CFM16720 - Taxing loan relationships: convertible and exchangeable securities: transitional rules: holders

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

Continuity of tax treatment: assets

For holders of a convertible security, under the former rules in FA96/S92 the only amounts brought in under the loan relationships rules were interest receivable, and exchange gains and losses, in respect of the security. All other gains and losses were taxed under the normal chargeable gains rules.

Broadly, the previous tax treatment is continued for a convertible security held by a company both before and after the start of its first period of account to begin on or after 1 January 2005. This is achieved by two separate provisions – one relating to the embedded derivative, and one to the host contract.

The embedded derivative

Where FA02/SCH26/PARA45D applies to a security which was held before the first accounting period beginning on or after 1 January 2005 (“existing assets”), FA02/SCH26/PARA45FA provides that no amounts are to be brought in under the derivative contracts rules. The security is not treated as a qualifying corporate bond and hence is not treated as exempt from chargeable gains.

As was the case under FA96/S92 (see CFM6151), adjustments are made to the capital gains disposal consideration to

• exclude any element of the consideration that, on a just and reasonable apportionment, relates to interest that is accrued but unpaid, and is already taxed under loan relationships; and
• reduce the consideration by the amount of any exchange gain already taxed under loan relationships, or increase it by the amount of an exchange loss.

The host contract

The treatment of the host contract is given by regulation 11 of the Disregard Regulations (SI 2004/3256 – see CFM13270). This applies where FA96/S92 applied to the security immediately before the start of its first accounting period to begin on or after 1 January 2005, and either

• FA96/S94A subsequently applied, or
• the company did not bifurcate the security in its accounts so that, without any special provision, all credits or debits would be brought into charge as income.

The effect of regulation 11 is that only interest, and exchange gains and losses, on the security are brought into account under loan relationships. Where the company accounts separately for the host contract, taxable interest must be ascertained without regard to amounts given by the effective interest rate method. This means that the interest credit shown in the accounts must be “unpicked”. If, for example, the company holds £1 million nominal of a convertible security paying 3 per cent per annum interest, the taxable interest credits will be £30,000. Any other credits (or impairment debits), apart from exchange differences, are disregarded.

The disregard extends to transitional credits or debits where the company adopts IAS 39 or FRS 26 for the first time. Regulation 11(4) specifically provides for these to be left out of account, except to the extent that the adjustment relates to a matter (such as exchange gains or losses) which is being taxed or relieved as income. Thus the Change of Accounting Practice Regulations ( CFM16500 onwards) have only a very limited application.