Derivative contracts: embedded derivatives: derivatives in non loan relationships
Overview of S616
Where a derivative is embedded into a contract such as a purchase contract or a lease but is accounted for separately, two tax problems might occur. First, it is not always clear how - if you were considering only the ordinary rules for trading income - the ‘bifurcated’ derivative would be treated. Second, there may be large fluctuations in the fair value of some embedded derivatives which, if the tax treatment simply followed the accounts, would lead to substantial volatility in taxable profits.
CTA09/S616, in conjunction with CTA09/S586, deals with these problems. S586 ensures that each of the derivatives embedded in a contract that is not a loan relationship is treated as a relevant contract for the purposes of Part 7. But the embedded derivative is then taxed as though it were closely related to the host contract. The overall effect is that the sale or purchase contract, lease or similar contract as a whole (referred to in the legislation as ‘the original contract’) is treated for tax purposes as if ‘old’ UK GAAP still applied. CFM52530 gives details. (See CFM20010 for meaning of ‘old’ UK GAAP.)
S616 also caters for the case where the original contract is a hybrid derivative (CFM52550).
Some companies may, however, prefer to follow the accounts, notwithstanding the resultant tax volatility. Companies can therefore elect out of S616, although such an election does not apply to embedded commodity derivatives (see CFM52560).
CTA09/S616, and its predecessor FA02/SCH26/PARA45L, apply to periods of account beginning on or after 1 January 2005. It was, however, amended by SI 2005/2082 and SI 2005/3440, so some provisions will not apply to short periods of account ending before 31 December 2005.