FUTURES AND OPTIONS: TRANSACTIONS WITH GUARANTEED RETURNS (Hansard, 11 March 1997)

§ The Economic Secretary to the Treasury (Mrs. Angela Knight)
I beg to move, That the clause be read a Second time.

§ Madam Speaker
With this it will be convenient to discuss Government new schedule 1—Futures and options: Taxation of guaranteed returns.

§ Mrs. Knight
The purpose of the new clause and the associated schedule is to counter an avoidance undertaken by the use of transactions in derivatives that produce a guaranteed return on investments.
The avoidance devices can take many forms, but essentially they turn income into capital gains. The background note to the explanatory note gives an example of an avoidance device that the new clause covers. It is called a "box spread", and it uses four options that are related to the FTSE 100 index. We first learned of the use of this avoidance device last summer. It was being used by an authorised unit trust. The Association of Unit Trusts and Investment Funds responded by suggesting that a change should be made to the accounting rules in the relevant statement of recommended practice—or SORP, for short—to prevent this abuse. We accepted the association's assurances.
Evidence has come to light, however, that the avoidance device was being used by others. For the moment, we shall keep faith with the unit trust industry's assurances that its SORP will be effective in countering any use of the device by authorised unit trusts. For others, the new clause will apply only where there is a scheme or an arrangement involving two or more transactions that is designed to produce a guaranteed return from the disposal of one or more futures or options, and only if that return is in substance similar to interest. It will apply from 5 March. I commend the new clause and associated schedule to the House.

§ Mr. Mike O'Brien (North Warwickshire)
We welcome the new clause as it will close a loophole. We accept many of the points that the Economic Secretary has made. There remain, however, some questions, some of them technical and others that are broader. Perhaps I should start with the broad questions.
First, how much will be saved by the implementation of the new clause? Is there some concern that the Government may be faced with the development of further avoidance techniques? What steps are the Government taking to prevent the similar exploitation of the different tax treatments of various financial instruments? We wish to be reassured that the Government have an overall strategy and that we are not merely waiting for some clever tax specialist to find a new angle to exploit. We hope that the Government have a strategy, by the use of which they will get ahead of the tax avoidance industry and ensure that revenue is protected.
163 Given the importance of the City and of the financial instruments that concern us, what steps are the Government taking to ensure that bona fine business does not suffer as a result of the misbehaviour of some? Those are some of the broader questions that we wish to raise.
As the Economic Secretary says, the new clause is aimed at counteracting an avoidance device that effectively turns interest coming to capital gains into something that may be more favourably taxed. As the House will know, futures and options are financial instruments that are used by companies and individuals to manage risk, and increasingly financial risks. For example, a metal-bashing company in the midlands may purchase an option contract on the London metal exchange to protect itself against unfavourable price changes in key raw materials. UK tax law treats futures and options as capital assets when they are in the hands of taxpayers who are not financial traders—not banks and the like. Therefore, if the midlands company exercised or sold the contract and made a gain, it would be taxed as receiving a capital gain. Similarly, a loss on the contract would be taxed as a capital loss.
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The abuse occurs when a taxpayer—usually a cash-rich taxpaying company—purchases a specially constructed financial derivative in favour of a usually higher-yielding conventional deposit. Such arrangements may not be abusive if the financial derivative exposes the purchasing company to the usual risks inherent in such instruments. However, the Government are rightly seeking to prevent cases where the derivatives are structured to expose the purchaser to essentially the same risks of movements in interest rates as the purchaser would be exposed to simply by purchasing a conventional deposit.
The new clause is broadly welcomed. Its objectives are worthy, but let us examine some of the more technical aspects. The new legislation seems to overcome the mischief by applying a charge under case IV of schedule D to profits realised on or after 5 March 1997 from the futures or options concerned. Some have suggested that taxing under case IV of schedule D is strange. Should they not be deemed to be non-trading debits and credits arising from a loan relationship under the Finance Act 1996? Those are amounts that are axiomatically equivalent to interest by definition arising from contracts which, but for failures in definition, would have been non-trading items under the Finance Act 1994 financial instruments regime. The legislation applies just as much to hedged transactions that were entered into for purely commercial reasons, with no intention to secure a tax advantage, as to avoidance transactions.
If schedule 5AA generates a D IV gain, a trader can eliminate it, presumably, by a corresponding non-trading deficit. However, if schedule 5AA generates a D IV loss, which can hardly have been an effective tax avoidance transaction under the existing rules, a trader cannot use this and will probably have to do an artificial schedule 5AA transaction in order to use the D IV loss. One of our advisers suggested to me that—to use his words—that might be daft. Perhaps the Minister can reassure us that that is not the case, and that, although we have only just 164 moved derivatives out of D IV and into D III and non-trading deficits, this way of dealing with matters will work.
The next issue is not so technical and concerns unit trusts. As the Minister pointed out, it became apparent in the summer of 1996 that unit trusts were exploiting this form of arbitrage to market a product for investors. The close capital account was the main example. I have a news report which is effectively an advertisement for the close capital account launched by Close Fund Management. Although the purpose was apparently to announce plans to outlaw moves in relation to unit trusts, it seems that the present clause does not apply to unit trusts. However, as the Economic Secretary pointed out, the intention was to try to deal with the matter by way of a practice direction issued by the Investment Management Regulatory Organisation—IMRO.
We need further reassurances that the Minister is satisfied not just by the Association of Unit Trusts and Investment Funds agreeing to abide by the direction. Perhaps she could provide more substantial reassurance that although a decision was initially made to examine unit trusts, they have now been satisfactorily dealt with. Will the Minister assure us that, if problems arise with unit trusts, the Treasury will act very quickly—general elections notwithstanding? The Treasury must monitor the situation closely, and the revenue must be protected for the sake of AUTIF and everyone else.
I seek the Minister's reassurances regarding a more technical area. Will she confirm that the schedule is being dealt with? That is very important. I have several questions about paragraphs 4(4) and 4(5) of schedule 5AA. If the Minister cannot respond to my somewhat technical points now—I appreciate that it may take some time to answer them—perhaps she could reply in writing.
The grants of options are not disposables under schedule 5AA—notwithstanding that they are under the Taxation of Chargeable Gains Act 1992—so long as there is a later disposal of something else. Where an option is granted and not exercised, the grant of an option is taken to be a disposal only as and when a disposal takes place with respect to a related transaction—not necessarily one arising under the option contract. Will the Minister clarify precisely what those parts of the schedule mean?
I do not see the point of paragraph 4(3)(c), given the definition of an option in paragraph 4(6); nor how that alters the definition in section 144(8)(c), as it already excludes traded options. Schedule 5AA is arguably retrospective as it applies to contracts in existence on 5 March 1997. What does "significant extent" in paragraph 3(1)(a) mean? The Minister may need to respond in writing.

§ Mrs. Angela Knight
It is estimated that the new clause would save £50 million. However, as people talk to each other, there could be more costs to the Exchequer. That is why we have moved quickly to introduce this measure. Obviously, others might look to other types of derivatives apart from those covered by the new clause. I assure the hon. Gentleman that we shall keep a close eye on how matters develop. If it is necessary to change the legislation, we shall do so. Otherwise, we shall ensure that other sorts of transactions are challenged within the existing legislation.
The hon. Gentleman asked whether the legislation would catch all taxpayers, including those engaged in bona fide transactions. I assure him that, with the 165 exception of financial traders whose profits from such transactions will already be taxed as part of their normal case 1 trading profits, the legislation catches everyone. There are a few more exceptions: charitable trusts, pension funds and authorised unit trusts. Therefore, the hon. Gentleman can see that those who are engaged in legitimate transactions will be able to continue with those transactions.
The hon. Gentleman referred to a metal-bashing company and asked several questions in that regard. All the points relating to that company and others come under the general hedging heading. No commercial hedging will be caught: the legislation applies only where the guaranteed return arises from the futures or options used. I remind the hon. Gentleman that I said in my opening remarks that the clause applies only to a scheme or arrangement, involving two or more transactions, that is designed to produce a guaranteed return from the disposal of one or more futures or options if the return is similar to interest. I can put his mind at rest on that.
The hon. Gentleman asked a number of questions relating to case IV, but the taxable income will be calculated under case VI of schedule D.

§ Mr. Mike O'Brien
The Minister is quite right; it is case VI rather than case IV.

§ Mrs. Knight
I can assure the hon. Gentleman that taxable income will be calculated in accordance with the principles of case VI. That will usually mean the profit or loss—the difference between the acquisition cost and the disposal proceeds of the future or option. I think that I have answered most of his questions in that area.
We will keep faith with the unit trust industry's assurances that the statement of recommended practice for the authorised unit trusts will be effective in countering any use of the device by authorised unit trusts. However, we shall not hesitate to bring them within the scope of the new clause in future if there is evidence that individual authorised unit trust fund managers are trying to get around the spirit of the accounting rules. I can assure the hon. Gentleman that we will keep this matter under very close watch.
The hon. Gentleman had a list of technical points. A firm of solicitors raised the same points. Indeed, we received a letter from one today. I sincerely trust that it will engage in useful dialogue with the relevant officials, as those points need to be covered. That would probably be a better way to reach a conclusion on them, but if the hon. Gentleman insists, I will, of course, write to him.

§ Mr. O'Brien
I do not know which firm of solicitors, as I have had no contact with it. The points were raised by our advisers, and not any firm of solicitors, so perhaps the Minister will, out of courtesy, write to me.

§ Mrs. Knight
I will, of course, write to the hon. Gentleman. I suggest that his advisers go back to the solicitors, who no doubt informed his advisers in the first instance.