Investment trusts: interest distributions: qualifying interest income - derivatives
Derivatives and hedging
An investment trust’s qualifying interest income (QII) is also increased by credits, and decreased by debits, arising on certain derivative contracts. These are contracts where the underlying subject matter consists wholly of loan relationships or currency. For contracts for differences, which can only be cash-settled (see the Corporate Finance Manual at CFM50380), interest rates and creditworthiness are added to that list.
As for loan relationships, capital profits, gains or losses which, in accordance with the AIC Statement of Recommended Practice for investment trusts are taken to capital reserves are excluded (CFM54030).
A company may use derivatives to hedge interest rate risk or foreign currency risk arising from particular investments, or to replicate the economic effect of holding some particular asset or assets. Provided that they are treated as income in the accounts, credits or debits from any derivative having the required subject matter are taken into account in computing QII - it does not matter whether the derivatives are being used for hedging or as a synthetic investment.
Derivative contracts - subordinate or small value subject matter
Although regulation 8 SI2009/2034 states that the underlying subject matter should consist wholly of loan relationships, interest rates, credit worthiness and currency, under regulation 9 minor underlying subject matter not derived from these categories will not necessarily be excluded from the calculation of QII, as described below.
The minor subject matter must be either:
- subordinate to the excluded underlying subject matter, or
- small in value when compared to the underlying subject matter of the contract as a whole.
If these conditions are fulfilled, you can disregard the minor subject matter.
The test of whether the minor subject matter is subordinate, or of small value, is applied at the date on which the company enters into or acquires the relevant contract.
The word ‘small’ is not defined, but if the value of the minor subject matter is 5% or less of the value of the entire subject matter of the contract, HMRC will regard it as being small.
An investment trust enters into a contract for differences (with a counterparty bank). The contract for difference (CFD) is based on movements in an emerging markets bond index. This index tracks the total return (interest coupons plus price movements) on international bonds issued by the governments of emerging market countries. The effect of the derivative is to give the investment trust a synthetic exposure to such emerging markets bonds - in other words, similar profits (or losses) to those that would be generated by investing directly in a portfolio of the bonds.
Because the derivative tracks total returns, the Board of the investment trust concludes that, in line with the AIC SORP, part of the return is equivalent to ‘interest’ and should be recognised as income, while the remainder is capital.
For tax purposes, the CFD is a derivative contract, where the underlying subject matter (CFM50500+) is made up of loan relationships. It therefore comes within regulation 8 SI2009/2034. Credits, in so far as they are not taken to a capital reserve, will therefore form part of qualifying interest income (and any debits that are treated as income will reduce the QII).
Suppose, however, detailed scrutiny of the make-up of the index reveals that two out of the 50 bonds which are tracked are not conventional debt securities, but Islamic bonds (sukuk). There is no information about whether these satisfy the UK tax law conditions to be ‘alternative finance investment bonds’ (see CFM44120) and therefore whether it would be treated as loan relationships. It might therefore be argued that the underlying subject matter of the derivative contract is not wholly derived from loan relationships.
But these particular components of the index are subordinate in the context of the index as a whole (and probably also of small value), and can therefore be ignored. Their inclusion has no consequences in relation to the Regulations.