The last 20 years has seen an explosion in the volume of equity and foreign exchange derivatives traded, but as yet the use of traded real estate derivatives has not taken off. One perceived reason is that the UK’s corporate tax regime for such instruments is unclear. The Government, then, is to be congratulated for introducing a corporate tax regime that attempts to clarify the treatment of derivative contracts relating to real estate. While clearer than its predecessor, the new regime is still in its infancy, and certain questions remain.
A liquid market in traded property derivatives can provide a convenient way of reducing or increasing exposure to UK or foreign real estate with much-reduced transaction costs. As the market develops, property derivatives may also provide a cheaper means of obtaining exposure to the risks and rewards of property ownership and it is thought more bespoke derivatives relating to specific assets or asset classes may subsequently develop. The area most likely to develop first is instruments, possibly listed, whose value moves in line with certain property indices (eg investment property databank (IPD) indices).
One major advantage of using property derivatives, rather than dealing in the underlying real estate, is that the transaction costs are likely to be substantially lower. Moreover, UK stamp duty land tax should not generally be chargeable so long as the derivative can only be settled in cash. To ensure this treatment, the derivative should be structured so as to provide no actual interest or rights over land (other than security interests), notwithstanding that its value may fluctuate in a way that corresponds to specified land values. A further advantage is that there is no need to withhold tax on payments under derivative contracts made to overseas persons – this is potentially better than the position for payments of rent. Indeed, one wonders whether in some cases the return from a swap over UK land would be sufficiently divorced from the UK to avoid any UK tax charge in the hands of a non-resident with no other connection with the UK.
Schedule 26 FA 2002 contains the legislation detailing the taxation of derivatives and has been amended to encompass property derivatives (the ‘new regime’). The intention is to bring the tax treatment of certain property derivatives held by companies into line with their accounting treatment. The place to start is therefore the accounting treatment for derivative contracts. The relevant accounting standard is likely to be FRS 26 or IAS 39, which provide for a fair value treatment. These standards provide that, in each accounting period, the change in fair value of the derivative contract is recognised in a company’s profit and loss together with any amounts actually paid or received under the derivative contract. However, some companies which are not required, and do not choose, to adopt FRS 26 or IAS 39 will not use fair value accounting. In such cases, the accounts will not show an annual charge on changes in fair value – rather, the historic cost basis is likely to be relevant.
The new regime applies to:
- Contracts for differences whose underlying subject matter is land (including indices over land). The term ‘contract for differences’ is defined widely and will include collars, caps etc.
- Certain options or futures relating to land. Generally this will be confined to cash-settled instruments rather than instruments entered into for the purpose of selling or obtaining the land itself.
Straightforward options expected to run to delivery held by investors will continue to be taxed under the capital gains rules.
For any contract falling within the new regime, any amounts recognised in the profit and loss line of the accounts are either taxed (if profit) or relieved (if loss). Accounts figures may be subject to adjustment under specific computational rules, which are generally designed to counter tax avoidance such as the ‘unallowable purpose’ rule. However, in the same way that under normal principles income and capital amounts are taxed differently, the new regime treats certain accounting profits derived from derivative contracts over real estate as taxable income and certain other accounting profits as capital gains. Where the derivative contract clearly relates to income from land rather than capital value (eg a rent for Libor (London interbank offered rate) swap), the new regime will tax or relieve those amounts as income. Where the underlying subject matter is the land itself rather than income from it (eg an agreement to pay or receive amounts in line with the movement of a particular property capital value index), then amounts will be treated as capital. Where the underlying subject matter relates to both property income and the capital value of land, the position is more complex, particularly where an index is not involved.
Where amounts are treated as capital, the credits and debits from the accounts are brought into charge or allowed as capital gains or allowable losses. Since the chargeable capital gain tracks the amount shown in the accounts, the normal rules for calculating capital gains do not apply. One disadvantage of this approach is that there is no indexation relief available to reduce the gain. Where capital treatment applies to debits, it is likely to be less attractive than income treatment, since it appears this sort of capital loss cannot be transferred around a group via a Section 171A TCGA election, as Section 171A assumes a disposal of the asset.
Whether taxed as income or capital gains, a key point to note is that amounts on these derivative contracts will be taxed or relieved on an annual basis in accordance with their accounting treatment. This is particularly important where the accounting treatment requires changes in fair value to be brought into account (as is the case for companies that have adopted IAS 39 or FRS 26 – eg listed companies). This point may weigh against such companies entering into a long-term bespoke contract which cannot be unwound easily or closed out.
There is a special rule that allows a two-year carryback of derivative contract capital losses against earlier derivative contract gains. The two-year rule perhaps reflects the sort of lifetime over which a derivative might normally be held. However, with a long-term contract, it is possible to envisage scenarios where there are losses that cannot be used to relieve taxable gains from the same contract.
Ian Johnson is a tax partner and Paul Miller a solicitor, both at Ashurst.