Derivative contracts: relevant contracts: loan relationships with embedded derivatives
Derivatives embedded in loan relationships
A company may, in accordance with GAAP, treat a creditor or debtor loan relationship as being divided between a host contract, which is a debt instrument, and one or more derivative financial instruments or equity instruments. The legislation uses the term ‘embedded derivative’ to cover either an embedded derivative financial instrument, or a compound financial instrument that contains an equity component.
Under CTA09/S415, the host contract is treated as being itself a loan relationship (see CFM37660). S585 provides the derivative contract counterpart to S415. Each embedded derivative is treated, for the purposes of CTA09/PT7, as a relevant contract - which may be an option, future or contract for differences, depending on its terms.
It is still necessary to apply the CTA09/S579 ‘accounting test’ to decide whether these embedded derivatives qualify as derivative contracts. In particular, an equity instrument (such as the equity component of a ‘standard’ convertible bond issued by the company) will not be accounted for as a derivative, and will therefore not meet the CTA09/S579(1)(a) condition.
A company that does not bifurcate the loan relationship in its accounts may nevertheless elect under CTA09/S416 for S415 to apply to the host contract, and S585 to the embedded derivative or derivatives. Guidance on elections under CTA09/S416 is at CFM37660.