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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Derivative contracts: tax avoidance: transfers of value to connected companies: example

Example of S695

Tewqer UK plc pays a premium of £2m to its Bermuda subsidiary for a call option over gilts currently worth £10m to be exercised in 6 months’ time. The option has a strike price of £9.5m and the terms are the same as would be agreed between parties acting at arm’s length.

At the exercise date, the bonds are worth £9.7m but Tewquer does not exercise the option. Therefore, the company has transferred £2 million (the cost of the premium) to its Bermudan subsidiary for no economic return. Without any other provision, Tewqer UK plc would get a deduction for the £2 million premium.

In order to determine whether there has been a transfer of value, S695 assumes that the option has been exercised. On that assumption, Tewquer would have made a gain of £200,000 on the gilts. There has been a transfer of value from Tewqer to the subsidiary.

S695(2) requires Tewqer plc to bring the £2 million premium into account for the accounting period in which the option expired. The company gets a £2 million deduction for the premium, but must also bring in an equivalent receipt. Note that you only assume exercise of the option for the purpose of deciding whether there has been a transfer of value - S695 does not replicate the tax effect of exercising the option (so the £200,000 assumed gain is not taxed). The credit to be brought in is always equal to the amount paid for the grant of the option (except in those circumstances where the option is only partially exercised).