CFM50070 - Derivative contracts: introduction: contracts outside of Part 7
Cases in which the derivative contracts rules do not apply
The great majority of derivatives held by companies will fall within the derivative contracts rules in Part 7 CTA09. Some contracts, however, may not meet any of the accounting conditions in CTA09/S579, or they may be equity derivatives that are excluded because they meet any of the conditions in CTA09/S591.
Other ways in which such derivatives might be taxed are considered below. These alternative possibilities also apply to derivatives held by persons other than companies within the charge to CT, for example, if a sole trader is party to a derivative for the purposes of his or her trade.
Where a company uses a forward contract or an option to buy or sell goods as a normal incident of its trade, it will not normally be accounted for as a derivative, and will therefore not satisfy the requirement in CTA09/S579(1)(a) - see CFM50210.
In many cases, the underlying subject matter (CFM50510) will be a commodity - for example, if a farming company enters into a forward contract with a grain wholesaler to sell its wheat crop. Where this is so, the contract satisfies the CTA09/S579(2)(a) condition, and is within Part 7.
Where it is not the case - for example, if a building company enters into an option agreement to buy land for the purposes of its trade - profits or losses on the contract will generally form part of the company’s trading profits. Since these will be computed on the basis of the accounts, it is in most cases immaterial whether the contracts are taxed under Part 7, or under the rules for trading income.
A non-corporate trader may use derivatives to hedge interest rates or other risks, in the same way as a company. Provided that the derivative is held for trade purposes, the profits will be trading profits. An individual may claim that his or her dealings in derivatives constitute a trade in itself - see BIM56880.
The profits of a property business within the scope of corporation tax are to be computed without regard to items giving rise to credits or debits within CTA09/PT5 or PT7. Thus amounts in respect of derivative contracts will give rise to non-trading amounts taken into account under CTA09/PT5.
Where an income tax payer uses a swap to hedge interest rate risk, foreign exchange risk, credit risk etc arising from assets, liabilities or transactions that are integral to a property business, profits or losses from the swap will form part of the profits or losses of the property business.
The derivative contracts rules do not apply to derivatives that are within the tax-exempt business of a UK Real Estate Investment Trust (REIT). There is more about this at GREIT04020 onwards.
Where a derivative is not within Part 7, and is not held for the purposes of a trade or property business, two possibilities for taxation remain - profits may constitute miscellaneous income (formerly Case VI Schedule D), or they may be taxable as capital gains. Normally, taxation as miscellaneous income would take priority over any capital gains charge. However, CTA09/S981 provides that gains arising to companies on financial futures, traded options or financial options are not taxable as miscellaneous income. ITTOIA05/S779 makes similar provision for income tax.
Gains on financial futures, and traded or financial options, are charged as capital gains under TCGA92/S143. (The same applies to commodity futures held by individuals for non-trade purposes - for companies, these will always be derivative contracts.) There is full guidance at CG55400 onwards. Options other than traded or financial options will nevertheless fall within capital gains rules on first principles - see CG12300 onwards.
If the derivative you are looking at is not a financial future (for example, a swap), profits and losses are likely to be taxable as miscellaneous income. HMRC’s views on this point were contained in Tax Bulletin article (TB66, September 2003), which is reproduced at CFM50080.
A ‘tax nothing’?
The legislation at Part 7 CTA09 forms a comprehensive code that over-rides any earlier case law principles. But where a derivative falls outside Part 7 (normally because it is not held by a company), it is possible for profits to be non-taxable, and losses not relievable, following principles laid down by case law. The most common example is spread bets entered into by an individual purely as a wager - see BIM22020. (This will not apply if the spread bet is used for a commercial purpose, for example as a hedge.) Note, however, that a spread bet entered into by a company will be a contract for differences and therefore a relevant contract and, unless the underlying subject matter is excluded, a derivative contract.
Where a derivative is entered into for no other reason than to gain a tax advantage, profits (or, more importantly, losses) may fall outside of Schedule D, on the authority of such cases as Lupton v FA & AB Ltd (47TC580) - see BIM20105.