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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Derivative contracts: exclusions from regime: hedging relationship: examples

Examples illustrating the definition of ‘hedging relationship’

Example 1

A company owns quoted shares which currently have a market value of £1.3 million. It wishes to protect itself from a fall in the value of its investment. It therefore buys a put option from a bank, with a strike price of £1 million, so that if the value of the shares falls below that figure the company can sell them to the bank for £1 million. Its potential loss is therefore limited to £300,000.

However, the bank requires a substantial premium for such an option. The company therefore enters into two further option contracts with the bank. It sells the bank a call option with a strike price of £1.6 million, so that its maximum profit on the shares is also limited to £300,000. It also sells a put option to the bank with a strike price of £800,000, so that if the value of the shares falls below that figure - an event judged to be extremely unlikely - it must buy the shares back from the bank. Overall, this reduces the net premium that the company must pay to the bank to a low figure, or even to zero.

The shares are clearly a recognised asset of the company, and changes in their value can affect the profit or loss of the company. This is most obviously so if the company accounts for its investment at fair value, but even if it is shown in the balance sheet at historic cost, it is reasonable to expect that the company will wish to realise the investment at some point, with a consequent profit or loss.

The intention of the company in buying the put option is to limit its exposure to the risk that the price of the quoted shares will fall. It is likely that the company will have documentation to demonstrate this - it may, for example, have a documented risk management policy, and there are likely to be internal minutes or notes leading up to the bank transaction. But even in the absence of such documentation, it is difficult to see what other motive the company could have for buying such an option.

It might be argued that the grant of the other options to the bank is merely ancillary to this intention, a necessary measure to limit the premium payable by giving the bank a chance to benefit from an increase in the share price and by limiting the bank’s downside exposure. HMRC would, however, take the view that all three options are an integral part of the hedge. This would be the case whether the company entered into three separate contracts with the bank, or whether - as is more likely in practice - the three options were combined into a single ‘collar’ contract.

There is therefore a ‘hedging relationship’ between each of the three options and the shares (or between a single collar contract and the shares), so the condition at CTA09/S591(3) is satisfied and the options are not derivative contracts.

Example 2

A non-UK company, X, holds 80% of the shares in a UK company, Y. Y, in turn, has a wholly owned subsidiary, Z, carrying on a trade in the UK. In return for a premium, Y grants an option to X: the option is cash-settled, and the underlying subject matter is Y’s shareholding in Z. On exercise of the option, X is entitled to a sum representing the excess of the market value of the Z shares over the strike price. The option, however, expires without being exercised.

Y claims that the option was intended to hedge its shareholding in Z, and therefore by virtue of CTA09/S591(3) is not within Part 7, so receipt of the premium gives rise to a capital gain rather than an income receipt.

HMRC would consider the claim on the basis of the detailed documentary and other evidence available. However, relevant factors that might be taken into account include:

  • To what extent, if at all, does the written option hedge Y’s exposure to changes in fair value of the Z shares? A written option cannot be designated as a hedging instrument under IAS 39 or FRS 26 (unless it offsets a purchased option), because in general it is not effective in reducing the profit or loss exposure of a hedged item. While it is not necessary for a hedge to be highly effective in order for a ‘hedging relationship’ within CTA09/S707 to exist, if - as a matter of fact - a purported hedge is not effective, it may cast doubt on the company’s intention in entering into the relevant contract.
  • Is it part of the company’s normal risk management policy to hedge shareholdings in subsidiaries, where these are accounted for at cost?
  • Is there any evidence pointing to some alternative intention? Here, at first glance, it seems possible that Y entered into the arrangements with the intention of distributing profits in the UK trading enterprise to X, over and above any dividend paid on ordinary shares.