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HMRC internal manual

Corporate Finance Manual

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Derivative contracts: group continuity: examples of transfers before 16 March 2005

Intra-group transfers before 16 March 2005: examples

Example 1

G Ltd draws up accounts to 31 December, and accounts for financial instruments on an accruals basis. On 1 July 2003, it enters into a 5-year interest rate swap. It was acquired for nil cost.

On 31 March 2004, G Ltd novates the swap to H Ltd, a company in the same group, which also prepares accounts to 31 December and accounts on an accruals basis. The swap is out of the money, and G Ltd pays £200,000 (the fair value of the liability) to H Ltd in consideration of the novation. G Ltd therefore shows a debit of £200,000 in its accounts. H Ltd initially recognises the swap as a liability of £200,000.

Under CTA09/S625, the debit of £200,000 in the accounts of G Ltd to 31 December 2004 is disregarded. Any credits or debits brought into account by G Ltd in respect of periodic payments made or received under the swap are taxed on G Ltd. The same applies to those brought into account by H Ltd.

G Ltd may amortise its £200,000 loss over the remaining term of the swap. Debits relating to such amortisation continue to be disregarded, even if they occur in the years subsequent to the transfer.

In the year ended 31 December 2005, H Ltd terminates the swap - which is still out of the money - by making a payment of £50,000 to the counterparty. For tax purposes, H Ltd and G Ltd are deemed to be a single company, which acquired the swap on 1 July 2003 for nil cost, has carried it at historic cost, and has then paid £50,000 to dispose of it. H Ltd must therefore bring in a debit of £50,000, even though for accounting purposes it will recognise a profit (representing the difference between the carrying amount of the derivative liability and the £50,000 paid to dispose of it).

Example 2

The facts are as in example 1, except that H Ltd accounts for the swap on a mark-to-market basis. After initially recognising the swap as a liability of £200,000, it values it as a liability of £90,000 at 31 December 2004 (thus bringing in a credit of £110,000 in its 2004 accounts). It brings in a further credit of £40,000 in year ended 31 December 2005, when it pays £50,000 to terminate the swap.

As in example 1, H Ltd and G Ltd are deemed to be a single company for the purpose of computing credits and debits (other than those stemming directly from the transfer). Nothing in the legislation identifies this single company either with G Ltd (which uses accruals accounting) or H Ltd (which uses mark-to-market): it is separate from both of them. It must be concluded that the deemed single company begins by accounting for the swap on an accruals basis, but changes to mark-to-market on 31 March 2004.

Such a change of accounting basis would result in the company bringing into account a debit of £200,000, representing the ‘step down’ from the historic cost of nil to the mark-to-market valuation of minus £200,000. The ‘deemed single company’, of course, exists only for computational purposes - the tax deduction is given to the real company, H Ltd (since the debit arises immediately after the time of transfer). Thereafter, credits and debits are computed on the basis that the ‘deemed single company’ accounts on a mark-to-market basis.

H Ltd will therefore bring in, for year ended 31 December 2004, both the mark-to-market credit of £110,000, and a debit of £200,000. It will bring in a further credit of £40,000 in 2005. G Ltd has neither gain nor loss on the swap. Thus overall the group’s economic loss of £50,000 on the derivative is relieved.