CFM51036 - Derivative contracts: the matters and computational rules: amounts recognised in OCI and not transferred to profit or loss

CTA09/S604A

This guidance is applicable to company periods of account beginning on or after 1 January 2016.

For earlier periods see CFM52050.

Circumstances in which amounts recognised only in OCI may be taxed

Background

F(2)A15 made a significant change to which amounts recognised in a company’s accounts, in respect of the derivative contracts (and loan relationships) matters, fall to be taken into account for tax, absent the application of special rules.

Before amendment there was an expanded tax definition of an “amount taken into account in determining a company’s profit or loss” in S597(1), as it then stood. This was primarily based on the statement in the account to which a debit or credit was taken, including the company’s profit and loss account, income statement or statement of comprehensive income for that period, statement of total recognised gains and losses, statement of recognised income and expense, statement of changes in equity or statement of income and retained earnings for a period. Numerous, often complex, special tax rules then limited the effect of this expanded meaning of profit or loss.

This complexity to some extent reflected evolving accounting standards but by the time F(2)A15 was enacted the position had stabilised. IAS and FRS102 (the UK domestic accounting standards generally applicable to all companies except micro entities that adopt FRS105) had converged to an approach where the primary distinction was between amounts treated as an item of profit or loss and amounts treated as items of other comprehensive income (OCI). The third option was for an amount to be taken into account in determining the carrying value of an asset or liability, in this regard see S604 and CFM52040. The name given to a particular statement in a company’s accounts was of lesser importance.

The changes to the derivative contracts (and loan relationships) legislation reflect the stabilisation of the accounting standards. It was then possible to make the primary determinant of whether an amount relating to one of the derivative contracts matters was to be taken into account for tax was whether it was treated as an item of profit or loss. Thus an amount taken directly to OCI would not be taxed unless a special rule intervened.

S597(IA) specifically includes an amount previously recognised in other comprehensive income, but transferred to profit or loss in a later period.

Tax ‘recycling’ under s604A

S604A deals with special cases where the normal rule is overridden and amounts taken directly to OCI may be taken into account for tax.

The special rule comes into effect if, in a company’s period of account, an asset or liability representing a derivative contract of a company ceases in accordance with GAAP to be recognised in the company’s accounts.

The rule can have effect in relation to amounts that:

  • are recognised in a company’s accounts
  • have been treated, in accordance with GAAP, as items of other comprehensive income; and
  • have not been subsequently transferred to profit or loss (had they so been, they would then have become taxable, applying s597(1A)).

Where one of two conditions are satisfied, such amounts can be taken into account. These conditions are:

  • at the time when the asset or liability ceases to be recognised, it is not expected that the amounts that have been recognised in OCI will in future be transferred to become items of profit or loss; or
  • at some later time it is not expected that the such amounts will in future be transferred to become items of profit or loss.

The later condition is applicable where amounts are recognised in accounts under GAAP after a company has ceased to be a party to a derivative contract.

The amount is brought into account for tax in the period in which the condition is satisfied; if amounts are subsequently transferred to profit or loss in a company’s accounts they are not then taxed.

This can be seen as enforced tax ‘recycling’. This is a term which has tended to fade out of use in accounting standards. It was used to describe the case where amounts previously recognised as items of OCI are subsequently reclassified as items of profit or loss; this is described as transferring to profit or loss in S597(1A).

Amounts recognised in OCI are eventually transferred to profit or loss, so only taxing amounts recognised in profit or loss gives rise to no more than a timing difference, as compared to the rules before F(2)A15. However, amounts originally recognised in OCI are not always transferred to profit or loss and S320A ensures that amounts in respect of the derivative contracts matters do not fall out of the scope of taxation altogether.

What if a company applies FRS105? {#}

Under UK GAAP, a company that is a micro entity is permitted, but not required, to draw up its financial statements under FRS105. This is a much simpler standard than FRS102 or IAS. No distinction is made between profit or loss and other comprehensive income; the company will simply take into all items of income and expense in presenting its profit or loss. Accordingly nothing can be recognised in OCI and subsequently fall with the scope of S320A.

Typically amounts that fall to be initially recognised in OCI in a company’s financial statements under FRS102 or IAS have arisen from fair value accounting. FRS105 requires entities to use an accruals (amortised cost) approach, as against fair value accounting. The amount recognised under FRS105 in respect of derivative contracts should be much the same as amounts either initially recognised in profit or loss, or transferred to profit or loss from OCI, under FRS102 or IAS.

As a practical matter, entities able to qualify as micro-entities will typically not be party to contracts within the derivative contracts rules, at least not the more sophisticated instruments. For more on FRS105 see CFM 20035.