CFM16695 - Taxing loan relationships: convertible and exchangeable securities: taxing the issuer: standard convertible

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

The accounting and tax treatment for the issuer of a standard convertible

For the issuer of a standard (“plain vanilla”) convertible, the embedded obligation to convert the debt into its own shares will generally be a “tax nothing”, giving rise to no taxable debits or credits under either an income or chargeable gains code. This mirrors the prescribed accounting, which does not recognise any change in the value of the obligation whether during the life of the security, or on eventual cash redemption or conversion.

This means that for the issuer, the embedded instrument can generally be ignored for tax purposes.

It is a “tax nothing” because for accounting purposes the potential obligation to convert is not classified as a derivative contract at all. It is classified as an “equity instrument”, for which a different accounting treatment is prescribed. This reflects the fact that an obligation to issue own shares is not regarded as a financial liability, see CFM16185. Equally an equity instrument does not rank as a “derivative contract” for the purposes of the derivative contracts tax rules of FA02/SCH26. It is not therefore taxable or relievable under either an income or chargeable gains code.

See CFM16695a for an example of the normal accounting and tax treatment of the issuer of a standard convertible.

Exceptional case: “cash out”

There is one, relatively rare, exception to the “tax nothing” rule. The issuer of a standard convertible security may “cash settle” the conversion obligation. This may happen where issuing the full amount of shares would exceed the company’s authorised share capital, or where the terms of the security permit cash settlement in exceptional situations. If that happens, FA02/SCH26/PARA45JA may allow the issuer to compute a one-off chargeable gains loss, see CFM16700.