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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Old rules: derivative contracts: qualified exclusions: Para 6 example

Box option scheme

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

B Ltd enters into the following four option contracts with a bank or other counterparty:

Option 1 

It buys a call option over the FTSE 100 index, with a strike of 2844.47. It is a European-style option, which can only be exercised in 12 months’ time. For each point that the FTSE 100 is above 2844.47 at the exercise date, the company will receive £750,000 - in other words, it buys 750,000 units of the option. B Ltd pays a premium of £168.75 million for this option.

If the FTSE 100 is below 2844.47, B Ltd will of course not exercise the option.

Option 2 

It sells to the counterparty 750,000 units of a put option over the FTSE 100 index, with a strike of 2844.47, exercisable in 12 months’ time. It receives a premium of £112.5 million.

If the FTSE 100 falls below 2844.47, the counterparty will exercise its option and B Ltd will pay £750,000 for every point by which the index is below 2844.47. If the index is above 2844.47, the option will lapse.

Option 3 

It buys 750,000 units of a put option over the FTSE 100, with a strike at 2950, exercisable in 12 months’ time. It pays £37.5 million for this option.

If the index falls below 2950, it will exercise the option and receive £750,000 for each point the index is below the strike. If the FTSE is above 2950 the option will lapse.

Option 4 

It sells 750,000 units of a FTSE 100 call option, with a strike at 2950, exercisable in 12 months’ time. It receives a premium of £18.75 million for this option.

If the FTSE 100 falls below 2950, this option will lapse. Otherwise B Ltd must pay the counterparty £750,000 for each index point above 2950.

If on the exercise date the FTSE 100 index stands at 2750, say, option 1 and 4 will not be exercised. Under option 2, B Ltd must pay the counterparty (2844.47 - 2750) x £750,000 = £70,852,500. But B Ltd will exercise option 3, and receive (2950 - 2750) x £750,000 = £150,000,000. So B Ltd will make a gain of £79,147,500.

The same analysis can be performed for other values of the FTSE 100 and some are shown in the table below (payments and receipts are shown in thousands of pounds, with payments in brackets):

FTSE 100 Option 1
£’000 Option 2
£’000 Option 3
£’000 Option 4
£’000 Overall
£’000            
             
  2750 Lapses (70,852.5) 150,000 Lapses 79,147.5
  2900 41,647.5 Lapses 37,500 Lapses 79,147.5
  2950 79,147.5 Lapses Lapses Lapses 79,147.5
  3000 116,647.5 Lapses Lapses (37,500) 79,147.5

Whatever the value of the FTSE 100 index, B Ltd always receives a net £79,147,500. Since the company has paid a net £75 million in premiums for the four options, this is equivalent to receiving a return of £4,147,500 on a 12-month investment of £75 million - or ‘interest’ of 5.53%.

Without any other provision, the company might return the profit of £4,147,500 as a chargeable gain - which would be reduced by indexation and might be covered by capital losses. However, if B Ltd carried out these transactions in an accounting period beginning on or after 1 October 2002, Para 6 would apply (in earlier periods, ICTA88/Sch5AA would be applicable).

Considering any of the four options:

  • It is clearly a relevant contract within Sch 26/Para 2(2) and would satisfy the accounting requirements test of Para 3.
  • Its underlying subject matter, determined in accordance with Sch26/Para 11 is shares.
  • The four options are associated transactions within Para 10, because they were all entered into as part of the same scheme or arrangement. The effect of the option under consideration, plus the other three associated option contracts, is to create a guaranteed return.

Therefore each of the four options comes within Sch 26 and B Ltd must account for it on a mark to market basis under Para 21 for tax purposes. The effect of mark to market accounting is to bring in to tax the overall profit of £4,147,500 as it accrues. This is because the fair value at any time of the box option arrangements, taken as a whole, equates to the value of a £75 million deposit earning interest at 5.53% - it is dependent only on the time value of money.