Debt cap: calculating the disallowance of financing expense amounts: embedded derivatives
Derivatives embedded in a loan relationship
IAS 39 or FRS 26 has the concept of an embedded derivative: a provision within a contract (the ‘host contract’) which, if it stood independently, would be classified as a derivative financial instrument. If an embedded derivative is not ‘closely related’ to the host contract, the accounting standards require the derivative element to be recognised separately. There is more detail, and examples, at CFM25030 - 25070.
Where a loan relationship contains an embedded derivative that is not closely related to the host contract, so that the instrument is split between the ‘host’ loan relationship and the derivative (known as ‘bifurcation’) for accounting purposes, CTA09/S415 and CTA09/S585 between them ensure that the tax treatment follows the accounting. The separately recognised host contract is treated as an independent loan relationship by S415, while the embedded derivative is treated as a relevant contract (which may or may not qualify as a derivative contract) by S585.
Where a company has issued, or holds, debt to which CTA09/S415 applies, only debits relating to the loan relationship element are taken into account when applying TIOPA10/S313(2). However, where debt contains an embedded derivative that is closely related to the host contract, and is therefore not accounted for separately, the financing expense amount will be computed by reference to the debt as a whole.
A UK company issues a security where the redemption amount is linked to the FTSE 100 index. Such an instrument contains an equity derivative (because the value of this component will change as share prices change) embedded in a debt security. The embedded derivative is not closely related to the host contract, and company accounts for it separately at fair value.
Under CTA09/S585, the embedded derivative is treated as a relevant contract - a contract for differences - which satisfies the conditions to be a derivative contract. Debits or credits may be brought into account under the derivative contracts rules; or, if the contract is an ‘exactly tracking contract’ a chargeable gain or allowable loss is brought into account under CTA09/S658 when the financial liability comes to an end. In neither case, however, will these amounts be included in financing expense amounts under section 313(2), or in financing income amounts under section 314(2). Amounts are only ‘brought into account in respect of a loan relationship’ for these purposes where they relate to the host contract - the separate loan relationship created by CTA09/S415.
A company has borrowed money at a variable rate of interest, but under the loan agreement the interest rate is capped at 6.5%. When the loan is first taken out, the company is paying interest at 5.25%.
The loan contains an embedded derivative (a cap), but this is closely linked to the debt, and is above the commercial rate of interest when the loan is taken out. The embedded derivative is closely related to the host contract, and does not need to be separated.
The accounts of the company show financing expenses calculated on an effective interest rate method, taking into account the effect of the cap. These are the debits that will constitute the company’s financing expense amounts in respect of the loan.
If, however, the company had borrowed at a variable rate, with no cap, but had purchased a separate interest rate cap (at 6%), the cap would be a derivative contract. The company’s financing expense amounts would be the (uncapped) interest payable under the loan itself. The premium paid by the company for the cap would not be a financing expense amount; nor would any amounts received under the cap contract be financing income amounts.