposes, unless it results from an arm’s length disposal of the option by the connected person to a third party who is not a connected person in relation to the connected person.

Warrants

A warrant is an option that is granted for the purpose of allowing the holder to subscribe for shares, bonds or other debt instruments. A warrant gives the holder the right, but not the obligation, to subscribe for a specific number of shares at a predetermined price. The exercise of a warrant results in the creation of a new financial instrument. Warrants have a limited life span, and if not exercised by maturity, expire and have no value.

A warrant is commonly issued together with a debt instrument, in order to enhance the value of the debt instrument; in this case the warrant is referred to as an “equity kicker”. Debt instruments issued together with warrants are economically similar to convertible bonds, except that the warrant element may be dealt with or sold separately from the debt instrument. The holder of such a debt instrument can potentially earn a profit from the warrant if the price of the underlying share increases. The price paid for a warrant reflects the current price of the company’s shares, its prospects for future growth, and the period over which the warrant must be exercised.

A covered warrant is an exception to the principle that the exercise of the warrant creates a new financial instrument, because a “covered equity warrant” is a call option over shares, issued by a third party who holds a company’s shares, so that when the holder of the warrant exercises it, he receives shares that already exist from the third party shareholder.

The Financial Services and Markets Act 2000 Schedule 2 Paragraph 14 defines “Instruments giving entitlement to investments” as including “Warrants or other instruments entitling the holder to subscribe for any investment”. Paragraph 14 adds that “It is immaterial whether the investment is in existence or identifiable”. The Financial Services and Markets Act 2000 Regulated Activities Order (SI 2001/544) states: “Instruments giving entitlements to investments 79. - (1) Warrants and other instruments entitling the holder to subscribe for any investment of the kind specified by article 76, 77 or 78. (2) It is immaterial whether the investment to which the entitlement relates is in existence or identifiable. (3) An investment of the kind specified by this article is not to be regarded as falling within article 83, 84 or 85.”

Warrant accounting

FRS 4 Capital instruments defines the term “capital instruments” as all instruments that are issued by companies as a means of raising finance, including warrants that give the holder the right to subscribe for or obtain capital instruments.

The term “warrant” is defined as “an instrument that requires the issuer to issue shares (whether contingently or not) and contains no obligation for the issuer to transfer economic benefits”.

FRS 4 says that warrants should be reported as part of shareholders’ funds in the period in which the warrants are issued, with the net proceeds being reported as movements in shareholders’ funds. The net proceeds from the issue of warrants for equity shares should thus be credited directly to shareholders’ funds. The amount attributed to warrants should not be subsequently adjusted to reflect changes in the value of the warrants. When a warrant is exercised, the amount previously recognised in respect of the warrant should be included in the net proceeds of the shares issued. When a warrant lapses unexercised, the amount previously recognised in respect of the warrant should be reported in the statement of total recognised gains and losses.

As to the classification of capital instruments, FRS 4 says that capital instruments should be accounted for as “liabilities” if they contain an obligation to transfer economic benefits. The most common example of such an obligation is the requirement to make cash payments that may be described as “interest” or an amount payable on redemption, to the holder of the instrument, but an obligation to transfer other kinds of property to the holder of an instrument would also cause the instrument to be classified as a liability.

FRS 4 requires warrants to be reported within shareholders’ funds, because by definition they do not involve an obligation to transfer economic benefits. The rationale for this is that, when a company issues warrants, its only obligation is to issue shares at a fixed price, if so required by the holder. The price paid for a warrant can thus be thought of as part of the subscription price of a share that may or may not be issued at a future date. Once the warrant expires unexercised, the amount paid for it accrues to the benefit of the shareholders. For this reason, FRS 4 requires that, on the expiry of a warrant, the amount previously recognised in shareholders’ funds must be recognised in the statement of total gain and losses, which provides a summary of changes in total reserves.

FRS 13 Derivatives and other financial instruments: disclosures defines the term “capital instruments” as “all instruments that are issue by reporting entities as a means of raising finance, including . . . warrants that give the holder the right to subscribe for or obtain capital instruments”. FRS 13 does not apply, however, to “warrants . . . on (equity) shares issued by the reporting entity, other than those that are held exclusively with a view to subsequent resale”.

Warrants to subscribe for equity shares should thus be reported as part of equity shareholders’ funds. The reason for this is that although warrants impose an obligation on the issuer to issue equity, there is no obligation to transfer economic benefits of any kind, such as interest or dividends. Where the warrant gives the holder the right to exchange the warrant for cash, it should be treated by the issuing company as a liability. When an equity warrant is issued by a company, is should be treated as an equity issue, and the proceeds credited to reserves, although it is best practice for such a reserve to be separately disclosed in the accounts. Value adjustments should not be made over the life of the warrant, regardless of the market price and any likelihood of exercise. When the warrant is exercised, the total consideration for the new equity will be the price payable on the exercise together with the price of the warrant. Any excess of these amounts over the nominal value of the shares issued should therefore form part of the share premium account. If a warrant lapses without having been exercised, the issuing company has a choice of two courses of action:

The holder of an equity warrant is not required to revalue the warrant on a regular basis, and can write off its cost on the date on which the decision is taken not to exercise it. If the warrant is exercised, then the holder’s investment in equity will be a combination of the amount paid on exercise, and the cost of the warrant. This may still be less than the market value of the shares, so that an unrealised gain will be made when the asset is next revalued.

FA 2002 Schedule 26

The term “warrant” is defined in FA 2002 Schedule 26 paragraph 12(9) as “an instrument which entitles the holder to subscribe for shares in a company or assets representing a loan relationship of a company; and for those purposes, it is immaterial whether the shares or assets to which the warrant relates exist or are identifiable”. For tax purposes, the scope of the definition is further limited by excluding contracts that are not treated as “derivatives” in a company’s accounts. For the purposes of Schedule 26, a warrant is deemed by paragraph 12(8) to be an “option”. Because the term “warrant” is defined in paragraph 12(9) as an instrument entitling the holder to subscribe for shares in a company or assets representing a loan relationship of a company, the statutory definition includes covered warrants, whose underlying asset is existing shares or bonds, as well as warrants that give the holder a right to subscribe to shares or bonds that have not yet been issued.

Capital gains

A warrant, or quoted option to subscribe for shares, is a type of call option to buy shares. The purchaser of the warrant is given the right to subscribe for shares in a company at a fixed price within a specified period. Warrants are bought and sold in the same way as traded options. TCGA 1992 section 144(8)(a) defines the term “quoted option” as an option which, at the time of abandonment or other disposal, is quoted on a recognised stock exchange. Sections 144(4) and 146 apply to quoted options to subscribe for shares in a company, but not to quoted options to subscribe for other types of securities. In such cases, the abandonment of the option is not treated as a disposal; if the option is sold, it is treated as a wasting asset, with the acquisition cost being reduced accordingly.

Where a “quoted option” is a share warrant that is attached to a bond or debenture, the amount paid by the holder for the combined instrument is apportioned between the warrant and the other security. If the warrant can be detached from the security and traded separately from it immediately the combined instrument is issued, HMRC accepts the apportionment of the cost of the warrant and the security as that given in the issuing circular or prospectus. In other words, where a “quoted option” takes the form of a share warrant attached to an issue of bonds or debentures, and the warrant is detachable from the securities, the warrant may be offered to investors as an inducement to purchase the bonds or to enable the company to achieve a satisfactory mix of debt and equity funding.

In such cases, the proceeds of the issue received by the company must be apportioned between the amount attributable to the securities and the amount attributable to the warrants, on a just and reasonable basis, in terms of TCGA 1992 section 52(4). HMRC usually accepts the apportionment figures given in a prospectus or offering circular, but if those documents make no reference to apportionment, or if the apportionment that they propose appears unreasonable to HMRC, then a just and reasonable apportionment is made, by reference to the respective market values of the bonds and warrants on the first day they are quoted separately.

In other cases, the cost is apportioned on a just and reasonable basis, in terms of TCGA 1992 section 52(4), based on the market values of the warrant and the security on the first day on which they are separately traded. If the warrant is detached from the security after the holder acquires the combined instrument, the warrant is treated as having been derived from the security, resulting in the application of TCGA 1992 section 43. As a result, the cost of the combined instrument is apportioned between the warrant and the security, based on their respective market values on the first day on which they are separately traded.

If the warrant is not detached from the security, it is not treated as a separate asset. If the warrant is exercised, the original acquisition cost is apportioned on a just and reasonable basis. If the warrant is exercised, its cost is added to the acquisition cost of the shares, to which indexation allowance or taper relief is applied. If the holder sells the warrant, the sale constitutes a disposal which is subject, in terms of TCGA 1992 section 146(1), to ordinary capital gains tax rules, and indexation allowance or taper relief is granted where applicable from the date on which the warrant was acquired. The warrant is not treated as a “wasting asset” and its acquisition cost is therefore not reduced, in terms of TCGA 1992 section 46.

From the perspective of the issuer, the issuance of a warrant constitutes the grant of an option which is within the scope of TCGA 1992 section 144. The issuance of the warrant constitutes the disposal of an asset, namely the option, in terms of section 144(1). The consideration for the disposal is the amount paid by the purchaser of the warrant, unless the issue of the warrant is not at arm’s length, in terms of TCGA 1992 section 17, in which case the proceeds of the disposal will be the market value of the warrant at the date of its issue. Valuation in this manner is only likely to occur in the event of a bonus issue of share warrants.

As to the position of the issuer if its warrants are exercised, TCGA 1992 section 144(2) deems the grant of the option and the issuance of the shares to be a single transaction, and any tax liability on the grant of the option is adjusted accordingly. The issuance of shares by the company is not treated as a “disposal”, and there is therefore no further tax charge on the company. For example, if the company received £200,000 for the grant of the warrants and £10 million for the issuance of the shares, it would be treated as if it had issued the shares for a consideration of £10.2 million.

HMRC has stated that it has identified situations in which a person other than the issuer (such as an overseas bank), issues the warrants with the object of enabling the issuer to avoid being taxed under TCGA 1992 section 144(1).

For example, an overseas bank issues a Eurobond with detachable warrants on behalf of a UK-resident company. The warrants are exercisable against the overseas bank, and are a legal obligation of the bank. The company and the bank enter into an agreement under which the company agrees to provide the bank with sufficient shares to meets its obligations under the warrants. The agreement provides that the bank is contractually obliged to request the company to issue the shares. Because the bank has no discretion in this regard, the agreement between the company and the bank cannot be treated as an “option’. It is also not possible to treat the arrangement as the issuance of an option by the company to the warrant holders. Therefore, from the company’s perspective, it has received no consideration for the grant of an option, and it has no liability under TCGA 1992 section 144(1).

HMRC has pointed out that the position could be different if bonds with detachable warrants are issued by an overseas subsidiary of a UK company, because the subsidiary would have to arrange to acquire shares in its holding company in order to enable it to fulfil its obligations under the warrants. The UK holding company may grant a parallel option to the subsidiary, so that if the warrants are exercised against the subsidiary, it in turn exercises its options against its holding company. In these circumstances, because the agreement between the holding company and subsidiary is an “option”, a charge to tax arises under TCGA 1992 section 144(1) in the hands of the holding company. The transaction is then between “connected persons”, with the result that the market value of the option issued by the holding company to the subsidiary is substituted for any consideration that is paid. In practice, this market value will be the value of the options issued by the subsidiary.

If the holding company is called upon to issue shares by the subsidiary, the tax liability under TCGA 1992 section 144(1) can be reduced accordingly.

HMRC has pointed out that in the event that companies argue that the agreement between the holding company and subsidiary is a single option, so that TCGA 1992 section 144(2) operates to negate the entire liability under section 144(1) if the holding company is required to issue a single share, then HMRC will not accept this argument. It holds the view that the agreement between the holding company and its subsidiary gives the subsidiary a number of options that is equal to the number of shares in the holding company whose liability the subsidiary may be required to procure, and that there is a tax liability under TCGA 1992 section 144(1), unless the holding company is required to issue the full number of shares that are subject to the agreement with the subsidiary.

Where a company makes a bonus issue of warrants to its shareholders, from the company’s perspective, the issue of warrants for no consideration is not an arm’s length transaction. The issuance of the warrants is treated as the grant of an option for a consideration equal to the value of the warrants, which in practice is taken to be the market value of the warrants on the first day on which they are traded. Any assessment raised on the grant of the option is either reduced or discharged if the warrants are eventually exercised. Unless TCGA 1992 section 147 applies, a shareholder is regarded as having received a capital sum derived from an asset, under TCGA 1992 section 22. The disposal proceeds is equal to the market value of the warrants on the first day on which they are quoted. If the warrants are exercised, the section 22 assessment is not discharged. A shareholder acquires the new shares at an amount equal to the price paid plus the market value of the option included in the section 22 computation. If the warrants are never exercised, the shareholder will have incurred a capital loss equal to the market value of the option included in the section 22 computation.

TCGA 1992 section 147 provides that if a quoted option to subscribe for shares in a company is dealt in on the stock exchange where it is quoted, within three months after the taking effect in relation to the company, of a reorganisation, reduction, conversion, exchange or scheme or reconstruction to which the provisions of TCGA 1992 relating to the reorganisation of share capital applies, then for the purposes of those provisions, the option is regarded as the shares that could be acquired by exercising it, and the market value of the option is to be determined in accordance with TCGA 1992 section 272(3). Section 147 thus covers share warrants issued at the same time as an event which is treated as a share reorganisation or conversion of securities. The most common examples are rights issues and bonus issues, and takeovers in which the acquiring company issues securities and share warrants in exchange for the shares that it acquires. The effect of TCGA 1992 section 127 is that these events are not treated as a “disposal” of the original shares or securities, nor as an acquisition of the new shares and securities.

Because share warrants are not shares, warrants that are issued at the time of a share reorganisation could give rise to an immediate charge to capital gains tax.

For example, if a company issued debentures with detachable share warrants in exchange for shares in a second company that it was taking over, TCGA 1992 section 127 could apply to the issue of the debentures by virtue of TCGA 1992 section 135. Section 127 provides that a reorganisation is not treated as a disposal of the original shareholding or the acquisition of a new shareholding, but that the original shareholding, regarded as a single asset, and the new shareholding also regarded as a single asset, are deemed to be the same asset acquired in the manner in which the original shareholding was acquired. Section 127 could not, however, apply to the share warrants. The result would be a part disposal of the original shares, equal in value to the value of the share warrants.

TCGA 1992 section 147 applies to share warrants which are “quoted options” as defined in TCGA 1992 section 144(8)(a), and it provides that the issue of share options in the course of a share reorganisation do not give rise to a part disposal by deeming the share options to be the shares which could be acquired by exercising the options.

The effect of this is that the share options become part of the “new holding” as defined in TCGA 1992 section 126(1)(b). The market value of the options is determined in the same way as if they were quoted shares, in terms of TCGA 1992 section 272(3).

Once warrants have been deemed by the operation of TCGA 1992 section 147 to be shares, the effect of this deeming remains in place in relation to any later share reorganisation.

For TCGA 1992 section 147 to apply, the option must be dealt in on the stock exchange where it is quoted within three months of a share reorganisation or conversion of securities falling within the scope of TCGA 1992 section 126, in terms of TCGA 1992 section 136. The Board of HMRC is, however, empowered to authorise an extension of the three month period. Should the company already have issued share warrants to which TCGA 1992 section 147 did not apply, and should it subsequently issue further identical warrants in the context of a share reorganisation to which section 147 did apply, all the warrants of that kind issued by the company will be deemed to be shares, in relation to any later reorganisation.

Traded options

A traded option is an option that is intended to be bought and sold in a traded options market. Investors and speculators in traded options intend to earn a profit by dealing in the options, rather than dealing in the underlying assets.

For disposals up to 31 March 1996, TCGA 1992 section 144(8)(b) defined the term “traded option” as an option which, at the time of its abandonment or other disposal, is quoted on a recognised stock exchange or a recognised futures exchange. In relation to disposals on or after 1 April 1996, section 144(8)(b) applies instead to options that are “listed” on such exchanges.

TCGA 1992 section 144 and TCGA 1992 section 144A apply to traded options, but with two changes:

Assuming that the taxpayer is liable for capital gains tax and is not taxable under Schedule D Case I, the tax treatment of traded options is as follows.

As regards the holder of the option, if the option is a call option and the option is exercised and the underlying asset is transferred to the holder, the purchase of the option and the purchase of the underlying asset are treated as a single transaction, the cost of the option is added to the cost of the underlying asset, and indexation allowance or taper relief is deducted, where applicable.

If a call option is exercised, and the grantor settles the option in cash, that payment is deemed to be consideration for the disposal of an asset, the acquisition of the option and the exercise of the option are treated as a single transaction that is deemed to take place on the date on which the option is exercised; the cost of the option is deductible as an acquisition cost in relation to the disposal; and indexation allowance or taper relief is deducted where appropriate.

Where the holder sells the option, the sale is treated as the disposal of an asset, and the usual capital gains tax rules apply.

If the holder abandons the option and receives a payment for abandoning it, the abandonment is deemed to be a disposal.

If the holder allows the option to lapse, he is entitled to a capital loss equal to the option premium plus applicable indexation allowance or taper relief.

The same tax consequences apply in relation to a put option, except that where the option is exercised and the underlying asset is transferred to the grantor of the option, indexation allowance is not available in relation to the option premium, which is treated as an incidental cost of the disposal.

As regards the grantor of the option, the grant of the option results in the option premium less incidental costs of disposing of the option being taxable as a gain that arises on the date on which the option is written.

When a call option is exercised, the grant of the option and the sale of the underlying asset are treated as a single transaction, and any assessment to capital gains tax that had been issued to the grantor in relation to the receipt by him of the option premium, is discharged.

The option premium is added to the proceeds of the sale of the underlying asset.

When a put option is exercised, the tax result is the same as in the case of a call option, except that the acquisition cost of the underlying asset is reduced by the amount of the option premium.

When a call option is exercised but is settled in cash, the exercise is treated as the disposal of an asset, and any amount paid to the holder is treated as an incidental cost of the disposal. The grant of the option and the exercise of the option are treated as a single transaction, and the consideration received for the grant of the option is treated as consideration for the disposal of the underlying asset. Where the option lapses, there are no tax consequences for the grantor. Where the option is closed out by the contracting of a second option contract, each contract is treated as a separate transaction for tax purposes, and there is no requirement for the tax consequences of the first contract to be held over until the second contract matures.

Financial options

TCGA 1992 section 144 describes “financial options” as a range of options issued by banks and other financial firms.

Unlike the terms “quoted option” and “traded option”, the term “financial option” does not have a specific commercial meaning outside of tax legislation.

The purpose of the rules in TCGA 1992 is to ensure that options that fall within the definition of “financial option” are subject to the same tax treatment as traded options.

TCGA 1992 section 144(8)(c) defines a “financial option” as an option which is not a traded option, but:

TCGA 1992 section 144(8)(c)(iii) includes within the definition of “financial option”, “an option which is not a traded option . . . but which . . . relates to currency, shares, securities or an interest rate and is granted to . . . an authorised person . . . and concurrently and in association with an option . . . which is granted by that authorised person . . . to the grantor of the first mentioned option”.

This provision refers to the so-called “min-max contract”, which is a contract in which the parties agree to grant options to one another, with one party granting a put option and the other party granting a call option, with the premiums payable for each option cancelling each other out. The options are usually foreign currency options, and the object is to hedge a rate within the limits set by the respective options.

For example, a manufacturing company anticipates having to buy US dollars, but does not wish to pay more than two euros per dollar, with the current exchange rate standing at EUR 1.50 to USD 1. The company accordingly contracts a dollar call option allowing it to buy dollars at two euros per dollar. The counterparty, usually a bank, contracts a dollar put option with the company, that allows the bank to put dollars to the company at EUR1.50 each. The premium payable for both options is the same and therefore no payment is made by either party at the time the option contracts are entered into.

The tax treatment of the grantor of a financial option is subject to the ordinary rules of TCGA 1992 section 144: the grant of the option is treated as the disposal of an asset, namely, the option itself. If the option is exercised, section 144(2) applies to deem the grant of the option and the exercise of the option to be a single transaction. The premium received is added to the disposal proceeds of any underlying asset sold, or is deducted from the acquisition cost of any underlying asset purchased. Any assessment that was raised on the grant of the option is discharged.

The tax treatment of the holder of a financial option is subject to the usual rules of TCGA 1992 section 144, which apply subject to TCGA 1992 section 144(4) and section 146. The grant and the exercise of the option are deemed to be a single transaction. If a shareholder exercises a call option and buys an asset, any premium paid is treated as part of the acquisition cost of the asset. Indexation allowance is given where appropriate on the premium from the date the premium was paid. If a put option is exercised and an asset is sold, the premium paid is treated as an incidental cost of disposal, and no indexation allowance is due. If the option is sold, expires or is abandoned, the expiry or abandonment is treated as a disposal which gives rise to a capital loss equal to the premium paid plus indexation allowance where appropriate, in terms of TCGA 1992 section144(4). The option is deemed not to be a wasting asset, in terms of TCGA 1992 section 146.

Artificial option transactions

Options can be used to generate a guaranteed return which, in economic terms, is equivalent to interest, and without anti-avoidance rules, any profits on such transactions would, except where income treatment was applied, be liable to capital gains tax. Capital gains treatment could benefit the taxpayer, because:

ICTA 1988 Schedule 5AA was introduced to combat such arrangements. Schedule 5AA applies where there is a disposal of an option which is one of two or more related transactions which are designed to produce a guaranteed return, whether comprising the return from that disposal, or from a number of disposals of options taken together. Where these rules apply, any profits on the options are charged to tax under Schedule D Case VI, and not to capital gains tax. Any losses are, similarly, dealt with as Schedule D Case VI losses. The ICTA 1988 Schedule 5AA rules apply to both traded options and financial options, but the rules cover a wider range of cases than those within TCGA 1992 section 143. The rules also operate with respect to the disposal of options.