IFM40775 - Treatment of certain payments: excluded indexed securities

Where a QAHC invests in debt instruments, it may receive returns which are capital in nature (for example, the QAHC may realise a gain on a debt instrument acquired at an undervalue – sometimes referred to as a ‘pull-to-par gain’). Such underlying gains will generally be taxed under the loan relationship rules in CTA09/PT5. There are similar considerations with respect to derivative contracts which are taxed under CTA09/PT7.

A QAHC may wish to return underlying gains realised on debt instruments and derivative contracts to investors in a way which means that UK tax resident individual investors are treated as receiving a capital return, not income, whilst also generating a deductible expense at the level of the QAHC.

In order to achieve this outcome, investors in a QAHC may hold securities which fall within the definition of excluded indexed security (EIS) in ITTOIA05/S433. Provided that the security meets the relevant conditions in ITTOIA05/S433, any profits returned to investors using an EIS would be subject to capital gains tax, not income tax, in the hands of the investors. This is because an EIS is excluded from the deeply discounted securities (DDS) rules (ITTOIA05/S432). See SAIM3050 for further information.

Whether any amounts returned to investors using an EIS are deductible for the QAHC will depend on the applicable accounting treatment and the normal application of the loan relationship rules in CTA09/PT5.

Note that the comments above relate to the use of an EIS to return underlying gains to investors. The EIS rules cannot be used to return income received by the QAHC in capital form.