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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Derivative contracts: partnerships: example

Example of S620 computation

Two unconnected companies, Hoonval Ltd and Ithlim Ltd, and an individual, Mr J, form a partnership to undertake a trading venture. The two companies each contribute 40% of the partnership capital, and are entitled to 40% of partnership profits. Mr J contributes 20% of capital and is entitled to 20% of profits. Losses are shared in the same way as profits. The partnership draws up its accounts to 31 December each year.

Hoonval Ltd is a subsidiary of a quoted company, Hoonval plc. It was set up for the sole purpose of holding the Hoonval group’s interest in the partnership, and channelling finance from the parent company to the partnership. Its accounting date is 31 December. It accounts for its investment in the partnership as a fixed asset, carried at the lower of cost and net realisable value.

Ithlim Ltd carries on a financial trade. It accounts for its interest in the partnership as an asset, which is shown at fair value. The company’s accounting date is 30 June.

In 2009, as a hedge against possible interest-rate rises, the partnership buys a 2-year interest-rate cap from its bank, capping the cost of its £10 million bank borrowing at 5.75%. This is an option product, for which the partnership pays a premium of £500,000 on 1 September 2009. In its accounts the partnership accounts for the interest-rate cap at fair value. Thus the partnership balance sheet at 31 December 2009 shows the option product as an asset with a fair value of (say) £400,000. Payments made by the bank under the option to offset the partnership’s interest costs are credited to P&L in the period in which they are received.

Tax treatment of the interest-rate cap by Hoonval Ltd

First we deem Hoonval Ltd to hold the derivative contract for the purposes of its business, and suppose that everything which the partnership does in relation to the contract is done by Hoonval Ltd.

Since the partnership fair values the option contract, Hoonval Ltd is deemed also to account for it on a fair value basis (see CFM52710).

Thus, supposing that Hoonval Ltd held the contract, total credits and debits for the year ended 31 December 2009 would be computed on a fair value basis as follows:

  Credit (debit)
Decrease in fair value of option (£500,000 - £400,000) (£100,000)
Payments made by bank (say) £ 40,000

40% of the debit of £100,000, or £40,000, is brought into the tax computations of Hoonval Ltd, as is 40% of the credit.

Are these trading or non-trading debits and credits? The interest-rate cap is deemed to be held for the purposes of the trade or business carried on by Hoonval Ltd. The company has a trade - the partnership trade which CTA09/S1259 deems it to be carrying on. (This is in addition to its activities of financing the partnership.) The derivative contract is held for the purposes of this trade, so that debits and credits are trading expenses and receipts respectively.

Tax treatment by Ithlim Ltd

In exactly the same way, we deem Ithlim Ltd to hold the derivative contract, compute the total credits and debits and then assign 40% of those credits and debits to the company.

However, since Ithlim Ltd is using fair value to account for its interest in the partnership, CTA09/S621 applies (CFM52730). We must use a fair value basis to compute the gross debits and credits. Since Ithlim Ltd’s accounting date is 30 June, it is necessary to value the contract at 30 June 2010. Suppose that its value is £360,000. Gross debits and credits in Ithlim Ltd’s accounting period to 30 June 2010 are therefore:

  Credit (debit)
Decrease in fair value of interest rate cap (£500,000 - £360,000) (£140,000)
Payments made by bank (say) £60,000

Ithlim Ltd will therefore bring into its computations a debit of £56,000 (40% x £140,000) and a credit of £24,000 (40% x £60,000). These amounts will not bear any simple relationship to figures in its accounts.

The derivative contract is deemed to be held for the purposes of the trade being carried on Ithlim Ltd. The credits and debits are therefore brought into account as trading receipts and expenses. (If the partnership was not trading, but carrying on an investment business, Ithlim Ltd would still have trading credits and debits.)

Tax treatment by Mr J

Mr J is chargeable to income tax, and his share of profits or losses on the derivative contract will be computed under income tax rules, provided that such profits or losses are trading receipts or expenses for Mr J; otherwise they will be chargeable to capital gains tax.