Derivative contracts: exclusions from regime: splitting options and futures
Contracts with excluded and non-excluded subject matter
CTA09/S593 applies in the unusual circumstance of a future or option (not a contract for differences) having underlying subject matter (USM) that falls into one (or more) of the excluded categories (see CFM50710), and also USM which is not excluded. An example is an option or future that has both shares and a loan relationship as its USMs.
The legislation provides for such ‘mixed’ derivatives to be split into two notional contracts: one contract over the excluded subject matter, and a second contract over the non-excluded subject matter. You can apportion amounts appearing in the company’s accounts, or in the contract documentation, between these two notional contracts in any way which is just and reasonable.
Any subject matter that is ‘subordinate’ or ‘small’ (CFM50580) is ignored in deciding, for this purpose, what constitutes the USMs of the derivative.
You then apply the appropriate tax treatment to each of the two notional contracts.
In its accounting period to 31 December 2009, Pixfik Ltd pays a premium of £200,000 for an option. The option gives the company the right, but not the obligation to buy a specified number of bonds with attached warrants for a specified price. It can be exercised at any time between 1 July and 31 December 2010. The bonds are issued by an unconnected company, and the warrants give the holder the right to subscribe for a total of 100,000 £1 ordinary shares in the company at par. The warrants are capable to being detached from the bonds and traded separately. Both the bonds and the warrants are listed on a recognised stock exchange.
When Pixfik Ltd buys the option, the market value of the bonds with the warrant is £1.5 million, and their value without the warrant is £700,000.
The property that falls to be delivered if the option is exercised is two-fold:
- Bonds - these are not excluded subject matter.
- Warrants - these are classified as options for the purposes of Part 7: if these options are exercised, shares will be delivered. Thus, by virtue of CTA09/S583(2)(b), shares are a USM of the option acquired by Pixfik Ltd and are “excluded property” (CTA09/S589(2)).
The option can therefore, under CTA09/S593, be split into two notional options.
The first of these will be an option to acquire the bonds. Profits or losses on this option will be dealt with under the derivative contract rules (such an option would be treated for accounting purposes as a derivative, and therefore passes the CTA09/S579 test).
The second will be an option to acquire the warrants. The USM of this notional contract will be wholly shares. Provided that the company is not holding the option as trading stock, it would fall within the ‘condition C’ exclusion at CTA09/S591(4). It will not be a derivative contract, and profits or losses on this option would be taxed as chargeable gains or allowable losses.
It is necessary to decide how much of the £200,000 premium paid relates to each of the notional contracts. The sum can be apportioned in any way which is just and reasonable.
The company might, in making its self-assessment, use an appropriate option-pricing model to estimate the fair value of each of the two notional options, and apportion the £200,000 on that basis. This would clearly be just and reasonable. But it might use some more approximate method. HMRC will not challenge any such method unless it does appear unreasonable, and material sums of tax depend on the apportionment.