CFM37660 - Loan relationships: ‘hybrid’ securities with embedded derivatives: bifurcation: tax rules follow the accounting treatment

CTA09/S415

Tax rules mirror accountancy rules

Many holders and issuers of convertible or exchangeable securities, or asset-linked securities, will account separately for the loan and the conversion / share-linked feature:

  • {CFM37625} explains the main accounting permutations.
  • CFM37640 explains the mechanics of how a company bifurcates an embedded derivative
  • {CFM37645} explains the mechanics of how a company splits a compound financial instrument into liability and equity components.

The tax rules mirror this accounting treatment. So, in particular, S415 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 CTA09/S585.

The loan element is taxed wholly under the loan relationship rules, while the derivative element is taxed separately under CTA09/PT7.

S415 applies both to hybrid and to compound financial instruments. Although the legislation uses the term ‘embedded derivative’, S415(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, CTA09/S585 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 CTA09/S576, in particular, the accounting test (CFM50220). 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 CFM55510.

See however CFM37770 on the treatment of issue costs of a compound instrument.

Companies which do not bifurcate an embedded derivative

Not all companies will bifurcate an embedded derivative, and will instead account for the whole instrument as a single item - typically the whole instrument will be measured at fair value.

In such cases S415 and S585 do not apply. See {CFM37780} for guidance on the treatment of hybrid debt where the company does not bifurcate.   

Note, however, that in certain limited cases a company can make an election for the instrument to be treated as being bifurcated - see CFM37720.