CFM6173a - Taxing loan relationships: convertibles: accounting treatment example

Tax effect of S92A: example

A Ltd issues a loan note for £500,000 on 1 January. The term of the loan is 2 years. The rights attached to the note allow the holder to exchange the loan for 50,000 £1 shares in C Ltd. B Ltd subscribes for the loan note.

Shares in C Ltd rise in value so that at the end of Year 1 they are worth £15. On the loan redemption date the shares are worth £13. B Ltd therefore opts to exchange the debt for shares.

A Ltd does not own shares in C Ltd. It therefore has to buy the shares to be able to fulfil its obligations under the loan agreement. The shares cost £650,000 to buy.

A Ltd has a 31 December accounting period. Its accounts will initially record the debt at £500,000. At the end of Year 1 it would have to pay £750,000 for the shares. Because they are worth more than the loan, B Ltd is likely to exercise its right to exchange. A Ltd may therefore choose to recognise this increasing obligation in its accounts by accruing an additional £250,000.

At the end of Year 2 the value of the shares has fallen by £100,000 so this amount will be reversed - again through P&L. Any additional costs of acquiring the shares in B Ltd will be taken to P&L as a cost of redeeming the debt.

The legislation will disallow the debit in the P&L of £250,000 in Year 1, ignore the credit of £100,000 and disallow any further debits for costs of acquiring the shares in Year 2.