CFM82480 - Old rules: asset-linked securities pre 2005: guaranteed returns: definitions
Meaning of guaranteed return
This guidance applies to periods of account beginning before 1 January 2005
There were two elements to identifying a guaranteed return.
- Was it reasonable to assume, from the likely effect of the transactions, and/or the circumstances they were entered into, that the main purpose was to achieve a guaranteed return?
- Was there a guaranteed return - that is, had the risks from the fluctuations in the underlying subject matter been eliminated or reduced so that the return was only incidentally affected by such fluctuations and was equivalent in substance to an investment of money at interest?
Main purpose
Was the main purpose, or one of the main purposes of the combined transactions, to ensure that there was a guaranteed return? This could be judged by considering the effect of the transactions and the circumstances in which the transactions were entered into.
Underlying subject matter
For loan relationships, the underlying subject matter was the linked chargeable asset or index - FA96/S93A(5)(a). To be within S93, the asset would have required to be an interest in land or an ordinary share listed on a recognised stock exchange.
Risks from fluctuations
A company can minimise the risk from fluctuations by deliberately choosing an underlying asset that does not, or is unlikely to, fluctuate. Where the low risk was the main reason for the choice, S93A(4) confirmed that this counted as ‘eliminating or reducing risk’ and the company would not get chargeable gains treatment.
Example: meaning of guaranteed return
Filbow Ltd subscribed £1m for a 1-year equity-linked bond redeeming on 31 December 2003. The bond paid interest of 1%, i.e. £10,000 per annum. The return was fully linked to the performance of ordinary shares in Gulcor Ltd, a listed company. Shares in Gulcor Ltd were trading at 400p at the time the bond was issued.
Filbow Ltd entered into two option contracts with Heston Ltd, a put option and a call option over shares in Gulcor Ltd. The put option gave Filbow Ltd the right to sell 250,000 shares in Gulcor Ltd on 31 December 2003 at a strike price of 420p per share, which was for a total payment of £1,050,000.
The call option gave Heston Ltd the right to buy 250,000 shares in Gulcor Ltd on 31 December 2003 at a strike price of 420p per share. That was for a total of £1,050,000.
Filbow Ltd and Heston Ltd would choose whether to exercise their option on the basis of the value of shares in Gulcor Ltd on the day. If the shares were trading below 420p per share then Filbow Ltd would exercise its option to sell the shares at 420p. If the shares were trading at more than 420p then Heston Ltd would exercise the option to buy the shares at 420p.
Instead of actually buying and selling the shares, the parties could hand over the cash difference between the exercise price (£1,050,000) and the market value of shares in Gulcor Ltd on the day. The table below shows the effect of the three contracts taken together for different values of shares in Gulcor Ltd on 31 December 2003.
| Shares are trading at | 360p | 400p | 440p | 480p |
|---|---|---|---|---|
| Bond interest | £10,000 | £10,000 | £10,000 | £10,000 |
| Adjusted principal | £900,000 | £1,000,000 | £1,100,000 | £1,200,000 |
| Put option | £150,000 | £50,000 | - | - |
| Call option | - | - | (£50,000) | (£150,000) |
| Total payments | £1,060,000 | £1,060,000 | £1,060,000 | £1,060,000 |
Where the shares are trading at a value below the exercise price, the lender makes less money on the bond but gains from exercising the put option.
Where the shares are trading at a value above the exercise price, the lender makes more money on the bond but has to pay out under the terms of the call option.
The combined effect of the three agreements is to ensure that the lender always gets a return of £60,000 on the lending of £1,000,000, regardless of the movements in the value of the shares. This is equivalent to an interest-like return of 6% over the period of the loan.