CFM16725 – Taxing loan relationships: convertible and exchangeable securities: transitional rules: issuers

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

Continuity of tax treatment: liabilities

For issuers of a convertible security, interest and exchange gains and losses in respect of the security were allowable under loan relationships rules, relief for the costs of issuing the security was restricted by FA96/S92A, and other gains and losses were tax nothings. As for holders ( CFM16720), the previous tax treatment is broadly continued for issuers of convertible securities where the liability straddles the start of the company’s first accounting period beginning on or after 1 January 2005.

The embedded derivative

The terminal capital gains treatment applicable to issuers of convertible securities under FA02/SCH26/PARA45J and PARA45JA ( CFM16690) is not available where the company was party to the instrument in accounting periods beginning before 1 January 2005. The only exception to this is where the company is party to a “non-standard” convertible which it cash settles under FA02/SCH26/PARA45J (7) ( CFM16710). In this case, the carrying cost of the option is treated as nil and the company is entitled to a terminal allowable loss equal to the amount paid to fulfil the contract.

The host contract

Regulation 12 of the Disregard Regulations (see CFM13270) applies for loan relationships purposes. It has effect for any debtor relationship where

• FA96/S92A applied immediately before the start of the company’s first accounting period beginning on or after 1 January 2005, but
• the company did not enter into the debtor relationship in the ordinary course of a banking or security dealing business.

Where these conditions are met, it applies both where the company accounts for the security as a financial liability and an equity element or an embedded derivative (so that FA96/S94A applies), and where it does not bifurcate.

Where the company does not bifurcate, debits are allowable to the extent that they would not have been disallowed under FA96/S92A(3). This means that interest and exchange losses are allowable (and exchange gains are taxable), but debits connected with the acquisition or issue of shares are not allowed. Thus the tax treatment formerly given by S92A simply continues.

Where the company does bifurcate, amounts to be brought into account in relation to the host contract are restricted to

• debits in respect of interest
• exchange gains or losses, and
• credits and debits in respect of discounts, premiums, fees and expenses, to the extent that these would not have been prohibited by S92A(3).

Amounts to be taxed or relieved are to be determined without regard to amounts given by the effective interest rate method. In particular, debits for the “implied finance cost” ( CFM16695a) are not allowed in the transitional case.

Before the amendment of the Disregard Regulations by SI 2007/948, which came into force on 11 April 2007, regulation 12(2)(a) referred merely to debits to the extent that they are within S92A(3). This means that issuers may have had “excessive” debits on transitional securities in accounting periods ended before 11 April 2007. A corresponding adjustment is made to the transitional amount recognised under the Change of Accounting Practice Regulations – see CFM16730.