HMRC internal manual

Corporate Finance Manual

CFM52510 - Derivative contracts: embedded derivatives: introduction

Introduction and layout of guidance

A contract may have features that function in the same way as a derivative. The accounting concept of an embedded derivative is explained at CFM25000+ including guidance on when the derivative element is regarded as not being closely related to the host contract.

In particular, such embedded derivatives can fall to be accounted for separately from the host contract under IAS 39 (and formerly FRS 26); this is sometimes referred to as ‘bifurcation’. This treatment is also adopted under IFRS 9, but does not apply to financial assets. Further, such treatment may also arise under FRS101 or where companies which apply FRS 102 choose the option to apply IAS 39 or IFRS 9.

Embedded derivatives in loan relationships

It is not unusual for loan relationships to contain residual equity elements or, less frequently, embedded derivatives. Convertible and exchangeable securities are the most common examples. For guidance on the treatment of the holder of convertible or exchangeable securities, see CFM55200+.

Embedded derivatives in non-financial contracts

Derivative elements may, however, be present in other contracts such as sale and purchase agreements or leases, or derivatives may even be nested inside other derivative-like contracts. The derivative contracts code contains provisions to allow such embedded derivatives to be treated as ‘relevant contracts’ in their own right. The relevant guidance is at CFM50410 (nested derivatives), [CFM50420](https://www.gov.uk/hmrc-internal-manuals/corporate-finance-manual/cfm50420) (derivatives embedded in loans) and CFM50430 (derivatives embedded in non-financial contracts).

Having identified an embedded derivative as a ‘relevant contract’, two further questions present themselves:

  • is it a derivative contract? and
  • if so, how is it treated for tax purposes?

The answer to the first question will - as for any other relevant contract - depend on whether it satisfies any of the accounting conditions (see CFM50200 onwards) and whether it is excluded because of its underlying subject matter (see CFM50700+).

This chapter concentrates on the second question. It covers

  • the treatment of derivative contracts embedded in host contracts that are not loan relationships (for example, in sale and purchase agreement)
  • the treatment of ‘hybrid derivatives’; and
  • the treatment of index-linked gilts where, exceptionally, an embedded derivative is separately recognised.

It does not cover derivatives embedded in loan relationships. Guidance on the special rules for convertible and exchangeable securities (where an equity option is embedded in a loan relationship) and asset-linked securities (which contain an embedded contract for differences) is at CFM55200+.