GREIT04023 - Tax-exempt income: loan relationships and derivative contracts: interpretation

Hedging – IAS designation and hedging relationships

If the company has, in its accounts, designated all or part of a derivative contract as a hedge, that designation is conclusive in determining whether, and to what extent, the contract is hedging (section 120(4)(b) FA 2006).

Where the contract does not meet IAS requirements for designation as a hedge (see CFM16267), it may nevertheless be accepted as ‘hedging’ for the purposes of section 120(3)(b)FA 2006. HMRC will accept that a derivative contract is hedging if it operates as a cash flow or fair value hedge in accordance with the criteria for a ‘hedging relationship’ to exist, as defined in regulation 2(5) of the 2004 Loan Relationships Disregard Regulations. This is explained in detail in CFM13274 onwards.

Property derivatives

Company C (a UK-REIT) may, as part of its business strategy, decide it wants exposure to shopping centres. To put that strategy in place, C may decide to acquire a property derivative that gives exposure to that sector for the length of time between deciding the strategy and buying some shopping centres.

Where the derivative is in relation to funds awaiting first investment in property, it will not be hedging in relation to C’s tax-exempt property rental business, because until the shopping centre is acquired, no asset of the tax-exempt business exists.

The derivative may be taken out as part of a strategy to switch an existing property portfolio from say commercial to shopping centres. Provided the commercial property was part of C’s tax-exempt business, and the derivative comes within the meaning of ‘hedging’ then the property derivative will be hedging in relation to C’s tax-exempt business.

Hedging derivatives normally get capital gains treatment under paragraph 45A Schedule 26 FA 2002. But the section 120(3) FA 2006 set-aside overrides paragraph 45A, and the gains or losses are within the ring fence in the same way as ‘income’ property derivatives.