CFM16630 - Taxing loan relationships: “hybrid” securities: mechanics of bifurcation

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

How a company bifurcates

A company which is a creditor or debtor for a convertible or exchangeable security, or an asset-linked security, is generally required to account separately for the loan and the “embedded derivative”, from the time it first acquired the security. It must allocate initial values to the two components whether or not it was a party to the security when originally issued.

Valuation of the components is a specialised exercise, see CFM16190. The embedded derivative within a hybrid financial instrument is measured at fair value. Broadly, the company works out what the notional fair value of the security would be, without the derivative component (the conversion or exchange rights or obligations in the case of a convertible or exchangeable security, or the asset-link rights in the case of an asset-linked security). This will normally be less than the fair value of the security as a whole, and provides the initial fair value of the loan element.

The fair value of the derivative component is determined separately using an appropriate valuation model. If it is impossible to reliably value the derivative in this way (for example, because the derivative is based on unquoted shares), its fair value is taken as being the difference between the fair value of the whole instrument and the fair value of the loan component.

The accounting treatment of a compound financial instrument – a financial liability plus an equity component – is slightly different. The fair value of the equity component when it is initially recognised is the difference between the fair value of the instrument as a whole, and the fair value of the “financial liability” component. The equity component is not subsequently revalued.

See example at CFM16630a.