Taxation of Derivatives

The pre-FA 2002 rules

The first financial instruments legislation came into force on 6 April 1985. Before that date, profits from the sale of commodities were taxable under Schedule D Case I as profit derived from “an adventure or concern in the nature of trade”: CIR v Fraser 24 TC 498; Wisdom v Chamberlain 45 TC 92. Profits derived from transactions in commodity futures were also taxable as “trading profits” under Schedule D Case I, or alternatively, under Schedule D Case VI: Cooper v Stubbs 10 TC 29; Townsend v Grundy 18 TC 140.

In Cooper v Stubbs, the Court of Appeal held that regular speculative transactions in cotton futures did not constitute a “trade” and were also not wagering contracts, but were nevertheless taxable under Schedule D Case VI.

The question whether Case I or Case VI applied was held to depend on the number and scale of the taxpayer’s transactions and the degree of organisation involved. If a company’s futures dealing transactions were “isolated” or its profits from such dealing were “occasional”, however, they fell outside the scope of Case VI, and were taxed as capital gains.

From 6 April 1985, profits of companies from transactions in exchange-traded financial futures were no longer taxable under Case VI, but were taxed as capital gains, and from 29 April 1988, profits of companies from transactions in over-the-counter futures and both traded and financial options were similarly taxed as capital gains.

FA 1993, FA 1994 and FA 1996 introduced a statutory code of rules governing the taxation of derivative contracts. The object of the legislation was to ensure that a company’s tax computation more closely resembled the profit figure in its statutory accounts. The legislation accepted the company’s accounting treatment, provided that the treatment complied with standards laid down by the tax legislation. The main aims of the legislation were, firstly, to ensure that profits derived from a range of financial instruments would be taxable as “income”, and secondly, to ensure the application of either an “accruals” or a “mark to market” accounting basis in determining such profits. For dealers in financial instruments, including banks, the rules laid down timing provisions which had the effect of bringing the timing of the recognition of accounting profits and tax profits and gains closer together, and of taking into account that the British Bankers’ Association’s SORPs aimed to ensure that derivatives held by banks should be classified in their statutory accounts according to the purpose for which they were held, with a “fair value” approach being followed for “trading” transactions, and an “accruals” approach being adopted for “non-trading” transactions.

The object of the legislation in FA 1994 was to designate a range of financial instruments held by companies that would be taxed on an “income” basis, irrespective of whether or not the companies that held those instruments were “dealers” in such instruments. Interest rate and currency instruments designated as instruments used to manage interest rate and currency risk were deemed to be “qualifying contracts” under FA 1994 section 147, and were thus brought within the scope of the 1994 legislation. Once an instrument had been deemed to be a “qualifying contract”, the legislation required that it be taxed either on a “mark to market” basis or an “accruals” basis.

FA 1994 enacted rules relating to the taxation of the profits of companies or the granting relief to companies for losses derived from instruments used to manage interest rate risk, including swaps, caps and floors, and forward rate agreements, as well as options to enter into such agreements. The scope of FA 1994 included recurrent payments under interest rate and currency swaps, interest rate futures and options, forward rate agreements, interest rate caps, collars and floor, as well as premiums or discounts on forward contracts, premiums paid for currency options, and derivative contract termination payments. In tandem with FA 1993, which dealt with exchange differences on forward currency contracts, currency futures and the currency exchange element of currency swaps, FA 1994 also dealt with financial instruments used to manage foreign exchange risk. FA 1994 was amended by FA 1996 in order to extend the range of instruments covered to include any derivative contract the underlying asset of which was a loan relationship, as well as gilt and bond futures and options.

For the range of “qualifying contracts” covered by FA 1993, FA 1994 and FA 1996, if a company was using a “mark to market” accounting basis in its accounts, and that basis qualified as an “authorised mark to market” basis for tax purposes, then the company was required to adopt a “mark to market” basis for tax purposes as well. In other cases, a company was required to adopt an “accruals” basis for tax purposes. An “authorised mark to market basis” required payments and receipts to be recognised on a due and payable basis, and for the contracts to valued on a “fair value” basis. “Fair value” was defined as the amount which a company would have been able to obtain, or would have had to pay, if it had disposed of the contract to a knowledgeable and willing party dealing with it at arm”s length. Under an “authorised accruals basis” of accounting, payments had to be allocated to the accounting period to which they “related”, and not to the accounting periods in which they were made or received, or become due and payable. Payments were deemed to relate to the accounting period to which reciprocal payments were allocated.

The result of these provisions was, for example, that under an interest rate cap, the premium was spread over the life of the cap, by reference to the period during which payments might be receivable, rather than written off upfront.

The “authorised accruals basis” in FA 1994 did not go as far as the accounting principle of “prudence”, and where there was a conflict between the tax legislation and the concept of “prudence”, the tax legislation took priority. These rules applied in both the Schedule D Case I “trading” context, as well as in the “non-trading” context.

A company was permitted to apply more than one accounting basis in its accounts, for example, the “mark to market” basis could be applied to its trading book of financial instruments, and the “accruals” basis could be applied to instruments used to manage its own risk, based on the British Bankers’ Association’s SORP on Derivatives. FA 1994 section 156 allowed the use of dual accounting bases, provided that it accorded with “normal accounting practice”. The legislation, however, prohibited companies from changing the tax treatment of instruments at will. HMRC took the view that it should have been clear whether a particular instrument should have been “accrued” or “marked to market”, but conceded that it was possible that, for example, an instrument had been used to manage a bank’s interest rate risk, and then became part of its “trading” book, a change from the “accruals” basis to the “mark to market” basis might then be appropriate. FA 1994 section 158 provided for the making of an appropriate adjustment whenever there was a change of accounting basis.

In applying “mark to market” valuation, standard valuation methods were to be used, subject to adjustment for various forms of risk, for example, credit risk or liquidity risk, as well as for the costs of executing transactions. HMRC accepted the making of such adjustments, but not for adjustments that resulted in the creation of a general reserve. Credit risk was to be assessed by reference to the status of individual counterparties, for example, by reference to credit ratings assigned by rating agencies. Under UK GAAP, companies would normally use “mark to market” accounting for their trading book, and apply the “accruals basis” to instruments used to hedge their own exposures. So where an entity such as a branch of a foreign bank used a basis in its accounts that was neither “mark to market” nor “accruals”, then the legislation permitted it to agree an acceptable “mark to market” or “accruals” basis for tax purposes with HMRC.

FA 1994 included two anti-avoidance provisions.

Section 168 extended the section 167 anti-avoidance rule to some “qualifying contracts” with non-residents. Transactions falling within the scope of section 168 were deemed not to have been concluded on arm’s length terms, with the result that cumulative losses were disallowed and cumulative gains were taxed. Section 168 provided for a number of exemptions from the scope of the section:

The term “financial trader” was defined in FA 1994 section 177, and the definition was elaborated on in SP3/95.

As regards the interaction of the tax rules with accounting practice in relation to instruments that were deemed to be “qualifying contracts” under FA 1994 and FA 1996, HMRC’s view was that there was no conflict between tax and accounting principles, except that the concept of “prudence” was not included in the financial instruments legislation for tax purposes. For other contracts that were not “qualifying contracts” - such as instruments linked to the value of share indices or commodity futures or options, that were held by a financial trader - HMRC’s practice was to accept the taxpayer’s accounts, and where the taxpayer was prepared to recognise profits for accounting purposes under a SORP, the same result was accepted for tax purposes.

In the case of trading or speculative contracts under which there had been no performance and which had not yet matured, and were not covered by the rules in FA 1994 or FA 1996, HMRC held the view that –

For hedging contracts not specifically dealt with in FA 1994 or FA 1996, the British Bankers’ Association’s SORP on Derivatives required that there had to be adequate procedures in place to identify “hedging transactions”, either at the outset, or when it was decided to use an existing transaction as a hedge. HMRC insisted on confirming that such procedures were in place, before it would accept the SORP’s accounting treatment for tax purposes. Where, in accordance with the SORP on Derivatives, profits or losses were recognised in the accounts as arising in respect of a hedge, and a profit or loss on the underlying item was recognised for tax purposes on a basis adopted in the accounts, the accounting treatment of the hedging contract was required to be applied for tax purposes. Where the tax treatment of the underlying item differed from the accounting treatment of the hedge, HMRC accepted that it would be difficult for it to argue that the accounting treatment of the hedge should be applied for tax purposes, particularly if the effect of doing so would be that significant profits or losses would be recognised for tax, while from a commercial point of view the taxpayer would be unlikely to receive such profits or incur such losses.

With regard to trading in derivative contracts, HMRC categorised “financial traders” as traders who carried on trading for their own account, or for the account of customers, in financial futures and options, foreign currency and interest rate instruments, as well as other kinds of financial assets. The governing criterion was whether the taxpayer was “trading” or “investing”. As to valuation and income recognition in relation to “trading” transactions, HMRC’s position was that because active market participants were usually able to dispose of positions through requests for prices or other contacts made during the course of a working day, they were therefore well-placed to take advantage of market price movements, and where market prices were quoted with a bid and offer spread, active market participants could use mid-market prices in determining market prices of derivatives contracts, if those were the prices that they were able to obtain. Banks that were not active participants in a market, however, were required to use the more prudent of bid or offer prices.

As to the taxation of derivatives held as “trading stock” on the “realisation basis”, HMRC had earlier held that view in relation to banks that where it had been a bank’s policy to vary its investments and thereby to “deal” in them, profits or losses on the “realisation” of investments were taxable under Schedule D Case I, except that no deduction was allowed at intervening balance sheet dates for any fall in an investment’s market value below cost, unless the investment had been held as trading stock. This was referred to as the “realisation basis” of taxation, and it was applied to assets that the bank needed to keep in realisable form to meet possible depositors’ demands for repayment – the policy being that those funds had to be invested and the investments varied in order to maximise the returns on them. From 1996 onwards, the “realisation basis” no longer applied to loan relationships, which had then become subject to their own rules, but it still applied to other current assets. The courts had never pronounced on the “realisation basis”, but HMRC regarded it as an application of the requirement of ICTA 1988 section 70(1) that tax was levied on the “full amount of profits and gains”. In particular, HMRC relied on California Copper Syndicate v Harris 5 TC 159 at page 166, where Clerk LJ had said: “Enhanced values obtained from realisation . . . of securities may be . . . assessable where what is done is not merely a realisation or change of investment but an act done in what is truly the carrying on or carrying out of a business,” and on Athena Investments Ltd v Tomlinson 48 TC 81, where it was held that investments that had been held on the “realisation basis” were trading stock for the purposes of ICTA 1988 section 100(2), notwithstanding that they were not “trading stock” in the sense that they could be written down below cost at the balance sheet date. But they were to be regarded as “trading stock” for purposes of ICTA 1988 section 100, for the purposes of identifying trading stock on the cessation of a trade, and for the purposes of TCGA 1992 section 161, in the context of the determination whether appropriations to and from trading stock had taken place. The “realisation basis” had applied in the past to investments as well as to current assets, such as a bank’s loan book and all of its derivative contracts. Profits or losses on current assets would be brought into trading profit and loss, or alternatively, the “realisation basis” could be applied. Where investments were held on the “realisation basis”, the carrying value of the assets in the accounts could be reduced below cost to reflect a diminution in value, and the amount by which the carrying value was reduced would be shown in the profit and loss account. This diminution in value was not, however, deductible for tax purposes. HMRC accepted that where a bank held investment assets for dealing purposes, they could be treated as “trading stock”.

FA 2002 Schedule 26

FA 2002 Schedule 26 made extensive changes to the rules governing the taxation of derivative contracts held by companies. The Schedule applies to accounting periods of companies commencing on or after 1 October 2002.

The Schedule 26 rules provide for “credits” and “debits” on derivative contracts of companies to be treated either as trading income or expenditure, or as non-trading credits or debits from a loan relationship. This treatment is conditional, firstly, on the contract in question being a “derivative contract” as defined in paragraph 2 of the Schedule, and secondly, on the company using an “authorised accounting method” to determine profits and losses from its derivative contracts. In other words, if a contract is a “derivative contract” as defined, and the company has used an “authorised accounting method” in relation to the contract, the tax result for the company will be a profit or loss that is taxable as “income”.

If the accounting treatment complies with the Schedule 26 tax accounting rules, then the tax treatment conforms with the statutory accounts. If the company applies an “accruals basis” of accounting, the cost of a derivative contract is deemed to be its carrying value on the balance sheet date, except that the cost is adjusted, firstly, for the difference between cost and the ultimate realisation proceeds, and secondly, for any bad debt claim that might be allowed in relation to the contract. If a company is a party to a derivative contract that is valued on the “mark to market” basis, the contract is valued at the balance sheet date at its market value.

The fundamental rule of Schedule 26, stated in paragraph 1(1), is that: “For the purposes of corporation tax all profits arising to a company from its derivative contracts shall be chargeable to tax as income in accordance with this Schedule.” Paragraph 1(2) provides that profits from derivative contracts are taxable exclusively under Schedule 26, and not under any provision of the Taxes Act. This means that Schedule 26 takes priority over other taxing legislation, so that if a contract falls within the scope of the Schedule, the resulting profits or losses cannot be taxed under Schedule D Case VI, or as capital gains under TCGA 1992. The single exception to this rule is contained in FA 1996 section 101, which provides that Schedule 26 does not apply to any profit or loss which in accordance with Schedule 26 accrues to a company on a derivative contract by virtue of which the company is a party to a loan relationship, if that profit or loss is brought into account under FA 1996. In other words, if a receipt from a derivative contract is taxable under the FA 1996 “loan relationship” rules, then those rules take priority. In most cases, however, the tax result would be the same, irrespective of whether the receipt was taxed under the derivatives rules or under the loan relationship rules. Schedule 26 paragraph 53 provides that a “relevant contract” is “acquired by a person” if that person becomes entitled to the rights and subject to the liabilities under the relevant contract, whether by assignment or otherwise.

UK GAAP is applied for the purpose of determining whether a derivative contract is held for “trading purposes” or for “hedging purposes”. If a company holds a derivative contract for the purposes of its trade, such as banking, insurance, or other financial trading, the normal accounting practice would be to value the contract on a “mark to market” basis. If a company holds a derivative contract for the purpose of hedging another transaction, the accounting treatment of the derivative contract would mirror that of the underlying risk, in order to ensure that the accounting treatment accords with the economic purpose of the derivative contract. HMRC’s view, however, is that there is no single “right” way of accounting for derivative contracts, and much depends on the facts of each case.

Application of Schedule 26 to “companies”

Schedule 26 only applies to “companies”, as defined in ICTA 1988 section 832. The definition in that section provides that “company” means “any body corporate or unincorporated association but does not include a partnership, a local authority or a local authority association.”. Consequently, unincorporated associations and companies that are members of partnerships are included within the scope of Schedule 26.

Contracts within the scope of Schedule 26

The determination of whether a contract falls within the scope of Schedule 26 involves a four-step process:

Schedule 26 is intended to cover only instruments conventionally thought of as derivative contracts. The type of contracts that fall within the scope of Schedule 26 are described in paragraph 2 of the Schedule, which provides in subparagraph (1) that “For the purposes of the Corporation Tax Acts a company’s derivative contracts are those of its relevant contracts which satisfy the . . . provisions of this Schedule.” Paragraph 2(2) provides that “For the purposes of this Schedule a ‘relevant contract’ is – (a) an option, (b) a future, or (c) a contract for differences.” Paragraph 2 thus provides that the “derivative contracts” of a company are those of its “relevant contracts” which comply with the provisions of Schedule 26. For a contract to fall within the scope of Schedule 26, therefore, it must first constitute a “relevant contract” as defined, that is, it must be an option, a future or a contract for differences.

Once a contract constitutes as a “relevant contract”, that is, once it has been established that it is an option, a future or a contract for difference, then in order for it to be deemed to be a “derivative contract” for purposes of Schedule 26, it must still comply with one of the following conditions.

Compliance with accounting requirements

Schedule 26 paragraph 3(1) provides that “A relevant contract is not a derivative contract for the purposes of this Schedule . . . unless (a) it is treated for accounting purposes as a derivative financial instrument.”. In other words, a “relevant contract” only qualifies as a “derivative contract” for the purposes of Schedule 26 if it is treated for accounting purposes as a “derivative financial instrument”.

Paragraph 3(3) provides that a “relevant contract” is deemed to be treated for accounting purposes as a “derivative financial instrument” if it is so treated for the purposes of the “relevant accounting standard” used by the company. Paragraph 3(5) defines the term “relevant accounting standard” as FRS 13, or any subsequent standard dealing with transactions that are derivative financial instruments or financial assets under FRS 13.

In the case of companies that do not apply FRS 13, namely:

paragraph 3(3) provides that FRS 13 is deemed to apply to such companies, and if a contract entered into by such a company passes the accounting test, then it is deemed to be a “derivative contract” of that company.

There is an alternative accounting test for contracts that are not deemed to be “derivative financial instruments”, but are deemed to be “financial assets” for accounting purposes. Certain contracts that do not comply with the accounting test are deemed to be “derivative contracts” for purposes of Schedule 26, in terms of paragraph 3(1)(b), which provides that a “relevant contract” that does not comply with the accounting test but produces a guaranteed return or a guaranteed amount payable on maturity and which is treated for accounting purposes as a “financial asset” is deemed to be a “derivative contract” for purposes of Schedule 26.

Paragraphs 3(1)(c) and 3(2)(a) and (b) provide that a “relevant contract” that does not comply with the accounting test but the underlying subject matter of which is commodities or, in the case of a “contract for differences”, is intangible fixed assets, weather conditions or creditworthiness, is deemed to be a “derivative contract” for purposes of Schedule 26. This deemed inclusion covers futures, such as weather futures, and some options. Paragraph 12(10) provides, however, that a contract the underlying subject matter of which is not capable of being delivered cannot be a future or an option for purposes of Schedule 26, and must therefore be a contract for differences.

The FRS 13 definition of “derivative financial instrument” is very wide, but before a contract can be a derivative financial instrument, it must first be a “financial instrument”. This term is defined in FRS 13 as any contract that gives rise to both a “financial asset” of one entity and a “financial liability” or “equity instrument” of another entity.

This means, for example, that a forward contract to purchase a commodity or other physical asset, is not a “financial instrument”. The cash payment that is made under such a contract may lead to the creation of a short-term trade debt, which is a “financial instrument”, because the debtor incurs a “financial liability”, namely, the liability to make a cash payment, while the creditor holds a “financial asset” consisting of a right to receive a cash payment: when these rights and obligations arise, then in terms of FRS 13 the contract constitutes a “derivative financial instrument”. A contract to buy bonds or shares forward, however, is always a “financial instrument”, because the right to receive or the obligation to deliver a bond or share is a “financial asset” or a “financial liability”.

Contracts that provide for the physical delivery of a commodity fall outside the scope of the definition of “derivative financial instrument” in FRS 13. But because a cash-settled commodity contract is similar to a financial instrument and can be used to hedge or speculate in the same way as a financial instrument, FRS 13 provides that the same disclosure requirements that apply to financial instruments apply for the purposes of cash-settled commodity contracts.

FRS 13 identifies two types of commodities: hard commodities (such as metals) and soft commodities (such as oils, grains, cocoa, coffee, cotton, soya beans and sugar), and states that cash or government securities are not treated as commodities for the purposes of the FRS. The term “commodity” is not defined in Schedule 26, and it therefore takes its ordinary language meaning. The term is defined in The New Oxford Dictionary of English as having a “core sense” of “a raw material or primary agricultural product that can be bought and sold, such as copper or coffee”, and a subsense of “a useful or valuable thing, such as water or time”. HMRC’s view is that the term “commodity” includes agricultural products (wheat, soya beans, orange juice, coffee, broiler chickens), metals (gold, silver, platinum, zinc), and hydrocarbon oil products (crude oil, kerosene, natural gas and propane), and that there is no requirement that for an asset to constitute a commodity, it must meet any standard of quality or quantity; nor does it have to be a tangible asset, so that electricity qualifies as a commodity.

For tax purposes, it may be difficult to determine whether a contract is intended to provide for physical delivery or not, and for this reason, Schedule 26 paragraph 3(2)(a) deems all commodity contracts to have passed the accounting test, whether they are cash-settled or not. The result is that some contracts that would not normally be thought of as derivative contracts fall within the derivative contract rules, but this has no effect on tax liability, and a company that is a party to contracts of this nature is not required to identify such contracts separately in its tax computation. In some cases, however, the characterisation will affect the tax result, for example, where a company concludes such a contract for a non-business purpose, so that the “unallowable purpose” provisions apply: paragraph 23 would then only be relevant if the contract qualified as a “derivative contract”.

Contracts that are expressly excluded

A contract may be excluded from the scope of the Schedule 26 derivative contract rules because of the form of its underlying subject matter. Thus Schedule 26 paragraph 4(1) provides that a “relevant contract” is deemed not to be a “derivative contract” for the purposes of Schedule 26, if its underlying subject matter either consists wholly of one or more excluded types of property, or is deemed to consist wholly of excluded types of property.

A company may use a derivative contract, such as a share index future, to hedge against a fall in the value of a share portfolio. If the company sells some of the underlying shares from its portfolio, the profit or loss will be taxed as a capital gain or loss, so that if the gain or loss on the hedging instrument was to be taxed as income, there would be a loss of symmetry of the tax treatment, and the effectiveness of the hedge would be lost. Parliament has therefore accepted that it is more appropriate in these circumstances for any gain derived from the derivative contract to be taxed under the capital gains rules of TCGA section 143. Under the principle that the tax treatment of the derivative mirrors the tax treatment of the underlying subject matter, derivative contracts with specified types of subject matter are deemed not to constitute “derivative contracts” within the scope of Schedule 26.

Schedule 26 paragraph 4(2) lists six categories of underlying subject matter in relation to which “relevant contracts” are deemed not to be “derivative contracts”:

Section 92 FA 1996 deals with convertible securities. It applies to an asset if the asset represents a “loan relationship” of a company, and the rights attached to the asset include provision that entitles the company to acquire shares in a second company, and the extent to which those shares may be acquired is not determined using a cash value specified in the provision, or which is determinable by reference to the terms of that provision, the asset is not a “relevant discounted security” within the scope of FA 1996 Schedule 13, on the date on which the asset came into existence, there was more than a “negligible likelihood” that the right to acquire shares in a company would in due course be exercised to a significant extent, and the asset is not an asset the disposal of which would be deemed to be a disposal in the course of activities forming an “integral part of a trade” carried on by the company. The amounts falling to be brought into account in respect of a creditor relationship represented by an asset to which this section applies, are confined to amounts relating to interest. FA 1996 section 93 applies to index-linked assets, that is, loan relationships that are linked to the value of capital assets, unless the disposal of the asset in question would result in a disposal in the course of activities forming an integral part of the company’s trade. The section is limited to amounts relating to interest. Convertible securities that fall within the scope of FA 1996 section 92 are excluded, because the value of such securities is partly attributable to the value of the shares into which they can be converted. Consequently, a company that holds convertible securities which comply with the tests in FA 1996 section 92, is deemed to hold a capital asset rather than being a party to a loan relationship; for the same reason, derivative contracts that have underlying subject matter consisting of convertible securities are deemed to be capital assets, and not derivative contracts. The same rules apply to securities that are linked to the value of capital assets. If a loan relationship which is linked to the value of capital assets falls within the scope of section 93 of the FA 1996, then it is “excluded subject matter” for purposes of paragraph 4 of Schedule 26.

The six categories are categorised in two groups-

Schedule 26 paragraph 4(2) provides that if the “relevant contract” is an option or a future, the excluded forms of property are:

Paragraph 4(3) provides that if the “relevant contract” is a “contract for differences”, the excluded forms of property are:

Multiple forms of underlying subject matter

Where a derivative contract has more than one form of underlying subject matter, it is deemed to be a “hybrid derivative contract“. The term “hybrid” is, however, not defined in Schedule 26. There are a number of possible combinations in relation to the forms of the underlying subject matter of a derivative contract. A hybrid derivative contract is only excluded from the scope of Schedule 26 if all of the forms of its underlying subject matters fall within excluded categories. If one or more, but not all, of the forms of underlying subject matter of a derivative contract constitutes “excluded subject matter”, the following chain of issues is considered:

Derivative contracts deemed not to be “excluded”

Schedule 26 provides that in a number of cases, derivative contracts that would not otherwise be taxable under the Schedule on account of their underlying subject matter constituting excluded subject matter, are nevertheless deemed to be derivative contracts within the scope of the Schedule.

1. Derivative contracts held by company for purposes of trade

Schedule 26 paragraph 5 provides that where a company holds a derivative contract for the purposes of its trade, the contract is deemed not to be an “excluded contract”, if the following conditions are met: the contract must be a “relevant contract” held by the company; the “relevant contract” must have been entered into or acquired by the company for the “purposes of a trade carried on by it”; and the underlying subject matter of the contract must be, or must be deemed to be, wholly either shares in a company; rights of a unit holder under a unit trust scheme; or assets representing “loan relationships” to which section 92 or 93 of FA 1996 applies.

The background to paragraph 5 is that paragraphs 4(2)(d) and 4(3) provide that derivative contracts which have shares or share indices as their underlying subject matter are not taxed as derivatives under Schedule 26. But because banks, financial institutions and share dealers often hold such derivative contracts as trading stock, and because it would be illogical where a company trades in derivatives to tax some of the contracts relating to its derivatives trading under the derivative contract rules, and other contracts relating to its derivatives trading involving equity derivatives under Schedule D Case I rules, Schedule 26 paragraph 5 qualifies the excluded “underlying subject matter” rule of paragraph 4, so that if a company –

then the contract is deemed for tax purposes to be a “derivative contract”.

The question whether a company has entered into or acquired a derivative contract for “the purposes of a trade carried on by it”, or for example, whether it holds equity derivatives as trading stock, is a question of fact, and depends on the company’s intention and the frequency of transactions in the derivative contracts. Paragraph 5 does not apply to contracts the underlying subject matter of which is land, chattels (other than commodities), or intangible fixed assets. But because (unlike in the case of shares) there is no public market in contracts of these kinds, it is unlikely that a company would trade in them.

There is a distinction between trading stock that falls within the scope of FA 2002 Schedule 26, which is governed by the rules in the Schedule, and trading stock that falls outside the scope of the Schedule. Derivative contracts that constitute “trading stock” and do not fall within the scope of Schedule 26 are valued at the lower of cost or market value, that is, according the “historical cost accounting” rules.

2. Derivative contracts that produce a guaranteed return

The anti-avoidance provisions contained in Schedule 26 paragraphs 6 and 7 aim to ensure that where a contract guarantees a company an income-like return, the profits generated by the contract will be taxed as “income”. If a contract falls within the scope of paragraphs 6 and 7, is deemed to meet the accounting test, even if it is not a “derivative financial instrument”, provided that it falls within the definition of “financial asset” in FRS 13. The definition of “financial asset” is wider than the definition of “derivative financial instrument”, and it includes, in addition to cash and shares, contractual rights to receive cash or other forms of financial assets; with the result that it includes trade debts, bonds and bank deposits. Contractual arrangements that fall within the scope of paragraphs 6 and 7 include prepaid contracts that resemble deposits, and derivative contracts that form part of structured financial products, which are all “financial assets”.

Schedule 26 paragraph 6 provides that where a company is a party to a derivative contract that will produce a guaranteed return, the contract is not an “excluded contract”. The contract must be a “relevant contract” whose underlying subject matter consists wholly of, or is deemed to consist wholly of shares in a company; rights of a unit holder under a unit trust scheme, or assets representing “loan relationships” to which FA 1996 sections 92 or 93 apply; and either the relevant contract is designed to produce a guaranteed return, or the relevant contract and one or more of its “associated transactions” are designed to produce a guaranteed return.

The expression “associated transaction designed to produce a guaranteed return” is defined as one or more other relevant contracts, the underlying subject matter of which consists wholly or partly of shares in a company, rights of a unit holder under a unit trust scheme, or assets representing “loan relationships” to which FA 1996 sections 92 or 93 apply, and which would otherwise be “derivative contracts”; or one or more assets representing “loan relationships” to which FA 1996 sections 92 or 93 apply, or one or more assets representing “loan relationships” to which FA 1996 section 93A applies. FA 1996 section 93A deals with securities where the amount payable on maturity or redemption reflects the exact and unrestricted change in the value of an asset, which is itself an asset in respect of which chargeable capital gains would arise in the hands of a holder, or an index of such assets, such as the FTSE 100. Section 93A is an anti-avoidance provision which sets out the securities that will cease to fall within the scope of section 93 without any change of ownership, and the consequences thereof. Schedule 26 paragraph 10(1) provides that two or more transactions are deemed to be “associated transactions” if they are all entered into or acquired in pursuance of the same scheme or arrangements.

Paragraph 6(4) defines the expression “return on a relevant contract” as any amounts arising to the company in respect of that contract for any accounting period. The expression “return on an asset representing a loan relationship” is defined as the amount that must be paid to discharge a money debt arising in connection with that relationship.

A relevant contract and its associated transactions are deemed in terms of paragraph 6(5) to be “designed to produce a guaranteed return” if having regard to the relevant contract, or having regard to both the relevant contract and the associated transactions, it would be reasonable to assume that the main purpose or one of the main purposes of the contract, or of the contract taken together with the associated transactions, was the production of a guaranteed return from that contract, or from the contract and one or more associated transactions. Whether a contract or a transaction would produce a guaranteed return, is determined from the likely effect of the contract, or the likely effect of the contract and the associated transactions, the circumstances in which the contract and any associated transactions are entered into or acquired, or both the likely effect and the circumstances of the acquisition. A relevant contract and transactions associated with it are deemed to produce a guaranteed return, if taking the relevant contract and the associated transactions together, risks from fluctuations in the underlying subject matter of the relevant contract, or of the relevant contract and the associated transactions, are eliminated or reduced so as to produce a return from the contract and the transactions which equates, in substance, to the return on an investment of money at interest.

Where the main reason or one of the main reasons for the choice of the underlying subject matter of the relevant contract and associated transactions, is either that there appears to be no risk that it will fluctuate, or that it appears that the risk that the underling subject matter will fluctuate appears to be insignificant, then the risks from fluctuations in the underlying subject matter of the relevant contract and associated transactions are such that the contract is deemed in terms of paragraph 6(7) to be a contract in respect of which risks from fluctuations in the underlying subject matter of the relevant contract or of associated transactions is eliminated or reduced.

The reference to an asset representing a “loan relationship to which FA 1996 section 92 applies to the underlying subject matter of a contract”, is deemed by paragraph 6(8) to be a reference to the value of shares in a company which may be acquired under the loan relationship. Where an asset representing a loan relationship to which FA 1996 section 93 or 93A applies, references to the “underlying subject matter” are taken to be references to the value of chargeable assets of a particular description to which that relationship is linked. The expression “fluctuations in the underlying subject matter of a relevant contract”, is deemed to mean fluctuations determined by reference to the underlying subject matter.

3. Derivative contract guaranteeing payment on maturity

Schedule 26 paragraph 7 provides that where a “relevant contract” provides for a guaranteed payment on maturity, it is not an “excluded contract” by virtue of its underlying subject matter. This deemed re-inclusion applies to a “relevant contract”, if its underlying subject matter consists wholly of shares in a company, rights of a unit holder under a unit trust scheme, or assets representing “loan relationships” to which FA 1996 sections 92 or 93 apply, and the “relevant contract” is designed to secure that the “relevant amount payable” in respect of the “relevant contract” does not fall below a guaranteed amount, or the “relevant contract” and one or more transactions are “associated transactions”, and the “associated transactions” are designed to secure that the relevant amount payable in respect of those associated transactions does not fall below a guaranteed amount.

An “associated transaction” is defined in paragraph 7(3) as a transaction which is another “relevant contract” whose underlying subject matter consists wholly or partly of shares in a company, rights of a unit holder under a unit trust scheme, or assets representing “loan relationships” to which FA 1996 sections 92 or 93 apply, and would otherwise be “derivative contracts”, or an asset representing a “loan relationship” to which FA 1996 sections 92 or 93 apply, or an asset representing a “loan relationship” to which FA 1996 section 93A applies.

A “relevant contract”, either alone or together with associated transactions, is deemed in terms of paragraph 7(4) to be designed to secure that the relevant amount payable in respect of that contract, or that contract together with an associated transaction, does not fall below a guaranteed amount, if from the contract alone or together with the associated transaction, it would be reasonable to assume from the likely effect of the contract either alone or together with the associated transaction, or from the circumstances in which the contract and the associated transaction was entered into or acquired, that the main purpose or one of the main purposes of the contract or the contract together with the associated transaction, is to secure that the relevant amount payable will not fall below the guaranteed amount.

For the purpose of determining whether the relevant contract is designed to secure that the relevant amount payable does not fall below the guaranteed amount, paragraph 7(5) provides that the “guaranteed amount” is deemed to be 80 percent of the amount paid or payable by the company for entering into or acquiring the contract, or where the relevant contract and associated transactions have been entered into, 80 percent of the consideration paid or payable by the company or a connected company in relation to that company, for entering into, or acquiring, the associated transactions.

For the purpose of determining whether a “relevant contract” is designed to produce a guaranteed return, the expression “relevant amount payable” is defined in paragraph 7(6) as the amount payable in money or money’s worth to any person on the maturity of that contract, or where the relevant contract and an associated transaction are designed to produce a guaranteed return, the amount payable in money or money’s worth to any person on the maturity of any one or more of the associated transactions.

In relation to a “relevant contract”, the term “amount payable on maturity” is defined in paragraph 7(7) as the amount payable on performance of that contract, or in the case of an asset representing a loan relationship, the amount that must be paid to discharge the money debt arising in connection with that relationship.

The term “connected company” is defined in paragraph 7(8) as a company in respect of which there is a connection between that company and another company, with whether there is such a connection is determined in accordance with section 87(3) and (4), and 87A of FA 1996, but disregarding section 88 of that Act.

4. Contracts held to provide insurance benefits

Schedule 26 paragraph 8 provides that notwithstanding the exclusion provisions of paragraph 4, a “relevant contract” may still qualify as a “derivative contract”, where the company that holds the contract is carrying on long-term insurance business, and it entered into or acquired the “relevant contract” for the purpose of providing benefits under life insurance policies or capital redemption policies, provided that the policy or contract terms permit part of the rights conferred by the policy or contract to be surrendered by the holder at intervals of one year or less, and the amounts payable on part surrender is substantially equivalent to the interest return on a cash investment. In addition, the underlying subject matter of the “relevant contract” must consist wholly of shares in a company, rights of a unit holder under a unit trust scheme, or assets representing a loan relationship to which section 92 or 93 of FA 1996 applies. The term “capital redemption policy” is defined in paragraph 12(2) as a contract effected in the course of capital redemption business, within the meaning of section 458 of ICTA 1988.

De minimis rule for subordinate subject matter

Schedule 26 paragraph 9 provides that where one form of underlying subject matter of a derivative contract is “small” or insignificant, it is ignored, under a de minimis rule. This means that when the underlying subject matter of a “relevant contract” is determined, the first step is to eliminate minor forms of subject matter that are subordinate to the main subject matter, or which have a value that is small in comparison to the total value of the underlying subject matter. In order to avoid situations where contracts the underlying subject matter of which consists of shares or other forms of excluded subject matters, are taxed on an “income” basis because the terms of the contract provide for it to have a second, minor, form of non-excluded subject matter, Schedule 26 provides that in defined circumstances, the underlying subject matter of such contracts is deemed to consist entirely of excluded subject matter. Schedule 26 paragraph 9 thus provides that the contract must have a form of underlying subject matter which falls into an excluded category (shares, unit trust units, convertible or asset-linked securities, land, chattels (other than commodities), and in the case of futures and options, intangible fixed assets), and it must also have some other form of minor underlying subject matter. The minor subject matter must be either subordinate to the excluded underlying subject matter, or it must be small in value in comparison to the excluded underlying subject matter. If these conditions are complied with, the minor subject matter is ignored. The operative date for determining whether subordination is a factor, or for determining the value of minor subject matter, is the date on which the company enters into or acquires the “relevant contract”. The meaning of the term “small” in this context is not defined, but HMRC’s practice is to regard underlying subject matter as “small” if its value is 5 percent or less than the value of the total subject matter of the contract.

Identifying the “underlying subject matter”

Schedule 26 paragraph 11 sets out the rules that are used to identify the underlying subject matter of a “relevant contract”. Paragraph 11 states that if the contract is an option, then its underlying subject matter is the asset that would be delivered if the option was exercised. If the contract is a future, the underlying subject matter is the asset that would be delivered if the contract matured.

The payment of cash on the maturity of a contract does not qualify as “property” that is “delivered” on the maturity of the contract: cash is regarded as the means of paying for property that is delivered, and is not the delivered property itself. This is the case even where the cash that is paid is foreign currency, or where a party’s obligation to pay cash is satisfied by the delivery of an asset, such as shares. Consequently, if the contract is a future or an option, and the property that is to be delivered is another derivative contract, then the underlying subject matter of the first contract is the underlying subject matter of the derivative contract that is required to be delivered in satisfaction of the obligations under the first contract.

On the other hand, if the contract is a contract for differences, and contractual payments are based on the price or value of an asset, the underlying subject matter of the contract is the asset itself. If the contract is a contract for differences where payments are determined with reference to an index, the underlying subject matter of the contract is the subject matter that determines the value of the index. Schedule 26 paragraph 11(5) provides that the underlying subject matter of a contract for differences may include interest rates, weather conditions or creditworthiness.

Paragraph 11(6) provides that the underlying subject matter of a contract is deemed not to be interest rates, where the terms of the contract specify that payment by a party to the contract may be made on a date that is variable, and that the amount of the payment varies by reference to a rate of interest, depending on the date on which the payment is made.

Splitting of derivative contracts

A contract that follows the form of an ISDA Master Agreement or some other master agreement, is usually regarded as a single contract, but both FA 1996 and Schedule 26 paragraph 3 provide that a contract is only included within the scope of Schedule 26 if it complies with the accounting test, with the result that in determining whether a derivative transaction constitutes one contract or several contracts, the accounting treatment of the transaction governs. The result is that even if a number of transactions are included within the scope of a single master agreement, this does not necessarily imply that the transaction constitutes a single contract: in other words, a single contract format is overridden by the accounting treatment. On the other hand, where two or more financial instruments are closely linked, they may be deemed to be a single composite transaction for tax purposes, under anti-avoidance principles.

Schedule 26 paragraph 12(1) provides that a contract cannot be both a future or an option, and a contract for differences. And where futures or options have both excluded and non-excluded forms of underlying subject matter, they are treated for tax purposes as separate contracts. Where a future or an option has one form of underlying subject matter that falls within the Group 1 exclusions and a second form of underlying subject matter that falls within the Group 2 exclusions, the contract is deemed for tax purposes to be two contracts.

Schedule 26 paragraph 46 provides that when the following conditions have been met, a hybrid option or futures contract may be split into two contracts: where the contract has both a form of underlying subject matter which falls into one or more of the excluded categories, and a form of underlying subject matter which is not excluded. For example, an option or future which has forms of underlying subject matters comprising both shares and loan relationships. This type of contract is split into two notional contracts: one contract that relates to the “excluded” subject matter, and a second contract that relates to the “non-excluded” subject matter.

Schedule 26 paragraph 47 provides that where a future or an option contract has forms of underlying subject matter of more than one excluded type, that is, it has subject matter that consists of shares, units in a unit trust scheme, or convertible or asset-linked securities, or any combination of these, and it has other forms of underlying subject matter consisting of land, chattels that are not commodities, or intangible fixed assets, or any combination of these, for example, a contract that provides for delivery of both shares and intangible fixed assets, then the option or futures contract can be split into two notional contracts: one contract the underlying subject matter of which consists of all the subject matter in the first group (equities and quasi-equities), and a second contract the underlying subject matter of which consists of all the property in the second group.

Paragraphs 46 and 47 only apply to futures and options, but in terms of paragraph 12(10), any contract that can only be cash-settled is not a future or an option. Futures and options contracts that provide for delivery of the underlying asset are usually simpler in form than other contracts for differences, such as swaps, and are easier to split. There are no provisions in Schedule 26 for splitting a contract for differences into two or more simpler contracts for tax purposes.

If a future or option is split under paragraphs 46 or 47, the following procedure is followed:

Recognised accounting methods

Companies are obliged to use one of two accounting methods in computing profits and losses from derivative contracts for purposes the purposes of Schedule 26. The general rule is that a company must use either “accruals” accounting or “mark to market” accounting, which must conform with UK GAAP, and with the legislative requirements laid down for the use of that method. Where a company does not use one of the approved accounting methods, it must make appropriate adjustments in its tax computation.

In determining a company’s liability for corporation tax, its profits and losses from derivative contracts are required by Schedule 26 paragraph 14(1) to be computed by using “credits’ and “debits’ determined for the accounting period. Schedule 26 paragraph 51 provides that no tax is deductible under section 349 or any other section of ICTA 1988, in relation to payments made under a derivative contract.

A company’s profits and losses on derivative contracts are brought into account for tax purposes pursuant to Schedule 26 paragraph 15. The amounts that are brought into account for corporation tax purposes, are called “credits” and “debits”, and these are computed using an authorised accounting method, and must fairly represent all profits, gains and losses, both capital and revenue, as well as charges and expenses, that relate to the company’s derivative contracts and related transactions.

Paragraph 14(2) provides that if a company has entered into a derivative contract for the “purposes of a trade” carried on by it, then the credits and debits that result from that contract are treated, if a credit, as a receipt of that trade to be brought into account in computing the profits of that trade for that period, or if a debit, as an expense of that trade which is deductible in computing those profits. In determining whether a debit is deductible under paragraph 14(2), paragraph 14(4) provides that it may be deducted irrespective of whether or deductibility would be denied by the provisions of ICTA 1988 section 74. In other words, the provisions of section 74 have no application in determining whether debits are deductible under Schedule 26.

Where the company entered into a derivative contract, but did not do so for the “purposes of a trade” carried on by it, Schedule 26 paragraph 14(3) provides that the debits or credits resulting generated by that contract are brought into account as “non-trading credits” or “non-trading debits”, which are taxable under FA 1996 Part 4 Chapter 2, in respect of the company’s loan relationships.

A company is deemed to be a party to a “trading derivative contract” if it enters into or acquires the contract for the purposes of its trade. For example, if a contract is entered into to purchase commodities by a manufacturer for use in its trade, the contract is a “trading derivative contract”. A company that sells or writes derivative contracts will be a party to trading derivative contracts, provided that the sale of derivative contracts is part of its trade; this would usually only be the case for banks and financial traders. A company is a party to a “non-trading derivative contract” if it is a party to a derivative contract but the purposes for which it entered into the contract were not the purposes of its trade. Examples of companies that enter into derivative contracts for purposes other than trade, are companies that do not carry on trade at all, such as investment holding companies, non-trading holding companies, or trading companies that hold derivative contracts for investment or speculative purposes.

Computation of credits and debits

Credits and debits (including exchange gains and losses) that relate to “trading derivative contracts” are treated as receipts and expenses of the company’s trade. Credits from “non-trading” derivative contracts are taxed under Schedule D Case III. Non-trading debits can be set off against other company profits for the accounting period, surrendered as group relief, carried back or carried forward.

Paragraph 14(4) provides that an amount which is deductible as an expense of a company’s trade because it constitutes a “trading debit” is not disallowed as a deduction by any of the provisions of section 74 of the Taxes Act. This rule is based on paragraph 1(2), which states that where amounts fall within the scope of Schedule 26, they are not brought into account for corporation tax purposes under any other legislative provision.

Schedule 26 paragraph 15(1) provides that the credits and debits which are required to be brought into account for tax purposes are the sums which, in accordance with an authorised accounting method, when taken together, fairly represent for the accounting period, all of the company’s profits and losses (excluding charges or expenses) from its derivative contracts and related transactions, and all charges and expenses incurred by the company under, or for the purposes of, its derivative contracts and related transactions.

The term “related transaction” is defined in Schedule 26 paragraph 15(7) as including any disposal or acquisition, in whole or in part, of rights and liabilities under a derivative contract; the maturity or closing out of a derivative contract, however achieved; and any sale, gift, surrender or release of rights and liabilities under a derivative contract. Paragraph 15(8) deems a number of transactions to be “related transactions”: these are transactions which occur where rights or obligations under derivative contracts are transferred or extinguished by sale, gift, surrender or release, as well transactions which occur where a contract is discharged by performance in accordance with its terms.

If a company becomes a party to a derivative contract for unallowable purposes, the resulting credits and debits are excluded entirely from its tax computation.

Profits or losses that are carried to a reserve in terms of UK GAAP, are specifically included in the Schedule 26 taxable amount. The background to this rule is that under UK GAAP, there are circumstances in which it is permitted to carry profits or losses to reserves, rather than reflect them in the profit and loss account. Schedule 26 paragraph 15(3)(a) provides that, notwithstanding such accounting treatment, profits, gains or losses on derivative contracts that are taken to reserves remain liable to be accounted for, for tax purposes. This rule does not apply, however, to amounts that are required to be transferred to the company’s share premium account: paragraph 15(2). Similarly, the rule does not apply to exchange gains and losses that are taken to reserves, which fall within the scope of paragraph 16.

Schedule 26 paragraph 15(3)(b) provides that forward premiums or discounts that arise from derivative contracts the underlying subject matter of which consists wholly or partly of currency, and which in accordance with UK GAAP, are brought into account as profits or losses, are deemed to be included in taxable profits and losses derived from derivative contracts.

Paragraph 15(4) provides for the deduction of a range of charges and expenses incurred by a company in concluding and terminating derivative contracts. Only charges and expenses that are incurred directly are deductible. Indirect expenditure, that is, expenditure that is not directly related to a specific derivatives transaction (for example, the costs of obtaining general advice on risk management, or the costs of becoming a member of a futures or options trading exchange) is not deductible. The direct charges and expenses that are deductible are those which are incurred directly in bringing a company’s derivative contracts and related transactions into existence, entering into or giving effect to a company’s derivative contracts and related transactions, making payments under or in pursuance of a company’s derivative contracts or related transactions, or taking steps to ensure the receipt of payments under or in accordance with derivative contracts or related transactions. The expenses that are deductible must have been incurred directly on the following activities:

Paragraph 15(6) provides that, where the company changes its authorised accounting method, and an amount representing either a profit or a loss is brought into the company’s accounts as a result, then that amount is to be included in the company’s taxable debits and credits. The paragraph provides that where a company uses different authorised accounting methods for different parts of a single accounting period in relation to one derivative contract, or it used different authorised accounting methods in relation to a single contract for different accounting periods, and an amount is brought into account for the purposes of the company’s statutory accounts in respect of the change of authorised accounting methods, then that amount must be included in the “sums” in respect of which credits and debits from derivative contracts are taxed.

Exchange gains and losses

The “profits and losses of a company from its derivative contracts and related transactions” are deemed in terms of Schedule 26 paragraph 16(1) to include exchange gains and losses accruing to the company from those contracts. Paragraph 16(1) thus states the principle, that exchange gains and losses which arise from a company’s derivative contracts are included in the profits, gains and losses of the company.

This principle is, however, subject to the application of the matching principle, which provide for the deferral of any tax liability or deduction on exchange gains and losses to which matching applies. The matching principle is applied by excluding a number of categories of exchange gains and losses from the scope of Schedule 26. Paragraph 16(3) to (6) thus provides for and extends the concept of “matching” which companies could elect under the FA 1993 foreign exchange rules. The paragraph 16 rules are, however, mandatory where the conditions of the exclusions are complied with. Where any of the conditions of the exclusion provisions is satisfied, the exchange gains and losses are disregarded for tax purposes. Paragraph 16 also provides that in order to qualify for matching, the offset must be made in the entity accounts, and not at the level of consolidation.

The gains and losses that are excluded under the matching principle are the following –

Paragraph 16(7) states that where an exchange gain or loss on a derivative contract is not taken into account because of the application of the matching principle exclusions listed in paragraph 16(3), then paragraph 15(3) (which relates to forward premiums and discounts arising from derivative contracts the underlying subject matter of which is wholly or partly currency) does not apply to that gain or loss. In other words, if the deemed inclusion of exchange gains or losses does not cover an amount excluded under the matching principle, then a forward premium or discount arising from a derivative contract whose underlying subject matter consists wholly or party of currency, and which in accordance with GAAP, would otherwise be taxable, is likewise deemed by paragraph 16(7) not to be taxable.

Authorised accounting methods

Schedule 26 paragraph 17(2) provides that in order to qualify as an “authorised accounting method”, an accounting method must comply with the following four conditions -

The consequences for a company of using an authorised accounting method for its derivative contracts are that its profit and loss account will reflect profits or gains resulting from an increase in the value of derivative contracts that it is holding or has sold, or from any reduction in the value of liabilities incurred under its derivative contracts, or losses resulting from decreases in the value of derivative contracts held or sold, or increases in the “fair value” of liabilities under its derivative contract. This methodology conforms with FA 1998 section 42, which requires the profits of a trade “to be computed on an accounting basis which gives a true and fair view, subject to any adjustment required or authorised by law”. When a transaction is hedged, HMRC accepts that, if the hedge and the hedged transaction are linked, the accounting treatment, in terms of which the hedge is valued on the same basis as the hedged item, is acceptable for tax purposes, provided that the company accepts the consequences of this treatment for tax purposes for both sides of the hedge. If a company wishes to depart from the profit or loss shown in the accounts for one side of the hedge only, then HMRC would insist that the normal tax principles should apply, that is, in the usual case, the “realisation basis” would be applied for the underlying item. HMRC’s view is that two transactions may be accepted as being &;ldquo;linked” only if neither made commercial sense independently.

Two accounting methods are authorised for use for derivative contracts: “accruals basis” accounting, and “mark to market basis” accounting.

Accruals basis accounting

Schedule 26 paragraph 17(2) provides that an accounting method is deemed to be authorised, if it contains inter alia - “proper provision for allocating payments under a derivative contract, or arising as a result of a related transaction, to accounting periods”.

In terms of paragraph 17(3), an “accruals basis” of accounting is deemed to contain “proper provision for allocating payments under a derivative contract to accounting periods”, if it complies with the following conditions -

An authorised “accruals basis” must therefore allocate payments to the accounting period to which they belong, ignoring when payments are actually made, and when they are due and payable. When the payments relate to more than one accounting period, they must be apportioned between those periods on a just and reasonable basis. “Payments” may include premiums and arrangement fees, which are spread across the life of the derivative instrument. Where a premium is spread across a number of accounting periods, the balance of the premium may be written off in an accounting period before prior to the accounting period during which the contract is due to terminate, if the rights under the contract are regarded as having no value and there is no prospect of recovery of any amount under the contract.

Mark to market accounting

For tax purposes, assets generally can be valued by being marked to market at the balance sheet date, or current assets can be taxed on the “realisation basis”, which would implies that they are not be valued at the balance sheet date, or on the “dealing basis”, under which they would be valued as trading stock at the lower of cost or market value. The commercial rationale for using mark to market accounting is that most companies that use mark to market accounting for derivative instruments are companies that trade in derivative instruments. The object of mark to market accounting is to show the derivative contracts at their “fair value”.

Schedule 26 paragraph 17(1) defines “mark to market accounting” as an accounting basis under which a derivative contract is brought into account in each accounting period at a “fair value”. A mark to market basis of accounting is deemed, in terms of paragraph 17(4), to make “proper provision for allocating payments under a derivative contract to accounting periods” where that basis makes provision which allocates payments to the periods in which they become due and payable.

The term “fair value” is defined in paragraph 17(6) as the amount which, at the time at which value is required to be determined, the company would obtain from or would pay to an independent person, for the transfer of all of the company’s rights under the derivative contract in respect of amounts which are not yet due and payable, and the release from all of the company’s liabilities under the derivative contract in respect of amounts which are not yet due and payable.

If a future or an option contract is quoted on a public exchange, its market value or “fair value” on a particular date is easy to determine. But where the contract is an over the counter contract, mathematical valuation techniques may have to be used. HMRC recognises that the value that a company places on a contract in its accounts will usually be an acceptable value and will conform with the statutory definition of “fair value”.

Application of accounting methods

In determining which of the two authorised accounting methods is to be used in relation to a derivative contract, the following rules apply -

If the company’s accounting method is neither an “authorised accrual method” nor an “authorised mark to market method” of accounting, that is, if paragraphs 18(3) or 19 to 21 do not apply, then paragraph 18(4) establishes a default rule that requires the company to ensure that an authorised accruals basis accounting method is used.

Paragraph 18(5) and (6) explain what is meant by an accounting method that “equates to” another accounting method. A basis of accounting “equates with an authorised accruals method”, if it purports to allocate payments under a derivative contract to accounting periods according to when they are taken to accrue, and a basis of accounting “equates with an authorised mark to market basis”, if it purports to produce credits and debits computed by reference to the determination at different timed during an accounting period of a fair value, and to produce credits or debits relating to payments under the derivative contract, according to when they become due and payable. Paragraph 18(5)(a) defines the term “accounting method that equates to an accruals method of accounting” as any accounting method that allocates payments to the profit and loss account when they accrue. An “accounting method that equates to the mark to market method of accounting” is an accounting method that provides that where a company accrues payments under a derivative contract, but brings in the fair value of the derivative contracts with the exclusion of those payments, and the resulting credits and debits correspond to the amounts that would be accounted for under the mark to market method of accounting. This latter method is referred to as the “clean mark to market” basis. An accounting method that brings in amounts that represent fair value, and allocates payments to the accounting period in which they become due and payable, is a method that equates to the mark to market method.

If an accounting method purports to make payment allocations to accounting periods under a derivative contract on an accruals basis, then in terms of paragraph 18(6), it is deemed to equate to an “authorised mark to market basis of accounting”, and not to an accruals basis, provided that it purports to bring a derivative contract into account in each accounting period at a value which would be a “fair value” if the contract was valued on the basis that any periodic payments made under it would be disregarded to the extent that they had already accrued, and the resulting credits and debits produced in respect of the contract by that method as properly applied, correspond for practical purposes, to the credits and debits produced in relation to the contract for that accounting period, by an “authorised mark to market” basis of accounting.

Elective mark to market accounting

If a company does not use mark to market accounting in its statutory accounts for the valuation of derivative contracts because the legislation in its country of incorporation does not provide for the use of mark to market accounting, then Schedule 26 paragraph 19(2) permits the company to elect to use mark to market accounting for its derivative contracts for UK corporation tax purposes, provided that it would use mark to market accounting if it were subject to UK GAAP. Paragraph 19(3) provides that this election must be made within two years, and in terms of paragraph 19(4) a company that makes the election is deemed to make the same election for the purposes of FA 1996 section 86(3A), in relation to “loan relationships”.

A non-resident company that would, were it to prepare its accounts in accordance with UK GAAP, use mark to market accounting for some of its derivative contracts, if it was to prepare its accounts in accordance with UK GAAP, is permitted to elect to use mark to market accounting for those contracts. This means that if a company falls within the scope of paragraph 52(1)(c) or (d) (companies whose statutory accounts are covered by Part 1 of Schedule 21C or 21D of the Companies Act 1985, or whose accounts are required to be drawn up under legal requirements of their country of incorporation), then the company may elect to use an “authorised mark to market basis of accounting” as its authorised accounting method, in relation to all derivative contracts which would be subject to that basis, if it were a UK company applying UK GAAP. This rule applies, therefore, where the company would use an authorised mark to market basis of accounting for some or all of its derivative contracts, if it were a UK company applying UK GAAP, but that basis is not the basis of accounting used for those derivative contracts in its statutory accounts. In other words, where a company’s accounts are prepared under the laws of its country of incorporation, but it does not use mark to market accounting for its derivative contracts in those accounts, and it would use mark to market accounting in its accounts if they were drawn up under UK GAAP, then it may elect in terms of paragraph 19(1) and 19(2), to use mark to market accounting for purposes of UK corporation tax. Paragraph 19(3) provides that this election must be made within two years of the end of the company’s first accounting period commencing on or after 1 October 2002, in which the company is a party to a derivative contract in relation to which the election is made. Once made, the election is irrevocable, and it is effective not only for the accounting period in which it is made, but also for all of the company’s subsequent accounting periods. Once the election has been made, it is also deemed to apply in terms of paragraph 19(4) for purposes of FA 1996 Part 4 Chapter 2, so that it has the same effect as an election made under section 86(3A) of FA 1996, for the same accounting periods as it is valid for derivative contracts, but in relation to the company’s loan relationships in those accounting periods. In other words, if the company makes the election in relation to its derivative contracts, it is deemed to make the same election in relation to its loan relationships under section 86(3A) of FA 1996.

Mandatory mark to market accounting

There are two sets of circumstances where mark to market accounting is mandatory for tax purposes:

Bad debts

Schedule 26 paragraph 22 contains rules regarding bad debts. The rules permit relief for bad debts, and do not impose any tax liability where a claim between connected parties is released. Paragraph 22(1) provides that in determining the credits and debits which are to be brought into account under an accruals basis of accounting, the assumption which normally applies to a company’s derivative contracts, namely, that all amounts payable under those contracts will be paid in full as they fall due, does not apply in the cases of bad debts, doubtful debts that are assumed to be bad, or releases of liabilities to make payments of amounts.

The three exceptions, provided for in paragraph 22(3) and (4), only apply if the company’s derivative accounting arrangements also require adjustments - in the form of credits - to be made, if the whole or part of a debt that was regarded as bad, or which is estimated to be the amount of a bad debt, is ultimately paid, or for some other reason the bad debt no longer qualifies for the debit. The company’s derivative accounting arrangements which allow for the debit, must also require an amount payable under a derivative contract to be left out of account to the extent that the debit applies, and to be brought back into account, if it becomes a credit resulting from the ultimate payment of a bad debt or a claim that for some other reason ceases to qualify for the exception.

Where a company has incurred a liability to make a payment under a derivative contract, and that liability is released during an accounting period in which an accruals method of accounting is being used for that contract, then no credit is required to be brought into account pursuant to the release, provided that the release is part of a “relevant arrangement or compromise” covered by ICTA 1988 section 74(2).

Reclassification of derivative contracts

Where a company has entered into or acquired a derivative contract for the purposes of a trade carried on by it, but the purposes for which it entered into or acquired the contract cease to be the purposes for which it holds it, in other words, the contract is no longer held for the purposes of trade, then Schedule 26 paragraph 44 deems the company to have disposed of the contract immediately before the original acquisition purposes ceased, for a consideration equal to the fair value of the contract on the date on which the original purposes ceased, and to have reacquired it immediately after that date for the same consideration. Where the contract falls within the scope of TCGA 1992 as a result of the reclassification, then it will be deemed in terms of TCGA 1992 section 161(2) to have been acquired at that fair value.

Where a company holds a derivative contract, the underlying subject matter of which consists or is deemed to consist wholly of shares, units in a unit trust scheme, or assets representing loan relationships to which FA 1996 sections 92 or 93 apply, and the derivative contract is a chargeable asset in the company’s hands, and it was not entered into or acquired by the company for the purposes of a trade carried on by it, and it is subsequently appropriated by the company for the purposes of a trade carried on by it, Schedule 26 paragraph 45 provides that TCGA 1992 section 161, which governs appropriations to and from trading stock, is to apply to the appropriation of the derivative contract. The company is not permitted to make an election under section 161(3) to defer any gain or loss that results from the appropriation. An asset is deemed to be a “chargeable asset” for the purposes of paragraph 45, if any gain accruing on its disposal by the company would be a chargeable gain for the purposes of TCGA 1992. Included in the scope of paragraph 45 are obligations under futures contracts which are regarded as chargeable assets the disposal of which is subject to capital gains treatment under TCGA 1992 section 143.

Partnerships

Schedule 26 paragraph 49 provides that where a trade, profession or business is carried on by persons in partnership, and one of the partners is a company, and the partnership is a party to a derivative contract, then in computing the partnership profits or losses for corporation tax purposes in terms of ICTA 1988 section 114(1), no credits or debits are brought into account under Schedule 26 in respect of the contract. Instead each corporate partner determines the credits or debits that are allocable to it, based on its participation in the partnership business, as if the contract had not been entered into by the partnership but had instead been entered into by the corporate partner itself. Each corporate partner then accounts for its appropriate share of the total credits and debits that result from the contract, determined in the manner that would be used for apportioning partnership profits and losses.

Anti-avoidance

When a company or a person other than a company enters into a derivative contract, the tax treatment of the derivative contract is a factor that is invariably taken into account. The tax treatment may confer tax advantages on the taxpayer, either in the UK or elsewhere. Under UK tax law, the fact that a derivative confers, in addition to hedging or investment benefits, tax advantages on the parties, is acceptable, except if the sole purpose of entering into the contract is to obtain tax advantages. FA 2002 Schedule 26 contains provisions aimed at preventing avoidance of the tax measures imposed by those Acts.

Derivative contracts for unallowable purposes

Paragraph 23 provides that where a company is a party to a derivative contract for an unallowable purpose, then the credits and debits to be brought to account are determined in terms of the paragraph. Paragraph 24(1) deems a derivative contract to have been concluded for an unallowable purpose if the purposes for which the company is a party to the contract, or the purposes for which it entered into a related transaction in relation to the contract, include an unallowable purpose which is not included in the business or other commercial purposes of the company.

The expression “business and other commercial purposes” of a company is deemed by paragraph 24(2) not to include the purposes of any part of the company’s activities in respect of which it is not liable for corporation tax. This means that if a non-resident company which trades through a branch in the UK concludes a derivative contract at or through the UK branch, but the derivative contract is used to hedge an asset held by the company at its foreign head office, or the contact is concluded for the purposes of another foreign branch of the company, the anti-avoidance rule does not apply.

If the company concludes a derivative contract or enters into a related transaction in relation to a derivative contract for more than one purpose, and one of those purposes is a tax avoidance purpose, and the tax avoidance purpose is not the main purpose or one of the main purposes for which the contract was concluded or the transaction entered into, then the tax avoidance purpose is deemed in terms of paragraph 24(3) to be a “business or other commercial purpose” of the company. The implication of this provision is that a derivative contract or related transaction is deemed to have an unallowable purpose where the main purpose or one of the main purposes of the contract or related transaction is tax avoidance. The term “tax avoidance purpose” is defined as a purpose of securing a “tax advantage” for the company or for any other person. The term “tax advantage” is defined in ICTA 1988 Part 17 Chapter I. Where these conditions are complied for any accounting period, the company is required by paragraph 20(2) to use mark to market accounting for that period, for every derivative contract that would have had mark to market accounting applied to it had the company had been a UK company applying UK GAAP.

Paragraph 23(2) provides that where a derivative contract has been entered into for an “unallowable purpose”, the “exchange credits” generated by that contract that are attributable to the unallowable purpose on the basis of a reasonable apportionment, are not included in the credits generated by that contract. This means that where credits arise from “exchange gains”, as defined in paragraph 23(9), and are referable on a just and reasonable apportionment to the unallowable purpose, they are disregarded.

Similarly, paragraph 23(3) provides that for tax purposes, the debits generated by the contract that are attributable on a reasonable apportionment basis to the unallowable purpose, are not included in the debits that are generated by the contract. This means that where debits are attributable on a just and reasonable apportionment to the unallowable purpose, they are disregarded.

Where the debits disallowed under paragraph 23(3) exceed the exchange credits disregarded under paragraph 23(2), the difference between the two amounts, referred to by paragraph 23(4) as the “net loss”, may be brought into account by the company under paragraph 23(5). The result is that if the company has “accumulated net losses”, these can be brought by it into account, provided that in the same accounting period it has “accumulated credits”, other than “exchange credits”, but limited to the amount of the accumulated credits. Paragraph 23(5) thus provides for the bringing into account of accumulated net losses, so that they are not disregarded, provided that there are accumulated credits from the same derivative contract for the accounting period.

The term “exchange credit” is defined as a credit that is attributable to an exchange gain which arises to a company and which is included in its profits, in terms of paragraphs 15(1)(a) and 16. Paragraph 23(6) provides that a company’s “accumulated net loss” is determined by deducting the “net loss” for any prior accounting period from its net loss for the current accounting period. The effect of paragraph 23(6) is thus to define “accumulated net losses” as the net losses that are brought into account in the period in which the net loss arises, or in any earlier accounting period commencing on or after 1 October 2002, but after deducting the amounts used in any earlier period to enable a net loss in that earlier period to be brought into account.

Paragraph 23(7) provides that a company’s “accumulated credits” (other than “exchange credits”) for an accounting period are determined by taking its credits (other than “exchange credits”) arising in respect of a derivative contract for that or for any earlier accounting period, and deducting the net loss arising in respect of the derivative contract which was brought into account in any prior accounting period. Paragraph 23(7) thus defines “accumulated credits” as credits (excluding exchange credits) that are brought into account in the period in which the net loss arises, or in any earlier accounting period beginning on or after 1 October 2002, but after deducting the amounts used in any earlier period to enable a net loss in that earlier period to be brought into account.

For example, if in accounting period 1 a company has 1,000 credits in respect of a derivative contract, which are not disregarded under par 23(2), and in accounting period 2, it has 5,000 debits in respect of the derivative contract, as well as 200 exchange gains, and all the debits and credits are attributable to unallowable purposes, the company has a net loss of 5,000 – 200 = 4,800. In accounting period 2, 1,000 of the net loss is brought into account, because it matches the taxable credit in accounting period 1, and the balance of the net loss of 3,800 is disregarded. Or if in accounting period 1, a company has 5,000 debits in respect of a derivative contract, and 200 exchange gains, and all its debits and credits are attributable to unallowable purposes. The company therefore has a net loss of 5,000 – 200 = 4,800. In accounting period 2, the company has 1,000 credits in respect of a derivative contract which are not disregarded under paragraph 23(2). A net loss of 1,000 brought forward is brought into account in accounting period 2, because it matches the “accumulated credit” of 1,000 in that accounting period. The balance of the net loss of 3,800 is disregarded in both accounting periods, but it may be matched with accumulated credits in accounting period 3 or in subsequent accounting periods.

Paragraph 23(8) provides that amounts which cannot be deducted because of the restrictions imposed by paragraph 23 may not be deducted under any other provision of ICTA 1988. The effect of this provision is that amounts that are disregarded under this paragraph may not be brought into account in any other way, for example, as a trade expense under Schedule D Case I.

Debits and credits as capital expenditure

Paragraph 23 provides that if UK GAAP permits a debit or credit produced by an authorised accounting method in respect of a derivative contract to be treated in the company’s accounts as “an amount brought into account in determining the value of a fixed capital asset or capital project”, then notwithstanding GAAP rules, the debit or credit must be brought into account for corporation tax purposes in the accounting period in which it is computed, in the same way as a debit or credit which is brought into account in accordance with GAAP in determining the company’s profit or loss for that period. The effect of this provision is that where debits or credits on a derivative contract are capitalised (for example, interest rate swap payments capitalised because associated interest payments are capitalised), and the capitalisation conforms with UK GAAP, the debits and credits may be brought into account in the period in which the capitalisation occurs. Paragraph 25(3) provides that a debit may not be brought into account under paragraph 25 if it is taken into account in determining the amount of expenditure in relation to which a debit may be obtained under FA 2002 Schedule 29.

Value to connected company

Transactions between connected persons involving derivative contracts are covered by ICTA 1988 Schedule 28AA, which deals with transfer pricing, and which is applied to derivative contracts by paragraph 15.

Paragraph 26 deals with options contracted between connected companies and then abandoned. It provides that the value to be brought into account where the option is not exercised is the amount paid for the option.

Where an option is held by a transferor company as a derivative contract, and the option expires, and a result of the expiry is a transfer of value by the transferor company to a “connected” transferee company, and the transferee company is not liable to corporation tax in respect of the contract pursuant to Schedule 26, the transferor is obliged to bring into account what is referred to as the “appropriate amount” as a credit in respect of the contract, in the “appropriate accounting period”. (paragraph 26(1),(3).) The term “appropriate amount” is defined as any amount paid by the transferor to the transferee for the grant of the option by the transferee. The term “appropriate accounting period” is defined as the accounting period of the transferor in which the option expires. (Paragraph 26(4).) This provision applies to all options and warrants, without any of the exclusions relating to options provided for in other parts of the Schedule. In determining whether a “transfer of value” has occurred, it is presumed that if the transferor and the transferee had not been connected, the option would not have expired, and the option would have been exercised on the date on which it expired. (Par 26(2).) Paragraph 26(6) provides that for the purposes of this provision, a company is deemed to be a “connected company” in relation to another company, if in the accounting period in question, a “connection” exists between the two companies, and whether a connection exists is determined according to FA 1996 sections 87(3), (4) and 87A, but disregarding section 88.

Exchange gains and losses

Paragraph 27 provides that where a company is a party to a derivative contract, and an exchange gain or exchange loss arises in relation to the contract, and ICTA 1988 Schedule 28AA provides that the company’s profits and losses are to be computed for tax purposes as if the company was not a party to the derivative contract, then that exchange gain or exchange loss is ignored for the purposes of determining its Schedule 26 credits and debits. The effect of this provision is that, instead of ring-fencing losses on such contracts, it disregards both gains and losses to the extent that Schedule 28AA applies to the contract. Paragraph 27(1) thus applies to derivative contracts where Schedule 28AA applies as if the derivative contract had not been made, and paragraph 27(2) provides that any exchange gains and losses arising in that period on the contract are disregarded, so that Schedule 28AA does not apply to exchange gains and losses.

Where a company is a party to a derivative contract, and the contract produces an exchange gain or exchange loss, and ICTA 1988 Schedule 28AA requires the company’s tax profits and tax losses to be computed as if the terms of the derivative contract were terms that would have been agreed by the company and the counterparty to the derivative contract, had they been dealing at arm’s length, then the company’s Schedule 26 credits and debits are required to be determined on the assumption that in the accounting period in question, the amount of any exchange gain or exchange loss arising to the company from the derivative contract is an “adjusted amount”, that is, the amount of the exchange gain or exchange loss (including an exchange gain or nil) which would have arisen from the derivative contract has its terms been such terms that would have been agreed by the company and the counterparty had they been dealing at arm’s length. Par 27(3) thus applies where ICTA 1988 Schedule 28AA applies to part only of the derivative contract, because at arm’s length the terms of the contract (including the amounts of any payments) would have been different. In such cases, paragraph 27(4) provides that only the “adjusted amount” of exchange gains and losses are to be brought into account under Schedule 26.

Intragroup transactions

A “group neutrality” rule applies to intragroup derivative transactions. The effect of this rule is that where one group company replaces another group company as a party to a derivative contract, the assignment is ignored, except for the purpose of determining in which company’s tax computation the contract credits and debits should appear. For the purposes of this provision, whether or not companies are members of the same group is determined pursuant to the terms of TCGA 1992 section 170.

The rule applies to any “related transaction” between two group companies that are liable to corporation tax in respect of the transaction, and any series of transactions which have the same effect as a single related transaction between two group companies, each of which has been a member of the group at any time when the series of transactions took place, and which is liable for corporation tax in respect of the related transaction; any inter-company transfer of a business which effects or carries out long-term insurance contracts, and which falls under an insurance business transfer scheme referred to in section 105 of the Financial Services and Markets Act 2000, including an “excluded scheme” as defined in section 105(3) Case 2, 3 or 4 of that Act; and any inter-company transfer of the business of an overseas life insurance company, which is a “qualifying overseas transfer” as defined in ICTA 1988 Schedule 19AC paragraph 4A.

If the result of the transaction or series of transactions is that the transferee company directly or indirectly replaces the transferor company as a party to the derivative contract, paragraph 30 provides that the credits and debits to be brought into account for the purposes of Schedule 26 are to be determined by disregarding the transaction or series of transactions that results in the replacement. In other words, the transferor company and the transferee company are deemed to be the same company, except for the purpose of identifying the company in whose accounts any debit or credit not relating to the transaction or series of transactions, is to be brought into account. A company is deemed to replace another party to a derivative contract, where it becomes a party to any derivative contract which confers rights or imposes duties which are equivalent to any rights or duties of the other company under a derivative contract, where that other company was a party to that derivative contract. This anti-avoidance provision does not apply where the transferor company uses mark to market accounting for the derivative contract concerned. The amount brought into account by the transferee company in respect of the transaction or the series of transactions must, however, be the fair value of the derivative contract as at the date of its transfer to the transferee company.

Paragraph 29(1) creates an exception to the intragroup transactions rule for insurance business. It disapplies the first two categories of intragroup rules, in relation to the transfer of an asset or of any rights or duties under an asset or an interest in an asset, where the asset is included in the categories of assets held for long-term insurance business listed in ICTA 1988 section 440(4)(a) to (e), either immediately before the transfer or immediately afterwards. Exceptions to the third and fourth categories of intragroup transfer rules are created by paragraph 29(2), in relation to the transfer of an asset, or of any rights or duties under or interest in an asset, if the asset is falls within one of the categories of assets listed in ICTA 1988 section 440(4), immediately before the transfer, and the asset is not included in the assets listed in that category immediately after the transfer. Where one of the companies is an “overseas life insurance company” as defined in ICTA 1988 Part XI Chapter 1, an asset is deemed to fall in the same category both before and after the transfer, if the asset was in one category immediately before the transfer, and the asset is in the corresponding category immediately afterwards.

Non-residents

Paragraph 31 contains an anti-avoidance rule that applies where specified derivatives contracts to which non-residents are parties, are entered into by companies that are taxable under the Schedule. The paragraph 31 rule disallows any payment to a non-resident, where the payment is determined wholly or mainly by reference to a rate of interest, for example, periodic payments made under interest rate swaps or currency swaps. Paragraph 31 provides that where a derivative contract is entered into with, or has as a counterparty, a non-resident of the United Kingdom, then no “relevant debit” may be brought into account. The term “relevant debit” is defined as the excess of debits over credits which relate to periodic payments of notional interest under the derivative contract. This rule applies where a UK-resident company and a non-resident become parties to a derivative contract, or a UK-resident company becomes a party to a derivative contract to which a non-resident is a party, or a non-resident becomes a party to a contract to which a UK-resident company is a party. If these circumstances occur, the result is that for each accounting period for any part of which the UK-resident company and the non-resident are both parties to the derivative contract, the UK-resident company’s Schedule 26 credits and debits in relation to that derivative contract are deemed not to include any “relevant debit” that arises in relation to that contract, if the contract provides for the making of notional interest payments. The term “relevant debit” is defined as the excess of the aggregate of notional interest payments made by the company to the non-resident at a time when both the company and the non-resident are parties to the contract simultaneously, over the aggregate of any notional interest payments made by the non-resident to the company during that time. A “notional interest payment” is defined as any payment the amount of which is to be determined in whole or in part by applying a specified rate of interest to a notional principal amount specified in a derivative contract for a period specified in the contract.

Paragraph 31(5) provides that the prohibition against the taking into account of debits resulting from “notional interest contracts” entered into with non-residents does not apply where –

The term “financial trader” is defined in paragraph 54(4) of Schedule 26. The approval of the Board of HMRC is required in the case of a financial trader who is not required to be regulated, and so would not otherwise qualify as a “financial trader”. Where an agent is acting for an disclosed principal, and the principal is entitled to rights and duties under the contract, the principal rather than the agent will have to be approved by the Board. Statement of Practice 4/02 sets out the guidelines that the Board applies in determining whether a company qualifies as a “financial trader”. The company must demonstrate:

The Statement of Practice points out that where a company enters into derivative contracts with associated companies, then it will be easier for it to satisfy the third leg of the test if it also concludes a significant number of derivative contracts with third parties on the same terms. If it only contracts with associated companies, it will have to show that it contracts with them in the same way as if they were not connected with it. Factors that will be relevant in this context will be, first, the type and range of contracts that are concluded; second, the management of market risk; third, the assessment of credit risk; and fourth the level of fees or the spread that is earned.

Outside the scope of Schedule 26

Derivative contracts that fall outside the scope of FA 2002 Schedule 26, because they fail the accounting test in Schedule 26 paragraph 3, or because they fail the underlying subject matter test in Schedule 26 paragraph 4, or because they are held by persons other than companies, are taxed under income and corporation tax rules.

Profits or gains on most contracts outside the scope of Schedule 26 are taxed as capital gains or losses. Derivative contracts held as trading stock are valued on the basis of the lower of cost or market value. Derivative contracts that do not constitute trading stock are taxed on the realisation basis.

ICTA 1988 section 128 provides that for the purposes, firstly, of income tax, any gain arising from dealing in “commodity or financial futures” or in “qualifying options” as defined in TCGA section 143, which gain is not taxable in terms of ICTA 1988 Schedule 5AA, and which would constitute profit or gain that would be taxable under ICTA 1988 Schedule D otherwise than as the profits of a trade, is not taxable under Schedule D; and secondly, for the purposes of corporation tax, any gain arising to a company from dealing in “financial futures” or in “qualifying options”, which would constitute profits or gains that are taxable under Schedule D but not as the profits of a trade, are not taxable under Schedule D Case V or Case VI. In other words, the profits or losses of companies on the contracts described in the section 128 cannot be taxed under Schedule D Case VI (or Case V, if the derivative is a “foreign possession”). Section 128 was amended by FA 2002 Schedule 26 to ensure that for corporation tax purposes, the section does not apply where the contract falls within the scope of the derivative contracts rules, and profits generated by the contract are taxable under Case III as “non-trading credits”.

Guaranteed return

ICTA 1988 section 127A and ICTA 1988 Schedule 5AA provide that where profits and gains, including capital gains, that arise from disposal transactions in futures and options that are designed to produce a guaranteed returns are not otherwise taxable under Schedule D Case I or Case V, are taxed on the realisation basis as income under Schedule D Case VI. A future or option transactions is deemed to produce a guaranteed return, if risks from fluctuations in the underlying subject matter are eliminated or reduced with the result that the return on the instrument is not significantly attributable to such transactions, and equates to the return on an investment of money at interest.

TCGA 1992

The main legislation dealing with capital gains tax treatment of futures and options is contained in TCGA 1992 sections 143 – 144A. Profits arising on or after 6 April 1985 from transactions in commodity futures on a recognised futures exchange are, unless they are “trading profits” and fall within Schedule D Case I, are taxed as capital gains under section 143 TCGA 1992. Accordingly, since 6 April 1985, profits from such transactions have not been taxable under Schedule D Case VI. The pre-1994 rules still apply to persons other than companies, as well as to derivatives held by companies that fall outside FA 2002 rules.

Statements of Practice

SP 14/91 Tax treatment of transactions in financial futures and options, describes the tax treatment of transactions that are within the ambit of TCGA 1992 section 143, for accounting periods commencing not later than 30 September 2002.

The stated ambit of the Statement is UK residents, including investment trusts, unauthorised unit trusts, charities, and other persons including companies that either do not trade at all, or the principal trade of which is outside the financial sector, as well as to persons who are not resident in the UK, including non-resident collective investment entities and pension funds, and companies that either do not trade or the principal trade of which is outside the financial sector. Authorised unit trusts and approved pension funds are exempt from UK tax, and the Statement is therefore not applicable to them.

The Statement defines “financial futures” as including both exchange-traded and over-the-counter contracts for the delivery of shares, securities, foreign currency and other financial instruments; and contracts for differences, both cash-settled and delivery-settled, including contracts the underlying asset of which is a notional asset. The term “options” is defined as including both exchange-traded and over-the-counter options, both cash-settled and delivery-settled, as well as warrants.

The Statement says that ICTA 1988 section 128 and TCGA 1992 section 143 provide that transactions in financial futures and options are treated as capital transactions, unless they are regarded as profits or losses of a trade; that “trading profits and losses” fall outside the ambit of the two sections, and that the critical issue is therefore whether the taxpayer’s transactions in futures and options give rise to “trading profits or losses”. The Statement says that whether the taxpayer is trading or not is a factual question, but that HMRC is unlikely to consider that an individual who enters into speculative transactions to be trading. The financial futures or options transactions of a company, on the other hand, may constitute either trading or capital transactions. The Statement adds that a financial futures or options transaction that is “clearly ancillary to a trading transaction on current account” will itself be a trading transaction. A financial futures or options transaction which is “clearly ancillary” to a non-trading transaction will be a capital transaction. Whether a financial futures or options transaction is a trading transaction depends on frequency and intention. Whether a financial futures or options transaction is “ancillary to” another transaction, the following factors are relevant: there must be another transaction, which must have been undertaken or must be intended; the intention of the futures or options transaction must be to eliminate or reduce risks or costs that relate to the other transaction; and the futures or options transaction must be “economically appropriate” to its risk or cost reduction objective. In determining whether a futures or options transaction is “economically appropriate” to its objective, it must be shown to be reasonably appropriate for use to eliminate or reduce risk, it is permitted to be based on an index, and the value of its principal must not exceed the value of the principal of the underlying transaction. If the hedged transaction is terminated and the futures or options transaction is not closed out, the Statement says that it may be arguable that any subsequent profit or loss is of a trading nature, but that HMRC is unlikely to take this point in the light of the taxpayer’s original intention.

SP 3/02 Tax treatment of transactions in financial futures and options, describes the tax treatment of transactions that are within the ambit of TCGA 1992 section 143, for accounting periods commencing on or after 1 October 2002. The Statement covers UK residents, including unauthorised unit trusts, charities, and other persons including companies that either do not trade at all, or the principal trade of which is outside the financial sector, and persons who are not resident in the UK, including non-resident collective investment entities and pension funds, and companies that either do not trade or the principal trade of which is outside the financial sector. Profits that are derived from futures and options and which accrue to approved pension funds are exempt from UK tax, and the Statement is therefore not applicable to them. The Statement applies in relation to companies, for accounting periods beginning on or after 1 October 2002, but only to financial futures and options the underlying subject matter of which is shares, holdings in authorised unit trusts, or securities to which FA 1996 sections 92 or 93 apply. The content of the Statement relating to the determination of the “trading” status of a person, and the classification of a transaction as a “hedge”, are similar to the rules laid down in SP 14/91.