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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 contractâ€�), and
• a ‘relevant contractâ€� (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.