CFM16685 - Taxing loan relationships: convertible and exchangeable securities: taxing the holder: interaction with TCGA 1992: conversion

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

Security converts into shares

In the example at CFM16675, Abacus converted a security into 10,000 ordinary shares in X plc. The transaction is one to which TCGA1992/S132 applies, so that no disposal of the “old asset” (the convertible security) is deemed to take place, and instead the base cost of the “new asset” (the shares) is identified with the cost of the “old asset“ (the convertible security). In that example, the cost was £1million.

However FA02/SCH26/PARA45H(4) adjusts this £1m base cost of the shares for the purposes of a subsequent disposal. It is treated as increased (or reduced) by the total of:

• the aggregate net chargeable gains (or allowable losses) already brought into account under FA02/SCH26/PARA45A, and
• the “relevant Chapter 2 amount” (or for periods ending before 30 December 2006, the initial carrying value of the embedded option).

The “relevant Chapter 2 amount” is the amount by which the carrying value of the host contract at the date on which the option is exercised exceeds the carrying value of that contract at the date on which the company became party to the security. “Chapter 2” is a reference to Chapter 2 Part 4 FA96: the purpose of the “Chapter 2 amount” adjustment is to prevent double-counting between loan relationships and chargeable gains.

Computation on conversion into shares

In the example:

• aggregate chargeable gains of £50,000 have already been brought into account under PARA45A , and
• the carrying value of the host contract (the creditor loan relationship) when the option is exercised is £1 million; its carrying value when Abacus first subscribed for the security was £950,000; so the “relevant Chapter 2 amount” is £50,000.

These two amounts are added together. (If the aggregate amount brought into amount under PARA45A was a loss, the loss would be subtracted from the “relevant Chapter 2 amount”).

The result is a profit of £100,000. This is added to the base cost of the conversion shares. A loss would be subtracted.

Thus, in the example, the base cost of the conversion shares is £1,100,000 (the £1 million base cost under TCGA92/S132, plus £100,000). This reflects the fact that Abacus’ economic profit of £100,000 from exercising the conversion option has already been taxed: £50,000 has been brought into account as loan relationship credits representing the accrual of the “implied discount” (see CFM16675). The unindexed gain or loss on subsequent disposal of the shares is limited to the profit or loss arising after the option has been exercised – although, for indexation purposes, the normal TCGA rules apply and the shares will be treated as having been acquired on 1 January 2006.

Suppose that, instead of having subscribed for the convertible on 1 January 2006, Abacus bought it in the market on 1 January 2007 for £1,081,000, subscribing £111,000 of the fair value to the embedded option and £970,000 to the loan relationship. When the option is exercised on 31 December 2008, the carrying values of the loan relationship and the embedded option are, again, £1 million and £100,000 respectively. In this case, an aggregate loss of £11,000 has been brought into account under PARA45A, while the “Chapter 2 relevant amount” is £30,000 (£1 million less £970,000). The aggregate of these amounts is a profit of £19,000. This is added to the amount treated as the base cost of the shares under TCGA92/S132 - £1,081,000 – to give a base cost of £1,100,000.

Thus the effect of these adjustments is always to exclude from the capital gains computation those amounts in respect of the convertible – including any exchange gains or losses, or impairment debits – that have already been taxed.