CFM63180 - Foreign exchange: matching: anti-avoidance: FA 2009: ‘one way exchange effect’: options and relevant contingent contracts

Options and relevant contingent contracts

Options

CTA09/S328F (and S606F) define ‘option’. The starting point is the definition of an option in CTA09/S580 - although this says only that an option includes a warrant. Otherwise the word takes its normal market meaning. However, CTA09/S580(2) and (3) are disapplied, so an option that can only be cash-settled - which would be a contract for differences under Part 7 CTA09 - is an option for the purposes of the one-way exchange effect rules.

Sections 584 to 586 allow an embedded derivative, which would have the characteristics of an option if it stood alone, to be an option for Part 7 purposes. CTA09/S328F(2) further widens the scope of the term by treating as an option any provision within a contract that it is possible to regard as an option. It is not necessary for the company to account separately for the embedded option, or even to be permitted by GAAP to do so.

For a contractual provision to have the characteristics of an option, it must have two key characteristics. It must permit a party to the contract to exercise a choice, and the likelihood of the party making that choice must be linked in a predictable manner to the price or value of an underlying subject matter. Since the legislation is concerned with the computation of exchange differences, an option-like clause is unlikely to require consideration unless the underlying subject matter is, or includes, a foreign currency.

For example:

• A foreign currency bank loan, used to hedge shares in an overseas subsidiary, is callable by the lender in the event of default. There is no predictable link between currency movements and the occurrence of a default, or the lender’s decision about whether or not to call in the loan if a default does occur. The arrangement would not be seen as containing an option just because of a provision of this sort.
• In the dual currency loan example at CFM63010, HoldCo has a choice under the terms of the dual currency loan to make repayment in either dollars or sterling. If the dollar depreciates, compared to its value when the loan is taken out, it is in HoldCo’s interest to repay in dollars because it will then have an exchange gain. There is a clear relationship between the value of the dollar and HoldCo’s likely decision. The dual currency feature of the contract is an ‘option’ within the meaning of the legislation.

Relevant contingent contracts

A relevant contingent contract is a contract to which the company doing the forex matching, or a company connected with it, is a party, and which contains an ‘operative condition’ (CTA09/S328G and CTA09/S606G). An operative condition is one that, if a particular contingency is met, changes a right or liability under the contract, and which operates directly or indirectly by reference to exchange rates.

Thus, in the dual currency loan that is being used as an example, the terms of the loan might provide that HoldCo must repay the loan in US dollars if, at the repayment date, the value of the dollar is less than it was at the start of the loan. Although this might sometimes be referred to as an automatically exercised option, it is not an option in legal terms, because HoldCo has no choice. But it would nevertheless come within the legislation as a relevant contingent contract.