Derivative contracts: embedded derivatives: example of S616
Example: embedded derivative in currency contract
Z Ltd, a company with a sterling functional currency, enters into a contract to buy widgets from Y Ltd, to be delivered in 6 months’ time. Payment is to be made on delivery, but the contract gives Z Ltd the option of paying either £1 million or Japanese Yen (JPY) 205.7 million for the widgets. (The figures reflect the GBP/JPY exchange rate at the start of the contract.) Widgets are not usually traded in Yen.
The currency feature in the purchase contract is a derivative, allowing Z Ltd to profit from favourable currency movements. When payment falls to be made, JPY 205.7 million is worth £980,000, so the company chooses to pay in Yen.
In its accounts, Z Ltd separates the embedded currency option, accounting for it at fair value. The accounts thus show the widgets as having been bought for £1 million, but there is a separate £20,000 profit on the currency option.
The embedded option is brought within CTA09/Part 7 by S586, and it fulfils the conditions to be a derivative contract.
But Z Ltd has not elected out of S616. S616(4) therefore applies to the purchase contract as a whole. It is treated as if the embedded feature was closely related to the host contract, and was not being accounted for separately at fair value.
CTA09/S46(1) requires Z Ltd to compute its trading profits on the basis of GAAP. However, S616(4) substitutes a ‘deemed GAAP’ for the actual basis of accounting. For the purposes of computing trading income, the widgets are treated as having been bought for £980,000. Fair value changes on the option are disregarded: the £20,000 currency ‘profit’ is effectively brought into account when the goods are sold.
The provision in CTA09/S699(1), which prevents profits on derivative contracts from being taxed otherwise than under Part 7 - and which might over-ride the above tax treatment - is explicitly switched off by S616(5).