This guidance applies to periods of account beginning on or after 1 January 2005
On 1 January 2007 X Ltd issues a 3-year security paying 4 per
cent interest. The terms are that it will redeem for cash at par
£1million or, at the holder’s option, convert into
100,000 of X Ltd’s ordinary £10 shares. X Ltd’s
issue costs are £20,000.
X Ltd bifurcates the security at issue, attributing initial
fair values of, say, £950,000 to the loan and £50,000 to
the equity instrument. It must also split issue costs in the same
ratio, allocating £19,000 to the loan and £1000 to the
equity instrument. The initial fair value of the loan obligation is
therefore £931,000, representing a discount of £69,000 on
its face value £1million. The initial fair value of the equity
instrument is £49,000. These total £980,000
(£931,000 + £49,000) being X Ltd’s net proceeds of
issue after its £20,000 issue costs.
Because X Ltd uses “split” accounting this is
followed for tax purposes (FA96/S94A). It is treated as a party to
both a debtor loan relationship, and a separate equity instrument.
The host loan relationship is taxed as a normal debtor loan
relationship (
CFM16640).
The implied discount of £69,000 is amortised to profit
and loss account over the term of the convertible. This means that
X Ltd can claim loan relationship debits for its “notional
finance cost” – the value of the conversion right
attached to the security – as well as for the actual interest
coupons that it pays. This represents a change from the tax
treatment applying in periods of account beginning before 1 January
2005.
The required accounting for an equity instrument is to credit
its initial fair value (here £49,000) to “equity”
in the balance sheet. It is not subsequently re-valued, so no
accounting debits or credits arise. On conversion or cash
redemption the face value of the security, here £1m, would be
transferred from the loan account and credited to equity. The
£49,000 carrying value of the equity instrument would remain
in equity (although it may then be transferred to another part of
the balance sheet).
The tax treatment is the same whether or not the holder
exercises the option, as follows.
If on the option exercise date the value of X Ltd’s shares
was £12 per ordinary £10 share, the holder would opt to
convert. X Ltd would issue 100,000 of its ordinary shares, then
worth £1.2million.
The initial £49,000 fair value of the conversion
obligation was credited to equity in X Ltd’s accounts, and
not subsequently re-measured. On conversion it remains in equity.
An equity instrument is not a “derivative contract” for
the purposes of FA02/SCH26, so no profits or losses arise under
either an income or chargeable gains code.
Had X Ltd’s share value in the above example been less
than £10 per share, the holder would have chosen to redeem for
cash at par £1million.
On redeeming for cash X Ltd will transfer the face value of
the loan, £1million, from loan account to equity. The accounts
carrying value of the equity instrument remains at £49,000
throughout, with no profit or loss recognised for accounting or tax
purposes.
