Loan relationships: tax avoidance: index-linked gilt-edged securities: example
A company holds index-linked gilt-edged securities and receives a total return from those gilts of £500m.
£400m of that return relates to the element that derives from movements in the RPI (i.e. the increase in carrying value relating to RPI).
The company has entered into a total return swap such that it pays away the return that it receives from holding the index-linked gilt-edged security (perhaps receiving a LIBOR-based return instead).
As the company will be paying away the return of £500m it will remain economically flat.
£400m of the return from the index-linked gilt-edged securities related to changes in carrying value due to movements in the RPI and so therefore only £100m of the total return of £500m will be taxable.
Against this, the full amount of £500m paid away under the total-return swap will be tax deductible.
The final position is:
Taxable Credits £100m
Taxable Debits £500m
So, a net tax loss of £400m is created from nothing more than a combination of essentially circular transactions. The end result is a significant tax advantage and no economic exposure.