CFM16620 -
Taxing loan relationships: “hybrid” securities:
headline changes
This guidance applies to periods of account beginning on or
after 1 January 2005
Accounting and tax consequences of new standards
Many UK companies will adopt International Accounting Standards
(“IAS”) for periods of account beginning on or after 1
January 2005. Others will adopt the new UK Standards that reflect
relevant IAS Standards. One novel feature of IAS and the new UK
Standards is that they treat a “hybrid” instrument as
separated into loan and an “embedded” derivative, which
in the case of a convertible or exchangeable security will comprise
an option to convert or exchange it for shares, and in the case of
an asset-linked security will be a “contract for
differences”. Where the issue of a security has consequences
for a company’s own share capital, such as a convertible
security, the issuer must similarly recognise separately a loan and
an equity component – this is a “compound”
instrument. The main accounting and tax consequences can be
summarised as follows.
- For accounting purposes, most companies
will “separate” (or “bifurcate”) the loan
element from the derivative element, and account for them as if
they were separate instruments.
- If they do so, the tax rules follow the
bifurcation. The loan element (which will normally be treated as a
discounted loan, with an issue price less than its redemption price
to reflect the reduced level of interest payable) is taxed wholly
under the loan relationships rules. The embedded derivative is
taxed separately under the derivative contracts rules of
FA02/SCH26. The main tax effect is to enable the holder of a
qualifying security to obtain special chargeable gains treatment on
the derivative component. It also means that in general, the income
element of the security is greater than previously, as the discount
on the loan element will be taxed under the loan relationships
rules in addition to any interest.
- Where chargeable gains treatment applies,
it applies only to the derivative element, not the loan
relationship element. The conditions are similar to those formerly
at FA96/S92 and FA96/S93, but have moved into the derivative
contracts rules of FA02/SCH26. Those rules have also been extended
to provide limited chargeable gains treatment for the issuer/debtor
company, but again only in relation to the derivative element.
- Where chargeable gains treatment applies
to the holder, chargeable gains or losses on the derivative are
computed and charged for each accounting period – not just on
redemption or earlier disposal (as was the case under FA96/S92 or
S93). By contrast where chargeable gains treatment applies to the
issuer, this is only given in the period of redemption or other
terminal event.
- If the derivative does not qualify for
chargeable gains treatment, separate treatment has little practical
consequence for tax purposes. All profits gains and losses are
brought into account as income, partly under the loan relationships
rules, and partly under the derivative contracts rules.
- Some companies, mainly banks and other
financial concerns, are not required to account separately for the
loan and derivative. Where a company accounts for the security as a
single instrument, it is taxed wholly under the loan relationships
rules, with all profits gains and losses brought into account as
income under FA96.
- Other kinds of company that hold the
security for the purposes of a trade may account separately for the
two components. In these circumstances, the two components are
taxed separately as income under the normal loan relationships and
derivative contracts rules.
- Some smaller companies will not be
required to adopt the new accounting Standards, and others may be
late adopters (that is, they will start to use them for a period of
account which is not their first to begin on or after 1 January
2005). They cannot therefore use “split” accounting.
Under a transitional rule, they can elect for existing securities
formerly within FA96/S92 to be treated as if that method had been
used.
