Derivative contracts: exclusions from regime: equity derivatives: condition B
Derivatives that hedge shares or share capital
The second, more general, condition is that the company has entered into or acquired the contract for non-trading purposes (or the company is a mutual trading company), and there is a hedging relationship (see CFM50770) between the contract and shares or unit trust units held by the company. For periods of account ending on or after 31 December 2005, this is extended to contracts hedging the company’s own share capital.
But the contract cannot be an embedded derivative to which the company is party by virtue of CTA09/S585(2) (loan relationships with embedded derivatives), for example an option over shares embedded in a convertible security.
An investment company holds shares in a quoted company, X plc, but wishes to swap the return from its X plc holding for a more broadly-based equity return. It therefore enters into an equity swap under which it pays the capital return from X plc shares and receives a return based on the FTSE 100 index. There is a hedging relationship between the swap and the shares in X plc, since the swap is intended to limit the company’s exposure to changes in the fair value of the X plc shares. The swap is therefore not a derivative contract within Part 7 CTA09. It is likely that profits or losses on the swap would be treated as chargeable gains or allowable losses.
The exclusion in CTA09/S591(3) is, in practice, a relatively narrow one. Thus suppose in the above example the company had entered into a total return swap that swapped the yield on X plc shares for an interest rate. The swap could not be an excluded contract, because its underlying subject matter does not consist wholly of shares or other ‘excluded property’ (CTA09/S589(1)).
Again, suppose that a company decided to acquire a 20% stake in a particular company, Z plc. In order to hedge against changes in the Z plc share price in the period before it is actually able to buy the shares, it enters into a contract for differences based on the value of Z plc shares. The ‘condition B’ exclusion will not apply to the contract for differences, because what is being hedged is not shares that represent an asset of the company - it is a future commitment, or forecast transaction, to acquire the Z plc shares.