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 CFM25030+, including guidance on when the derivative element is regarded as not being closely related to the host contract. Under IAS 39 or FRS 26, such embedded derivatives fall to be accounted for separately from the host contract: a technical term you may hear used for this is ‘bifurcation’.
You are most likely to encounter derivatives embedded in loan relationships - convertible and exchangeable securities are the most common example. 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 - 50430.
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 in CTA09/S579 (see CFM50200 onwards) and whether it is excluded because of its underlying subject matter (see CFM50700 onwards).
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
- 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+.