CFM16705 - Taxing loan relationships: convertible and exchangeable securities: taxing the issuer: non-standard convertible

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

The accounting and tax treatment of the issuer of a non-standard convertible or exchangeable

For the issuer of either:

• a “non-standard” convertible, or
• an exchangeable security

the embedded obligation to convert or exchange is classified for accounting purposes as a derivative financial instrument - an option. That is, the issuer is the counterparty to the option it has granted the holder. The option is a derivative contract for tax purposes.

Taxing the embedded option

The required accounting, as for any derivative, is to carry the option at its fair value, taking any movements through profit and loss account. Accounting debits and credits may therefore arise in each accounting period.

Where the issuer accounts separately for the loan and option, FA96/S94A requires the option to be dealt with under the derivative contract rules of FA02/SCH26. Under those rules, credits and arising from an option are generally taxed or relieved as income. This would create a significant mismatch in tax treatment between a company issuing such a security, and one issuing a bond with an attached warrant conferring similar rights.

The grantor of a “stand alone” option that is settled in cash will have a capital loss (or, more rarely, a gain) under TCGA92/S144A (2). Similarly, if the option is settled by a transfer of shares, the premium received for the option forms part of the capital gains computation on the share disposal – TCGA92/S144 (2). But TCGA92 does not recognise an embedded option as an asset separate from the security itself.

The purpose of FA02/SCH26/PARA45J is therefore to ensure that the issuer’s loss (or profit) from an option embedded within a security is brought into account as an allowable loss, or a chargeable gain, on a realisation basis – in other words, in a manner comparable to TCGA92 treatment.

The rules in FA02/SCH26/PARA45J work in two stages as follows.

• First they switch off the normal “income” treatment applying to credits and debits arising from an option. They do not substitute any different tax treatment, whether under the capital gains code or otherwise. This means that the annual accounting credits and debits are “tax nothings”, and must be adjusted out in the tax computations.
• Then, in due course the rules compute a chargeable gain, or allowable loss, but only for the terminal period when the security redeems or converts/exchanges. The PARA45J gain or loss will not equate to any accounting debits or credits, all of which must be adjusted out in its corporation tax computations for each accounting period, including the last.

See CFM16710 for the rules for computing the PARA45J chargeable gain or allowable loss.

Exclusions from chargeable gains treatment

PARA45J does not disapply “income” treatment, or allow the issuer to compute a terminal chargeable gain or allowable loss, where:

• the company entered into the debtor loan relationship for the purposes of its trade as a bank or securities house; or
• the company is an Authorised Unit Trust, Investment Trust, Open Ended Investment Company or Venture Capital Trust; or
• the “original relationship” (that is, the contract falling within the loan relationships rules) is one to which the issuer was a party before its first accounting period to begin on or after 1 January 2005 ( CFM16720).

For periods beginning on or after 1 January 2005 and ending before 16 March 2005, capital gains treatment was also denied where the option was one to which any of FA02/SCH26/PARA6 to 8 applied. These paragraphs were repealed for accounting periods ending on or after 16 March 2005.