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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Derivative contracts: embedded derivatives: tax treatment under S616

When S616 applies and what it does

CTA09/S616 will apply to a derivative embedded in a contract other than a loan relationship (in other words, where the company is party to the relevant contract under S566) provided three further statutory conditions are met.

  • The embedded future, option or contract for differences must pass the ‘main accounting test’ in S579(1)(a) - it must be treated as a derivative for accounting purposes. It is difficult to conceive of circumstances where this condition would not be satisfied, since an embedded element will only be accounted for separately if, viewed as a stand-alone, it comes within the IAS 39 or FRS 26 definition of a derivative.
  • The embedded derivative must not be an interest rate contract to which regulation 9 of the Disregard Regulations applies (CFM57290).
  • CTA09/S592 (CFM52580) does not apply to the contract.

The company must not have elected out of S616 or, if it is has made an election, the embedded derivative is one to which the election does not apply (CFM52560).

Where all these conditions are satisfied, the contract is treated for all purposes of the Corporation Tax Acts as though the embedded derivative were closely related to the host contract, and was not separated out. Furthermore, it is treated as though fair value accounting were not used in relation to it.

This means that if, for example, the contract as a whole is a trading item, Case I profits will be computed on the basis of this deemed accounting, rather than the actual accounting. Debits or credits that arise on the derivative contract are not brought into account. CFM52540 gives an example.

The wording of the erstwhile FA02/SCH26/PARA45L(1) which applied in periods of account beginning on or after 1 January 2005 and ending before 16 March 2005 referred only to non-trading debits or credits on ‘Para 45L derivatives’ being left out of account. This was amended to refer to both trading and non-trading debits and credits. HMRC staff should seek advice from CTIAA (Financial Products Team) in any case where Para 45L applies in a period of account ending before 31 December 2005, and it appears that the amendments to the paragraph made by SI 2005/2082 or SI 2005/3440 have significant tax consequences.