CFM16610 - Taxing loan relationships: “hybrid” securities: what is a “hybrid security?

This guidance applies for periods of account beginning on or after 1 January 2005

What is a “hybrid” security?

It should be noted that the word “hybrid” is used in this section of the Corporate Finance Manual, as it is commonly in commercial parlance, as a shorthand way of describing convertible, exchangeable, asset-linked and similar securities, for which there is a special tax treatment within the loan relationships and derivative contracts rules.

Accounting practice makes a distinction between hybrid financial instruments, comprising one or more derivatives embedded in a financial asset or liability, and compound financial instruments, comprising a financial liability plus an equity component – CFM16195 explains the difference between the two. This guidance covers instruments – such as a convertible security issued by a company – that are, in accounting terms, compound financial instruments, as well as those that an accountant would recognise as “hybrid”.

It should also be noted that the derivative contracts rules in FA02/SCH26 refer to a particular type of derivative as a “hybrid derivative”. This is different to the more colloquial use of the word “hybrid” to describe convertible, exchangeable and asset-linked securities.

Embedded derivatives in non-financial contracts

The types of “bifurcated” accounting treatment described in CFM16620 does not only apply to contracts that are loan relationships, and the special tax rules in the “paragraph 45 alphabet” apply to cases other than derivatives that are embedded in “hybrid” financial instruments. These include property derivatives (FA02/SCH26/PARA45C and 45G), and derivatives embedded in contracts other than loan relationships (FA02/SCH26PARA45L and 45M). CFM13500 onwards has more on the tax treatment of these types of derivatives.

Index linked gilts

FA96/S94 contains tax rules for index-linked gilt-edged securities. This section was repealed at the same time as FA96/S92 to S93B. This repeal was reversed by FA05/SCH4/PARA27 (which deems FA96/S94 never to have been repealed). Where – exceptionally – such instruments are treated as bifurcated, FA02/SCH26/PARA45I excludes any debits and credits on the embedded contract for differences from the derivative contracts rules in FA02/SCH26 – see CFM13550. The guidance at CFM5940 continues to apply to such securities for accounting periods beginning on or after 1 January 2005.

Non-embedded share options or futures running to delivery

FA02/SCH26/PARA45HA provides for “plain vanilla” options and futures relating to shares, that are not embedded derivatives within FA96/S94A and where delivery of the shares is taken. The base cost of the shares for the purposes of TCGA92/S38 is adjusted to take account of the debits and credits arising under FA02/SCH26 on the option or future.