Policy paper

Statement of Practice 4 (2002)

Published 6 April 2002

Statement of Practice 4 (2002)

General

1. For accounting periods of companies beginning on or after 1 October 2002, Finance Act (FA) 2002 schedule 26 provides rules for the tax treatment of derivative contracts. This means futures, options warrants and contracts for differences, except where the underlying subject matter is:

• land, tangible assets (excluding commodities) or intangible fixed assets
• in some cases, shares

2. An anti-avoidance rule in FA 2002 schedule 26 paragraph 31 applies where certain derivative contracts to which non-residents are also party are entered into by companies to which the schedule applies. Broadly, this rule (which replaces FA 1994 section 168) disallows any payment to the non-resident which is determined (wholly or mainly) by reference to a rate of interest. This applies for example to periodic payments under an interest rate swap or currency swap. However, paragraph 31(5) of the schedule provides an exemption where the paying company is a bank, building society, clearing house or financial trader, holding the contract solely for the purposes of a trade carried on by it in the UK, and to which it is party as principal.

Definition of financial trader

3. The term ‘financial trader’ is defined in FA 2002 schedule 26 paragraph 54(4) as meaning, any person who (a):

• (i) falls within Financial Services and Markets Act (FSMA) 2002 section 31(1)(a), (b) or (c)
• (ii) has permission under that Act to carry on one or more of the activities specified in Article 14 and, in so far as it applies to that Art, Article 64 of the FSMA 2000 (Regulated Activities) Order, Statutory Instrument 2001/544

or

• (b) any person not falling within para (a) who is approved by the Commissioners for HM Revenue and Customs (HMRC) for the purposes of paragraph 54

4. The Commissioners’ approval under (b) above will, for instance, be relevant for a financial trader who does not need to be regulated and so would not qualify automatically as a financial trader by virtue of paragraph (a) above. Where an agent is acting for a disclosed principal and the principal is entitled to rights and subject to duties under the contract, the principal, as opposed to the agent, will require approval under (b).

5. This Statement of Practice explains the guidelines which the Commissioners for HMRC will operate in considering whether any person not within (a) above should be approved as a financial trader for the purposes of FA 2002 schedule 26 paragraph 54.

Financial trader guidelines

6. To obtain the Commissioners’ approval, a company must demonstrate that:

• it is carrying on a trade, the profits or losses of which would fall to be dealt with under Case I of schedule D
• this trade includes the provision of derivative contracts (within the meaning of FA 2002 schedule 26) to counterparties in the normal course of trade
• this part of the trade, on its own, satisfies the test in IRC v Livingston (11 TC 538) - ie, the operations involved must be of the same kind and carried on in the same way as those which are characteristic of ordinary trading in the line of business in which the venture is made

7. Where a company enters into derivative contracts with associated companies, then it will be easier for it to demonstrate that the third part of this test is satisfied if it also enters into derivative contracts to a significant extent with third parties on the same terms. Failing this, a company will need to produce evidence that it is conducting its operations with its associated customers in the same way as if they had been unconnected. Relevant considerations will include:

• the type and range of contracts into which it enters
• the management of market risk
• the assessment of credit risk
• the level of reward obtained in terms of fees or spread