Chapter 4: Further provision about credits and debits to be brought into account
Section 612: Overview of Chapter
1658.This section describes the purpose and content of the Chapter. It is new.
Section 613: Introduction to sections 614 and 615
1659.This section sets out when sections 614 and 615 apply. It is based on paragraph 50A(1) and (1A) of Schedule 26 to FA 2002 and paragraph 7(6) of Schedule 6 to F(No 2)A 2005.
1660.A company may decide to apply a different set of standards to the presentation of the company’s results. Regulatory rules may also require that a company switches to a different set of standards. If there is such a change of accounting policy, the value of the company’s assets and liabilities at the start of the first period of account to which the change applies are restated in accordance with the standards adopted.
1661.This section applies only if the change is from an accounting policy that “accords with the law and practice applicable” in relation to the earlier period to another such policy in relation to the next. The law and practice in question is that provided in particular by the Companies Acts and the Accounting Standards Board (or their equivalents in its country of residence if the company is non-UK resident but within the charge to corporation tax in respect of a derivative contract).
1662.Sections 614 and 615 prescribe the credit or debit to be brought into account on a change of accounting policy, according to whether the value of the company’s assets and liabilities increases or decreases on the change.
1663.Subsection (4) treats a particular situation as a change of accounting policy although there is no change in the actual accounting policy used by the company from one period to the next. International accounting standards and new UK generally accepted accounting practice require a company, in certain circumstances, to divide a loan relationship between rights and liabilities under a loan relationship and rights and liabilities under one or more derivative financial instruments or equity instruments (see section 585(1)).
1664.Section 416 allows a company subject to old UK generally accepted accounting practice (which does not permit it to divide a loan relationship in that way) to elect that a loan relationship is treated as divided as mentioned in section 415(1) (the equivalent for loan relationships of section 585(1)), if division would be permitted under new UK generally accepted accounting practice or international accounting standards. Section 416 applies an election made under it for the purposes of this Part as well as for Part 5.
1665.The result of such an election is a change in accounting policy for the purposes of sections 614 and 615, but only in relation to all the derivative financial instruments or equity instruments in the company’s affected loan relationships. This rule applies from the date the election has effect. Broadly, the election has effect from the beginning of the period of account in which the first loan relationship is acquired to which an election can apply.
Section 614: Change of accounting policy involving change of value
1666.This section treats the increase or decrease in the carrying value of a derivative contract on a change of accounting policy as a credit or debit to be brought into account in the later period. It is based on paragraph 50A(2), (3) and (5) of Schedule 26 to FA 2002.
1667.“Carrying value” is defined in section 702.
1668.Subsection (3) makes an exception to the general rule in so far as a credit or debit arising from the change of accounting policy is brought into account for the purposes of this Part under another provision. For example, a prior period adjustment brought into account under section 597(2) would be excepted from the general rule in this section.
Section 615: Change of accounting policy after ceasing to be party to derivative contract
1669.This section requires a credit or debit to be brought into account, similarly to section 614, in a case where section 608(2) applies. It is based on paragraph 50A(3C), (3D) and (5) of Schedule 26 to FA 2002.
1670.Section 608 applies if profits and losses arising to a company from a derivative contract for the accounting period in which the company ceases to be a party to the contract are not wholly reflected in credits and debits brought into account under this Part for that period. In effect, it is a “post-cessation receipts” provision.
1671.Because the derivative contract from which the income or loss derived is either no longer in existence or no longer held by the company, section 613 cannot apply in this case. Section 615 deals with the amount by which the value of the residual deferred income or loss in respect of the former contract alters as a result of the change of accounting policy affecting a subsequent period.
1672.Subsection (4) corresponds to the rule in section 614(3).
1673.Subsection (6) corrects a minor error in the source legislation. Paragraph 50A(3D) of Schedule 26 to FA 2002, in defining the “amount outstanding”, refers to an amount recognised “in respect of the profits, gains or losses that arose from that relationship or a related transaction in the cessation period (within the meaning of section 103(6))”. The words with emphasis are of course appropriate to the loan relationships provisions and not to those for derivative contracts. They reflect the wording of paragraph 19A(4C) and (4D) of Schedule 9 to FA 1996 (rewritten as section 318 in Part 5), on which paragraph 50A(3C) and (3D) of Schedule 26 to FA 2002 was modelled. More appropriate wording has been substituted.
Section 616: Disapplication of fair value accounting
1674.This section reverses the effect of sections 584 and 586 if certain conditions are met by reference to an embedded derivative identified by either of those sections. It is based on paragraphs 45L(1), (1A), (1B), (1C), (2) and (3) of Schedule 26 to FA 2002.
1675.Because the contract out of which the embedded derivative arose is treated as one that is not split in accordance with section 584 or 586, the section disapplies sections 573 and 574 to that derivative.
1676.It also sets aside fair value accounting as an accounting basis in calculating profits and losses on the contract in question. For contracts to which this section applies, splitting of the contract under section 584 or 586, or the use of fair value accounting, may produce unacceptably volatile results for tax purposes.
1677.The section does not apply to an embedded derivative within section 584 that comes within section 592 (so that it may meet the “excluded property” conditions in section 589). Nor does it apply if regulation 9 of the Disregard Regulations applies (SI 2004/3256, as amended). That regulation prescribes credits and debits, in the case of derivative contracts that are interest rate contracts, for the purposes of paragraph 17B of Schedule 26 to FA 2002 (rewritten in section 597).
1678.Nor does the section apply if an election is made under section 617 for this section not to apply. A company may choose to make such an election if it prefers to retain fair value accounting for contracts within section 584 or 586.
1679.Subsection (3) treats the relevant contract that was divided under section 584 as not so divided. It is therefore treated as a single derivative contract for the purposes of this Part. But again the contract is treated as one to which fair value accounting does not apply.
1680.Subsections (4) and (5) treat the contract that was divided under section 586 as not so divided. The contract is therefore outside the scope of this Part. It is dealt with for tax purposes according to what sort of contract it is. Subsection (5) also provides that section 46 in Part 3 of this Act (calculation of trade profits in accordance with generally accepted accounting practice) applies as if fair value accounting was not generally accepted accounting practice for that company.
1681.Subsections (3) and (4) apply to the “original contract” (defined in subsection (7)) rather than (as in the source legislation) the “contract” to avoid confusion with the relevant contract referred to in subsection (1)(a).
Section 617: Election for section 616 not to apply
1682.This section allows a company to elect that section 616 does not apply to its contracts. It is based on paragraph 45L(2A), (2B) and (2C) of Schedule 26 to FA 2002.
1683.For some companies the benefit afforded by section 616 may be disproportionate to the administrative and accounting burden of distinguishing and tracking affected contracts. Or the degree of volatility in the tax consequences of splitting the contract or using fair value accounting may be acceptable to the company holding the contract.
1684.An election under this section applies to all of a company’s contracts. Section 618 contains further provisions modifying or extending the effect of an election made by a member of a group of companies.
1685.Subsection (2) excludes two types of contract from an election. They are, first, a “contract of long-term insurance” (defined in section 431(2) of ICTA) and, second, a contract where the embedded derivative identified by section 584 or 586 has commodities as its underlying subject matter.
1686.Subsection (2)(b) says “embedded derivative” rather than “embedded derivative contract”. The Finance Act 2002, Schedule 26, (Parts 2 and 9) (Amendment) Order 2006, SI 2006/3269 omitted the definition of “embedded derivative contract” from the source legislation. But the use of the term in paragraph 45L(2A) of Schedule 26 to FA 2002 was missed. “Embedded derivative” matches the amendments introduced in this respect by that Order. See in particular sections 584 and 586.
1687.Unlike the source legislation, the section does not specify how the election must be made. See Change 1 in Annex 1.
Section 618: Elections under section 617: groups of companies
1688.This section applies or disapplies the effect of an election under section 617 in a number of cases where a party to a contract is a member of a group of companies. It is based on paragraph 45LA of Schedule 26 to FA 2002.
1689.In the first case, subsection (1) treats the group member who is a counterparty to a contract to which a fellow group member is a party as having made an election in relation to that contract if that fellow group member has made an election. This rule ensures parity of treatment of the contract within the group.
1690.In the second case, subsection (2) provides that a group member to whom a fellow group member has transferred a contract is treated as having made an election in relation to that contract if the fellow group member makes an election. This rule applies even if that fellow group member makes the election at a time after the transfer has been made or at a time when the companies are no longer members of the same group. This rule ensures that a company cannot exclude some of its contracts from the effect of an election by first transferring them to another group member.
1691.The reference in subsection (2) to a contract “to which section 584… or section 586… applies” corrects a missed consequential amendment to paragraph 45LA(3)(b) of Schedule 26 to FA 2002. The reference there to “paragraph 2(3)” is otiose following the replacement of that provision by paragraph 2(2A) of Schedule 26 to FA 2002 (by article 3 of the Finance Act 2002, Schedule 26, (Parts 2 and 9) (Amendment) Order 2006, SI 2006/3269) and the insertion of paragraphs 2A and 2B of Schedule 26 to FA 2002 (by article 4 of that Order). Sections 584 and 586 apply to the types of contract to which paragraph 2(3) of Schedule 26 to FA 2002 applied.
1692.The third case is if:
B becomes a party in place of A to a relevant contract treated as such by section 584 or 586, at a time when they are members of the same group;
that contract was within section 616 in A’s hands (that is, A had not made an election); and
B’s other contracts are outside section 616 by virtue of an election B has made (whether an election made before B has succeeded A as a party to the contract or one made later).
1693.Subsection (4) ring-fences the contract in question, so that any existing or later election by B is ineffective in relation to that contract. This rule ensures that a contract cannot be selected for preferential treatment under another group member’s election if the member who is the original party to the contract does not otherwise wish to make an election. This rule is however disapplied if A makes an election in respect of its contracts subsequent to B becoming a party to the contract in place of A.
Section 619: Partnerships involving companies
1694.This section and the next two set out how a company partner brings into account credits and debits in respect of its share of a firm’s derivative contracts. This section provides that each company partner, not the firm, brings credits and debits into account in calculating its profits chargeable to tax. It is based on paragraph 49(1) and (2) of Schedule 26 to FA 2002.
1695.Paragraph (c) in subsection (1) requires that the firm is a party to a contract that “is a derivative contract or would be a derivative contract if the firm were a company”. A firm is not a company. So a contract held by a firm would not meet any test under which a contract is or is treated as a derivative contract because it is held by a company.
1696.Subsection (2) switches off the normal rule in section 1259 (which rewrites section 114(1) of ICTA) under which the profits of the firm’s trade etc are calculated, in accordance with the partners’ interests in the firm, as if the firm were a company.
Section 620: Determination of credits and debits by company partners
1697.This section determines the credits and debits to be brought into account under section 619(3) by each company partner in a firm. It is based on paragraph 49(3), (4), (5) and (6) of Schedule 26 to FA 2002.
1698.Subsections (2) to (4) attribute the actions of the firm to the partner for the purposes of applying the rules that determine the credits and debits to be brought into account in accordance with this Part.
1699.“Profit-sharing arrangements”, in relation to a partnership, is defined in section 710. A firm’s “profit-sharing arrangements” are described in section 1262, in the sections rewriting section 114 of ICTA, as “the rights of the partners to share in the profits of the trade and the liabilities of the partners to share in the losses of the trade”.
Section 621: Company partners using fair value accounting
1700.This section applies fair value accounting, in determining under section 620 the company partner’s share of the credits and debits arising in respect of the firm’s derivative contracts, if that company partner uses fair value accounting in relation to its interest in the firm. It is based on paragraph 50 of Schedule 26 to FA 2002.
Section 622: Contracts ceasing to be derivative contracts
1701.This section provides that, if a relevant contract to which the company continues to be a party ceases to be a derivative contract, there is a deemed disposal of the contract at the time of that cessation. It is based on paragraphs 43A(5) and 43B of Schedule 26 to FA 2002.
1702.Subsection (2) deems the company to have disposed of the contract in a “related transaction” (defined in section 596) for consideration equal to the “notional carrying value” of the contract at the time it ceases to be a derivative contract. Depending on the amount of the consideration attributed to that disposal under this subsection, a credit or debit arises to be brought into account under this Part. That credit or debit is additional to any other credit or debit that arises in relation to the contract, while it was a derivative contract, for the accounting period in which the deemed disposal occurs. “Carrying value” is defined in section 702.
1703.The source legislation for subsection (4) refers to the amount that would have been the carrying value of the contract in the accounts of the company “if an accounting period had ended immediately before that time”. The source legislation for the equivalent definition in section 625(6), paragraph 28(3) of Schedule 26 to FA 2002, refers to the value found “if a period of account had ended immediately before” the requisite time. But, if a period of account comes to an end, that is the end of an accounting period under section 10. The two definitions have been brought into line using “period of account”.
1704.After the contract ceases to be a derivative contract, it is likely to be a chargeable asset for the purposes of corporation tax on chargeable gains. Subsection (5) therefore signposts section 662 which prescribes the acquisition cost of the contract for that purpose.
Section 623: Index-linked gilt-edged securities with embedded contracts for differences
1705.This section provides that credits and debits arising in respect of an embedded derivative in an index-linked gilt-edged security are not brought into account under this Part if conditions are met. It is based on paragraphs 12(1), (11A) and (11B) and 45I of Schedule 26 to FA 2002.
1706.If the embedded derivative is closely related to the host contract, generally accepted accounting practice does not in fact require the company to divide the security as mentioned in section 585. In that case, sections 399 and 400 in Part 5 (loan relationships) apply. But, for example, a company whose functional currency is not sterling may be required to divide its index-linked securities between an embedded derivative and a host contract, in which case this section may apply.
