CFM52560 - Derivative contracts: embedded derivatives: elections out of S616

CTA09/S617

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.

Elections out of S616

Companies that do not want to make the computational adjustments necessitated by CTA09/S616 may elect out of its provisions. This is subject to two qualifications. A ‘disapplication election’ does not apply to

• any contract where the underlying subject matter of the embedded derivative is, or includes, commodities; or
• a contract of long-term insurance.

The exclusion for commodities is because a number of supply contracts, particularly in the oil and gas sectors, contain embedded derivatives linked to the wholesale prices of - in particular - crude oil or natural gas. Because of the volatility in the price of these commodities, and the high value of some of these contracts, taxing such contracts on the basis of fair value changes would lead to considerable volatility in the tax payable by companies that are party to the contracts.

These two provisos, however, apply only to accounting periods ending on or after 31 December 2005. An election made in respect of a period beginning on or after 1 January 2005, but ending before 31 December 2005, applies to all of a company’s contracts.

A disapplication election must be made in writing to HMRC, and is irrevocable. It must be made before the end of the first accounting period ending on or after 17 August 2005 in which the company was party to contracts to which CTA09/S616(1) applies. It is possible for this deadline to fall considerably later than 2005, for instance if the company had not previously applied accounting standards requiring bifurcation, or if it simply had not been party to any contracts to which bifurcation was applicable under the standards it applied.

Example

A company draws up its accounts to 31 December. In the year ended 31 December 2017 it was not party to any non loan relationship contracts containing embedded derivatives. In the year ended 31 December 2018, it leased new business premises. The rent payments under the lease were, for the first five years, adjusted for inflation at twice the change in the retail price index (RPI).

When it entered into the contract, the company drew up its accounts under FRS 102. The RPI-linked clause was therefore not an embedded derivative for accounting purposes. On 1 January 2019, however, changes its accounting framework and adopts IFRS (including IFRS 9).

Since the inflation adjustment is leveraged, the company’s accountants advised that the embedded derivative must be separated from the host lease. The conditions in S616(1) are therefore satisfied, for the first time, in year ended 31 December 2019.

If the company wishes to elect out of S616, it must do so on or before 31 December 2019

Note: it might be argued that the underlying subject matter of the derivative embedded in the lease includes commodities because the RPI is based on a ‘basket’ of goods and services that may include commodities. However, HMRC’s view is that this would be subject matter which is subordinate or of small value and can be disregarded for the purposes of S617. Any commodity component of the index is ‘subordinate’ for this purpose.

Each company within a group can decide independently whether or not to make a disapplication election under S617. But special rules apply where a contract is between two group companies, or is transferred within a group - see CFM52570.