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.