CFM52550 - Derivative contracts: embedded derivatives: hybrid derivatives

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.

Application of S616 to hybrid derivatives

‘Hybrid derivative’ is the term used in the legislation for a contract that

• viewed as a whole, is a relevant contract, and - while not accounted for as a derivative - satisfies the condition in CTA09/S579(1)(b),
• is separated, in accordance with GAAP, into a host contract and one or more embedded derivatives, and
• where the host contract, viewed in isolation, would be a relevant contract.

For this situation to arise:

• The accounting standards applied must require the separation of an embedded derivative; and
• the contract within which the derivative is embedded would itself be a derivative contract. This must inevitably be a result of the accounting condition in S579 being deemed to be satisfied, even though the contract is not itself accounted for as a derivative, most likely because of the nature of the underlying subject matter of the contract, see CFM50220+.

In practice, this is most likely to be the case in respect of relevant contracts whose ‘main’ underlying subject matter is commodities (leading to deemed satisfaction of the accounting condition), but whose fair value also varies in response to some other unrelated variable, which is the subject matter of the embedded derivative.

Under CTA09/S584, a company with such a hybrid derivatives is treated as being party to the embedded derivatives and, separately, to the relevant contract represented by the host contract. See CFM50410.

CTA09/S616 also applies to hybrid derivatives and that ensures such contracts are also, in effect, taxed on the basis of ‘old’ UK GAAP. The contract is treated under S616(3) as though the embedded derivative or derivatives were closely related to the host contract. Credits and debits on the embedded derivative are not brought into account, nor is fair value accounting used for the contract as a whole.

The conditions in S616(1) (see CFM52530) apply in the case of hybrid derivatives as well. In particular, where CTA09/S592 applies to a hybrid derivative (CFM52580), that treatment will take priority. An election under CTA09/S617 to disapply S616 will apply to any hybrid derivatives held by a company, as well as to derivatives embedded into other non-loan contracts.