Ask a tax expert: The tax treatment of a put option

First published in Tax Journal – 07.07.2017
In a recent article published in the July 2017 edition of the Tax Journal, Jackie Wheaton, Associate Director at Moore Stephens answers a query on whether the treatments of option contracts for income taxpayers and corporation taxpayers are different.
A client is considering acquiring a put option as a hedging transaction, rather than as a speculative investment. A premium of approximately $300,000 will be charged to purchase the option. Will this be treated as a trading or capital matter, and will the premium qualify as an allowable deduction for tax purposes? Also, what will the position be if the option is not exercised?
The tax treatments of option contracts for income taxpayers and corporation taxpayers are different and are summarised as follows.
Income taxpayers
HMRC’s Capital Gains Manual at CG55402 confirms that: ‘It is a question of fact whether transactions in options themselves amount to a trade. Individuals in particular are unlikely to carry on a trade of dealing in options. Transactions may however be entered into which are ancillary to trading transactions on revenue account.’
HMRC’s view of what constitutes trading is set out in Statement of Practice SP 3/02. "is document includes an example of a taxpayer who has borrowed money at a floating rate of interest, for trade purposes, and enters into an interest rate future or option with a view to protecting itself against rises in interest rates. In this case, receipts or payments relating to the future or option would be taken into account as trading income or expenditure on current account, because the future or option is ancillary to a trading transaction, i.e. the payment of interest for trade purposes.
Any gain or loss arising in the course of dealing in commodity or financial futures, or in traded or financial options on a recognised exchange, other than in the course of trade, is dealt with under the chargeable gains rules and is not chargeable to tax as trading income. Where an option is held as a speculative investment it will be dealt with under the chargeable gains rules. "rules for the capital treatment of options are found in TCGA 1992 ss$144–148. In general, when a put option is exercised the costs of acquiring the option are treated as costs of acquisition to be deducted from the disposal consideration. If, however, the option is abandoned by the person entitled to exercise it, this does not constitute a disposal (TCGA 1992 s 144(4)) and so does not give rise to an allowable loss, except in certain circumstances. In this case the premium of $300,000 will not be deductible.
Corporation taxpayers
Specific legislation provides that certain disposals which would have been dealt with under the capital gains rules are deemed instead to give rise to income profits or losses. "is includes, for corporation tax purposes only, where the options fall within the legislation in CTA 2009 Part 7 (derivative contracts).
For accounting periods beginning on or after 1 January 2016, the general rule is that the amount which is brought into account for tax purposes in computing a company’s profits for the purposes of this legislation is the amount that is recognised in the company’s accounts for the period as an item of profit or loss (CTA 2009 s 597(1)). The matters in respect of which amounts are to be brought into account are (CTA 2009 s 594A(1)):
  • profits and losses of the company which arise to it from its derivative contracts and related transactions (excluding expenses); and  
  • expenses incurred by the company under or for the purposes of those contracts and transactions. The expenses which may be taken into account for the purposes of the derivatives contracts legislation are set out in CTA 2009 s 594A(2) and include those incurred directly in bringing a derivative contract into existence. HMRC states (Corporate Finance Manual at CFM51090) that this includes paying a premium for an option. Therefore the premium should be an allowable expense.
The disregard regulations
The Loan Relationships and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses). Regulations, SI 2004/3256, often referred to as the ‘disregard regulations’, apply to certain loan relationships and derivative contracts which are in place for hedging purposes, including where hedge accounting is not adopted.

Under IFRS and new UK GAAP, all derivatives are recognised on the balance sheet at fair value even if in place for hedging purposes, although hedge accounting can be adopted in certain circumstances. If no fair value movements in respect of the hedged item are recognised in the profit and loss account before realisation, this can result in a mismatch leading to fluctuating taxable profits. Where hedge accounting is adopted, the overall profit and loss account impact may be minimal, depending on how effective the hedge is. However, if the instrument is used for hedging purposes and for whatever reason hedge accounting is not adopted, a significant profit and loss account impact may be experienced.

For accounting periods starting on or after 1 January 2015, the amounts in the accounts will be followed and the disregard regulations will not apply unless they are elected into. When an election is made, the broad effect is that profits and losses in respect of the derivative contract will be recognised for tax purposes on the same basis as profits and losses arising in respect of the hedged item when reflected in the company’s accounts, or earlier when the company ceases to be a party to the derivative contract. "e deadline for making such an election for companies which are not ‘large’ for senior accounting officer purposes is 12 months after the end of the first accounting period in which the company measures the contract at fair value.
Assuming that the client is a company, then if the put option is acquired for a hedging transaction for trading purposes, the receipts and payments relating to the option, including the premium of $300,000, will generally be subject to tax under the derivative contracts legislation and therefore be taxable as a trading profit or loss. As the option will be in place for hedging purposes, the disregard regulations should be considered. Depending on a review of the figures, it may be beneficial for the company to elect for the regulations to apply by making an election within the strict time limit.

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