Derivative contracts: embedded derivatives: elections out of S616
Elections under CTA09/S617
Companies that do not want to make the computational adjustments necessitated by CTA09/S616 may elect out of its provisions. This is subject to two qualifications. A ‘disapplication election’ does not apply to
- any contract where the underlying subject matter of the embedded derivative is, or includes, commodities; or
- a contract of long-term insurance.
The exclusion for commodities is because a number of supply contracts, particularly in the oil and gas sectors, contain embedded derivatives linked to the wholesale prices of - in particular - crude oil or natural gas. Because of the volatility in the price of these commodities, and the high value of some of these contracts, taxing such contracts on the basis of fair value changes would lead to considerable volatility in the tax payable by companies that are party to the contracts.
These two provisos, however, apply only to accounting periods ending on or after 31 December 2005. An election made in respect of a period beginning on or after 1 January 2005, but ending before 31 December 2005, applies to all of a company’s contracts.
A disapplication election must be made in writing to HMRC, and is irrevocable. It must be made before the end of the first accounting period ending on or after 17 August 2005 in which the company held contracts to which CTA09/S616(1) applies.
A company draws up its accounts to 31 December. In the year ended 31 December 2005 it was not party to any non loan relationship contracts containing embedded derivatives. In the year ended 31 December 2006, it leased new business premises. The rent payments under the lease were, for the first 5 years, adjusted for inflation at twice the change in the retail price index (RPI).
When it entered into the contract, the company drew up its accounts under ‘old UK GAAP’. (See CFM20010 for meaning of ‘old UK GAAP’.) The RPI-linked clause was therefore not an embedded derivative for accounting purposes. On 1 January 2010, however, it adopts FRS 26.
Since the inflation adjustment is leveraged, the company’s accountants advise that the embedded derivative must be separated from the host lease. The conditions in S616(1) are therefore satisfied, for the first time, in year ended 31 December 2010.
If the company wishes to elect out of S616, it must do so on or before 31 December 2010
Note: it might be argued that the underlying subject matter of the derivative embedded in the lease includes commodities because the RPI is based on a ‘basket’ of goods and services that may include commodities. However, HMRC’s view is that subject matter which is subordinate or of small value can be disregarded for the purposes of S617, and any commodity component of the index is ‘subordinate’ for this purpose.
Each company within a group can decide independently whether or not to make a disapplication election. But special rules apply where a contract is between two group companies, or is transferred within a group - see CFM52570.