A company owns quoted shares which currently have a market value
of £1.3 million. It wishes to protect itself from a fall in
the value of its investment. It therefore buys a put option from a
bank, with a strike price of £1 million, so that if the value
of the shares falls below that figure the company can sell them to
the bank for £1 million. Its potential loss is therefore
limited to £300,000.
However, the bank would require a substantial premium for
such an option. The company therefore enters into two further
option contracts with the bank. It sells the bank a call option
with a strike price of £1.6 million, so that its maximum
profit on the shares is also limited to £300,000. It also
sells a put option to the bank with a strike price of
£800,000, so that if the value of the shares falls below that
figure – an event judged to be extremely unlikely – it
must buy the shares back from the bank. Overall, this reduces the
net premium that the company must pay to the bank to a low figure,
or even to zero.
The shares are clearly a recognised asset of the company, and
changes in their value can affect the profit or loss of the
company. This is most obviously so if the company accounts for its
investment at fair value, but even if it is shown in the balance
sheet at historic cost, it is reasonable to expect that the company
will wish to realise the investment at some point, with a
consequent profit or loss.
The intention of the company in buying the put option is to
limit its exposure to the risk that the price of the quoted shares
will fall. It is likely that the company will have documentation to
demonstrate this – it may, for example, have a documented
risk management policy, and there are likely to be internal minutes
or notes leading up to the bank transaction. But even in the
absence of such documentation, it is difficult to see what other
motive the company could have for buying such an option.
It might be argued that the grant of the other options to the
bank is merely ancillary to this intention, a necessary measure to
limit the premium payable by giving the bank a chance to benefit
from an increase in the share price and by limiting the
bank’s downside exposure. HMRC would, however, take the view
that all three options are an integral part of the hedge. This
would be the case whether the company entered into three separate
contracts with the bank, or whether – as is more likely in
practice – the three options were combined into a single
“collar” contract.
There is therefore a hedging relationship between each of the
three options and the shares (or between a single collar contract
and the shares), so the condition at Para 4(2B) is satisfied and
the options are not within Sch 26.
A non-UK company, X, holds 80% of the shares in a UK company Y.
Y, in turn, has a wholly owned subsidiary, Z, carrying on a trade
in the UK. In return for a premium, Y grants an option to X: the
option is cash-settled, and the underlying subject matter is
Y’s shareholding in Z. On exercise of the option, X is
entitled to a sum representing the excess of the market value of
the Z shares over the strike price. The option, however, expires
without being exercised.
Y claims that the option was intended to hedge its
shareholding in Z, and therefore by virtue of Para 4(2B) is not
within Sch 26, so receipt of the premium gives rise to a capital
gain rather than an income receipt.
HMRC would consider the claim on the basis of the detailed
documentary and other evidence available. However, relevant factors
that might be taken into account would be:
