CFM16730 - Taxing loan relationships: convertible and exchangeable securities: transitional rules: issuers: Change of Accounting Practice Regulations

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

First-time adoption of IAS 39 or FRS 26 by issuers of convertibles

General guidance on the tax treatment of transitional adjustments arising when a company adopts International Accounting Standards (IAS) or “new UK GAAP” for the first time is given at CFM16500 onwards.

Where the issuer of a convertible security begins to account for it as a compound or a hybrid financial instrument for the first time, there will typically be an accounting credit in respect of the financial liability (which may appear as a prior period adjustment or only in a transition statement). For example, a security previously accounted for as a liability of 100 might be bifurcated into an equity component of 30 (being the fair value of the equity component at issue) and a financial liability of 80. There will be a credit of 20 (100 – 80) resulting from the revaluation of the loan relationship component.

Regulation 12(3) of the Disregard Regulations ( CFM13270) provides that transitional adjustments on a change of accounting policy are brought into account only to the extent that they reflect interest, exchange differences, or expenses or discounts that are not within FA96/S92A(3), without regard to amounts given by an effective interest rate method. For example, a transitional adjustment might relate, in part, to issue costs of a convertible that were allowed under S92A: that part of the transitional adjustment would be a “prescribed” credit or debit under regulation 4 of the Change of Accounting Practice Regulations (SI2004/3271). But the credit described in the above example, which arises from beginning to account for the financial liability component as a discounted security, would not be taxable.

An adjustment is, however, made to the “prescribed” credit or debit that is spread in accordance with the Change of Accounting Practice Regulations, in order to correct any over-allowance of debits in an accounting period beginning before 11 April 2007.

The adjustment is calculated by taking the difference between the amount actually allowed in any accounting period ending on or after 27 December 2006 and before 11 April 2007, and the amount that would have been allowable had the amendment to regulation 12(2)(a) of the Disregard Regulations, made by SI2007/948, been in force for this period. The disregard of transitional credits imposed by regulation 12(3) is then restricted by this amount – see the example below.

The above guidance applies only to the loan relationship element of the bifurcated security. For a “standard” convertible security, the equity element is not a derivative contract, so no transitional amount can be brought into account under either PARA50A or PARA17B of SCH26. And transitional debits or credits relating to the derivative contract element of a “non-standard” convertible or exchangeable security are never brought into account, by virtue of regulation 3C(2)(a) of the Change of Accounting Practice Regulations.

Example

A company, which accounts to 31 March, issued convertible securities (maturing in 2010) before 31 March 2005. The company is not a bank or a dealer in securities. On 1 April 2005, it adopted IAS for the first time, accounting for the securities as a compound financial instrument (financial liability plus equity component). On transition, a loan relationships credit of £500,000 would – but for regulation 12(3) of the Disregard Regulations – fall to be brought into account under FA96/SCH9/PARA19A.

In its accounting period ended 31 March 2006, the company – using an effective interest rate method – debits £150,000 in respect of the financial liability component. None of this debit is a “share-related” amount within FA96/S92A(3), so on the formulation of regulation 12(2) applying at the time, the entire debit is allowable. But had the amendment made by SI 2007/948 been in force, to exclude the “implied finance cost”, only (say) £90,000 would have been allowable.

Thus for the accounting period ended 31 March 2007, an adjustment of £60,000 (£150,000 - £90,000) is computed under regulation 4(1B) of the Change of Accounting Practice Regulations. This restricts the credit that is disregarded under regulation 12(3) of the Disregard Regulations. Suppose it is agreed that, save for this restriction, £450,000 of £500,000 transitional credit would be thus disregarded. The £60,000 adjustment made reduces the disregarded amount to £390,000. So the amount which is a “prescribed credit” for the Change of Accounting Practice Regulations is £110,000 (£500,000 - £390,000). This is spread over 10 years, starting in year ended 31 March 2007, under regulation 3A.

If, in this example, the amount otherwise falling to be disregarded under regulation 12(3) of the Disregard Regulations was only £50,000, the restriction would reduce the “disregarded amount” to nil. The full transitional credit of £500,000 would be taxable under the Change of Accounting Practice Regulations.

Banks and dealers in securities

Regulation 12 of the Disregard Regulations does not apply where a company has entered into the debtor loan relationship in the ordinary course of a business of banking or dealing in securities. “Ordinary course of banking business” should be interpreted in accordance with Statement of Practice 4/96 (see BAM44055), so that if a bank issues convertible securities as part of its Tier 1, 2 or 3 capital, they will not have fallen with FA96/S92A(4) prior to 1 January 2005 and will not be within the exclusion from regulation 12.

Where a security was previously within FA96/S92A(4), all transitional credits or debits are left out of account completely. The statutory authority is regulation 3C(2)(f) of the Change of Accounting Practice Regulations.