PIM2140 - Deductions: interest: swaps held by IT payers
Swap contracts, such as interest rate or currency swaps or
certain kinds of credit derivative, are now widely used by
investors to hedge financial risks or to change their risk profile.
In TB66 published in August 2003 we set out our views on the
tax treatment of swaps held by non-corporates. The term
‘non-corporates’ includes individuals, whether trading
or not; trusts (including approved and unapproved pension schemes
and charitable trusts); and partnerships whose members include
individuals or trusts. TB66 deals with the general position of non-
corporates who hold swap contracts. It relates only to swaps
(except in so far as it specifically refers to other sorts of
derivatives). Different tax considerations may apply to other sorts
of derivatives, such as futures and options.
The word ‘swap’ is not found in the Taxes Acts.
For the purposes of TB66 the term relates to any financial
arrangement which would be regarded by the financial markets as a
swap.
Extract from TB66: The general position of non-corporates
Our general view is that profits or losses on a swap held by a
non-corporate, if they are not within Case I of Schedule D, will
fall within Case VI.
Case I takes priority over any other possible charge to tax.
Receipts or payments under a swap contract are on trading account
where either
- the swap forms part of the circulating capital of a financial trade being carried on by the non-corporate,
- the swap transaction is clearly ancillary to a trading transaction on current account. Swaps that hedge borrowing undertaken for trade purposes fall into this category, following the approach of example 10 in paragraph 17 of SP 3/02.
Where a swap is taken out by a non-corporate to hedge interest
payments which are deductible in computing the profits or losses of
a Schedule A business, then profits or losses on that contract will
normally be taxed or relieved as receipts or deductions of that
Schedule A business.
Profits or gains that are not of a capital nature, and which
are not within Case I or Schedule A, will constitute ‘annual
profits or gains not falling under any other Case of Schedule
D’ and will therefore be chargeable under Case VI (unless,
exceptionally, they are within Case V). Periodic payments under a
swap are not annual payments within Case III because they are not
pure income profit - the person who receives them has
counter-obligations under the swap contract. It follows that such
sums are payable without deduction of income tax.
The case of Curtis Brown v Jarvis [1929] 14TC744 makes it
clear that in assessing receipts under Case VI it is permissible to
deduct associated payments. And, under ICTA88/S69, income tax under
Case VI is charged on the full amount of profits or gains for the
year of assessment. So the amount to be taxed under Case VI (or the
Case VI loss) for a year of assessment will be the net amount
receivable (or payable) under the swap contract in that year. If,
however, the non-corporate prepares accounts and accounts for the
swap on either an accruals or a mark to market basis, there is no
objection to using the accounts figure as the measure of the
‘full amount of profits or gains’, provided that the
accounts bring in the full economic profit on the swap over the
life of the contract.
Users of swaps may sometimes receive or pay lump sums. For
example, one party may pay a premium to enter into a swap, or a
lump sum representing the net present value of outstanding rights
and obligations under the contract may change hands if a swap is
assigned or terminated early. Such lump sums will also be within
Case VI if they are on revenue account. Whether a receipt or
payment is capital or income is a question of fact in any
particular case. But in general all cashflows made or exchanged
under or in connection with a swap will be income, whether they
take the form of periodic payments or are rolled up into a lump sum
payable at any point.
It is sometimes contended that certain swaps are
‘financial futures’ that, if not within Case I, are
taken out of Schedule D by ICTA88/S128 (1) and are chargeable to
capital gains tax by virtue of TCGA92/S143. Statement of Practice
SP3/02 (or its earlier incarnation, SP14/91) is sometimes quoted in
support of this view.
We do not agree. Paragraph 4 of SP3/02 makes the point that
the statutory phrase ‘financial futures’ is a wide
term, encompassing cash-settled contracts as well as those settled
by delivery, and over the counter contracts (including forward rate
agreements) as well as exchange-traded contracts. But, wide as it
is, it can only cover derivatives that are ‘futures’.
The word ‘future’ must be interpreted in its normal
commercial sense. And - while there is some fluidity in commercial
usage - the market will generally see swaps as falling into a
different category from futures.
SP3/02 deals with the tax treatment of transactions in
financial futures and options, not swaps. Nevertheless, when
looking at a question of whether a swap transaction is within Case
I, rather than Case VI, HMRC will apply the general principles set
out in SP3/02.
ITTOIA05 changes
For 2005-06 onwards replace the references to:
- Case 1 of Schedule D by trading income within Part 2 of ITTOIA05.
- Schedule A by property income within Part 3 of ITTOIA05.
- Case VI of Schedule D by income within ITTOIA05/S688.
