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

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

  • Derivative contracts—taxation of compound financial instruments: holders
  • Compound financial instruments
  • No bifurcation required—holders
  • Bifurcation required—holders
  • Loan relationships with embedded derivatives—loan relationships regime
  • Loan relationships with embedded derivatives—derivative contracts regime
  • Index-linked gilts with embedded contracts for differences

The general rule is that:

  1. the loan relationships regime forms a self-contained, exclusive, regime for the taxation of corporate debt (ie very broadly, a company's lending and borrowing activities), and

  2. the derivative contracts rules form a self-contained, exclusive, regime for the taxation of a company's holdings of derivative financial instruments

Certain financial instrument, securities and contracts, however, do not naturally fall within the scope of just one regime. Such instruments, however, often contain characteristics that, if they existed in isolation and would be accounted for, and taxed (and, even more importantly, relieved) in different ways if they existed separately from each other. As such, difficulties can sometimes arise where instruments contain characteristics of both debt and equity (or two or more different types of equity).

Where this is the case, the fluctuations in the value of such instruments can be attributable to either, or both:

  1. the rights and obligations arising in relation to the debt element of the instrument—eg in respect of a loan note, movements in interest rates, and

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

The result, from a tax (and accounting) perspective, is that such instruments can create problems when it comes to measuring their value and taxing (or relieving) the profits, gains and or losses that arise