Loan relationships: ‘hybrid’ securities with embedded derivatives: what is a ‘hybrid security’?
What is a ‘hybrid’ security?
It should be noted that the word ‘hybrid’ is used in this section of the Corporate Finance Manual, as it often is in commercial parlance, as a shorthand way of describing convertible, exchangeable, asset-linked and similar securities, for which there is a special tax treatment within the loan relationships and derivative contracts rules.
Accounting practice makes a distinction between hybrid financial instruments, comprising one or more derivatives embedded in a financial asset or liability, and compound financial instruments, comprising a financial liability plus an equity component - CFM25080 explains the difference between the two. This guidance covers instruments - such as a convertible security issued by a company - that are, in accounting terms, compound financial instruments, as well as those that an accountant would recognise as ‘hybrid’.
It should also be noted that the derivative contracts rules in CTA09/PT7 refer to a particular type of derivative as a ‘hybrid derivative’. This is different to the more colloquial use of the word ‘hybrid’ to describe convertible, exchangeable and asset-linked securities.
Embedded derivatives in non-financial contracts
The type of ‘bifurcated’ accounting treatment described in CFM25040 does not only apply to contracts that are loan relationships, and the special tax rules for derivative contracts apply to cases other than derivatives that are embedded in ‘hybrid’ financial instruments. These include derivatives embedded in contracts other than loan relationships. CFM52520 onwards has more on the tax treatment of these types of derivatives.