CFM50410 - Derivative contracts: relevant contracts: hybrid derivatives with embedded derivatives

CTA09/S584

Treatment of ‘nested derivatives’

Occasionally a contract - when viewed as a whole - may be a relevant contract, but may also contain features that are themselves embedded derivatives. Such an embedded derivative is referred to in this guidance as a nested derivative, but this is not a term used in the legislation.

This is particularly likely to be encountered with contracts for the supply of commodities, such as oil or gas, where the value of the contract as a whole is dependent on the price of the underlying commodity. Such a contract may not fall to be accounted for as a derivative under IAS 39, IFRS9 or FRS102 (or formerly FRS26), perhaps because it is always intended to proceed to delivery, but it may nonetheless be a {future CFM50360}, and therefore a relevant contract. As its underlying subject matter is commodities, it is deemed to satisfy the accounting condition.

Such a contract may contain clauses (for example, an option to settle in a different currency) that constitute embedded derivatives, which are not closely related to the host contract.

If the whole contract satisfies the accounting definition of a derivative in IAS 39, IFRS9, FRS 26 or FRS102, the contract as a whole would fall to be accounted for at fair value through profit and loss. This is unlikely to give rise to tax problems. The accounting condition at CTA09/S579(1)(a) is satisfied, so the contract is a derivative contract. The credits or debits to be brought into account will (normally) simply be based on the accounts figures.

A more problematic situation arises where the contract is not accounted for as a derivative. Nevertheless, it may satisfy one of the ‘alternative accounting conditions’ at CTA09/S579(1)(b) or (c) (see CFM50200+), and hence be a derivative contract for tax purposes. At the same time, the accounts of the company under IAS39 or IFRS9 (or previously FRS26) may recognise separately the derivative or derivatives embedded in the contract. Without specific legislation, it would be unclear whether this bifurcation should be respected for tax purposes.

S584 is intended to deal with this situation.

Conditions

This provision applies where:

  • the contract as a whole is a relevant contract (a future, option or CFD), which is not treated for accounting purposes as a derivative, but satisfies the condition in CTA09/S579(1)(b) or (c),
  • in accordance with GAAP, the company splits the contract into a host contract plus one or more embedded derivatives, and
  • the host contract, looked at by itself, would be a relevant contract.

Such a contract, viewed as a whole, is dubbed a ‘hybrid derivative’ for the purposes of CTA09/Part 7.

Effect

Where the conditions are met the company is treated as being party to one or more relevant contracts, representing the embedded derivatives, plus a further relevant contract, consisting of the rights and liabilities under the host contract. Each of these will be either a future, an option or a contract for differences, depending on their individual character.

In most cases, each of the relevant contracts that are so recognised will be a derivative contract. The overall effect will normally be that the tax treatment of the ‘hybrid derivative’ follows the accounting treatment.