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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Derivative contracts: relevant contracts: hybrid derivatives with embedded derivatives

Treatment of ‘nested derivatives’

Occasionally a contract may - when viewed as a whole - resemble a derivative, but also contain features that are themselves embedded derivatives. This is particularly likely to be encountered with contracts for the supply of commodities, such as oil or gas, where the value of the contract as a whole is dependent on the price of the underlying commodity. But the contract may contain clauses (for example, an option to settle in a different currency) that constitute embedded derivatives, which are not closely related to the host contract.

In some cases, the company’s auditors may decide that the whole contract satisfies the accounting definition of a derivative in IAS 39 or FRS 26, and accordingly the contract as a whole will be accounted for at fair value through profit and loss. This is unlikely to give rise to tax problems. The accounting condition at CTA09/S579(1)(a) is satisfied, so the contract is a derivative contract. The credits or debits to be brought into account will (normally) simply be based on the accounts figures.

A more problematic situation arises where the contract is not accounted for as a derivative. Nevertheless, it may satisfy one of the ‘alternative accounting conditions’ at CTA09/S579(1)(b) or (c) (see CFM50200 onwards), and hence be a derivative contract for tax purposes. At the same time, the accounts of the company may recognise separately the derivative or derivatives embedded in the contract. Without specific legislation, it would be unclear whether this bifurcation should be respected for tax purposes.

CTA09/S584 is intended to deal with this situation. It applies where

  • the contract as a whole is a relevant contract (a future, option or CFD), which is not treated for accounting purposes as a derivative, but satisfies the condition in CTA09/S579(1)(b) or (c),
  • in accordance with GAAP, the company splits the contract into a host contract plus one or more embedded derivatives, and
  • the host contract, looked at by itself, would be a relevant contract.

Such a contract, viewed as a whole, is dubbed a ‘hybrid derivative’ for the purposes of CTA09/Part 7.

CTA09/S584(2) then provides that the company is treated as being party to one or more relevant contracts, representing the embedded derivatives, plus a further relevant contract, consisting of the rights and liabilities under the host contract. Each of these will be either a future, an option or a contract for differences, depending on their individual character.

In most cases, each of the relevant contracts that are so recognised will be a derivative contract. The overall effect will normally be that the tax treatment of the ‘hybrid derivative’ follows the accounting treatment.