CFM52540 - Derivative contracts: embedded derivatives: example of S616

CTA09/S616

This guidance is relevant to cases where the accounting standards applied result in the separation of an embedded derivative. For details of the accounting treatment for embedded derivatives and hybrid debt see CFM25020.

Example: embedded derivative in currency contract

Z Ltd, a company with a sterling functional currency, enters into a contract to buy widgets from Y Ltd, to be delivered in 6 months’ time. Payment is to be made on delivery, but the contract gives Z Ltd the option of paying either £1 million or Japanese Yen (JPY) 205.7 million for the widgets. (The figures reflect the GBP/JPY exchange rate at the start of the contract.) Widgets are not usually traded in Yen.

The currency feature in the purchase contract is a derivative, allowing Z Ltd to profit from favourable currency movements. When payment falls to be made, JPY 205.7 million is worth £980,000, so the company chooses to pay in Yen.

In its accounts, Z Ltd separates the embedded currency option, accounting for it at fair value. The accounts thus show the widgets as having been bought for £1 million, but there is a separate £20,000 profit on the currency option.

The embedded option is brought within CTA09/Part 7 by S586, and it fulfils the conditions to be a derivative contract.

But Z Ltd has not elected out of S616. S616(4) therefore applies to the purchase contract as a whole. It is treated as if the embedded feature was closely related to the host contract, and was not being accounted for separately at fair value.

CTA09/S46(1) requires Z Ltd to compute its trading profits on the basis of GAAP. However, S616(4) substitutes a ‘deemed GAAP’ for the actual basis of accounting. For the purposes of computing trading income, the widgets are treated as having been bought for £980,000. Fair value changes on the option are disregarded: the £20,000 currency ‘profit’ is effectively brought into account when the goods are sold.

The provision in CTA09/S699(1), which prevents profits on derivative contracts from being taxed otherwise than under Part 7 - and which might over-ride the above tax treatment - is explicitly switched off by S616(5).