This paper sets out the comments of the Chartered Institute of Taxation, submitted on 19 April 2002, on the draft legislation that was circulated for comment on 27 March 2002.
We would like to express our appreciation to the Inland Revenue for giving us and other representative bodies an opportunity to comment on the revised drafting for the derivative contracts definitions. The use of FRS 13 in defining derivatives has its attractions but also, as can be seen below, significant problems, in particular the mismatch between accounts and tax arising from companies which do not apply FRS 13 and the statutory application as if they did. We therefore believe that careful thought should be given as to whether it is truly appropriate to define in this way the derivates that will fall within the legislation.
All references are to the numbering of the draft paragraphs.
Paragraph 3(1), (3), (4) and (5)
In our view some changes are needed to the draft paragraph 3 to reflect the following points:
FRS 13 is not, in strictness, a standard that determines how financial instruments are accounted for; it only concerns disclosures in accounts. Further it does not apply to all entities. Part A applies (with exceptions) to, “a reporting entity … that has any of its capital instruments listed or publicly traded on a stock exchange or market …”. Parts B and C also apply to a limited range of companies. It would, however be desirable for the references to “derivative financial instrument” in FRS 13 to apply regardless of whether the company in question is actually subject to any of the disclosure requirements in FRS 13. We do not consider that the existing drafting within sub paragraphs (4) and (5) goes wide enough to cover cases where a company is not within the scope of FRS 13.
FRS 13 is unlikely to undergo evolutionary change as envisaged in paragraph 3(5)(b). Instead, by 2005, the whole body of current UK accounting standards is expected to be replaced by International Accounting Standards, at least for certain reporting entities. Following the European Parliament decision reported on 12 March, it is expected that this will be the case generally throughout the EU for the consolidated accounts of listed companies. It is not yet clear to what extent other UK companies will be affected. The applicable standard is IAS 39, but this may be subject to significant revision.
The definition of a derivative financial instrument in IAS 39 differs from that in FRS 13. In particular a contract that requires significant initial net investment, such as a deep in the money option, is excluded.
We understand that it is envisaged that all UK companies within consolidated groups to which International Accounting Standards apply will themselves be bound by those standards.
In the light of the above we would make the following suggestions:
· Paragraph 3(1) plays a structural role and can be retained, so long as the cross-reference to FRS 13, currently in Para 3(5), is appropriately worded.
· Paragraphs 3(3) and (4) do not work so well – it would probably be better to move straight on from para 3(1)(a) to a reference to FRS 13. We would suggest applying the definition of “derivative financial instrument” in FRS 13 in any period of account to which, under UK GAAP, the disclosure requirements of Part A of FRS 13 would apply to a company within its scope. This should be the case whether or not the company in question is actually within the scope of those disclosure requirements (for instance the vast majority of UK companies that have no listed capital instruments and non-UK companies). This would replace paragraphs 3(3) and 3(5)(a), to the extent the latter deals with derivative financial instruments.
· A similar approach could be applied in relation to the reference to “financial asset” in para 3(1)(b), this time replacing paragraphs 3(4) and 3(5)(a) to the extent the latter deals with financial assets.
· So far as para 3(5)(b) is concerned there appear to be two choices. One is to omit it altogether, relying on regulations under paragraph 13(4). The other is to make a pre-emptive reference to IAS 39, constructed on similar lines to the reference to FRS 13, but in this case applicable in periods of account to which, under UK GAAP, IAS 39 would apply to a company within its scope. The switch to an IAS-based definition would then occur once, under UK GAAP, IAS 39 applied to at least some companies. To ensure consistency, it would also be necessary for the reference to FRS 13 to be overridden at that point, even if its disclosure requirements still applied to some UK companies.
· As pointed out above there is a different definition of derivative financial instrument is in IAS 39. It might be possible to deal with this by requiring that the exclusion of an instrument “that requires no initial net investment or little net investment relative to other types of contract that have a similar response to changes in market conditions” to be ignored.
It is not clear that electricity derivatives are covered and we have been asked to raise this point with you. Although electricity is generally seen as a commodity, it is at first sight not tangible moveable property.
The definition refers to "the risk of providing credit". We do not consider that this definition is apt to cover cases where debt instruments are acquired in secondary markets since the purchaser of such instruments has not "provided credit" although it clearly has a credit exposure in respect of the debt instrument.
Paragraphs 4, 9 and 47
We have had some difficulty in understanding the interaction of paragraphs 4, 9 and 47 and we would request that the wording of the draft legislation be clarified to put beyond doubt where a derivative contract which includes excluded property will or will not fall within the new derivative contracts legislation.
We would welcome an extension to the bifurcation provisions contained in paragraph 47. We accept that any such bifurcation should be limited to futures, option and warrants. What we would request is that, where the contract would not be excluded from the derivative contracts legislation under the provisions of paragraph 4(2), and the underlying subject matter includes excluded property in all cases the contract should be split between its excluded and non-excluded elements where the holder would be within the charge to corporation tax on chargeable gains in respect of the excluded subject matter. The non-excluded element of the contract should then be dealt with under the provisions of the derivative contracts legislation, whilst the excluded element would be dealt with under the capital gains tax legislation. At the very least such treatment should be applied to cases where the contract provides for the physical delivery of such excluded items.
We note that the Inland Revenue have expressed concerns about contracts being bifurcated in the context of total return swaps. As such contracts would be contracts for differences and not futures options or warrants, they would fall within the derivative contracts legislation in all cases.
We consider that the terms "subordinate" and "of small value" ideally should be defined in the derivative contracts legislation. We appreciate, however, that given the current timetable it would not be possible to agree the wording of a statutory definition with all interested parties. We would suggest, therefore, that the Inland Revenue initially issue guidance on which taxpayers may rely on the meaning of such terms with a view to introducing a statutory definition by statutory instrument once further consultation has taken place. If the Inland Revenue decide against introducing a statutory definition guidance on the meaning of these terms should be given in the form of a Hansard statement.
We note that the definition of the underlying subject matter of an option would result in a cash settled option over shares or other excluded assets being brought within the new derivative contracts legislation were the derivative contacts definitions to be mutually exclusive (ie were a cash settled option not to be treated as a contract for differences) – see also our comments on paragraph 12 below.
We consider that the list of subject matter of a contract for differences, as set out in the subparagraph (6), is not exhaustive. It would, however, be helpful if the Inland Revenue could confirm that this is the case in any guidance issued on the new draft legislation as included in the Finance Bill.
We note that the definitions of the various derivative contracts that fall within the new regime are not mutually exclusive. In order to avoid uncertainty, particularly when deciding whether a contract should be bifurcated under the provisions of paragraph 47, we would request that the definitions be made mutually exclusive, or at least that provision be made that where a contract satisfies the definition of a future, option or warrant the contract will not be treated as a contract for differences.
We welcome the fact that the definition of a contract for differences has now been made exhaustive. We consider that the proposed definition still has a subjective element as it still refers to a "purpose or pretended purpose". The reference to “pretended purpose” in particular is giving rise to concern and with this in mind we wonder whether it would be possible to replace pretended purpose with, say, ”object”.
We still have some concern that it is not explicitly stated that cash is not to be regarded as the underlying subject matter of a derivative contract. If there is some concern that foreign currency hedges might thereby be excluded, this exclusion might be tempered by an exclusion for derivative contracts whose “purpose or object is to make a profit or avoid a loss by reference to fluctuations in the relative value of different currencies”.
19 April 2002
020 7235 9381