Two taxpayers have lost their cases on the derecognition of derivative contracts. The taxation of derivative contracts, in general, follow that of the accounting treatment of GAAP compliant accounts. Anything that is recognised for accounting purposes is generally recognised for tax purposes, as long as those accounting entries ‘fairly represent’ the transactions that have taken place.
The taxpayers, a subsidiary of Caledonia Investments plc and a subsidiary of Ladbrokes Group, both held derivative contacts that were ‘in the money’ and transferred the economic performance of these contracts to the parents by way of a bonus issue of shares that paid dividends in relation to the cash received under the derivative contract. This was a scheme marketed by a Big 4 accountancy practice.
Under accounting rules (both international and UK) this required that the taxpayers charge their accounts with a derecognition charge amounting to the fair value of the derivatives at the date the economic benefits were transferred. Both taxpayers claimed a deduction against corporation tax for the values so charged.
The case was heard at the lower tribunals and made its way to the Court of Appeal (CoA). The CoA found in favour of HMRC holding that the accounting entities didn’t ‘fairly represent’ any loss that the taxpayers had incurred. The CoA imagined a hypothetical situation where the taxpayers were insolvent and in liquidation or a distributing administration and noted that the proceeds of the derivative contracts would be used to pay proven creditors of the taxpayers and not the shareholders by way of the special dividends. While the economic benefits of the contacts had been transferred to the parents the taxpayers themselves hadn’t incurred any real loss. The resulting dividends under the newly issued shares could not be considered losses.
The CoA referred to two case we have analysed, both concerning the rules regarding loan relationships that in a similar manner to the derivative contract rules, follow the accounting entries where there accounting entries fairly represent the transactions. The first case (our analysis here) considered gains on assigned debt and the second case (our analysis here) considered exchange differences on loans. In the first case, it was held the accounting entries didn’t fairly represent the transactions but the second case found that the accounting entries did. The scheme marketed by a Big 4 practice was shown to be ineffective.
The decision can be found at: The Union Castle Mail Steamship Company Ltd v HM Revenue and Customs & Ors – Find case law (nationalarchives.gov.uk)
Please let us know if you have any questions around derivative contracts. We can help with their valuation, appropriate accounting under international and UK GAAP and their tax treatment.
