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HMRC internal manual

Corporate Finance Manual

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Derivative contracts: exclusions from regime: contracts beginning or ceasing to be derivative contracts

Contracts moving in or out of Part 7

It is possible for a relevant contract to move into, or out of, the derivative contracts regimes. This will most commonly happen to equity derivatives where one of the exclusions in CTA09/S591 either begins or ceases to apply. But this is not the only circumstance in which a contract might begin or cease to be a derivative, and this part of the guidance does not apply only to equity derivatives.

Example 1

A company holds shares in a quoted company, Y plc. It hedges itself against changes in the fair value of the portfolio by entering into a short position in exchange-traded futures over Y plc shares. (Thus, if the share price falls, the value of its derivatives position will increase.) It is agreed that there is a hedging relationship between the futures contracts and the shares, so the exemption at CTA09/S591(3) applies, and the futures are not ‘derivative contracts’. Subsequently, however, the company disposes of its shares without closing out the futures position. There is no longer a hedging relationship, and the exemption no longer applies - profits or losses on the futures are now taxed as income.

Example 2

A bank holds an option to subscribe for shares in a company. The option is listed on a recognised stock exchange. However, the option is held on the bank’s trading book (i.e. for the purposes of the bank’s trade), so the exemption at CTA09/S591(4) for quoted options does not apply - the option is a derivative contract. But the bank subsequently transfers the option from its trading to its banking book (i.e. it becomes an investment rather than trading stock). The exemption will now apply, and the option ceases to be a derivative contract.

CTA09/S661 covers the case where a contract, which was previously a chargeable asset, becomes a derivative contract. CTA09/S622 and CTA09/S662 between them cover the converse case where a contract ceases to be a derivative contract, and becomes a chargeable asset - S622 deals with the derivative contracts implications, and S662 with chargeable gains. In both instances, the aim is to ensure that all profits and losses on the contract are taxed once (and only once) over its life.

‘Chargeable asset’ is defined (for the purposes of Part 7 generally) at CTA09/S703. It is an asset, gains on disposal of which would be chargeable gains. ‘Asset’, for this purpose, specifically includes obligations under a futures contract within TCGA92/S143.

Sections 661 and 662 only apply if the relevant contract, not being within Part 7, is a chargeable asset. They have no application if profits or losses on the contract would, in the absence of the derivative contracts legislation, be charged as trading income or miscellaneous income (although this will be less usual).

These provisions, previously at FA02/SCH26/PARA43A and 43B, apply only where a contract begins or ceases to be a derivative contract on or after 30 December 2006, in an accounting period ending on or after that date. See CFM50850 if such a transition happens before that date.

More detailed guidance on section 661 and sections 622 and 662 is at CFM50830 and CFM50840 respectively.