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Example

A company holds index-linked gilt-edged securities and receives a total return from those gilts of 拢500m.

拢400m of that return relates to the element that derives from movements in the RPI (i.e. the increase in carrying value relating to RPI).

The company has entered into a total return swap such that it pays away the return that it receives from holding the index-linked gilt-edged security (perhaps receiving a LIBOR-based return instead).

Economic Position

As the company will be paying away the return of 拢500m it will remain economically flat.

Tax Position

拢400m of the return from the index-linked gilt-edged securities related to changes in carrying value due to movements in the RPI and so therefore only 拢100m of the total return of 拢500m will be taxable.

Against this, the full amount of 拢500m paid away under the total-return swap will be tax deductible.

The final position is:

Taxable Credits 拢100m

Taxable Debits 拢500m

So, a net tax loss of 拢400m is created from nothing more than a combination of essentially circular transactions. The end result is a significant tax advantage and no economic exposure.