GREIT04025 - Tax-exempt income: loan relationships and derivative contracts: interest and netting off

Section 120(3) FA 2006 allows credits and debits from loan relationships and derivative contracts to be taken into account in arriving at profits of the tax-exempt business, so far as the loan relationship or derivative contract relates to tax-exempt business. Note however that this does not allow interest to be included in the profits of the tax-exempt business in the way that for example, interest on working capital is included in the profits of a trade.

In particular, interest received on funds held at the bank awaiting reinvestment falls outside the ring fence and is part of the income of the residual business. See also GREIT09010 regarding the treatment of funds awaiting re-investment for the purposes of the 75/25 income and asset tests.

The reasons for this are as follows. Rules that apply for Schedule D Case I apply also to computing the profits of a Schedule A business, unless otherwise provided (section 21A ICTA). One such exception is paragraph 2(3) section 15(1) ICTA. The partial set-aside of this exception for the profits of a tax-exempt business means that interest payable can be deducted in computing the Schedule A profits. What the set-aside cannot do is re-characterise Schedule D Case III income as Schedule A income, because of the mutual exclusivity of the schedules.

This is different from loan relationships relating to trade. Income from a trade is assessable under Case I of Schedule D. Although interest comes within the definition of income chargeable under Case III of that Schedule, the cases of Schedule D are not mutually exclusive and it is quite possible, where the creditor loan relationship is integral to the trade, for the interest to a receipt of that trade and within Case I. The commonest example of this is interest on working capital.

The netting off that normally applies for non-trading loan relationship debits and credits (section 82(3) FA 1996) does not apply here either. When the prohibition on loan relationship debits and credits is partially lifted for the tax-exempt business the effect is to take into the tax-exempt business profits computation debits and credits that relate to Schedule A business – which will automatically rule out interest on bank deposits, because this is taxable under Schedule D (Case III if there is no connected trade). Amounts arising under Schedule D (and thus outside the ring fence) cannot be netted off with amounts taken into a Schedule A calculation (and thus inside the ring fence).

The credits that will feature in computing the profits of the tax-exempt business will generally relate either to derivatives or to exchange gains. Suppose for example, the company has a currency derivative (under which it has a commitment to buy dollars for sterling) to hedge part of the dollar value of its USA property portfolio. If the dollar increases in value compared to sterling, the fair value of the contract will increase and give rise to a credit that would be available to net off, in the same way that a movement the other way would give rise to an allowable deduction.