CFM52520 - Derivative contracts: embedded derivatives: derivatives in non loan relationships

CTA09/S616

This guidance is relevant to cases where the accounting standards applied result in the separation of an embedded derivative. For details of the accounting treatment for embedded derivatives and hybrid debt see CFM25020.

Tax issues if there is an embedded derivative for accounting purposes

Where a derivative is embedded into a contract such as a purchase contract or a lease, but is accounted for separately, two tax problems might occur. First, it is not always clear how - if you were considering only the ordinary rules for trading income - the ‘bifurcated’ derivative would be treated. Second, there may be large fluctuations in the fair value of some embedded derivatives which, if the tax treatment simply followed the accounts, would lead to substantial volatility in taxable profits.

CTA09/S616, in conjunction with CTA09/S586, deals with these problems. S586 ensures that each of the derivatives embedded in a contract that is not a loan relationship is treated as a relevant contract for the purposes of Part 7 (see {CFM50430}). But the embedded derivative is then taxed as though it were closely related to the host contract. The overall effect is that the sale or purchase contract, lease or similar contract as a whole (referred to in the legislation as ‘the original contract’) is treated for tax purposes as if ‘old’ UK GAAP still applied. CFM52530 gives details. (See CFM20010 for meaning of ‘old’ UK GAAP.)

S616 also caters for the case where the original contract is a hybrid derivative (see CFM52550).

Some companies may, however, prefer to follow the accounts, notwithstanding the resultant tax volatility. Companies can therefore elect out of S616, although such an election does not apply to embedded commodity derivatives (see CFM52560).