Derivative contracts: underlying subject matter: introduction
The relevance of underlying subject matter
A key part of the accounting definition of a derivative (CFM50230) is that its value changes in response to a movement in an underlying subject matter (sometimes referred to as ‘underlying’ or ‘USM’). In many cases, the identity of that USM is intuitively obvious. For example, the value of a currency option will change with the spot price of the foreign currency concerned.
In other cases, the concept of the USM is more difficult to pin down. If an exchange-traded future is based on the price of gilts, for example, that price will change as interest rates change. Is the USM gilts, or is it interest rates? If a property derivative is based on an index of the total yield from commercial property (change in capital value plus rental income), is there a single USM or are rents and capital value changes two different things?
The legislation in Part 7 of CTA09 addresses these and similar questions by statutorily defining the USM of a derivative contract at S583. This chapter discusses the definition.
But why are we concerned to identify the USM (or subject matters) of a contract?
When the derivative contracts rules were introduced in 2002, certain derivatives were excluded because it was felt they were more aptly brought into account under some other regime. For example, futures and options over intangible fixed assets were - and still are - excluded because they are already dealt with by the intangible fixed assets rules in Sch 29 FA 2002.
Changes to the Sch 26 FA 2002 regime in 2004 and 2005 considerably reduced the number of derivatives that fall outside its scope because of their USM. However, some derivatives remain excluded - CFM50700+ deals with contracts that are excluded because of their subject matter.
If the USM of a relevant contract is shares (and nothing else) it will in many cases still be within the derivative contracts rules. There are, however, exceptions in which a contract over shares is excluded - see CFM50730.
Other parts of the derivative contracts legislation treat certain contracts differently because of their USM.
- Relevant contracts that have commodities as their USM satisfy the CTA09/S579 ‘accounting conditions’, even if they are not accounted for as a derivative (CFM50240). The same applies to contracts for differences with certain other USMs (CFM50380).
- The application of the Disregard Regulations (CFM57000 onwards) depends on the underlying subject matter of the contracts concerned. Thus Regulation 7 applies to contracts that have currency as their USM, Regulation 8 to commodity and debt contracts, and Regulation 9 to contracts that have interest rates as an USM.
- The provisions at CTA09 Part 7 Chapter 7 for some derivative contracts to be taxed on a chargeable gains basis (see CFM55000) applies only to contracts with certain USMs.
- There are other statutory provisions that relate to particular types of contract, where the USM is one criterion in deciding whether the provision applies - for example, CTA09/S645 applies only to embedded options where the USM is particular types of shares (CFM55220).