GREIT04020 - Property rental business income: loan relationships and derivative contracts: general
Loan relationship and derivative debits and credits are excluded from the computation of profits for a property business by section 211 CTA 2009. This prohibition is partly set aside in computing the profits of the property rental business (section 599(3) CTA 2010).
This set-aside allows the following credits and debits to be taken into account in arriving at the profits of the property rental business:
- those arising from a loan relationship if and in so far as it relates to property rental business
- those arising from a hedging derivative contract if and in so far as it relates to property rental business, and
- those arising from embedded derivatives if and in so far as the relevant contract is entered into for the purpose of the property rental business.
Section 599(4) CTA 2010 also ensures that not only is account taken of debits and credits from derivative contracts that hedge risk in relation to assets of the property rental business but also from derivative contracts that hedge risk in relation to a liability of the property rental business (e.g. debts used to fund the property rental business, which would be debtor loan relationships if and in so far as they relate to the property rental business), and to risks in relation to rent and expenses related to an asset (as well as the asset itself).
A derivative contract is hedging in relation to a company (in this case the deemed company which carries on the property rental business) if or in so far as it is acquired as a hedge of risk in relation to an asset by the exploitation of which the property rental business is conducted. For example, the company may have 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. In addition to hedging the value of the asset, section 599(5)(b) also ensures that profits attributable to it are also covered. The meaning of ‘hedging’ is explored further at GREIT04023.
Embedded derivative and relevant contract take the meaning provided in the derivative contracts legislation in Part 7 CTA 2009. More information on these definitions can be found in the Corporate Finance Manual glossary.
An example of an embedded derivative entered into for the purposes of the property rental business is where a lease contains a provision that the rent is adjusted upwards every year at five times the increase in the retail price index. The index-linking term is a derivative embedded in a host contract (the lease), and because the inflation adjustment is leveraged, the company may have to recognise the derivative separately in its accounts. Provided the lease itself is within the property rental business, the embedded derivative will also be part of the property rental business.
Where a property rental asset is hedged by a loan relationship with an embedded derivative (for example a Property Index Certificate (PIC) issued by the company owning the property), movements in the value of the PIC are within (section 599(3)(b) CTA 2010 (as it relates to the property rental business). Although shares in property companies or units in property unit trusts may appear to be property related these assets are outside the property rental business and it therefore follows that debits and credits arising on derivatives where these are the underlying subject matter are excluded for the purposes of calculating the profits of the property rental business.
These rules apply to calculate the profits of the property rental business of each member of a Group REIT to the extent that it carries on a qualifying property rental business.