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Property based total return swap

This - example illustrates the position for contracts entered into on or after 1 August 2004 in an AP ending on or after 17 September 2004.

Y plc is an investment company that holds a portfolio of fixed income securities. It wishes to reduce its exposure to such securities, and gain exposure to the commercial property market. As a short-term measure, while seeking suitable property investment opportunities, it enters on 15 January 2006 into a property based total return swap. »Ê¹ÚÌåÓýapp swap has a notional principal amount of £6 million, and a maturity of 12 months.

One leg of the swap is based on the IPD (Investment Property Databank) annual index of capital growth of all properties. »Ê¹ÚÌåÓýapp counterparty makes payments at quarterly intervals based on the published estimate of the index: payments are calculated on the basis of the percentage rise in the index since December 2005, less amounts already paid. »Ê¹ÚÌåÓýapp company makes payments on the basis of a fixed interest rate of 6.5%.

Net payments are therefore made as follows (index values quoted are fictitious):

Payment date	Index value	% rise from Dec 05	Paid to company	Paid by company
-	247.00 (Dec 05)	-	-	-
15 April 2006	254.30 (March 06)	2.96%	£177,600 (£6m x 2.96%)	£97,500 (£6m x 6.5% x 90/360)
15 July 2006	254.00 (June 06)	2.83%	(£7,800)\n(£6m x 2.83%) - £177,600	£97,500
15 October 2006	258.10 (Sept 06)	4.49%	£99,600\n(£6m x 4.49%) - (£177,600 - £7,800)	£97,500
15 January 2007	262.31 (Dec 06)	6.20%	£102,600\n(£6m x 6.20%) - (£177,600 - £7,800 + £99,600)	£97,500
Total	-	-	£372,000	£390,000

»Ê¹ÚÌåÓýapp company accounts for the derivative at fair value. At 30 September 2006, it is shown in the balance sheet as an asset with fair value £5,000.

»Ê¹ÚÌåÓýapp profit and loss account for year ended 30 September 2006 shows a debit of £20,200, made up of the net cash paid of £25,200 paid under the contract in the period, less a £5,000 increase in fair value.

For year ended 30 September 2007, the profit and loss account shows a credit of £2,200, being the net cash of £7,200 received less a £5,000 decrease in fair value. Overall, therefore, the accounts bring in a debit of £18,000, the company’s economic loss on the contract.

Tax treatment

For tax purposes, the contract falls within CTA09/S650. Applying the formula at S659(4) in the first accounting period,

N (notional principal amount of the contract) = £6,000,000

R (the percentage change in the index up to 30 September 2006) = + 4.49%

This is a positive amount, since an increase in the index will result in a payment to the company, and hence a credit in the company’s books. Had the company been called up to make payments if the index rose, R would be a negative amount.

Thus a credit of 4.49% x £6,000,000 = £269,400 falls to be brought into account as a chargeable gain in year ended 30 September 2006.

To produce the overall net debit of £20,200, a debit of £289,600 (£269,400 - (- £20,200) falls to be brought into account as a non-trading debit.

In year ended 30 September 2007, the ‘relevant periodâ€� is 1 October 2006 to 15 January 2007, when the contract matured. During this period, the index rose from 258.10 at 30 September 2006 to 262.31 at 31 December 2006, a percentage change of 1.63%. (»Ê¹ÚÌåÓýapp 15-day lag period between the month end and publication of the monthly figure being ignored.)

»Ê¹ÚÌåÓýapp credit brought into account as a chargeable gain is therefore 1.63% x £6,000,000 = £97,800. This is counterbalanced by a non-trading debit of £95,600 (£97,800 less the accounts credit of £2,200).

Overall, therefore, £367,200 is brought into account as a chargeable gain (compared with £372,000 actually received under the ‘property� leg of the swap) and £385,200 is relieved as a non-trading deficit (compared with £390,000 paid under the ‘interest� leg).