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:

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.