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HMRC internal manual

Corporate Finance Manual

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Old rules: derivative contracts: qualified exclusions: overview of Para 6

Contracts giving rise to guaranteed returns

This guidance applies to periods of account beginning before 1 January 2005, or beginning after that date and ending before 16 March 2005

Derivative contracts could be used to generate a guaranteed return which is in economic terms equivalent to interest but which is received as capital gains. The contracts in point were ones whose underlying subject matter was an excluded matter for the purposes of Schedule 26 (in particular equities where the company did not hold the derivative contracts for the purposes of a trade). Less tax may have been payable on those gains because

  • indexation allowance was due, or
  • the gains were covered by allowable losses.

To prevent avoidance of this kind, Para 6 was included in Sch 26, FA 2002. It replaced ICTA88/SCH5AA for the purposes of corporation tax.

An example of a scheme designed to produce a guaranteed return from the use of derivative contracts to which SCH26/PARA6 applied is given at CFM83110.

FA02/SCH26/PARA6 provided that where a relevant contract

  • had subject matter consisting wholly of shares, unit trust units or securities within FA96/S92 or FA96/S93, and
  • was designed to give a guaranteed return (CFM83130) either by itself or together with one or more other relevant contracts or loan relationships within sections FA96/S92, 93 or 93A

the relevant contract was treated as a derivative contract for the purposes of Sch 26, and profits and gains from the contract were brought into account using an authorised mark to market method - FA02/SCH26/PARA21(1)(a).

A contract satisfying the conditions of Para 6 was nevertheless still excluded from the derivative contract regime if it did not meet the accounting requirements test in SCH26/PARA3. However, it was not necessary for the contract to be accounted for as a derivative financial instrument in order for it to satisfy the Para 3 requirement.

There was some modification to these statutory provisions where, exceptionally, a company in a period beginning on or after 1 January 2005 but ending before 16 March 2005 was party to a contract that, either by itself or with other financial instruments, gave rise to guaranteed returns. The broad effect remained unchanged, however. Para 6 did not apply where such periods end after 16 March 2005, since equity derivatives will (subject to the exceptions described at CFM50730) come within Sch 26 (now CTA09/PT7) in any case.

Unlike the position for Schedule 5AA, authorised unit trusts (AUTs) and open-ended investment companies (OEICs) were not exempted from the legislation. Whether the profits arising from Para 6 contracts were within the charge to tax depended on their accounting treatment.

Schedule 5AA

ICTA88/SCH5AA, was inserted by FA97/SCH11 and provided a Case VI charge on profits realised on or after 5 March 1997 from the futures or options concerned. This legislation, which is now in Chapter 12 Part 4 ITTOIA 2005, continues to apply for income tax.

FA02/SCH28/PARA6 contained transitional rules for contacts that were within Schedule 5AA immediately before the company’s first accounting period to begin on or after 1 October 2002. Details are at CFM85060.