CFM16645 - Taxing loan relationships: “hybrid” securities: taxing the embedded derivative: overview

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

Taxing the embedded derivative

For periods of account beginning before 1 January 2005, the loan relationships rules provided for the holder of a “hybrid” security to be taxed under the chargeable gains code in respect of all profits or losses arising from the security (apart from interest and exchange gains and losses which were brought into account under the loan relationships rules). FA96/S92 applied to the holder of a qualifying convertible or exchangeable security, and FA96/S93 applied to the holder of a qualifying asset-linked security.

This “whole loan relationship” approach is not appropriate in an era where such securities are accounted for as a loan and a separate embedded derivative. The bifurcated accounting treatment more precisely identifies the element potentially qualifying for chargeable gains treatment.

FA96/S92 to S93B have therefore been replaced. Where the security qualifies for it, chargeable gains treatment is given only on the derivative element, not the underlying loan relationship. The conditions for chargeable gains treatment have moved into the derivative contracts rules in FA02/SCH26 at PARA45A onwards. They are similar, but not identical to, those formerly applying under FA96/S92 and FA96/S93.

Holders

For holders of a “hybrid” security, these rules provide for a form of annual chargeable gains treatment on the derivative component of the contract.

PARAGRAPH 45A sets out the circumstances in which chargeable gains treatment applies to the holder of an embedded derivative.

PARAGRAPH 45B sets out the rules on carrying back losses on derivatives to which paragraph 45A applies. CFM13518 explains the computational rules on carry back.

PARAGRAPHS 45D and 45E apply to the holder of a convertible/exchangeable security.

PARAGRAPH 45F applies to the holder of a share-linked security.

Issuers

For issuers of a “hybrid” security, the rules provide chargeable gains treatment on the derivative component of the contract in a limited number of circumstances where the contract comes to an end.

PARAGRAPHS 45J and 45JA apply to the issuer of a convertible/exchangeable security.

PARAGRAPH 45K applies to the issuer of a share-linked security.

Interaction with TCGA 1992

PARAGRAPHS 45H, 45FA, 45HZA and 45KA contain additional rules that prevent double counting of gains, or deal with transitional situations.

Summary of the “paragraph 45 alphabet”

CFM16650 contains a summary of the rules in the “paragraph 45 alphabet”.