CFM2400 - Taxing derivative contracts: what's new

The FA 1994 financial instruments legislation has been repealed and replaced by the derivative contracts legislation set out in Schedules 26, 27 and 28 FA 2002. The new Act extends the scope of the contracts that fall within an income regime, and the tax treatment now follows generally accepted accounting practise more explicitly. FA 2002 takes a completely different approach from FA 1994. In general it follows the style and language of the loan relationship legislation.

You will find that all of this part of the manual is new, so this page seeks to give only a brief overview of the changes introduced by FA 2002. Each section will tell you where to find more detailed instructions on the new rules. Summaries of the changes made in subsequent Finance Acts are also given on this page.

To use this page you can scroll down and read the whole text, or you may prefer to use the links below to jump to a particular section.

Scope

Basic rules

Bad debts

Anti-avoidance rules

Other special rules

Qualified exclusions

Special types of companies

Transitional rules

FA2003 amendments

Scope

FA 2002 introduces a new definition of what constitutes a derivative contract. The broad aim of FA 2002 is to include all types of contracts that are generally thought of as derivative contracts, whilst excluding the contracts that might be caught by a broad definition but which are not generally considered derivatives, e.g. insurance policies or guarantees.

The most complex part of the new rules is to decide if the contract you are examining is governed by the FA 2002 rules. To decide you need to go through four steps:

Is the contract an option, a future or a contract for differences? If yes, go to step 2. If no, it is not taxed under FA 2002.

Is it treated for accounting purposes as a derivative financial instrument (FRS13), or does it pass the accounting test? If yes, go to step 3. If no, it is not taxed under FA 2002.

Is the contract excluded from the derivative contracts regime because of its underlying subject matter?

There are special provisions for certain sorts of contract that have more than one underlying subject matter.

If the answer is no, then it is taxed under the FA 2002 rules. If yes, go to step 4.

Is it included because of special circumstances? The case you are likely to meet most frequently is if a company holds a contract for the purposes of its trade and the underlying subject matter is shares. Such a contract will be within the regime as it is held for the purposes of its trade, although the underlying shares are usually excluded at step 3. If no special circumstances apply it is not taxed under FA 2002.

CFM13200+ gives full details of the conditions that must be met, including a flowchart to help you decide if the FA 2002 rules apply.

Basic rules

The derivative contract rules follow the basic rules for loan relationships.

The debits and credits follow the accounting treatment as long as the company has used the authorised accounting method in FRS13 (or an equivalent calculation if it is a small company or foreign branch not operating FRS13).

The legislation goes on to treat

• trading exchange gains or losses as Case I credits or deductions, while
• non-trading exchange gains and losses are aggregated with other non-trading amounts to arrive at the Case III profit or non-trading deficit.

There are rules to deal with the situation where a contract either begins or ceases to be held for the purposes of a trade.

The basic tax treatment can be found at CFM13500+.

Bad debts

FA02/SCH26/PARA22 contains a similar rule on bad debts to that in the loan relationship legislation. A debit is allowed to the extent that the debt is a bad debt or estimated to be bad, providing that the accounts would include a credit for any release. Any exchange gain or loss must not be calculated on a bad or doubtful debt.

Unlike loan relationships, there is no restriction for bad debts between connected parties in respect of derivative contracts.

You will find full details on bad debts at CFM13605.

Anti-avoidance rules

Para 23, Sch26 FA 2002 reproduces the unallowable purposes provision also introduced for loan relationships by FA 2002. The rule applies with effect from 26 July 2001.

If a derivative contract is made for an unallowable purpose, any credits or debits are disregarded for tax, except to the extent that any net loss on the contract can be carried forward and set against future credits from the same contract.

There are also provisions which apply if a company transfers value to a connected company by letting a valuable option expire; or if a company makes, in certain circumstances, interest-like payments under a derivative contract to a non-UK resident.

These anti-avoidance rules are covered in the chapter on special tax rules, at CFM13600+.

Other special rules

Schedule 26 contains provisions to deal with other situations you are likely to meet less frequently. These are where:

• a derivative contract is transferred between companies in a group
• debits or credits relating to derivative contracts have been capitalised
• a transfer pricing adjustment falls to be made on a derivative contract, and exchange gains and losses arise under that contract, or
• the company's accounts show gains or losses on a contract which arise after the company has ceased to be a party to the contract.

There is guidance on these specialised provisions at CFM13600+.

Qualified exclusions

The normal rules for determining whether a contract is within Schedule 26 are dealt with at CFM13200+. If the underlying subject matter of the contract is shares, or an asset similar to shares, and the contract is not held for the purposes of a trade, it will fall outside of Schedule 26. However, such contracts are brought within the income regime in certain unusual circumstances. These are where there are arrangements to produce a guaranteed return, or a guaranteed amount payable on maturity, or the contract is held by the company to produce insurance benefits.

These qualified exclusions are covered at CFM13400+. You are most likely to need to look at this chapter if you deal with insurance companies.

Special types of companies

There are special rules for

• collective investment schemes
• insurance and mutual trading companies (guidance on the derivative contracts regime as it applies to insurance companies is given in the Life Assurance Manual, LAM4D.51+).

Transitional rules

Transitional rules prevent companies from shortening their accounting periods on or after 1 October 2001 in order to delay entry into the new regime. A company may want to delay because

• a credit would be larger, or a contract would now fall within the new rules
• a debit would be smaller

if taxed under the new rules.

To apply a company must have a shortened accounting period beginning on or after 1 October 2001 that ends before 30 September 2002. If the purpose of the shortened period is to avoid FA 2002 changes, then the new rules will apply from the beginning of the accounting period that includes 1 October 2001.

FA02/SCH28/PARA2 provides for contracts that have ceased before the accounting period beginning on or after 1 October 2002 but credits or debits were spread forward by an authorised accounting method. The amounts that should be brought in to each AP are taxed and relieved as if the legislation had not changed.

FA02/SCH28/PARA3 is a general transitional rule for existing financial instrument contracts under FA 1994, that makes sure that no amounts are brought into account twice, and no amounts are left out.

FA02/SCH28/PARA4 deals with contracts that were taxed as capital gains but are now treated as derivative contracts. The contract is valued at the beginning of the first AP within the new regime and any capital gain or loss calculated at that time. The future credits and debits are then treated as credits and debits under the derivative contract rules.

FA02/SCH28/PARAs 5 and 6 are transitional provisions for guaranteed amount payable on maturity and guaranteed return type contracts.

See CFM13700+ for details.

FA2003 amendments

The only amendments to the derivative contracts legislation made by FA2003 are to the provisions dealing with intra-group transfers of derivative contracts. They apply to transfers made on or after 9 April 2003.

FA02/SCH26/PARA28 has been amended to ensure that exchange differences arising on derivative contracts up to the date of transfer are charged on the transferor company, and those arising subsequently are charged on the transferee – see CFM13636. And it is made clear that Para 28 applies to transfers by way of novation, as well as assignment.

FA02/SCH26/PARA30 has been replaced by a new Para 30, which ensures that, where the transferor company accounts for the derivative on a mark to market basis, both transferor and transferee companies bring in the contract at the same fair value – see CFM13639.