Clause 585: Loan relationships with embedded derivatives

1544.     This clause treats the embedded derivative or embedded derivatives in a company’s loan relationship as relevant contracts. It is based on section 94A of FA 1996.

1545.     It applies if a loan relationship is treated under generally accepted accounting practice as divided between rights and liabilities under one or more derivative financial instruments or equity instruments (the embedded derivative(s)) and the remaining rights and liabilities which by themselves constitute a loan relationship.

1546.     For the meaning of “equity instrument”, see clause 710 (that is, it has the meaning it has for accounting purposes). It is defined in paragraph 11 of International Accounting Standard 32 as follows: “an equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities”.

1547.     Subsection (4) is a signpost to clause 415 in Part 5 (loan relationships) which deals with the remaining rights and liabilities which by themselves constitute a loan relationship.

1548.     Subsection (5) includes a signpost to clause 416 which provides for a company to elect that certain of its loan relationships shall be split as mentioned in clause 415 and this clause, if they would not be so split under the accounting practice the company uses.

Clause 586: Other contracts with embedded derivatives

1549.     This clause provides for the embedded derivative or embedded derivatives in a contract that is neither a hybrid derivative nor a loan relationship to be treated as relevant contracts. It is based on paragraph 2A of Schedule 26 to FA 2002.

1550.     It applies if such a contract is divided under generally accepted accounting practice between one or more embedded derivatives and the remaining rights and liabilities under the contract.

1551.     Subsection (2)(a) is written in terms of the rights and liabilities of the embedded derivative rather than, as in the source legislation, simply referring to the embedded derivative. This aligns the rule here with the expression of the similar rule in the preceding two clauses.

1552.     The source legislation for subsection (2)(b) refers at the equivalent point to a contract “whose rights and liabilities consist only of one of the non-financial embedded derivatives”. “Non-financial” is part of the label “non-financial embedded derivative” in paragraph 2A of Schedule 26 to FA 2002, which applies to the relevant contract to which the company is deemed to be a party under this provision. It is not appropriate to the embedded derivative itself by virtue of which the company is treated as a party to a relevant contract. That is, the embedded derivative has first to be identified before there is a deemed relevant contract to which such a label can be applied. “Non-financial” has therefore not been rewritten in subsection (2)(b).

Clause 587: Contract relating to holding in OEIC, unit trust or offshore fund

1553.     This clause treats as a derivative contract a relevant contract that is not otherwise such a contract if its underlying subject matter consists wholly or partly of a holding in a collective investment scheme and that scheme fails to meet a “qualifying investments test”. It is based on paragraph 36(1), (2), (3) and (4) of Schedule 26 to FA 2002.

1554.     A number of the contracts to which this clause would appear to apply are in fact already derivative contracts because their underlying subject matter does not qualify as “excluded property” under clause 589. This clause therefore sweeps up any relevant contract that fails to meet the conditions for a derivative contract despite its underlying subject matter consisting wholly or partly of a “relevant holding”.

1555.     The words “but for this section”, at the end of paragraph (a) in subsection (1), avoid conflict between the effect of the clause (the contract is a derivative contract) and the condition for the clause to apply (the contract is not a derivative contract).

1556.     If subsection (2) applies to treat the relevant contract as a derivative contract in a particular accounting period, that treatment persists for so long as the contract is a relevant contract of the company (even if the circumstances that first led to it being treated as a derivative contract no longer apply).

1557.     Subsection (3) describes what a “relevant holding” is for the purposes of the clause. It is drafted in terms of the underlying subject matter of the contract rather than, as in the source legislation, referring to a relevant holding of a “person”. This corrects a misfiring of the provision that arose from adapting a similar provision for loan relationships (see paragraph 4(1) of Schedule 10 to FA 1996, rewritten in clause 490 of this Bill). See Change 63 in Annex 1. (This Change also applies to clause 601; see the signpost to that clause in subsection (6).)

1558.     The meaning of “material interest in an offshore fund” in subsection (3)(a)(iii) is provided by reference to Chapter 3 of Part 6 of this Bill, where the definition is based on paragraph 7 of Schedule 10 to FA 1996, to which the source legislation for this clause refers. But that definition pleads into the meaning given to “offshore fund” in clause 489(1), which is slightly wider in scope than that given in section 756A of ICTA. See Change 60 in Annex 1.

1559.     Subsection (5) refers to the power to amend the definition of “relevant holding”, by regulations under section 17 of F(No 2)A 2005, in relation to the source legislation for both this clause and its loan relationships equivalent (clause 490 in Part 5). The power has not yet been exercised.

1560.     The provisions mentioned in subsections (6) and (7) are those that deal specifically with contracts to which this section applies. But a contract treated as a derivative contract by this clause is subject to other provisions that operate on derivative contracts so far as the context permits.

Clause 588: Associated transaction treated as derivative contract

1561.     This clause treats an “associated transaction” in respect of shares held by an “investing company” as either a derivative contract or a transaction in respect of a derivative contract, if it would not already be such a contract or transaction. It is based on section 91B(5) of FA 1996.

1562.     If the clause does so, credits and debits arising from the associated transaction are then brought into account under this Part under clause 603.

1563.     Chapter 7 of Part 6 (shares with guaranteed returns etc) deals with certain shares which in substance are equivalent to loan relationships. It provides that the same consequences follow for tax purposes as if the company’s holding of shares were a loan relationship.

1564.     Clause 523 (which is also based on section 91B of FA 1996) applies to “non-qualifying shares”. A share is “non-qualifying” if one of various conditions is met. One of those conditions (see clause 532) is that there is a scheme or arrangement under which the share and “one or more associated transactions” are designed to equate to an investment yielding a commercial rate of interest. An “associated transaction” is one of entering into, or acquiring rights and liabilities under, a derivative contract or contracts having some similarity to a derivative contract or a contract of insurance or indemnity.

1565.     Subsection (4) applies if there is such an associated transaction (the “associated transactions condition”).

Clause 589: Contracts excluded because of underlying subject matter: general

1566.     This clause, supplemented by the next four, provides that a relevant contract is not a derivative contract if its underlying subject matter falls wholly into certain categories (or is treated as doing so) and one or more conditions applies. It is based on paragraph 4(1), (2), (2ZA) and (4) of Schedule 26 to FA 2002.

1567.     Profits and losses arising in relation to such contracts are therefore not brought into account under this Part but are taxed as appropriate under other provisions, primarily as chargeable gains.

1568.     Subsection (1) introduces the term “excluded property” to describe underlying subject matter that causes the relevant contract not to be a derivative contract. Subsection (2), supplemented by subsections (3) to (6) defines the term, with further detail appearing in clauses 590 to 592.

1569.     Intangible fixed assets are excluded property, but only in the case of an option or future. Profits and losses in respect of such a contract are dealt with primarily under Part 8.

1570.     The major categories of excluded property, in relation to any type of relevant contract, are (a) shares in a company and (b) rights of a unit holder under a unit trust scheme. But in such cases the relevant contract must both satisfy one of the conditions in clause 591 and not have the characteristics of a commercial investment.

1571.     Subsection (3) takes certain types of share out of the excluded category. These are:

• shares dealt with by Chapter 7 of Part 6 (shares with guaranteed returns etc); and

• shares in an open-ended investment company if that company fails to meet the qualifying investments test for the purposes of the loan relationships provisions.

1572.     For more on the qualifying investments test, see the commentary on clause 587.

Clause 590: Disregard of subordinate or small value underlying subject matter

1573.     This clause provides that the parts of a relevant contract’s underlying subject matter that are subordinate or of small value are ignored in determining for the purposes of clause 589 whether its underlying subject matter consists wholly of excluded property. It is based on paragraph 9 of Schedule 26 to FA 2002.

1574.     A relevant contract may contain a number of minor elements in addition to its main purpose. For example, there may also be an option to settle the contract in one or more currencies by reference to a particular exchange rate or there may be some minor leeway as to the settlement date.

1575.     Subsection (3) provides that any question of whether part of the underlying subject matter is “subordinate” or of “small value” is determined by reference to the time the company enters into or acquires the contract. But the clause does not otherwise provide any definition of “subordinate” or “small value”. Paragraph CFM13120 of HMRC’s Corporate Finance Manual (and the examples in CFM13120a) provides guidance.

1576.     See also clause 593 which deals with the case of an option or future where the part of the underlying subject matter that is not excluded property is neither subordinate nor of small value.

Clause 591: Conditions A to E mentioned in section 589(5)

1577.     This clause provides the conditions mentioned in clause 589(5)(a) which govern whether shares in a company or rights of a unit holder under a unit trust scheme are excluded property under that clause. It is based on paragraphs 4(2A) to (2D) and 12(1) and (11A) of Schedule 26 to FA 2002.

1578.     Condition A applies to certain relevant contracts entered into or acquired by life insurers that are an “approved derivative” within the meaning of Rule 3.2.5 of the Insurance Prudential Sourcebook issued by the Financial Services Authority on 25 October 2006 or, in the case of an overseas life insurance company which is a European Economic Area firm or a “treaty firm”, are derivative instruments falling within article 23.3 of the EC Consolidated Life Directive (EC/2002/83).

1579.     Rule 3.2.5 of the Insurance Prudential Sourcebook sets out a number of conditions to do with the purposes for which the derivative is held, how the risk under the derivative is managed and the circumstances in which it is entered into or acquired. See the definition of “Insurance Prudential Sourcebook” in section 431(2) of ICTA.

1580.     Condition A does not apply to a relevant contract that meets the condition in clause 579(1)(b) (one that is treated by accounting standards as a financial asset or liability, but is not treated as a derivative by accounting standards because of the size of the initial outlay).

1581.     The source legislation for condition A applies only to cases where the contract is “entered into” by the company. But the source legislation for conditions B to D in this clause applies if the company enters into or acquires the contract. This condition has been brought into line with those conditions. See Change 64 in Annex 1.

1582.     See also clause 592 which extends the application of condition A to certain rights and liabilities that are treated as a relevant contract by clause 584.

1583.     Condition B applies if the company is not a party to the relevant contract for the purposes of its trade and there is a “hedging relationship” (defined in clause 707) between the relevant contract and either (a) shares or rights of a unit holder in a unit trust scheme or (b) the company’s share capital or related liability.

1584.     Condition B does not apply if the relevant contract is one treated as such by clause 585 (that is, it is an embedded derivative in a loan relationship).

1585.     Condition C applies if the company is not a party to the relevant contract for the purposes of its trade and the contract is a quoted option to subscribe for shares.

1586.     Condition D deals with a relevant contract that relates to the acquisition by company A of a major investment in the share capital of company B other than for the purposes of core activities of company A’s trade. The reference to “activities forming an integral part of a trade” ensures that the condition is not disapplied in the case of, say, a financial trader. For a financial trader, the particular contract may be relevant to its structural assets, which might be regarded as held in the course of its trade, but may not actually be relevant to its core trading activities. The contract must be an option or future for the acquisition or delivery of shares. As with condition B, condition D does not apply if the relevant contract is one treated as such by clause 585.

1587.     Condition E applies if there is a hedging relationship between the relevant contract and an asset or liability representing a loan relationship to which clause 585 applies. The second leg of condition E is that each of the relevant contracts to which the company is treated as a party under that clause is a derivative contract to which one of the provisions specified in paragraph (b) of subsection (6) applies. Under the provisions listed in subsection (7), credits and debits are brought into account in calculating chargeable gains rather than as income. Part 10 of Schedule 2 extends that list in respect of certain rules in that Part.

1588.     The clause does not rewrite those parts of paragraph 4(2B)(a), (2C)(a) and (2CA)(a) of Schedule 26 to FA 2002 that refer to the trading activities of an insurance company or mutual trading company. They are redundant following changes in the source legislation for clauses 633 and 634.

Clause 592: Embedded derivatives treated as meeting condition in section 591 etc

1589.     This clause extends the ability to satisfy one of the conditions in clause 591 to certain embedded derivatives within the meaning of clause 584. It is based on paragraphs 2B(3), 45M and 54(1) of Schedule 26 to FA 2002.

1590.     If this clause applies, the underlying subject matter of the embedded derivative may satisfy the definition of “excluded property” in clause 589(2). The embedded derivative may thereby not be a derivative contract for the purposes of this Part.

1591.     The clause applies only if the “hybrid derivative” (within the meaning of clause 584) is a relevant contract within clause 579(1)(b). That is one that is not treated as a derivative by accounting standards because of the size of the initial outlay (for example, a prepaid equity forward) but is treated as a financial asset or liability. Also, the “host contract” (subsection (5)) must be treated for accounting purposes as (or as part of) a financial asset.

1592.     The embedded derivative must itself satisfy clause 579(1)(a) (a relevant contract that is treated for accounting purposes as a derivative). And its underlying subject matter must be wholly shares in a company or rights of a unit holder in a unit trust scheme. Subsection (4) indicates that clause 590 applies if appropriate to determine whether the “wholly” test in paragraph (c) of subsection (1) is met.

1593.     If the clause applies, the embedded derivative is treated as satisfying one of the conditions in clause 591, and therefore meets one element of the meaning of “excluded property” in clause 589(2). In the source legislation the embedded derivative is treated as meeting condition A in clause 591 because this rule is expected to be relevant primarily (although not exclusively) to insurance companies (and condition A specifically applies to such companies). But it is sufficient to deem the embedded derivative to meet any one of the conditions in clause 591 for the purposes of clause 589(2).

1594.     The clause does two more things. First, it treats the embedded derivative (which in all likelihood is not now a derivative contract, because of clause 589) as a “chargeable asset” for the purposes of this Part and TCGA. See the definition of that term in clause 703.

1595.     Second, the host contract is treated as a “creditor relationship” of the company for the purposes of the Corporation Tax Acts. That primarily affects the operation of Parts 5 and 6 (loan relationships). But it also affects those clauses in this Part that operate by reference to a creditor relationship (for example, clause 631(4)). See the definition of “creditor relationship” in clause 704.

Clause 593: Contracts where part of underlying subject matter is excluded property

1596.     This clause provides for an option or future to be treated in certain cases as divided between a relevant contract whose underlying subject matter consists wholly of excluded property within the meaning of clause 589 and one whose underlying subject matter consists wholly of other underlying subject matter. It is based on paragraph 46 of Schedule 26 to FA 2002.

1597.     See the commentary on clause 589 for the significance of the underlying subject matter of a contract being or not being “excluded property”.

Chapter 3: Credits and debits to be brought into account: general

Clause 594: Overview of Chapter

1598.     This clause describes the purpose and content of the Chapter. It is new.

1599.     The Chapter provides in particular for the application of generally accepted accounting practice in determining the profits and losses to be brought into account under this Part. In some cases, it provides for departure from generally accepted accounting practice for that purpose. Chapter 4 contains provisions about credits and debits for a number of special situations.

Clause 595: General principles about the bringing into account of credits and debits

1600.     This clause specifies for the identification of the credits and debits to be brought into account under this Part. It is based on paragraphs 15(1), (4) and (9) and 17A(1) of Schedule 26 to FA 2002.

1601.     Subsections (1) and (2) make general statements on the part played by accounts prepared in accordance with generally accepted accounting practice in identifying credits and debits for the purposes of this Part. “Generally accepted accounting practice” is defined by section 832(1) of ICTA by reference to section 50(1) of FA 2004. If a company prepares accounts in accordance with international accounting standards, those standards constitute generally accepted accounting practice. Otherwise UK generally accepted accounting practice applies.

1602.     The general statement in subsection (2) refers to credits and debits which are amounts “recognised in determining the company’s profit or loss” for the period. For the meaning of “recognised” in this context, see clause 597.

1603.     But that statement is qualified by the more specific rule in subsection (3) that those credits and debits must “fairly represent” profits, losses and expenses that arise in respect of the derivative contract or arise from certain transactions in respect of the contract (labelled “related transactions”).

1604.     There is a further significant rule in subsection (7) that makes both the general statement in subsection (2) and the rule in subsection (3) subject to the qualifying effect of “the following provisions of this Part”.

Clause 596: Meaning of “related transaction”

1605.     This clause provides the meaning of “related transaction” for the purposes of this Part. It is based on paragraph 15(7) and (8) of Schedule 26 to FA 2002.

1606.     The term is used extensively in this Part in provisions which may apply to or involve consideration of the acquisition or disposal of a derivative contract.

Clause 597: Amounts recognised in determining a company’s profit or loss

1607.     This clause explains what “an amount recognised in determining a company’s profit and loss” means. It is based on paragraph 17B of Schedule 26 to FA 2002.

1608.     The various statements listed in paragraphs (a) and (b) of subsection (1) are those mentioned in UK generally accepted accounting practice or international accounting standards. But subsection (1)(c) caters for amounts recognised in any accounting statement not among those listed.

1609.     The statements listed in paragraphs (a) and (b) of subsection (1) include a “statement of comprehensive income”, “statement of recognised income and expense” and “statement of income and retained earnings”. These statements are not mentioned in the source legislation but are the equivalents in more recently applying accounting standards of the statements listed there.

1610.     So far as the terms in those paragraphs derive from accounting standards, they are defined in clause 710 as having the meaning they have for accounting purposes.

1611.     Subsection (2) brings in prior period adjustments for this purpose but subsection (3) excludes amounts recognised “by way of correction of a fundamental error”. Such amounts are brought into account in the prior period affected by the error (so that the amounts so brought into account “fairly represent” profits and losses etc in respect of the contract in that period).

1612.     See also clauses 613 to 615 for the treatment of adjustments shown in accounts on a change of accounting policy.

Clause 598: Regulations about recognised amounts

1613.     This clause provides powers for regulations that amend the amounts regarded as “recognised” in one or other of the various statements mentioned in clause 597(1). It is based on paragraph 17C of Schedule 26 to FA 2002 and paragraph 52 of Schedule 4 to FA 2005.

1614.     For regulations made under this power, see the Loan Relationships and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses) Regulations 2004 (SI 2004/3256), as amended, and the Loan Relationships and Derivative Contracts (Change of Accounting Practice) Regulations 2004 (SI 2004/3271), as amended.

Clause 599: Meaning of “amounts recognised for accounting purposes”

1615.     This clause defines “amounts recognised for accounting purposes” by reference to the case of a company that has not prepared accounts in accordance with generally accepted accounting practice. It is based on paragraph 17A(2), (3) and (4) of Schedule 26 to FA 2002.

1616.     This clause is particularly relevant to the application of clause 595 and the interpretative provision in clause 597.

1617.     See the commentary on clause 595(2) for the relevance of “generally accepted accounting practice”. Unless a company uses international accounting standards for a period, the default meaning of “generally accepted accounting practice” is UK generally accepted accounting practice (see section 50(1) of FA 2004). When this clause applies, it therefore uses UK generally accepted accounting practice (as defined in section 50(4) of FA 2004).