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HMRC internal manual

Corporate Finance Manual

Old rules: derivative contracts: qualified exclusions: Para 7 introduction

Contracts securing a guaranteed minimum return (FA02/SCH26/PARA7)

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 can be used to replicate a loan, the return on which is dependent on a rise in an index, but which protects the holder from any downside risks so that he will, whatever happens to the index, get his initial amount back at the end of the period. The derivative contracts used are ones whose underlying subject matter is an excluded matter for the purposes of FA02/SCH26 (in particular, equities where the company does not hold the derivative contract for the purposes of a trade).

Equity-linked bonds giving a guaranteed minimum return are issued by banks and building societies.

  • Where they are held by a company, profits or losses will be taxable or relievable as income. This is because, for accounting periods beginning before 1 January 2005, the ‘floor’ prevented the bond from falling within FA96/S93. For later accounting periods, where the security is bifurcated into a loan relationship and a derivative contract, the contract will not be an ‘exactly tracking contract’ and will therefore not fall within FA02/SCH26/PARA45F (now CTA09/S648) (CFM55100).
  • Where they are held by a person other than a company, the asset is a deeply discounted security on which the entire return is taxable as income to income tax on realisation.

Many insurance companies have issued policies (often known as guaranteed equity bonds) to policyholders which contain similar terms. In fact the only difference between them and the bank/building society bonds is that there is a (usually insignificant) death benefit payable above the surrender value of the bond.

Insurance companies need to find an asset that will produce the cash necessary to pay the policyholder when the bond matures. Most such assets have involved derivative contracts, albeit of an unusual type. Attempts to tax the return from such contracts under FA96/CH2/PART4 (loan relationships) failed before the Special Commissioners - (HSBC Life (UK) Ltd v Stubbs SpC 298). But they are now brought fully within the derivative contract rules in FA02/SCH26 (now CTA09/PT7).

No examples have been seen of derivative contracts of the type that Para 7 was aimed at being issued other than by companies carrying on life assurance business. Accordingly, there is full guidance on these in the Life Assurance Manual and only an overview in this manual.