CFM37610 - Loan relationships: ‘hybrid’ securities: overview

Overview

Some debt instruments may include an equity element or may otherwise be linked to shares in a company. In this guidance they are referred to, for convenience, as hybrid securities. However, this is not a term used in the tax legislation, nor does it have a specific accounting meaning. It is intended to encompass such instruments described in the derivative contracts guidance, at {CFM55410} as ‘standard convertibles’ (convertible into a fixed number of the issuer’s own shares), ‘non-standard convertibles’, and ‘share-linked securities’ (where the amount payable on redemption is linked to the value of certain shares or a share index).

Depending on the accounting standards applicable, such hybrid securities may be regarded, or have been regarded in the past, as containing an embedded derivative; for that reason these pages of guidance formerly referred to “hybrid securities with embedded derivatives”.

The loan relationships rules have recognised that in some circumstances it may be appropriate to tax the holder’s profits or gains (but not interest) from a ‘hybrid’ security under the chargeable gains tax rules, in cases where a security has equity features or where its redemption price exactly tracks a qualifying chargeable asset. CFM37620 has more on the meaning of ‘hybrid’.

The position has changed over time

Over time, there have been changes in both the tax treatment applicable and the accounting treatments that apply. There have been changes in tax law that applied specifically to relevant debtor loan relationships with equity features. There has also been a trend for the tax treatment of loan relationships to become ever more closely linked to their accounting treatment.

The accounting treatment of the instruments has also changed; historically an accruals basis of accounting might have applied to the entire instrument. Then the concept of bifurcating the instrument into a host debt accounted for on an amortised cost basis and an embedded derivative accounted for at fair value through profit or loss. More recently, there is a trend - particularly for financial assets - towards disclosing for the entire instrument at fair value, with all amounts recognised as items of profit or loss. However, at any particular time there have been two or more possible accounting treatments, to some extent dependent on the status of the company concerned. The accounting changes can in turn impact on the tax treatment.

Accounting periods beginning before 1 January 2005

For accounting periods beginning before 1 January 2005, hybrid financial instruments would typically have been accounted for on an accruals basis. FA96/S92 to S93B provided special rules for such ‘hybrid’ types of security (see CFM82000 onwards).

The only credits and debits taxable or relievable as income under the loan relationships rules were those relating to interest, and in some cases exchange gains and losses. Other profits and losses on the security were within the chargeable gains rules, or were ‘tax nothings’, and FA96/S92A restricted relief for the issuer of the security for the costs of issuing or delivering shares.

Periods of account beginning on or after 1 January 2005 and before 1 January 2015

From 1 January 2005 UK companies were either required or permitted to adopt either IAS39 under International Financial Reporting Standards (IFRS) or FRS26 under UK GAAP. In particular, UK companies with listed debt or equity were required to apply IAS39 or FRS26. In practice, however, most companies that were able to continue to account under old requirements under UK GAAP could continue to apply an accruals basis.

IAS39 and FRS26 radically changed the way companies account for ‘hybrid’ loan relationships (see CFM25000). IAS 39 (and previously under FRS 26) requires in many cases a company to divide (or ‘bifurcate’) the contract into the ‘host contract’ and an ‘embedded derivative’. The embedded derivative in such cases is the option to acquire shares, or the ‘contract for differences’, or other rights or obligations that meet the definition of a derivative under IAS 39 (see CFM24200). Typically, the host debt could be accounted for on an amortised cost basis, whereas fair value accounting had to be applied to the embedded derivative.

For periods of account beginning on or after 1 January 2005 the tax rules matched the prescribed accounting for such ‘hybrid’ instruments. FA96/S92 to S93B were repealed. Under these new rules, where a company bifurcates the debt contract for accounting purposes:

  • the ‘host contract’ (the loan element) is taxed under the loan relationship rules - in general, the income element of the security taxable under loan relationships will be greater than previously, and will include the discount on the loan element in addition to any interest
  • the embedded derivative is dealt with under the derivative contracts rules - these rules may provide the issuer or holder of a qualifying security with a special chargeable gains treatment on the derivative component (CFM55000 onwards).

A similar accounting treatment applied to compound financial instruments which were required to be split into separate liability and equity components. However, the separated equity instrument would not be revalued (unlike the treatment of an embedded derivative). Again, the tax treatment would follow the accounting treatment, with the instrument treated as being split into a debt host and equity instrument. (Note, however, that the equity instrument would not satisfy the conditions to be a derivative contract under CTA09/PT7.)

Some companies, mainly banks and other financial concerns, were not required to account separately for the loan and derivative. Where a company accounts for the security as a single instrument, it is taxed wholly under the loan relationships rules, with all profits gains and losses brought into account as income under CTA09/PT5.

Note that if the embedded derivative is not treated as a derivative contract qualifying for chargeable gains treatment, separate treatment has little practical consequence for tax purposes. All profits gains and losses are brought into account as income, partly under the loan relationships rules, and partly under the derivative contracts rules. Guidance on the tax treatment of the embedded derivative is found at {CFM55200}+.

Position for periods of account beginning on or after 1 January 2015

The position changed further in 2015 as a result of accounting changes, rather than further changes of tax law.

All the existing accounting standards under UK GAAP (including FRS26) were withdrawn for periods beginning on or after 1 January 2015 (1 January 2016 for small companies). Companies could then apply one of the following sets of standards:

  • IFRS: with the treatment of financial instruments set out in IAS 39, but which is being replaced by IFRS9;
  • FRS101, which contained the same recognition and measurement requirements of IFRS
  • FRS102
  • FRS105, but only in the case of micro-entities.

Section 12 of FRS102 (“other financial instruments issues”) does not permit bifurcation of embedded derivatives. Instead an instrument which contains an embedded derivative must be carried at fair value through profit or loss. However, within FRS102 there is an option to apply the recognition and measurement requirements of either IAS39 or IFRS9.

IFRS9 does not permit the bifurcation of embedded derivatives in respect of financial assets. Instead, a hybrid instrument would typically be measured at fair value through profit or loss.

It would be unusual for an entity that applies FRS105 to hold such an instrument but, if it did, it would not bifurcate the instrument but apply an amortised cost basis, allocating interest and costs over the life of the instrument and providing for impairment, where appropriate.

Bifurcation of embedded derivatives is still required under IAS39 and, in respect of financial liabilities and non-financial contracts, IFRS9.

Note that compound financial instruments are still normally required to be split into separate liability and equity components under all of the accounting frameworks.

There has been no change to the tax rules as a result of the 2015 accounting changes. So, in particular:

  • Where the instrument is split into a debt host and an embedded derivative or equity instrument, this split will be followed for tax purposes under the loan relationships and derivative contract rules.
  • Where the instrument is not split in this way, the whole instrument will be taxed under the loan relationship provisions.

As a result, where IFRS9 or section 12 of FRS102 are applied, amounts arising in respect of the holder of a hybrid instrument, a creditor loan relationship, will be taken into account for tax as income items under the loan relationships provisions, CFA09/PT5.