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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Loan relationships: ‘hybrid’ securities with embedded derivatives: tax rules follow the accounting treatment

Tax rules mirror accountancy rules

Many holders and issuers of convertible or exchangeable securities, or asset-linked securities, will account separately for the loan and the embedded derivative. CFM37640 explains how the company allocates initial fair values to the two elements.

The tax rules mirror this accounting treatment. CTA09/S415 provides that where a company accounts for its rights (or liabilities) as divided between a loan and one or more embedded derivatives, tax treatment follows. The company is treated as being a party to both:

  • a loan relationship (corresponding to the ‘host contract’), and
  • a ‘relevant contract’ (corresponding to the derivative) for the purposes of the derivative contracts rules at CTA09/S585.

The loan element is taxed wholly under the loan relationship rules, while the derivative element is taxed separately under CTA09/PT7.

CTA09/S415 applies both to hybrid and to compound financial instruments. Although the legislation uses the term ‘embedded derivative’, S415(1)(b) makes it clear that this takes in both embedded derivatives in the accounting sense, and the equity component included in a compound instrument.

However, CTA09/S585 only treats the ‘embedded derivative’ as a relevant contract - it does not say that it is a derivative contract. The resultant option or contract for differences must still be subjected to the tests at CTA09/S576, in particular, the accounting test (CFM50220). Because an equity component is not treated for accounting purposes as a derivative financial instrument, it will not pass the ‘accounting test’ and, rather than being a derivative contract, will be a ‘tax nothing’ - see CFM55510. See however CFM37770 on the treatment of issue costs of a compound instrument.

Companies which do not ‘bifurcate’

CTA09/S415 only provides for separate taxation of the loan relationship and the option where that is the accounting treatment. Although many companies will bifurcate, there are exceptions. These include where:

  • the company is a bank or other financial trader which entered into the security for the purposes of a trade of dealing in securities, and accounts for the whole security at ‘fair value through profit and loss’ (corresponding to the former ‘mark to market basis’); or
  • bifurcation is impracticable, because there is no readily available means of valuing the embedded option - say because the company into whose shares the security may convert is unquoted; or
  • the company has not (or not yet) adopted IAS or revised UK GAAP, so is not for the time being permitted to use separate accounting.

Where a company accounts for the security as a single instrument, the security falls wholly within the loan relationship rules, with all profits gains and losses brought into account as income under CTA09/PT5.

CFM55250 explains the capital gains consequences for the holder of a convertible security where CTA09/S415 does not apply.

CFM37720 deals with elections for CTA09/S415 to apply.