CFM16635 - Taxing loan relationships: “hybrid” securities: alignment of the tax and accountancy rules

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

Tax rules mirror accountancy rules

Most holders and issuers of convertible or exchangeable securities, or asset-linked securities, will account separately for the loan and the embedded derivative. CFM16630a explains how the company allocates initial far values to the two elements.

The tax rules have been changed to mirror this accounting treatment. FA96/S94A provides that where a company accounts for its rights (or liabilities) as divided between a loan and one or more embedded derivatives, tax treatment follows. The company is treated as being a party to both:

• a loan relationship (corresponding to the “host contract”), and
• a “relevant contract” (corresponding to the derivative) for the purposes of the derivative contracts rules at FA02/SCH26.

The loan element is taxed wholly under the loan relationship rules, while the derivative element is taxed separately under FA02/SCH26.

FA96/S94A applies both to hybrid and to compound financial instruments. Although the legislation uses the term “embedded derivative”, S94A(1)(b) makes it clear that this takes in both embedded derivatives in the accounting sense, and the equity component included in a compound instrument.

However, S94A(2)(b) only treats the “embedded derivative” as a relevant contract – it does not say that it is a derivative contract. The resultant option or contract for differences must still be subjected to the tests at, in particular, FA02/SCH26/PARA3 ( CFM13078). Because an equity component is not treated for accounting purposes as a derivative financial instrument, it will not pass the “accounting test” and, rather than being a derivative contract, will be a “tax nothing” – see CFM16695.

Companies which do not “bifurcate”

FA96/S94A only provides for separate taxation of the loan relationship and the option where that is the accounting treatment. Although many companies will bifurcate, there are 3 exceptions. These are where:

• the company is a bank or other financial trader which entered into the security for the purposes of a trade of dealing in securities, and accounts for the whole security at “fair value through profit and loss” (corresponding to the former “mark to market basis”); or
• bifurcation is impracticable, because there is no readily available means of valuing the embedded option – say because the company into whose shares the security may convert is unquoted; or
• the company has not (or not yet) adopted IAS or revised UK GAAP, so is not for the time being permitted to use separate accounting.

Where a company accounts for the security as a single instrument, the security falls wholly within the loan relationship rules, with all profits gains and losses brought into account as income under FA96.

However under a transitional rule (F2A05/SCH6/PARA7), a company in the third category may elect to be treated for tax purposes as if it had used split accounting. This benefits companies holding existing securities formerly within FA96/S92, for which chargeable gains treatment would otherwise be unavailable.