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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Derivative contracts: issuers of convertible or share-linked securities: 'exactly tracking contract' - example

Example of exactly tracking contracts

Exactly tracking contract

On 1 January 2006, Y Ltd issues a 3 year security at par £1million. The redemption price is the full issue price increased, or reduced, by the full percentage change in the value of its ordinary shares. Suppose its shares were respectively worth £40 and £50 on 1 January 2006 and 31 December 2008, an increase of 25 per cent over the life of the security. In order to be an ‘exactly tracking’ contract, the security must redeem for £1.25 million.

‘Almost exactly tracking’ contract

The facts are the same as in the above example, except that the redemption price of the security is subject to a minimum of £100,000 should the value of Y Ltd’s ordinary shares fall by more than 90 per cent over the relevant period. Suppose their respective values on 1 January 2006 and 31 December 2008 were £40 and £2, a percentage decrease of 95 per cent over the life of the security. The security therefore redeems for the minimum £100,000. The contract is ‘almost exactly tracking’ because this does not exceed 10 per cent of the £1million issue price.

This is relevant only for periods of account ending on or before 31 December 2006 (see CFM55480). In practice, most ‘nearly exactly tracking’ contracts (those with a floor of 10% or less) will have been issued in a period of account beginning before 1 January 2005, and will be subject to the transitional treatment outlined at CFM55540.

Neither ‘exactly tracking’ nor ‘almost exactly tracking’

Had the contract guaranteed a minimum of, say, £150,000 of the original loan, the derivative would not qualify for chargeable gains treatment as this exceeds 10 per cent of the issue price of £1million.