CFM37620 - Loan relationships: ‘hybrid’ securities: what is a ‘hybrid security’?

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 often is 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.

The legislation, at CTA09/S415 and S585 does not refer to hybrid securities, but rather to 'loan relationships with embedded derivatives'. This chapter also covers situations where a company has a compound financial instrument which contains both liability and equity components.

Note that the accounting standards make an important 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 - CFM25080 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 containing an embedded derivative.

It should also be noted that under FRS102 there is no concept of bifurcation of an embedded derivative unless the company opts to apply the measurement and recognition requirements of IAS39 or IFRS9 (as permitted by FRS102). For companies that apply IFRS9 (including via FRS101 or FRS102), they are not permitted to bifurcate an embedded derivative out of a financial asset. See {CFMXXX+} for the treatment in cases where bifurcation is not applied.

It should also be noted that the derivative contracts rules in CTA09/PT7 refer to a particular type of derivative as a ‘hybrid derivative’. This use of the description 'hybrid' is different to the more colloquial use of the word ‘hybrid’ to describe convertible, exchangeable and asset-linked securities.

Reference is also made to 'hybrid' in the 'Hybrid and Other Mismatch' legislation, TIOPA10/PT6A; CH3 counters hybrid and other mismatches from financial instruments. This may counter features of a financial instrument, which lead to a mismatch in tax treatment between entities taxed in different tax jurisdictions. This is yet another meaning ascribed to 'hybrid', though it is fair to say that the hybrid securities dealt with in this guidance may sometimes give rise to such mismatching tax treatment.

Embedded derivatives in non-financial contracts

The type of ‘bifurcated’ accounting treatment described in CFM25040 does not only apply to contracts that are loan relationships, and the special tax rules for derivative contracts apply to cases other than derivatives that are embedded in ‘hybrid’ financial instruments. These include derivatives embedded in contracts other than loan relationships. CFM52520 onwards has more on the tax treatment of these types of derivatives, including 'hybrid derivatives', which are contracts which are regarded as derivative contracts for tax purposes, but which are accounted for as non-derivative contracts containing an embedded derivative - see {CFM52550}.