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HMRC internal manual

Company Taxation Manual

Distributions: general: interest or other value in respect of securities - hedging arrangements

CTA10/S1008 and CTA10/S1012

A company issuing a security the performance of which is designed to reflect the performance of underlying assets will not usually wish to assume the risk associated with that security. For example, if the company issues a security that reflects the performance of a leading FTSE100 company, it will want to be covered against the risk that the value of that company’s shares increases. The issuer will not want to make a loss on the transaction and may, therefore, enter into hedging arrangements.

Hedging arrangements are defined in CTA10/S1014 as arrangements whose purpose, wholly or in part, is to provide income or gains intended to offset the amounts payable under the terms security. The wording of the subsection is phrased in accountancy terms; a Revenue Accountant should be consulted in material cases of difficulty concerning the existence of hedging arrangements.

Hedging arrangements may be indirect and do not have to involve, for example, the issuer holding the shares whose performance the security reflects. The management by the issuer of the security of the risks involved may result in the issuer holding unrelated assets, financial instruments or even liabilities.

CTA10/S1012 (1) disapplies CTA10/S1008 if there are or were hedging arrangements relating to all or some of the issuing company’s obligations under the security.

This subsection has the effect of reinstating the amount of the principal secured as the minimum amount of capital guaranteed to be returned on redemption. This increases the probability of the return on the security being treated, at least in part, as a distribution under CTA10/S1000 (1) E.

There is an exception to this general rule, so that CTA10/S1008 will apply, if four conditions (A to D in CTA10/S1013) are met. Treatment under CTA10/S1008 is never available once the security has fallen foul of any of the four conditions, even if that failure has been put right (CTA10/S1012 (2)).

Condition A (CTA10/S1013 (2))

The hedging arrangements, or a wider scheme or arrangement that includes them, should not have as a main purpose of the avoidance of tax or stamp duty. A number of points arise.

  • The legislation clearly envisages that there can be more than one main purpose, and the tax avoidance aspect of the scheme or arrangements need not be the hedging arrangements.
  • To consider this test, it may be necessary to decide the nature of the wider scheme or arrangement. It is a broad test and may reach beyond consideration of the security in question.
  • It is not sufficient for tax avoidance to be present. If the avoidance feature of the scheme or arrangements is minor or incidental, it may not be significant enough to constitute a main purpose.

Condition B (CTA10/S1013 (4))

Where there is a CT deduction in relation to a security by the issuing company every amount that is intended under the hedging arrangements to offset that deduction must be realised

  • in the issuing company or in a group member of the issuing company
  • at the same time or within a reasonable amount of time.

This condition prevents companies or groups obtaining a significant timing advantage. In practice, the very nature of hedging arrangements will mean that there will be only a negligible time difference in most cases.

The deduction is likely to be the interest, and the word ‘offset’ is in the context of definition of hedging arrangements. The ‘incoming’ need not reduce the amount of the deduction for interest, but it must be an amount intended to have the end effect of meeting some or all of that cost.

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Condition C (CTA10/S1013 (6))

Condition C requires that every amount of income or gain that is intended under the hedging arrangements to offset the amounts paid out under the security (see condition B above, CTA10/S1013 (4) and (5))

  • must be brought into charge to CT in the issuing company, or
  • must be brought into charge to CT in one or more of its group companies.

This does not prevent there being reasonable expenses for establishing and administering hedging arrangements because these amounts will not impact on the incomings.

If all or part of the assets held under the hedging arrangements are equities, the issuing company might not meet this condition as distributions received from UK companies would not be taken into account in computing income (because of CTA09/S931A).

In the case of banks and securities houses, however, the distributions are taken into account in computing profits under CTA09/S931W.

It does not matter if the income or gains are first realised in a foreign group company provided the end result is that the full amounts are brought within the charge to CT within a reasonable amount of time as required under condition B.

The purpose of this condition is to prevent, for example, a deduction being allowable for tax purposes, perhaps in a bank’s account, with the dividend income representing an offset under the hedging arrangements arising in an investment company subsidiary where it is not liable to CT.

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Condition D (CTA10/S1013 (7)

Condition D deals with avoidance that may occur due to excessive expenses relating to the hedging arrangements. These could arise, for example, if hedging arrangements were established and administered in an overseas subsidiary of the issuer. The provision requires any deductions for CT in respect of the expenses of the hedging arrangements to be:

  • reasonable, and
  • proportionate to the amounts brought into charge to CT as required under condition C.

It is possible for a security to meet the four conditions and subsequently fall foul of one or all of them. In this situation:

  • CTA10/S1000 (1) E comes back into operation at the time of the failure to meet the conditions.
  • When this happens, the view of what is a commercially reasonable return for the principal secured (regardless of the amount of new consideration) is considered according to the relevant facts as they would have applied at time the security was issued. The commerciality of the return is not judged according to the facts applying at the time of the failure - CTA10/S1012 (2).

Members of the same group are identified using the group relief rules (CTA10/S1013 (8)).