Derivative contracts: chargeable gains on derivates: S641 treatment: examples
Examples of CTA09/S641 and S642 treatment applying to accounting periods beginning on or after 1 January 2005
On 1 February 2008, in its accounting period ending 31 December 2008, a company, X Ltd, acquires a convertible security issued by an unrelated trading company, Z plc. The security matures on 30 June 2009, and is convertible into ordinary shares in Z plc.
Under FRS26, the company accounts separately for the host contract and for the embedded option, initially recognising the option at a fair value of £500,000. At 31 December 2008, the option has a fair value of £600,000. However, on maturity in 2009 the company does not exercise the conversion option, instead redeeming the security for cash.
The embedded option is treated as a relevant contract by CTA09/S585, and this contract is a derivative contract that meets the conditions of S645 (CFM55220). In the year ended 31 December 2008, a credit of £100,000 arises on the option under S595. This credit is brought into account in 2008 as a chargeable gain, by virtue of S641.
In the year ended 31 December 2009, the option expires without being exercised, giving rise to a debit of £600,000 for 2009. This is brought into account as a capital loss. X Ltd may elect to carry back part of the loss against the gain in the previous year.
The facts are as in the first example, except that on 1 March 2008 X Ltd acquires a 20% shareholding in Z plc.
It is necessary to consider whether
- if the embedded option were a separate option,
- the option was disposed of at the end of the accounting period, and
- a chargeable gain accrued on that disposal,
the substantial shareholdings exemption (SSE) would apply to that gain.
In the year ended 31 December 2008, we must deem a disposal of the option at 31 December. At that time, X Ltd has not held a substantial shareholding in Z plc for 12 months, so SSE would not apply. S641 applies to bring a chargeable gain of £100,000 into account.
In the year ended 31 December 2009, it is necessary to deem a disposal of the option at 31 December 2009 (even though, in fact, the option ceased to exist at an earlier date). At that time, X Ltd has held more than 10% of the shares in Z plc for a continuous period of 12 months in the previous two years. Provided all other conditions were met, SSE would apply. For this accounting period, S642 disapplies S641, with the result that the loss of £600,000 is not brought into account.