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 convertible
into its own ordinary shares. It is a “non-standard”
convertible, see
CFM16705, because the terms permit the
option, if exercised, to be cash settled. On 31 December 2009 the
conversion shares are only worth £975,000. The holder abandons
the option and X Ltd redeems for cash at par, £1million.
X Ltd is required to account separately for the loan and the
embedded option. Using the principles outlined at
CFM16630, suppose it attributed an
initial fair value of £50,000 to the option. It is required to
recognise subsequent changes in its fair value through profit and
loss. Assume it considers its fair value to be:
| Date | Fair value |
| 1 January 2007 | £50,000 (as above) |
| 31 December 2007 | £60,000 |
| 31 December 2008 | £20,000 |
| 31 December 2009 | £Nil |
For the 3 periods to 3 December 2009 X Ltd accordingly brings in:
reflecting the amount by which its obligation has become greater
or less.
The above debits and credits must be adjusted out in the
corporation tax computations. This is because FA02/SCH26/PARA45J
(3) disapplies income treatment. Instead FA02/SCH26/PARA45J (9) to
(9B) computes a chargeable gain, but only for the terminal period
to 31 December 2009.
The expiry of the option is treated for capital gains
purposes as a disposal of an asset.
The gain is the amount by which the initial carrying value of
the option, here £50,000 exceeds the amount paid to redeem the
entire security (£1m) reduced by the fair value of the loan
element (also £1million). This gives a chargeable gain of
£50,000 (50,000 – [1,000,000 -1,000,000]). This might be
thought of as X Ltd having received a £50,000
“windfall” for granting an option that was never
exercised. Overall, the company has an income loss of £50,000
on the host contract, and a capital gain of £50,000 on the
option element.
It is not normally possible for the issuer to make an
allowable loss under PARA45J (9). If the terminal carrying value of
the option were any positive amount, it would be “in the
money” and so not abandoned by the holder. Should the holder
of a convertible who is connected with the issuer decline to
exercise a valuable conversion option, the application of
FA02/SCH26/PARA26 may need to be considered.
