CFM16605 - Taxing loan relationships: “hybrid” securities: impact of new accounting standards

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

Features and overview

The loan relationships rules have always recognised that it is appropriate to tax the holder’s profit from a “hybrid” instrument under the chargeable gains tax rules, in cases where a security has share/equity like features or where its redemption price exactly tracks a qualifying chargeable asset.

For example, a security may be issued on terms that allow the lender to convert the security into shares of the issuing company (a “convertible”) or exchange it for shares in a different company (an “exchangeable”). Or the amount the lender gets on redemption may be linked to the change in value of a specific asset (such as a particular company’s shares), or index of such assets (such as the FTSE-100), over the life of the security. In such a case, the lender’s return is the same or resembles that from owning the asset outright.

For accounting periods beginning before 1 January 2005 (see CFM6100), FA96/S92 to S93B provided special rules for such “hybrid” types of security. The only credits and debits taxable or relievable as income under the loan relationships rules were those relating to interest, and in some cases exchange gains and losses. Other profits and losses on the security were within the chargeable gains rules, or were “tax nothings”, and FA96/S92A restricted relief for the issuer of the security for the costs of issuing or delivering shares.

Periods of account beginning on or after 1 January 2005

Apart from certain smaller companies to which special exceptions apply, most companies will adopt either International Accounting Standards (IAS) or revised UK GAAP, and may do so from 1 January 2005. CFM16000 has more on the adoption of IAS.

For periods of account beginning on or after 1 January 2005 the tax rules have been changed to match the prescribed accounting for such “hybrid” instruments. The accounting treatment under IAS requires in many cases, a company to divide (or “bifurcate”) the contract into the “host contract” and an “embedded derivative”. The embedded derivative in such cases is the option to acquire shares, or the “contract for differences”, or other rights or obligations that meet the definition of a derivative under IAS (see CFM16090).

Central to these changes were the repeal of FA96/S92 to S93B and the introduction of new rules at FA96/S94A and at FA02/SCH26/PARA45A to PARA45M (the so-called “paragraph 45 alphabet”). Under the new rules, where a company bifurcates the debt contract for accounting purposes:

• FA96/94A applies to tax the “host contract” (the loan element) under the loan relationship rules;
• the embedded derivative is dealt with under the derivative contracts rules in FA02/SCH26/PARA45A onwards.

The effect of the change is to broadly reproduce the chargeable gains treatment under the rules in FA96/S92 to S93B, but under a different mechanism. The changes relate to both holders and issuers of “hybrid” instruments.