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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Loan relationships: ‘hybrid’ securities with embedded derivatives: overview

Overview

The loan relationships rules have always recognised that it is appropriate to tax the holder’s profit from a ‘hybrid’ instrument 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’.

For example, a security may be issued on terms that allow the lender to convert the security into shares of the issuing company (a ‘convertible’) or exchange it for shares in a different company (an ‘exchangeable’).

Or the amount the lender gets on redemption may be linked to the change in value of a specific asset (such as a particular company’s shares), or index of such assets (such as the FTSE100), over the life of the security. In such a case, the lender’s return is the same or resembles that from owning the asset outright.

For accounting periods beginning before 1 January 2005 (see CFM82000 onwards), FA96/S92 to S93B provided special rules for such ‘hybrid’ types of security. 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

From 1 January 2005 UK companies must or may adopt either International Financial Reporting Standards (IFRS) or revised UK GAAP, although many companies continue to account under ‘old UK GAAP’. IFRS radically changes the way companies account for ‘hybrid’ loan relationships (see CFM25000). IAS 39 (or 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).

For periods of account beginning on or after 1 January 2005 the tax rules match the prescribed accounting for such ‘hybrid’ instruments. FA96/S92 to S93B were repealed. Under the 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).

Some companies, mainly banks and other financial concerns, are 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.

If the derivative does not qualify 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.