CFM16625 - Taxing loan relationships: “hybrid” securities: accounting treatment of bifurcation
This guidance applies to periods of account beginning on or after 1 January 2005
The accounting treatment of bifurcation
International Accounting Standards (and revised UK GAAP) treat certain financial assets and liabilities as if they were two (or more) sets of rights bundled together, at least one of which has the characteristics of a derivative. Securities that are convertible into or exchangeable for shares, or which are linked to the value of other assets, fit this description. IAS and revised UK GAAP require both holder and issuer to separate (“bifurcate”) the security into these two components:
- the underlying “host contract”, a financial asset or liability which has the characteristics of a simple (though discounted) loan, and
- an “embedded derivative”, which will be:
- in the case of a convertible/exchangeable, an option to convert/exchange the security for shares, or
- in the case of an asset-linked security, a “contract for differences” under which the amount payable on redemption will depend on the percentage rise or fall in the value of the specified assets over the life of the security.
Who must “bifurcate”?
CFM16105+ outlines the accounting principles that decide whether a company must bifurcate. Broadly, bifurcation allows different accounting methods to be used for the two components. This is necessary because IAS generally requires derivatives (such as options and “contracts for differences”) to be accounted for at “fair value”, whereas most companies will account for the loan element on an amortised cost basis. In practice, most holders of convertibles and exchangeables will bifurcate, unless the company is required to use the same accounting method for both components anyway – so there would no point splitting the security. This exception will apply mainly to banks and other financial traders holding securities on trading account. All issuers (borrowers) will bifurcate unless, exceptionally, there is no readily available way of attributing a “fair value” to the embedded option or equity component, or they are issuing the security in the course of a financial trade.
Non-bifurcators
Where a company accounts for the security as a single
instrument, it is taxed as a normal loan relationship, with all
profits, gains and losses taxed or relieved as income in the usual
way.
However under a transitional rule, a company may elect for an
existing security formerly taxed under FA96/S92 to be treated for
tax purposes as if split accounting had been used, see
CFM16635.
Bifurcation is an accounting not a legal concept
It should be noted that in legal form, a compound or “hybrid” security is a single instrument, not two. Bifurcation should be thought of as an accounting device only.
