CFM13118b - Taxing derivative contracts: underlying subject matter: Para 46 example

Example of splitting an option

In its accounting period to 31 December 2003, Pixfik Ltd pays a premium of £200,000 for an option. The option gives the company the right, but not the obligation to buy a specified number of bonds with attached warrants for a specified price. It can be exercised at any time between 1 July and 31 December 2004. The bonds are issued by an unconnected quoted company, and the warrants give the holder the right to subscribe for a total of 100,000 £1 ordinary shares in the company at par. The warrants are capable to being detached from the bonds and traded separately. When Pixfik Ltd buys the option, the market value of the bonds with the warrant is £1.5 million, and their value without the warrant is £700,000.

The property that falls to be delivered if the option is exercised is two-fold:

• Bonds - these are not excluded subject matter.
• Warrants - these are classified as options for the purposes of Schedule 26: if these options are exercised, shares will be delivered. Thus, by virtue of Para 11(2) (b), shares are a USM of the option acquired by Pixfik Ltd and, in 2003, are an excluded subject matter.

The option held by Pixfik Ltd is a derivative financial instrument within the FRS13 definition, and therefore passes the accounting test in Para 3.

The bonds are clearly not of small value compared to the USM of the option considered as a whole, so nothing falls to be disregarded under Para 9.

The option can therefore, under FA02/SCH26/PARA46, be split into two notional options:

• The first of these will be an option to acquire the bonds. Profits or losses on this option will be dealt with under the derivative contract rules.
• The second will be an option to acquire the warrants. The USM of this notional contract will be wholly shares. If this notional contract was entered into for the purposes of the company's trade (for example, if Pixfik Ltd is a bank or financial trader) it would be brought within the derivative contract regime by Para 5 (see CFM13132). In these circumstances it would, of course, be pointless to split the contract under Para 46. But if the notional contract is not held for the purposes of the company's trade, it would be dealt with under CG rules.

It is necessary to decide how much of the £200,000 premium paid relates to each of the notional contracts. The sum can be apportioned in any way which is just and reasonable.

The company might, in making its self-assessment, use an appropriate option-pricing model (see CFM11084) to estimate the fair value of each of the two notional options, and apportion the £200,000 on that basis. This would clearly be just and reasonable. But it might use some more approximate method. HMRC will not challenge any such method unless it does appear unreasonable, and material sums of tax depend on the apportionment.