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Derivatives
on the books Perhaps the most common use of derivatives by pension funds is the purchase of futures contracts to rebalance very quickly from one asset class to another, a practice known as ‘tactical asset allocation.’ In the eyes of the Inland Revenue, using derivatives in this way is probably ‘investment activity’. Alongside these practical uses of derivatives, however, a massive trading market has grown up to profit from derivative contracts in isolation. The value of a derivative contract is only partly related to the value of the underlying assets; the rest of their value is based on premium, the additional amount a derivative contract buyer is willing to pay to secure a certain outcome in a specific situation. Canny traders look at hundreds of contracts daily and purchase a handful in order to assemble a portfolio which they believe will unwind profitably (such trading made a household name of Nick Leeson). When derivatives are used in this way, they may cross over the boundary of investment and into the realm of trading, a taxable for pension schemes. Although a Statement of Recommended Procedure (SORP) makes accounting for derivatives a simple matter for UK pension funds, the Accounting Standards Board (ASB) notes that the audit industry has had difficulty keeping up with the development of derivatives: “The last ten years or so have seen a rapid growth in the use of financial instruments… Unfortunately accounting practice has struggled to report the significance and effect of financial instruments in a comprehensive, timely and relevant manner,” the ASB says. As Barings Bank and the world learned after Mr Leeson’s mischievous derivative plays, the fortunes of a corporation can make radical changes of direction as derivative contracts unwind. That makes critical the methods used to record them on balance sheets. Alas it remains a grey area. Derivatives can be valued either at their historical cost, their market value, or both. Generally speaking, instruments held for trading purposes are measured at market value, current asset investments are valued at the lower of cost and market value, and fixed asset investments are marked down to represent any permanent depreciation. But the mixed measurement system is confusing and often inaccurate. Historic or purchase-price values are often wildly inaccurate, and the market-to-market difference may be formally recognised only when that gain or loss is realised through a sale. Losses tend to be reported immediately, while gains wait for cashflow. Hence under a system where derivatives have been used to hedge a specific risk, only one side of the transaction is reported initially. The balancing transaction may not be realised for some time, making accounting for financial instruments a particularly uneven practice. So-called ‘hedge accounting’ has been developed to address this accounting conundrum. The system defers recognition of derivative losses until the offsetting gains are recognised. But hedge accounting itself is an evolving practice, without specific guidelines. Pension funds, however, do not face these challenges. An ASB SORP defines a very straightforward procedure for funds to account for derivatives. Called the Associated Economic Exposure method, it accounts for futures contracts as though they have already been executed. Jo Rodgers, senior manager in the Pensions Audit Group at Deloitte & Touche, explains. “If a pension scheme entered a stock index futures contract to purchase UK equities three months hence, it would treat it as though it had been executed today. The net asset statement would show the equities as an asset, and a provision would be made under ‘Cash Backing Open Futures Positions’ for the money that would have been spent on buying the equities. As time progresses there may be margin calls, which are written to the fund account. The rationale is that, by showing the executed position, there is a better picture of the scheme’s actual exposure.” A change is on the cards, but it is not expected to have a dramatic impact. The SORP is being updated to bring it more into line with those that define accounting practice related to derivatives for unit trusts and Open-Ended Investment Companies. “The Accounting Standards Board is keen that the pensions SORP mirrors the others, but the differences are not that different. Funds will still show an executed position,” Mr Rodgers says. For pension schemes, the greatest possible pitfall of using derivatives is their potential to attract tax. Pension funds’ income from ‘investments and deposits’ is not taxable, and such income clearly includes dividends, capital gains, income from coupons, and other conventional sources of investment income. However, if pension funds have ‘trading income’ it could give rise to taxation. “Unfortunately neither ‘investments and deposits’ nor ‘trading’ are defined in legislation, so we have to look at case law,” says Kevin Corcoran, a tax partner at PricewaterhouseCoopers. He says there are certain behaviours which could attract the attention of the Inland Revenue. “One thing indicative of trading is any kind of activity with a high level of turnover, and the use of derivatives may give rise to a very high level of turnover of portfolio assets.” The concern is not just theoretical. Over the past three or four years the Revenue has taken an active interest in the alleged trading activity of UK pension schemes, and has made a formal challenge in some cases, arguing that they should pay tax on profits from the activity. Recently the Revenue argued that sub-underwriting commission received by BT’s pension fund over ten years constituted trading income, and the case went as far as the Court of Appeal. In the end BT won, but the challenge provides strong evidence that the tax authorities will take UK pension schemes to court over such issues. It would seem helpful that Section 659A of the Tax Act states that income arising from ‘futures and options’ is specifically included in income from investments. Categorically,
it seems, any income from futures and options activities must be
exempt from tax. But Mr Corcoran says the clause simply pushes the
question back, as there is no definition of contracts which are
considered ‘futures and options’ for the purposes of the Act. In
fact, he says, conflicting definitions can be found. “There is a
particular question about whether over-the-counter futures and options
fall under 659A,” says Corcoran. “Trustees should tread ahead with
caution, and understand what the consequences of dealing in a particular
instrument may be, perhaps through an audit or due diligence procedure,
before stepping in.” BACK
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