CFM16690 - Taxing loan relationships: convertible and exchangeable securities: taxing the issuer

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

How the embedded option is taxed on the issuer

See CFM16605 to CFM16645 for an overview of the taxation of “hybrid” securities. CFM16690 to CFM16710c explain the detailed rules that apply to the issuer a convertible security.

Where the issuer of a convertible or exchangeable security accounts separately for the loan and option elements, FA96/S94A provides for the option element to be dealt with under the derivative contracts rules in FA02/SCH26. However those rules apply with the modifications at FA02/SCH26/PARA45JA and 45J. Which of those two paragraphs applies depends both on whether the option element is accounted for as an equity component or as an embedded derivative, and on how the company’s obligations under the option are, in fact, fulfilled.

Where the security is exchangeable for shares in a company other than the issuing company, or the “share option” component can only be settled for cash, the option component will be treated as an embedded derivative for accounting purposes. This is also likely to be the case if the security is convertible into shares of the issuing company, but a cash alternative is available. Where there is no such cash alternative (or it is available only in exceptional circumstances, for example in the event of a takeover), the obligation to issue shares will generally be accounted for as an equity instrument. Even here, however, the issuing company may in certain circumstances have to pay out cash instead – see CFM16700.

The table below summarises the issuer’s tax treatment in this range of circumstances:

Exceptionally, a combination of these settlement methods may be encountered – for example, a convertible may be settled partly by a share issue and partly in cash. The legislation does not cater explicitly for these cases. They should be dealt with on a pragmatic basis by treating the embedded derivative as two separate options and applying the appropriate statutory provision to each part.

For convenience, this guidance refers to “standard” or “plain vanilla” convertibles where the company’s obligation to issue shares is treated as an equity instrument, with all other convertibles referred to as “non-standard”. These terms are not statutory.

There is no requirement under either PARA45J or PARA45JA for the convertible to fall within PARA45D in the hands of the holder. The tax treatment is considered separately for holder and issuer, even where these are companies in the same group.

Definition of option

Both PARA45J and PARA45JA use the term “option”. This has the meaning that it has in FA02/SCH26/PARA12, except that PARA12(10) – which treats an option that can only be cash settled as a contract for differences – does not apply.

The option embedded within a convertible security may, in some cases, be automatically exercised – on maturity, shares are issued (or their cash equivalent paid) where this is economically favourable to the holder, without the holder needing to give notice of exercise. Automatic exercise does not disqualify it from being an “option” within PARA45J or PARA45JA. If, however, a so-called option is always automatically exercised, whatever the value of the conversion shares, you will need to look more closely at the nature of the security. Even if it is described as a “convertible”, neither PARA45D (for the holder) nor PARA45J and 45JA (for the issuer) are likely to be relevant.