Derivative contracts: chargeable gains on derivatives: property based total return swaps: example
Property based total return swap - example applying to contracts entered into on or after 1 August 2004 in an AP ending on or after 17 September 2004.
Y plc is an investment company that holds a portfolio of fixed income securities. It wishes to reduce its exposure to such securities, and gain exposure to the commercial property market. As a short-term measure, while seeking suitable property investment opportunities, it enters on 15 January 2006 into a property based total return swap. The swap has a notional principal amount of £6 million, and a maturity of 12 months.
One leg of the swap is based on the IPD (Investment Property Databank) annual index of capital growth of all properties. The counterparty makes payments at quarterly intervals based on the published estimate of the index: payments are calculated on the basis of the percentage rise in the index since December 2005, less amounts already paid. The company makes payments on the basis of a fixed interest rate of 6.5%.
Net payments are therefore made as follows (index values quoted are fictitious):
|Payment date||Index value||% rise from Dec 05||Paid to company||Paid by company|
|247.00 (Dec 05)|
|15 April 2006||254.30 (March 06)||2.96%||£177,600 (£6m x 2.96%)||£97,500 (£6m x 6.5% x 90/360)|
|15 July 2006||254.00 (June 06)||2.83%||(£7,800)|
|(£6m x 2.83%) - £177,600||£97,500|
|15 October 2006||258.10 (Sept 06)||4.49%||£99,600|
|(£6m x 4.49%) - (£177,600 - £7,800)||£97,500|
|15 January 2007||262.31 (Dec 06)||6.20%||£102,600|
|(£6m x 6.20%) - (£177,600 - £7,800 + £99,600)||£97,500|
The company accounts for the derivative at fair value. At 30 September 2006, it is shown in the balance sheet as an asset with fair value £5,000.
The profit and loss account for year ended 30 September 2006 shows a debit of £20,200, made up of the net cash paid of £25,200 paid under the contract in the period, less a £5,000 increase in fair value.
For year ended 30 September 2007, the profit and loss account shows a credit of £2,200, being the net cash of £7,200 received less a £5,000 decrease in fair value. Overall, therefore, the accounts bring in a debit of £18,000, the company’s economic loss on the contract.
For tax purposes, the contract falls within CTA09/S650. Applying the formula at S659(4) in the first accounting period,
N (notional principal amount of the contract) = £6,000,000
R (the percentage change in the index up to 30 September 2006) = + 4.49%
This is a positive amount, since an increase in the index will result in a payment to the company, and hence a credit in the company’s books. Had the company been called up to make payments if the index rose, R would be a negative amount.
Thus a credit of 4.49% x £6,000,000 = £269,400 falls to be brought into account as a chargeable gain in year ended 30 September 2006.
To produce the overall net debit of £20,200, a debit of £289,600 (£269,400 - (- £20,200) falls to be brought into account as a non-trading debit.
In year ended 30 September 2007, the ‘relevant period’ is 1 October 2006 to 15 January 2007, when the contract matured. During this period, the index rose from 258.10 at 30 September 2006 to 262.31 at 31 December 2006, a percentage change of 1.63%. (The 15-day lag period between the month end and publication of the monthly figure being ignored.)
The credit brought into account as a chargeable gain is therefore 1.63% x £6,000,000 = £97,800. This is counterbalanced by a non-trading debit of £95,600 (£97,800 less the accounts credit of £2,200).
Overall, therefore, £367,200 is brought into account as a chargeable gain (compared with £372,000 actually received under the ‘property’ leg of the swap) and £385,200 is relieved as a non-trading deficit (compared with £390,000 paid under the ‘interest’ leg).