CFM52040 - Derivative contracts: the matters and computational rules: capitalised amounts

CTA09/S604

This guidance covers cases in which amounts in respect of derivative contracts are capitalised in a company’s financial statements and therefore do not immediately give rise to amounts recognised as items of profit or loss. Such amounts are most likely to arise in respect of derivatives used to hedge interest rate risk, for example interest rate swaps or forward rate agreements. Both the accruing interest and amounts in respect of the hedging instrument may be capitalised.

Like the corresponding loan relationship provision, CTA09/S320 (see CFM33160), S604 allows amounts to be taken into account for tax notwithstanding this treatment. This section was amended by F(2)A15 for company period of account beginning on or after 1 January 2016, but without major changes to the general effect of the provision. The main change is that the special rule is no longer limited to amounts taken to the carrying value of a ‘fixed capital asset or project’, terminology not current in UK GAAP.

Position for accounting periods beginning on or after 1 January 2016

The general rule in s595 is that amounts arising in respect of the derivative contract matters set out in S594A are only taken into account for tax under CTA09/PT7 if they are treated, under GAAP, as items of profits or loss. S604 can override this rule where GAAP allows amounts to be recognised in determining the carrying value of an asset or liability. Before the changes made by F(2)A15, special treatment could only apply where a credit or debit was taken into account in determining the value of a “fixed capital asset or project”.

Where amounts are recognised in determining the carrying value of an asset, this does not give rise to an amount recognised as an item or profit or loss unless and until the asset is amortised or derecognised. The amount would then not be characterised as interest for accounting purposes.

S604(1) lists three conditions that must be satisfied for special treatment to apply:

• An amount must be in respect of one of the matters in s594A(1);
• GAAP allows the amount to be recognised in determining the carrying value of an asset or liability;
• any profit or loss for corporation tax purposes in relation to that asset or liability will not fall to be calculated in accordance with generally accepted accounting practice.

The third requirement means that if the asset or liability will give rise to amounts treated as income under an accounts-based regime, special treatment does not apply. The obvious example is amounts taken into account in determining the carrying value of inventory, typically something that takes some time to manufacture for sale, say an aircraft. In that case the accounts are simply followed.

The effect of special treatment is that the amount is taken into account when capitalised, as if it were treated as an item of profit or loss. But then to the extent that an amount so treated gives rise to a debit on amortisation, depreciation or writing down, is not taken into account for tax.

The treatment in S604 does not apply to amounts taken to the carrying value of an intangible fixed asset to which a writing down at fixed rate election applies CTA09/S730. This election cuts the direct link with accounting.

Position for accounting periods beginning before 1 January 2016

Before the F(2)A 15 changes, CTA09/S604 followed CTA09/S320 (deduction for loan relationship debits where the debits are capitalised - see CFM33160).

It applied where credits or debits on a derivative contract were brought into account as part of the value of a fixed asset or project. For example, interest rate swap payments may be capitalised where interest payments are also capitalised, or profits and losses on a currency contract hedging exchange rate risk on purchase of a fixed asset may be taken to the fixed asset account - see example below. In such cases the debits and credits should be brought into account on the same basis as they would have been recognised in the company’s accounts, had they not been capitalised.

CTA09/S604(3) prevents double counting by ensuring that an amount cannot be taken into account both for the derivative contracts rules and under the intangible assets rules.

In addition, sub-section (5) gives a ‘no second bite of the cherry’ rule, in line with that for loan relationships - it applies for periods of account beginning on or after 1 January 2005. If, by virtue of CTA09/S604, a debit arising from a derivative contract is allowed for tax purposes in advance of its recognition in the accounts, the company cannot claim a second deduction when the loss is recognised in the accounts, whether through writing down the value of the capital asset or project, or through amortisation or depreciation. Although the legislation refers only to debits, HMRC will similarly not argue that a credit brought into account under S604 should be taxed again when it affects the profit and loss account.

Example (rules as they applied before the F(2)A15 changes)

In its accounting period ended 31 December 2010, a company places an order for a piece of machinery, for which it will have to pay $3 million on 1 May 2011. It hedges exchange rate risk on the prospective purchase by entering into a forward currency contract to buy $3 million for £1.5 million on 1 May 2011 (in other words, a contracted rate of $2.0/£). On 1 May 2011, $3 million is worth £2 million (a spot rate of $1.5/£), so that the company has made a profit of £500,000 on the derivative contract.

The company has not adopted IAS 21 or FRS 23, and continues to account for exchange gains and losses in accordance with SSAP 20. As permitted by SSAP 20, it does not recognise the £500,000 in its profit and loss account in year ended 31 December 2010, but instead translates the $3 million purchase price at the rate of exchange implied by the currency contract - in other words, it treats the machinery as acquired for £1.5 million. This means that, in 2011 and subsequent periods, depreciation charged by the accounts is based on an initial cost of £1.5 million, not the spot price of £2 million. Thus the £500,000 ‘profit’ on the currency contract is brought into account over the economic life of the asset, because the depreciation charge is less than it otherwise would have been.

But for tax purposes, S604 applies: the £500,000 gain on the contract is brought into account for year ended 31 December 2010. The whole of the depreciation on the machinery will be added back in the tax computations, so there is no double taxation of the £500,000 profit. Similarly, if there had been a loss on the currency contract, it would have been brought into account in 2010 by virtue of S604, while S604(5) makes it clear that the company could not subsequently seek to deduct any part of the depreciation charge.

For capital allowances purposes, the foreign currency expenditure is translated at the spot rate for the date on which it is treated as incurred for capital allowances purposes (CA11750). Assuming this date to be 1 May 2011, the company’s qualifying expenditure is £2 million. Overall, S604 ensures that the tax treatment is precisely the same whether the gain (or loss) on the currency contract is recognised immediately, or whether it is capitalised.