CFM50550 - Derivative contracts: underlying subject matter: contracts for differences examples

Examples of underlying subject matter of CFDs

Example 1

A company enters into an interest-rate swap whereby it pays an amount computed by applying a floating rate of interest on a notional principal amount at a floating rate, and receives an amount equal to the interest arising on a fixed rate bond of an equal principal amount (the reference bond). (Payments might be subject to netting under the terms of the master agreement governing the contract).

It might possible to take two views on the application of CTA09/S583(4) to such a contract. The payments made under the contract will depend on the market rate of interest, which is equivalent to the interest on the notional debt. The USM of the swap, a contract for differences, might be seen as a loan relationship, the reference bond. Alternatively, interest rate(s) will be a factor designated by the contract, so the USM can be seen as being an interest rate or rates. As there is no possibility of the reference bond being delivered and the amount payable does not depend directly on the value of the bond, the latter view is more compelling.

In any case, HMRC’s view is that little, if anything, hinges on this point. For the purposes of Regulation 9(4) of the Disregard Regulations (SI 2004/3256), the subject matter of the contract will be, or will include, interest rates, so it will be an ‘interest rate contract’ as defined. The inclusion of ‘interest rates’ as a possible USM of a CFD in S583(5) is for the avoidance of doubt.

As with futures, the statute draws a distinction between the property described in the contract, and any property that might be used to make payments under the contract. Suppose, in this example, the notional principal amount of the swap was designated in euros, and the company was swapping floating-rate euro interest for fixed-rate euro interest. It would therefore be making payments in euros. This does not mean that currency is an USM of the swap.

On the other hand, if the floating interest rate was in sterling, but the reference bond denominated in euros and the difference between the two notional principal amounts had to be settled on maturity of the swap.

If under one leg of the swap involved payment by the company of a floating rate of interest on a notional principal amount, plus any fall in the value of the reference bond over the interest period and the other leg receipts equal to the fixed interest on the reference bond, plus any increase in value of the bond over the interest period, the underlying subject matter would then be the reference bond. The floating rate leg would simply be a neutral anchor, as if the company had borrowed at floating rate to buy the actual reference bond. At the start of each interest period, the present value (discounted) of the payments eventually due to be made floating leg plus notional principal would always approximate to the notional principal.

Example 2

A company enters into an option contract based on a commercial property price index. If the index rises above a specified reference level, the company can exercise the option and will receive a payment based on the difference between the reference level and the actual level of the index at the exercise date.

For the purposes of CTA09/PT7, the contract is a CFD because there is no property which is capable of being delivered when the option is exercised (see CFM50340). The index is compiled by taking a weighted average of the market values (excluding any rental income) of a defined basket of commercial properties. The matter by which the index is determined is therefore, ultimately, land - this is the USM of the option contract.