Embedded derivatives

By Tolley
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The following Corporation Tax guidance note by Tolley provides comprehensive and up to date tax information covering:

  • Embedded derivatives
  • Introduction
  • What is an embedded derivative?
  • Accounting for embedded derivatives
  • The taxation of embedded derivatives

Introduction

This note explains the concept of embedded derivatives, a term introduced by International Accounting Standards (IAS), and how they are taxed.

Associated HMRC guidance can be found in CFM52500.

What is an embedded derivative?

A derivative contract is a financial instrument, or security, whose price is dependent on, or derived from, one or more underlying assets or indices. It is simply a contract between two or more parties whose value is determined by fluctuations in the underlying asset or index.

An embedded derivative is a particular form of derivative contract that came to be known by this name on the introduction of IAS. It is defined (only) in paragraph 10 of IAS 39 as follows:

‘An embedded derivative is a component of a hybrid (combined) instrument that also includes a non-derivative host contract - with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract.’

In other words, it is a feature that sits within another contract (the host contract) and causes some or all of the cash flows of the host contract to change, according to a specified index or other variable.

The host contract might be a debt or equity instrument, a lease, an insurance contract, or a sale or purchase contract.

For example, a typical convertible security comprises a loan note and a conversion option. The

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