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HMRC internal manual

Corporate Finance Manual

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Old rules: derivative contracts: transitional provisions: Para 4B and 4C examples

Examples of Paras 4B and 4C

Example 1

A company prepares annual accounts to 30 September. On 5 January 2005, it paid a premium of £1,000,000 for a cash-settled option, the underlying subject matter of which is an equity index. It exercised the option on 1 December 2005, and received cash of £1,700,000. The option was not held for trade purposes.

Although the company held the contract on 16 March 2005, Para 4A could not apply since 16 March did not fall into a period of account beginning on or after 1 January 2005. Instead, without Para 4B, the option would have become a derivative contract at the start of the first period to which the SI 2005/646 amendments to Sch 26 applied - i.e. on 1 October 2005.

However, the effect of para 4B was that the option became a derivative contract on 28 July 2005. Suppose that the fair value of the option on that date was £1,100,000. For capital gains purposes, it was treated as having been disposed of for £1,100,000 on 28 July. An unindexed gain of £100,000 therefore arose, with indexation running from 5 January to 28 July (TCGA92/S144A). This gain is brought into account for the period in which the company disposes of the contract, in other words in the year ended 30 September 2006.

For Sch 26 purposes, the company is treated as acquiring the option for £1,100,000 on 28 July. Suppose that the company marks to market the option, and its value at 30 September 2005 is £900,000. The company would bring in a debit of £200,000 for year ended 30 September 2005, and a credit of £800,000 (£1,700,000 less £900,000) in the year ended 30 September 2006.

Example 2

The facts are as in example 1, except that the company acquired the option (again, for a premium of £1,000,000) on 2 August 2005.

Here again, Para 4A could not apply, and Para 4B did not apply because the option was not held before 28 July 2005. The option would therefore (apart from Para 4C) be a chargeable asset when it was acquired. However, Para 4C did apply here, with the result that the option was treated as a derivative contract from 2 August 2005.

In the year ended 30 September 2005, the company has a Sch 26 debit of £100,000 (the mark to market value of £900,000 on 30 September, less the £1 million premium paid). It has, as in the first example, an £800,000 credit in the subsequent year.

Example 3

The facts are as in the first example, except that the company exercised the option on 1 July 2005. In this case, Para 4B could not apply since the company was not party to the contract on 28 July. The contract was, and remained, a chargeable gains asset, and any profit accruing to the company on exercise of the option was a chargeable gain.

Example 4

Again, the facts are as in example 1, except that the company prepares its accounts to 31 March. In this case, Para 4A could not apply because the contract was not acquired in a period beginning on or after 1 January 2005. But the contract comes within Sch 26 for the period 1 April 2005 to 31 March 2006. So Para 4B is inapplicable, since the option was not a chargeable asset immediately before 28 July 2005. There is no specific transitional rule to deal with this situation. The company should compute a chargeable gain on disposal of the option on 1 December 2005, and exclude from the gain amounts that have already been taxed or relieved as income under Sch 26 in year ended 31 March 2006, since such amounts cannot be brought into account under any other provision - FA02/SCH26/PARA1(2).