Derivative contracts: introduction: Tax Bulletin 66 (Sept 2003)
Swaps held by non-corporates: Tax Bulletin article
This article was published in Tax Bulletin 66 (September 2003). Although it deals with the position of non-corporates, the principles also apply where - exceptionally - a swap held by a company is not within Part 7 CTA09.
Swaps held by non-corporates
All statutory references are to ICTA 1988 unless otherwise stated.
Swap contracts, such as interest rate or currency swaps or certain kinds of credit derivative, are now widely used by traders and investors to hedge financial risks or to change their risk profile. Almost all swaps used by companies will fall within the derivative contracts rules of Schedule 26 FA 2002 (for accounting periods beginning on or after 1 October 2002). But we have been asked to clarify our views on the tax treatment of swaps held by non-corporates. The term “non-corporates” includes individuals, whether trading or not; trusts (including approved and unapproved pension schemes and charitable trusts); and partnerships whose members include individuals or trusts.
More specifically, we have been asked:
- whether profits from swaps held by exempt approved retirement benefit schemes come within the exemption in section 592(2) for “income derived from investments”, and
- whether, for a charity, a swap is capable of being a “qualifying investment” within Part I Schedule 20
- This article therefore deals both with the general position of non-corporates who hold swap contracts, and with the more specialised issues relating to approved pension schemes and to charities. It relates only to swaps (except in so far as it specifically refers to other sorts of derivatives). Different tax considerations may apply to other sorts of derivatives, such as futures and options.
The word “swap” is not found in the Taxes Acts. For the purposes of this article the term relates to any financial arrangement which would be regarded by the financial markets as a swap.
The general position of non-corporates
Our general view is that profits or losses on a swap held by a non-corporate, if they are not within Case I of Schedule D, will fall within Case VI.
Case I takes priority over any other possible charge to tax. Receipts or payments under a swap contract are on trading account where either
- the swap forms part of the circulating capital of a financial trade being carried on by the non-corporate, or
- the swap transaction is clearly ancillary to a trading transaction on current account. Swaps that hedge borrowing undertaken for trade purposes fall into this category, following the approach of example 10 in paragraph 17 of Statement of Practice 3/02
Where a swap is taken out by a non-corporate to hedge interest payments which are deductible in computing the profits or losses of a Schedule A business, then profits or losses on that contract will normally be taxed or relieved as receipts or deductions of that Schedule A business. There is further guidance on this in the Property Income Manual (PIM2100).
Profits or gains that are not of a capital nature, and which are not within Case I or Schedule A, will constitute “annual profits or gains not falling under any other Case of Schedule D” and will therefore be chargeable under Case VI (unless, exceptionally, they are within Case V). Periodic payments under a swap are not annual payments within Case III because they are not pure income profit - the person who receives them has counter-obligations under the swap contract. It follows that such sums are payable without deduction of income tax.
The case of Curtis Brown v Jarvis (14TC744) makes it clear that in assessing receipts under Case VI it is permissible to deduct associated payments. And, under Section 69, income tax under Case VI is charged on the full amount of profits or gains for the year of assessment. So the amount to be taxed under Case VI (or the Case VI loss) for a year of assessment will be the net amount receivable (or payable) under the swap contract in that year. If, however, the non-corporate prepares accounts and accounts for the swap on either an accruals or a mark to market basis, there is no objection to using the accounts figure as the measure of the “full amount of profits or gains”, provided that the accounts bring in the full economic profit on the swap over the life of the contract.
Users of swaps may sometimes receive or pay lump sums. For example, one party may pay a premium to enter into a swap, or a lump sum representing the net present value of outstanding rights and obligations under the contract may change hands if a swap is assigned or terminated early. Such lump sums will also be within Case VI if they are on revenue account. Whether a receipt or payment is capital or income is a question of fact in any particular case. But in general all cashflows made or exchanged under or in connection with a swap will be income, whether they take the form of periodic payments or are rolled up into a lump sum payable at any point.
It is sometimes contended that certain swaps are “financial futures” that, if not within Case I, are taken out of Schedule D by section 128(1) and are chargeable to capital gains tax by virtue of section 143 TCGA 1992. Statement of Practice 3/02 (or its earlier incarnation, SP 14/91) is sometimes quoted in support of this view.
We do not agree. Paragraph 4 of SP 3/02 makes the point that the statutory phrase “financial futures” is a wide term, encompassing cash-settled contracts as well as those settled by delivery, and over the counter contracts (including forward rate agreements) as well as exchange-traded contracts. But, wide as it is, it can only cover derivatives that are “futures”. The word “future” must be interpreted in its normal commercial sense. And - while there is some fluidity in commercial usage - the market will generally see swaps as falling into a different category from futures
SP 3/02 deals with the tax treatment of transactions in financial futures and options, not swaps. Nevertheless, when looking at a question of whether a swap transaction is within Case I, rather than Case VI, the Revenue will apply the general principles set out in SP 3/02.
Approved pension schemes
Section 592(2) allows exempt approved retirement benefit schemes to claim exemption from income tax in respect of income from investments, provided those investments are held for the purposes of the scheme. There are similar exemptions for retirement annuity schemes (section 620(6)), approved personal pension schemes (section 643(2)), schemes approved before 6 April 1980 (section 608(2)(a)), Parliamentary pension funds (section 613(4)) and certain overseas pension schemes (S614(3)). And section 271(1) TCGA 1992 contains related exemptions for capital gains accruing on the disposal of such investments.
Case law has established that the word “investment”, where used in the Taxes Acts, is to be understood in its normal commercial meaning. In particular, it is not limited to an income-producing asset: in Marson v Morton (59TC381), it was emphasised (at p393) that the interpretation of “investment” should reflect current commercial reality.
It is against this background that the question of whether a particular swap held by an approved pension scheme is an “investment” needs to be considered. Section 659A specifically provides that futures and options are investments for the purposes of section 592(2) and the related statutory provisions mentioned above. It was brought in by FA 1990 as a clarificatory measure; it is silent on swaps because, at that time, the use of swaps by investment funds was in its infancy. Section 659A therefore has no bearing on the tax status of swaps.
The question of whether a swap is held for the purposes of a trade is one of fact. Where a swap transaction by an approved pension scheme appears to fall close to the trading/investment borderline, the Revenue will look at the case on its merits.
However, where an approved pension scheme uses interest rate swaps, currency swaps, equity swaps, credit derivatives or similar instruments:
- to hedge risks inherent in its existing investment portfolio of shares, bonds or similar securities, or
- as part of an investment strategy to enhance the return from its existing investment portfolio, or
- to create a synthetic exposure to investments of a particular type or in a particular market, in line with the fund’s normal policies of investing directly in such instruments,
the Revenue will normally regard such swaps as investments.
The charity tax exemptions are subject to rules designed to restrict the exemptions where charities’ income and gains are used for non-charitable purposes. These rules also apply where charities make “non-qualifying” loans or investments. Where a charity invests its funds in a “non-qualifying investment”, the amount invested is treated as expenditure incurred for non-charitable purposes (section 506(1) and (4)). Part I Schedule 20 lists those investments that are “qualifying investments”. Para 9 Schedule 20 allows the Board to extend the “qualifying investment” designation to an investment not specifically listed, where such treatment is claimed. The Board must be satisfied that the investment is made for the benefit of the charity, and not for tax avoidance.
As outlined above in relation to approved pension schemes, “investment” takes its normal commercial meaning. It is capable of including a swap. While we cannot give advance confirmation that a particular swap will be a qualifying investment we can confirm that we will follow the Charity Commission guidance in their leaflet CC14 in deciding whether a particular swap is an investment. There is guidance in Annex III to the Detailed Guidance notes in the Charities pages on the Inland Revenue website that sets out the approach we adopt in deciding whether or not a particular investment is a qualifying investment.
However, even where the Board is satisfied that a swap contract held by a charity is a qualifying investment, profits arising on the swap will only be exempt from income or corporation tax if they fall within one of the categories listed in section 505(1).
The types of swap in normal commercial use will fall within the Schedule 26 FA 2002 derivative contracts regime (for accounting periods beginning on or after 1 October 2002) where the charity concerned is a company or unincorporated association. In such cases, profits from the swap will normally give rise to non-trading loan relationship credits, taxable under Schedule D Case III. The exemption for Case III income in section 505(1)(c)(ii) will apply.
Where the swap is held by a charitable trust, however, profits will in many instances fall within Case VI (see the above discussion of the general position for non-corporates). Case VI income from such a source does not fall within any of the section 505 exemptions. But there is a de-minimis exemption in section 46 FA 2000 which exempts most case VI income of charities below £5,000. It also exempts the lesser of £50,000 or the income if it is less than 25% of the charities’ incoming resources for the chargeable period.