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HMRC internal manual

Corporate Finance Manual

Derivative contracts: introduction: fundamental rules

CTA09/S594A, S595

Amendments were made to the basic machinery provisions in F(No.2)A15, applicable to accounting periods beginning on or after 1 January 2016.

Post 1 January 2016

Determining what is to be brought into account, how much and when involves two basic elements. The nature of the amounts to be brought into account (“the matters”) is primarily determined by S594A. Then, the amounts and timing are determined primarily by reference to amounts recognised as profit or loss in a company’s financial statements as prepared in accordance with generally accepted accounting practice (GAAP) - S595.

The matters

S594A sets out the subject matter of taxation under the derivative contracts provisions. The ‘matters’ in respect of which amounts are brought into account under PT7 in respect of a company’s derivative contracts are:

  • profits and losses of the company which arise to it from its derivative contracts and related transactions (excluding expenses), and
  • expenses incurred by the company under, or for the purposes, of those contracts and transactions.

‘Related transaction’ has a very broad meaning, to include any disposal or acquisition, in whole or in part, of rights or liabilities under a derivative contract. There is more about this at CFM51060. S594A(2) sets out what may be regarded as expenses.

The amounts to be brought into account in respect of the matters

S595(2) sets out the general rule which is that the amounts to be brought into account by a company as credits or debits for any period for the purposes of PT7 in respect of the matters mentioned in section 594A(1) are those which are recognised in determining the company’s profit or loss for the period in accordance with generally accepted accounting practice.

Generally accepted accounting practice (GAAP) is defined in CTA10/S1127 as IAS where a company prepares IAS accounts and will mean UK GAAP in other cases. IAS accounts are accounts prepared in accordance with International Accounting Standards, and a standard may be applied in its current form at any particular time, or as adopted by the EU. (More recent international standards are entitled, International Financial Reporting Standards, or IFRS, but these fall within the ambit of the statutory definition of IAS).

The meaning of “taken to profit or loss” is expanded in S597. It is an amount that is recognised in a company’s accounts for a period as an item of profit or loss. This will be the amounts recognised in the company’s income statement or profit and loss account, assuming that it prepares such a statement.

In particular it will not include an amount recognised as an item of other comprehensive income (OCI). However, S597(1A) specifically includes an amount previously recognised in other comprehensive income at the point it is transferred to profit or loss in later period. In addition, it will not include an amount recognised directly in equity. This pattern is exactly the same as for loan relationships, see CFM33065.

The limitation of the normal scope of the amended legislation to amounts recognised in determining the company’s profit or loss is a change from the earlier legislation. Although there are still special rules which modify the basic rule, there are fewer more cases whether amounts reflected in a company’s accounts do not directly determine the amount taken into account for tax purposes.

The F(No.2)A15 changes have continued the process of aligning the fundamental operation rules in the loan relationships and derivative contracts ever more closely with amounts recognised in GAAP-compliant amounts. Now the fundamental determinant of whether an amount in respect of a ‘matter’ is taxable or not is whether it is, under GAAP, treated as an item of profit or loss.

Pre 1 January 2016

For accounting beginning before 1 January 2016, s595, as it then stood, set out both the subject matter of taxation and how amounts brought into account were to be determined.

The basic rule was as follows. The credits and debits to be brought into account are those which, when taken together, ‘fairly represent’ for the accounting period in question all profits and losses of the company which arise to it from its derivative contracts and related transactions, and all expenses incurred by the company under or for the purposes of those contracts or transactions (CTA09/S595).

The credits and debits in question were those that are recognised in determining the company’s profit or loss for the period in accordance with generally accepted accounting practice (GAAP). For the meaning of ‘GAAP’, see above.

However, there was a tax definition of amounts recognised in determining a company’s profit or loss which was broader in scope than the accountancy meaning of profit or loss.. This earlier legislation also made reference to accounting terminology that is now obsolete. In particular, credits or debits in reserves, for example, the Statement of Total Recognised Gains and Losses, or the Statement of Changes in Equity were brought into account as well as those in the profit and loss account or income statement.

The phrase “fairly represents” has been the subject of judicial guidance in HMRC v GDF Suez [2018] EWCA Civ 2075, where it has been shown that it can act as a statutory override to the amounts recognised in the company’s account. See CFM51050.

Overview of provisions that may modify the effect of the basic rules

The effect of the basic rules may be modified or clarified by further detailed provisions. Some of these rules were changed by F(No.2)A 2015, but in most cases the position was not materially changed. The most important rules are as follows:

  • If the company does not draw up accounts in accordance with GAAP, the rules operate as if it did.
  • Amounts shown in the accounts relating to derivative contract “matters” are brought into account for tax purposes even if the company is no longer party to the derivative contract S607A, previously S608.
  • There are special provisions to ensure that amounts do not drop out of account when a company changes its accounting policy, even if profits or losses from a revaluation of the company’s derivative contracts are not explicitly shown in the accounts (CFM52030).
  • Where a derivative contract is transferred between two companies in the same group, the transfer is treated as giving rise to neither a gain nor loss (CFM53000).
  • The Disregard Regulations modify the normal computational rules in certain situations where a derivative contract acts as a hedge (CFM57000).
  • Foreign exchange gains and losses on derivative contracts that are used to hedge a company’s investment in a foreign operation may be disregarded (and may later be brought back into account) under the ‘forex matching’ provisions (CFM62000).
  • Securities that are convertible into, or exchangeable for, shares, or securities where the redemption value is linked to the value of shares, may contain embedded derivatives from a tax perspective. Where these are recognised separately for tax purposes, special rules apply. There are also special provisions for derivatives embedded into other types of contract and for certain sorts of property derivatives (CFM55000).
  • Anti-avoidance rules may apply in certain cases (CFM56000). Before the F(No.2)A15 changes, targeted anti-avoidance provisions in CTA09/S606A prevent exchange gains from being matched where a ‘one way exchange effect’ is present (CFM63100). These have been superseded by the regime-wide anti-avoidance rules in S698B-698D {CFM56200}.

Other rules

The amounts to be brought into account under the derivative contracts regime may be affected by other rules outside of the regime. The main rules which can apply are:

  • Transfer pricing rules (CFM56050)
  • Hybrid mismatch rules (INTM850000)
  • Group mismatch rules (CFM77500)
  • Corporate interest restriction (CFM95000)

Further guidance

For detailed guidance on the matters and computational provisions, see CFM51000+.