Removal of regulatory loan and tax impediments

In the UK, the removal of regulatory and tax impediments revealed the tax efficiency of property derivatives over direct investments. In 2002, the Financial Services Authority (FSA) decided to allow life insurance companies to include real estate swaps and forward contracts as admissible assets in the computation of their solvency ratios. Further, the inland revenue legislation from September 2004 established a regime for taxation of property derivatives, thereby removing tax as a barrier to trading property derivatives. Key points were that no stamp duty is levied, be it land tax or reserve tax, on the issue or transfer of property derivatives. This gave rise to an immediate benefit over purchasing property, as stamp duty of up to 4% of the property value is saved.

UKregulators ruled that property derivatives are taxed under derivatives contracts legislation, which broadly taxes all profits and losses as income. There are some exceptions for property derivatives. The taxation of income and capital gains will depend on what type of entity enters the derivatives transaction. The law defines two categories of institutions:

Derivatives as a primary business. In such a case, the gains and losses are treated, and taxed, as income.

Derivatives not as the primary business of the respective company. In this case the capital element will be subject to capital gains and the income element will be charged by a corporation tax.

Capital losses arising on contracts can be carried back against capital gains on similar derivatives arising in the previous two accounting periods. In general, capital gains may also be offset against other existing capital losses. Property Index Certificates (PICs), some of the earliest property derivatives in the UK, are treated as loans for tax purposes. Often, the PIC is split for accounting purposes into a loan and an embedded derivative. The latter is taxed separately under the derivative contracts legislation. The new collective investment scheme “Sourcebook COLL” allows authorized retail and nonretail funds to hold property derivatives. Two key legislative changes have cleared the way for a commercial property derivatives market in the UK. To summarize, companies can include property derivatives in their solvency calculations and capital losses can be offset against tax.