Derivative contracts—bifurcation of compound financial instruments: holders
Derivative contracts—bifurcation of compound financial instruments: holders

The following Tax guidance note provides comprehensive and up to date legal information covering:

  • Derivative contracts—bifurcation of compound financial instruments: holders
  • Hybrid instruments
  • Accounting bifurcation—holder
  • Conditions for bifurcation
  • Measurement of bifurcated contract

Certain securities and contracts do not naturally fall within just one of the loan relationships regime or the derivative contracts regime. In addition, some contracts which at first glance appear to fall outside the scope of both regimes contain characteristics that would, if they existed in isolation, be covered by one of them. The difficulty normally arises because such contracts contain characteristics of both debt and equity.

Such contracts are normally referred to in this context as being hybrid (or, in certain circumstances, compound) contracts or securities.

From the tax (and accounting) perspective such instruments create problems when it comes to measuring their value and taxing (or relieving) the profits (or losses) that arise in respect of them.

This is because, broadly, the value (and so the profits and losses) of such compound contracts will fluctuate according to both:

  1. the rights and obligations of the host contract (eg the loan note), and

  2. movements in the value of the underlying equity element (eg the shares which are the subject of the embedded option)

Where:

  1. such hybrid instruments are issued or held otherwise than for the purposes of a trade (ie as an investment), and

  2. certain conditions are met

the two elements of the instrument are accounted for and taxed (and, more importantly, relieved) in different ways as if they existed separately from each other.