CFM16660 - Taxing loan relationships: convertible and exchangeable securities: taxing the holder

This guidance applies to periods of account beginning on or after 1 January 2005

Whether to tax as income or a chargeable gain

See CFM16605 to CFM16645 for an overview of the taxation of “hybrid” securities. CFM16660 to CFM16685 explain the detailed rules that apply to the holder of a convertible security.

Accounting treatment

Where the holder of a convertible or exchangeable security accounts separately for the embedded option, it ascribes an initial fair value to it – CFM16630.

Any subsequent changes in the fair value of the option must be recognised at each accounting date. Its value at any one time will reflect, among other factors, the value of the shares into which the security may convert or exchange. If their value rises, the value of the option will also tend to increase, and may give rise to a net credit. If their value falls, so may the value of the option, giving rise to a net debit. However other factors will also affect its value, such as how long the option has left to run.

Tax treatment: annual chargeable gains: FA02/SCH26/PARA45A

Under the normal operation of FA02/SCH26, debits and credits arising from options are taxed or relieved as income. This has not changed. However subject to certain conditions the above credits and debits, found in accordance with FA02/SCH26, may qualify to be treated as chargeable gains or allowable losses under FA02/SCH26/PARA45A. Because the holder revalues the option at each balance sheet date, such chargeable gains or allowable losses may arise in each accounting period. This contrasts with the former position under FA96/92, where no chargeable gain or allowable loss arose until a disposal for the purposes of TCGA1992, that is, at the redemption or earlier disposal of the security.

The conditions for chargeable gains treatment are at FA02/SCH26/PARA45D and 45E – CFM16665.

Claim by holder to carry back allowable losses

Where the holder has unused PARA45A allowable losses in an accounting period, it may carry them back to cover chargeable gains arising in accounting periods falling within the previous 24 months. The detailed rules are at FA02/SCH26/PARA45B, see CFM13518.

Carry back only applies to the holder, not the issuer. Although the tax rules for issuers may result in chargeable gains or allowable losses, these are not annual chargeable gains brought into account under PARA45A, and are therefore not within the PARA45B provisions for carry-back.