CFM16710 - Taxing loan relationships: convertible and exchangeable securities: taxing the issuer: non-standard convertible: chargeable gains treatment

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

The chargeable gains treatment of the issuer of a non-standard convertible or exchangeable

CFM16705 explains that (unless any of the exclusions applies), any non-trading debits and credits arising from the embedded option are tax nothings for the issuer. Under FA2002/SCH26/PARA45J the issuer may compute a one-off chargeable gain, or allowable loss, for the period of redemption or other terminal event. The amount of the gain or loss depends on the circumstances as follows.

Option exercised and shares issued or delivered

The rules in FA02/SCH26/PARA45J (4A) and (5) apply where on the holder exercising the conversion/exchange option, the issuer duly issues its own (or delivers another company’s) shares. The issuer is treated for the purposes of TCGA92/S144 (2) as having granted the option for a consideration equal to its initial carrying value. The approach of S144 (2) is to treat the grant of a share option as part of the wider transaction.

For an exchangeable security, the wider transaction is the company’s acquisition of shares to fulfil its obligations, followed by the disposal of those shares to the holder. On that basis PARA45J (5) computes a chargeable gain, or allowable loss, by comparing the issuer’s consideration for granting the option with its eventual costs of fulfilling the option. Where the company issues its own shares, the wider transaction is the share issue. In terms of S144(2), the option binds the grantor neither to buy nor to sell anything: there is no chargeable disposal. Thus there are no capital gains consequences for the issuer.

FA02/SCH26/PARA45J (5) additionally provides that TCGA92/S17 (1) does not apply. This prevents the “consideration” being treated as any different amount (from its initial carrying value) by TCGA92/SS144ZB to 144ZD.

See CFM16710a for examples.

Option exercised but cash settled

The rules in FA02/SCH26/PARA45J(6), (7) and (8) apply where on the holder exercising the option, the issuer fulfils its obligation by paying the holder the cash equivalent of the conversion or exchange shares, as permitted under the original terms of issue of the security.

The issuer is treated as making a chargeable gain or allowable loss in the terminal period. The gain or loss is found by comparing amounts E and F. If E is greater than F, there is a chargeable gain; if F exceeds E, an allowable loss.

E is the initial carrying value of the option in the usual case where the company paying the cash equivalent was also the issuer. In a case where the paying company became a party to the security by novation after issue, E is the carrying value of the option in its accounts at the time it became a party.

F is the amount paid by the debtor in fulfilment of the obligations under the entire security (that is, the loan element plus the embedded derivative – referred to as “the original relationship”) reduced (but not below nil) by the fair value of the “loan-contract host contract” (that is, the loan element) at the date on which the option is exercised. This amounts to the amount the issuer pays to fulfil the option obligation.

For periods ending on or before 30 December 2006 F was defined simply as the part of the total amount paid in fulfilment of the obligations under the entire security that relates to the option element, but the effect was the same.

See example at CFM16710b.

Option lapses unexercised

The rules in FA02/SCH26/PARA45J(9) to 9B apply where the holder does not exercise the option, and takes cash redemption; the issuer is treated as making a chargeable gain. The gain is found by comparing the amounts G and H.

G is the deemed disposal consideration and is the initial carrying value of the option in the usual case where the company paying the cash equivalent was also the issuer. (In a case where the paying company became a party to the security by novation after issue, G is the carrying value of the option in its accounts at the time it became party).

H is the deemed acquisition cost and is the amount paid by the company by way of cash redemption of the entire security (that is, the loan element plus the embedded derivative – referred to as “the original relationship”) reduced (but not below nil) by the fair value of the “loan-contract host contract” (that is, the loan element) at that time.

In the unusual case where the issuing company cease to be a party to the security (for example by novation) at a time when the option is unexercised, H is the consideration given by the company ceasing to be party to the original relationship reduced (but not below nil) by the fair value of the host loan relationship contract at that time.

For periods ending on or before 30 December 2006, the comparison was simply between the carrying value of the option at the terminal event and its initial carrying value.

See example at CFM16710c.