CFM16675 - Taxing loan relationships: convertible and exchangeable securities: taxing the holder: example of chargeable gains treatment

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

An example of chargeable gains treatment for the holder of an embedded option

Abacus Software Ltd accounts to 31 December. On 1 January 2006 it subscribes for a 3 year security issued by X plc at par £1million, carrying interest at 5 per cent. It redeems for cash £1million or, at the option of Abacus, is convertible into 10,000 ordinary £10 shares in X plc. On 31 December 2008 X plc’s shares are worth £110 per share. Abacus therefore exercises the conversion option and acquires 10,000 X plc shares worth £1,100,000. Its commercial profit from the option is therefore £100,000.

Abacus accounts separately for the loan and the option. For convenience, assume it ascribed initial fair values to the loan and option of £950,000 and £50,000 respectively.

Accounting and tax treatment of the loan element

Abacus will treat the loan as acquired for £950,000, a discount of £50,000 to its face value £1m. It accrues credits for the discount over the 3 year term. These credits are taxable under the loan relationship rules in addition to the interest receivable.

Accounting for the embedded option

For accounting purposes Abacus must recognise any changes in the option’s fair value at each balance sheet date. Assume it considered its fair value to be:

Accordingly, in its accounts for the 3 periods to 31 December 2008, Abacus respectively brings in a credit of £61,000, a debit of £7000, and a debit of £4000.

Taxing the embedded option: FA02/SCH26/PARA45A, 45D and 45E

The above credits and debits are taxable under the derivative contracts rules of FA02/SCH26. If the conditions for chargeable gain treatment are met, see CFM16665, the usual income treatment does not apply, and Abacus has a corresponding chargeable gain, or allowable loss, in each relevant accounting period.

Over the 3 year period Abacus has been taxed on net chargeable gains of £50,000 (£61,000 - 7000 - 4000). This represents the difference between its £100,000 commercial profit from the option and its £50,000 initial value on bifurcation. The remaining £50,000 of the overall £100,000 profit has been taxed as income under loan relationships, in respect of the notional issue discount.

Carry back of allowable losses

Abacus may be able to carry back the allowable losses for the periods to 31 December 2007 and 2008, see CFM16660.