Hybrid contracts & Embedded Derivatives: transitional rules

This note sets out effect of changes to the taxation of assets and liabilities representing loan relationships where the contract concerned is treated for accounting purposes as containing one or more embedded derivatives, where the contract was made in a period beginning before 1 January 2005 (the "last old period") and was in existence at the beginning of the first period to begin on or after that date (the "first new period".

These cases where the derivative is embedded in a financial asset or liability are referred to here as hybrid financial instruments.

It also considers cases where the derivative is embedded in a contract which is not one representing a loan relationship. These cases where the derivative is embedded in a financial asset or liability are referred to here as non-financial hybrid instruments.

A final case is where a derivative is embedded in another contract which is or is treated as a derivative contract by Schedule 26 FA 2002.

Background: the position in pre-IAS periods (periods beginning before 1 January 2005).

In the case of hybrid financial instruments, tax law generally applied the provisions of Chapter 2 Part 4 FA 1996 to the entire instrument including profits and losses arising in respect of the embedded derivative. There were however two important exceptions:

The first main exception related to those hybrid financial instruments where the embedded derivative consisted of an option to acquire shares in the issuer (a convertible) or any other company (an exchangeable) and where a number of threshold conditions were met. In such a case, the provisions of Chapter 2 Part 4 FA 1996 applied to the holder only to a limited extent, namely to bring into account amounts representing

interest and
exchange gains and losses

but the asset as a whole was treated as one which was subject to the rules of TCGA 1992, such that any disposal of the asset for the purposes of that Act could give rise to a chargeable gain or allowable loss.

Such an asset was not a qualifying corporate bond, so that on conversion the provisions of section 132 TCGA 1992 were capable of applying (except in the case of an exchangeable) with the result that sections 127 to 130 of that Act had the effect of giving the shares acquired as a result of the exercise of the option the same base cost as the hybrid financial asset and had the effect of there being no disposal at the time of conversion.

Section 92A FA 1996 provided that the issuer of a financial liability which contained an embedded derivative which consisted of an option to acquire shares in the issuer or another company was wholly within Chapter 2 Part 4 FA 1996, subject to no relief being given for the costs of acquiring the shares which were the subject of the option and any related costs.

The second main exception was the case of exactly-tracking asset linked securities although, in this case, the rules applied both to the holder and the issuer (unless the issuer was a dealer in such securities). The only parts of Chapter 2 Part 4 FA 1996 that applied were those relating to interest , leaving the provisions of TCGA to apply to any other gains or losses arising on disposal of the asset.

One further minor case where special treatment was given to an embedded derivative concerned index-linked gilts where the RPI element, which constitutes a contract for differences, was in general exempt from tax.

In the case of non-financial hybrid instruments UK GAAP would not normally require separate recognition of the embedded derivative and the tax treatment would follow that of the same instrument without an embedded derivative.

Background: the changes made by Schedule 10 FA 2004 and Schedule 4 FA 2005 for new issues

In relation to hybrid financial instruments, Schedule 10 FA 2004 repealed sections 92, 92A and 93 FA 1993. It also mistakenly repealed section 94 (index-linked gilts), though that repeal was undone by paragraph 27 Schedule 4 FA 2005.

In their place section 94A FA 1996 was inserted which provided as a general rule that where accounting practice required an embedded derivative to be separated from its host contract (and hence in accordance with IAS39 and FRS26 to be accounted for on a fair value basis) then tax law would treat the host contract as being a loan relationship in its own right, with the rights and liabilities of that relationship not including any of the rights and liabilities under the embedded derivative and would also treat the embedded derivative as a relevant contract for the purposes of Schedule 26 FA 2002 – section 94A(2) FA 1996.

This treatment applied whether the embedded derivative was treated as a derivative financial instrument by GAAP or, in the case of an issuer, as a component of equity (which is the case in most issues of convertibles over the issuer’s own shares).

Because companies which adopted neither IAS 39 nor FRS 26 would not be required to separate embedded derivatives, paragraph 7 Schedule 6 Finance (No. 2) Act 2005 permits them to elect to be treated as if they had followed IAS or new UK GAAP (i.e. FRS 26).

This election does not apply to companies which account for assets or liabilities at fair value through profit or loss. They do not bifurcate embedded derivatives and accordingly must apply loan relationships treatment to the entire asset or liability.

Section 94A treats the embedded derivative as a relevant contract for the purposes of Schedule 26 but not as a derivative contract. This means that without more a contract whose underlying subject matter (USM) is an excluded USM for the purposes of Schedule 26 would not be a derivative contract. At the time of the enactment of FA 2004 shares were an excluded subject matter, as was land. Land was removed from the categories of excluded subject matter by SI 2004/2001, but shares were only so removed subject to exceptions in paragraph 4(2A) to (2D) for accounting periods ending on or after 16 March 2005 (subject to transitional rules in paragraphs 4A to 4C Schedule 26.

In order to ensure that shares were not an excluded USM in relation to an embedded relevant contract paragraph 5A Scheduled 26 FA 2002 was inserted by SI 2004/3271 so that shares were never an excluded USM where the relevant contract was one created by section 94A. Paragraph 5A was then repealed as unnecessary by SI 2005/646 with effect for accounting periods ending on or after 16 March 2005.

The outcome is that a relevant contract deemed to exist by section 94A and whose USM is shares will fall within Schedule 26 FA 2002, unless the relevant contract

falls within sub-paragraphs (2A) or (2D) of paragraph 4, or
is treated as a component of equity. In that case, the relevant contract will fail the accounting test in paragraph 3 Schedule 26 and will not be a derivative contract.

One of the objects of section 94A was to facilitate the reproduction for the holder of the chargeable gains treatment of the share element of a loan relationship previously falling within section 92 and 93 FA 1996. This is achieved, for acquisitions in the first new period or later, by paragraph 45D and 45F Schedule 26 FA 2002 which define the circumstances in which chargeable gains treatment is given to the credits and debits found by Schedule 26 in relation to the embedded derivative. The conditions of paragraph 45D and 45F in general follow closely those of section 92 and 93. The main exception is that the exclusion of connected person transactions from section 92 is not continued in paragraph 45D.

The embedded derivative and the host contract do not, when looked at separately, correspond exactly to the CG and non-CG elements of a section 92 or 93 asset.

In general, in the case of a convertible security, a greater amount of credits will be brought into account under Chapter 2 Part 4 FA 1996 than was the case under section 92 because the host contract will generally be treated as a discounted security. So Chapter 2 will bring into account the accreting discount as well as any actual interest. On the other hand, it will allow relief under Chapter 2 for expenses through their incorporation in the effective interest method of calculating the effective interest rate on the host contract, whereas expenses were not allowed for a former section 92 security, and it will allow impairment losses on the host contract (subject to any disallowance under paragraph 6 Schedule 9 FA 1996).

It is more likely that for a former section 93 security the CG treatment that will follow under IAS/FRS26 accounting will be closer to that under UK GAAP. But as for former section 92 cases, it will allow relief under Chapter 2 for expenses through their incorporation in the effective interest method of calculating the effective interest rate on the host contract, whereas expenses were not allowed for a section 93 security, and it will allow impairment losses on the host contract (subject to any disallowance under paragraph 6 Schedule 9 FA 1996).

As far as issuers are concerned then, for issues and acquisitions in the first new period or later, a distinction is made between the case where the embedded derivative is treated as a component of equity and that where it is treated as a derivative financial instrument.

In the first case the equity component is never recognised for the purposes of Schedule 26. The effect of this is that the debits to be brought into account will include the effective interest rate on the host contract and exchange gains and losses, while no debits or credits are brought into account in relation to the equity component. But for the first time any loss to the company in a case where it has to pay, for whatever reason, cash to a holder in place of the issue of shares, will be an allowable loss for the purposes of TCGA 1992 – paragraph 45JA Schedule 26 applying for accounting periods ending on or after 16 March 2005.

In a case where the liability contains an embedded derivative which has the character of an option and it is not treated as an equity component, then, for issues and acquisitions in the first new period or later, Schedule 26 will apply to any gains and losses on the derivative contract. But this is subject to the provisions of paragraph 45J which treats certain amounts in relation to the derivative contract as giving rise to TCGA 1992 gains and losses. This applies where the option is exercised so that securities are transferred to the holder, where the option is not exercised and is simply abandoned and where the option is cashed-out. In all these cases the profit and loss accruing to the issuer in relation to the embedded option is treated as within TCGA 1992. Paragraph 45J applies is some circumstances to liabilities existing at the end of the last old period.

In a case where the liability contains an embedded derivative which has the character of a contract for differences, then, for issues and acquisitions in the first new period or later, Schedule 26 will apply to any gains and losses on the derivative contract, unless paragraph 45K applies (exactly tracking contracts) to treat as an allowable loss a loss on disposal of an embedded derivative which is treated as a contract for differences. Paragraph 45K also applies to cases where the contract is not an exactly tracking contract simply because there is a "floor" of not less than 90% of issue price.

Non-financial hybrid instruments are governed by paragraphs 2(3) to (5) and 45L Schedule 26. The former paragraph provides that a derivative which is embedded in a contract which is not a loan relationship and which is treated as not closely related to the host contract (and thus required by GAAP to be separated from the host contract) falls within Schedule 26. But paragraph 14 Schedule 26 is disapplied so that the Schedule does not apply to any credits and debits given in relation to the fair value profits and losses arising on the contract but instead profits and losses are brought into account in respect of the host contract as if the derivative embedded in it were closely related. The effect of this is that the host contract is taxed as it would have been under previous UK GAAP.

But paragraph 45L(2A) allows a company with a derivative embedded in a non-loan relationship host contract to elect to follow the accounting so that Schedule 26 will apply on a fair value basis.

Certain types of contract with a derivative embedded in a non-loan relationship underlying contract where that contract is not treated as a loan relationship, or those held by certain types of company, are ones where the Government considers it inappropriate for bifurcation (division) of the contract to be followed for tax purposes. This is the case with

those contracts where the underlying contract is a contract of long-term insurance (as to recognise an embedded derivative in an I minus E basis computation would run counter to the objectives of that basis)
contracts whose underlying subject matter is commodities. This will apply in particular to those long-term oil and gas supply contracts which contain derivatives in their pricing mechanisms where the accounting arguments for treating the derivatives as closely related or not (and so bifurcated) are finely balanced.

Paragraph 45L is in turn is subject to paragraph 45LA which provides that where a company which is a member of a group makes an election, any other group company which is a party to the relevant contracts will be deemed to have made it if it has not actually done so.

Also, where a contract which is the subject of an election is transferred in circumstances where paragraph 28 or 30 Schedule 26 would apply to the embedded derivative, the transferee will be required to adopt the same tax treatment in relation to the contract as applied to the transferor.

There is one other type of non-financial hybrid contracts not within paragraph 45L, a contract falling within paragraph 45M – see paragraph 45L(1)(ab)

Contracts fall within paragraph 45M if they are ones where the host contract is treated as a financial asset, and the USM is shares. This will apply to prepaid equity forwards of the type used by life assurance companies to back guaranteed bonds, and which were previously within paragraph 7 Schedule 26 FA 2002. Paragraph 45M continues the treatments previously given by paragraph 48 Schedule 26.

Transition to the changes made by Schedule 10 FA2004 and Schedule 4 FA 2005

The objective for the transition is to ensure that no amounts fall out of account and no amounts are counted twice.
The transition is however complicated by the Change of Accounting Practice (CofAP) Regulations which defer many transitional adjustments arising on a change to either IAS39 or FRS26 until 2006 from when they fall to be spread over 10 years.

Originally, regulation 4(6) and (7) of those regulations sought to exclude adjustments on certain hybrid instruments from this rule. Those paragraphs also laid down a treatment of the transitional adjustment which took into account credits and debits arising in the first post-transition period but this was clearly a stop-gap measure.
Regulations 11 and 12 of the Disregard regulations laid in July 2005 replaced regulation 4(6) and (7) of the CofAP regulations and provide for the complete disregard for certain credits and debits under Chapter 2 Part 4 FA 1996, not merely transitional adjustments.

In addition regulation 3C of the CofAP regulations provides for the disregard of all transitional derivative contract amounts where

section 92A FA 1996 (convertible securities etc: debtor relationships) applied to the contract at the end of the company’s period of account immediately preceding the first period of account to begin on or after 1st January 2005;
paragraph 45L of Schedule 26 to the Finance Act 2002 (derivatives not embedded in a loan relationship) applies.

The transitional rules for the different types of contract are set out in more detail below. In these descriptions, "transition" means the move from the last old period to the first new period. Changes of accounting basis or tax basis after the start of the first new period are discussed at the end.

1. Convertible securities to which section 92 FA 1996 does NOT apply immediately before transition which are bifurcated (or electively treated as bifurcated) in the first new period.

This covers those securities which were held for the purposes of a trade (other than life assurance), or failed the other conditions in section 92. Here "convertible" includes "exchangeable" (i.e. the right is to acquire shares in a company other than the issuer of the hybrid security)

Assets held on transition – Transitional adjustments

The accounting value of the security at the end of the company’s final earlier period will either be its market value (where an authorised MTM basis is used)) or, in an accruals basis case, the value at which the host contract would be redeemed (host redemption value) in the absence of conversion or, possibly, a value which recognises accrual towards the value of the shares into which it converts (accretion to share value), subject to any provision for bad or doubtful debts.

The accounting value of the security at the beginning of the company’s first new period will either be its fair value (if it is a FVPL security) or the host contract will be accounted for on the basis of fair value (if available-for-sale) or amortised cost, and the derivative will be accounted for at fair value.

It is unlikely that the tax adjusted accounting value for the purposes of paragraph 19A Schedule 9 FA 1996 will differ, unless

section 87(2) (accruals basis to be used for tax in connected party cases) forced accruals accounting for tax purposes in a case where market to market was, or fair value is, used for accounting purposes
or paragraph 6(3) Schedule 9 FA 1996 applies (no bad debt debit for transaction between connected person).

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing (tax adjusted) accounting value and the tax adjusted accounting value of the host contract. This will usually result in a debit in the non-MTM/FVPL case, representing the implied discount in the host contract. In the MTM or other accretion to share value case, there will be a further debit representing the difference between that value and the host redemption value.

In a case where the old carrying value is equal to the aggregate new carrying values (i.e. where in old periods MTM or accretion to share value was used and followed for tax), the transitional adjustment for Chapter 2 and for Schedule 26 will be equal and opposite.

In a case where the old carrying value was not equal to the aggregate new carrying values (i.e. where in old periods cost was used and followed for tax), the transitional adjustment for Chapter 2 and for Schedule 26 will not be equal and opposite (in general the Schedule 26 transitional will be a credit greater than the Chapter 2 debit: but where the option is out of the money there will be no Schedule 26 credit or debit).

In either case regulation 3A of the CofAP regulations provides that both adjustments will be brought into account over a 10 year period beginning in 2006 unless the creditor loan relationship comes to an end in 2005 (see below).

Post transition new periods – assets held on transition: general rule

The general rule will be that credits and debits given in accordance with the accounting treatment in new accounting periods will be brought into account in accordance with Chapter 2 or Schedule 26 as appropriate.

In a case where the holder is connected with the issuer and the holder accounts for the contract so as to bifurcate, the question arises as to what section 87(2) requires. Since section 94A treats only the host contract as a loan relationship it follows that it is the host contract only that must be accounted for tax purposes on an amortised cost basis. The derivative contract element is brought into account for tax purposes on a fair value basis, as there is no equivalent of section 87(2) in Schedule 26.

Where the security is one to which section 87(2) applies, that subsection and paragraph 6 Schedule 9 FA 1996 will, in an earlier period, have required the security, if marked to market, to be accruals accounted (with no possibility of a deduction for a decrease in value of the option element) and with no deduction for any bad debt. Paragraph 6(6) will continue to apply to the host contract to debar any impairment losses on disposal in 2005 or later.

Example 1a & 1b

Assume

convertible security outside section 92 issued at 100 redeemable at 100
it pays 3% interest (AI)
on 31 December 2004 carrying value is 100 (cost case)
on 1 January 2005 it is bifurcated to 80 host contract, 30 embedded option
from 1 January 2005 effective interest rate on host contract is 5%

1a. On the assumption that the asset goes to conversion and the loan relationship exchanged for shares with value of £145 there will be -

A transitional loan relationships amount (spread 10 yrs 2006+) Dr 20 [100 – 80]

A transitional derivative contract amount (spread 10 yrs 2006+) Cr 30 [30 – 0]

Post FA 2004 period loan relationships credits Cr 20

Post FA 2004 periods derivative contract credit Cr 15

Total profits brought into account:

Pre Sch 10 0

Post Sch 10 45

1b. On the assumption that the asset is redeemed in accordance with terms at 100 (because option out of the money), there will be -

A transitional loan relationships amount (spread 10 yrs 2006+) Dr 20 [100 – 80]

A transitional derivative contract amount (spread 10 yrs 2006+) Cr 30 [30 – 0]

Post FA 2004 period loan relationships credits Cr 20

Post FA 2004 periods derivative contract credit/debit Dr 30

Total profits brought into account:--

Pre Sch 10 0

Post Sch 10 0

Example 2a & 2b

Assume

convertible security outside section 92 issued at 100
it pays 3% interest (AI)
on 31 December 2004 carrying value is 110 (MTM or accretion to share value)
on 1 January 2005 it is bifurcated to 80 host contract, 30 embedded option
from 1 January 2005 effective interest rate on host contract is 5%

On the assumption that the asset goes to conversion and loan relationship exchanged for shares with value of £145, there will be -

A transitional loan relationships amount (spread 10 yrs 2006+) Dr 30 [110 – 80]

A transitional derivative contract amount (spread 10 yrs 2006+) Cr 30 [30 – 0]

Post FA 2004 period loan relationships credits Cr 20.

Post FA 2004 periods derivative contract credit Cr 15 [(145– 100) - 30]

Total profits brought into account:

Pre Sch 10 10

Post Sch 10 35

On the assumption that the asset is redeemed in accordance with terms at 100 (because option out of the money), there will be -

A transitional loan relationships amount (spread 10 yrs 2006+) Dr 30 [100 – 80]

A transitional derivative contract amount (spread 10 yrs 2006+) Cr 30

Post FA 2004 period loan relationships credits Cr 20

Post FA 2004 periods derivative contract credit/debit Dr 30

Total profits brought into account:

Pre Sch 10 10

Post Sch 10 -10

Application of TCGA 1992 on conversion in a new period

On conversion into shares of the issuing company, under pre 2005 law, by virtue of section 116(8A), Chapter 2 had effect as if the asset had been disposed of for the purposes of Chapter 2 for its market value. This rule required credits (and debits) to be brought into account on the basis of such a disposal.

But paragraph 8 Schedule 4 Finance (No. 2) Act 2005 inserted section 116(8B) as a result of which subsection (8A) no longer applies to any conversion of a loan relationship occurring after 26 May 2005.

Where a conversion took place before that date, the question for determination was whether section 116(8A) is treated as applying to the whole loan relationship or just the host contract. If the latter it would normally be expected that the market value of the host contract would be equal to its redemption amount; if the former that it would be equal to the value of the shares acquired. HMRC considers that the former interpretation (application to the whole contract) is the better one. This is because section 116(8A) is not itself part of Chapter 2, whereas section 94A applies only for the purposes of Chapter 2; and because the reference to the asset is to the whole actual asset representing the entire loan relationship including the embedded option. The market value of the asset on conversion will equal the value of the shares to be acquired.

The chargeable gains position in relation to holdings of shares of the issuer of the hybrid instrument acquired on conversion in a new period is that section 116 TCGA will apply (as the case will be one where sections 127 to 130 TCGA would apply by virtue of section 132, but for section 116). By virtue of section 116(6) the shares have a base cost equal to the market value of the asset representing the loan relationship (as a whole) – section 94A not applying for the purposes of TCGA.

In the case where the conversion is into shares of another company (exchangeables), section 132 TCGA cannot apply, so sections 127 to 130 cannot apply. Accordingly, there is a disposal of a QCB and the acquisition of shares for the market value of the asset representing the loan relationship (as a whole).

New periods – exception for maturity in 2005

Where the loan relationship matures in 2005 (whether as a result of conversion or otherwise), regulation 4(3) and (4)(a) of the CofAP regulations applies to require the transitional loan relationship and derivative contracts credits and debits to be brought into account.

2. Convertible securities to which section 92 FA 1996 does apply immediately before transition which are bifurcated (or electively treated as bifurcated) in the first new period..

Here "convertible" includes "exchangeable" (i.e. the right is to acquire shares in a company other than the issuer of the hybrid security)

Deemed disposal at transition

Where a security within this part (a former section 92 security) is held at the start of the first new period, paragraph 9(2) Schedule 10 FA 2004 has effect. This means that section 92(7) FA 1996 (deemed disposal and re-acquisition) has effect: the company is deemed for the purposes of TCGA to have disposed of the asset (the loan relationship) for the "relevant consideration", and immediately reacquired it. But by section 92(8), section 116 TCGA is treated as applying for the purposes of the TCGA 1992. Thus a non-QCB is treated as exchanged for a loan relationship which is treated as a QCB by virtue of section 117(A1). A gain (or loss) calculated by reference to the relevant consideration is deferred until a disposal of the deemed QCB which is not a no gain/no loss disposal – section 116(10). But the market value used to determine the would-be gain or loss is whatever is the accounting value of the asset using the "relevant accounting method".

There is a question as to whether the accounting value on the date of deemed disposal (e.g. 31st December 2004) or deemed reacquisition (e.g. 1st January 2004) is used, and if the latter whether the value is that of the host contract only or the entire (actual) loan relationship. Section 92(9) says in terms that it is the method used on disposal.

Section 92(11) seems to contradict that by requiring that the relevant consideration be determined by using the accounting method on reacquisition.

However subsection (11) is difficult to make work in this case. It assumes that the reacquisition will be part way through an accounting period ("that part of the accounting period"), and so makes the natural assumption that the same accounting method will be used on disposal and reacquisition as they will fall within the same accounting period. Secondly, "accounting method" is not a term used in Chapter 2 for new periods (except in the heading to two sections (87 and 88A) and in parenthetical references to one of those sections). No part of the operative text of Chapter 2 uses the term. As a result, the Revenue view is that the relevant consideration is determined by reference to the use of an authorised accruals basis or authorised mark to market basis as the case may be at the end of the final earlier period. Given paragraph 1(1A) Schedule 11 FA 1996, it is likely that most holders of convertibles within section 92 will be companies which use a mark to market basis.

Transitional adjustments

The accounting value of the security at the end of the company’s final earlier period will either be its market value (where an authorised MTM method has been used) or, in an accruals basis case, the value at which the host contract would be redeemed (host redemption value) in the absence of conversion or, perhaps unlikely, a value which recognises accrual towards the value of the shares into which it converts (accretion to share value), subject to any provision for bad or doubtful debts.

The "old" tax adjusted accounting value will be the issue price, adjusted only for exchange gains and losses.
The accounting value of the security at the beginning of the company’s first new period will either be its fair value (if it is a FVPL security) or the host contract will be accounted for on the basis of fair value if AFS or amortised cost, and the derivative will be accounted for at fair value.

It is unlikely that the tax adjusted accounting value for the purposes of paragraph 19A Schedule 9 FA 1996 will differ, unless

section 87(2) (accruals basis to be used for tax in connected party cases) forced accruals accounting for tax purposes in a case where market to market was, or fair value is, used for accounting purposes
or paragraph 6(3) Schedule 9 FA 1996 applies (no bad debt debit for transaction between connected person) and
the security is one grandfathered by section 73 FA 2002.

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing (tax adjusted) accounting value and the tax adjusted accounting value of the host contract. This will usually result in a debit in the non-MTM/FVPL case, representing the discount in the host contract and in the accretion to share value (MTM or other) case, a further debit representing the difference between that value and the host redemption value. This adjustment falls within the amounts prescribed by regulation 11 of the Disregard regulations and so does not come into account for tax purposes

Paragraph 50A Schedule 26 FA 2002 applies to the (dis)embedded derivative contract. There is an accounting value of that contract at the opening of the first new period equal to the fair value of the derivative element, and an accounting value of nil at the end of the final earlier period. This adjustment falls within paragraph 15 Schedule 26 but is disregarded in accordance with paragraph 45FA(1)(a) Schedule 26 FA 2002 (unless the first new period ended before 16 March 2005)

Post transition new periods – assets held on transition: general rule

In order to maintain the previous tax treatment of section 92 securities, regulation 11 of the Disregard regulations (SI 2004/3256 as amended by SI 2005/2012) has the effect that existing pre-IAS treatment is continued until the company ceases to be a party to the loan relationship. In other words the only credits that will be brought into account for loan relationships will be credits in respect of actual interest accruing rather than the full amount accruing under the effective interest method, together with exchange gains and losses.

Where the security is one to which section 87(2) applies, that subsection will, in an earlier period, have required the security, if marked to market, to be accruals accounted (with no possibility of a deduction for a decrease in value of the option element). There will have been no deduction for any bad debt because of section 92(2). Regulation 11 of the Disregard regulations will apply to the host contract to debar any impairment losses for a period or on disposal in 2005 or later.

In relation to the derivative contract element, paragraph 45FA Schedule 26 FA 2002 (inserted by SI 2005/2082) prevents any charge arising under Schedule 26. Paragraph 45FA also provides that the total asset is not treated as a QCB. Thus there will be a disposal for TCGA purposes on conversion or earlier sale etc for which the consideration is the value of the shares acquired and the base cost the re-acquisition value under section 92(7) as applied by paragraph 9(2) Schedule 10 FA 2004. Any section 92(7) gain will also be triggered.

Note that where there is a chargeable gain accruing any accrued interest included in the sale consideration will be excluded by virtue of section 37 TCGA. Any net exchange gain or loss that has been brought into account under Chapter 2 Part 4 FA 1996 will be excluded by virtue of section 80(5 FA 1996.

This is subject to section 132 TCGA applying to carryover both any gain or loss on conversion and section 92(7) gain.
This will ensure that on disposal, conversion or redemption without conversion, the same credits and debits and the same chargeable gains will have been given as would have been given had Chapter 2 as it stood before FA 2004 continued to apply.

Example 1a & 1b

Assume

convertible security within section 92 issued at 100
it pays 3% interest (AI)
on 31 December 2004 carrying value is 100
on 1 January 2005 it is bifurcated to 80 host contract, 30 embedded option [total 110]
from 1 January 2005 effective interest rate on host contract is 5%

1a. On the assumption that the asset goes to conversion and loan relationship exchanged for shares with value of £145, there will be -

A transitional loan relationships amount (disregarded) Dr 20 [100 – 80]

A transitional derivative contract amount (disregarded) Cr 30 [30 – 0]

Section 92(7) gain 0

Gain on conversion 45*

Total non actual interest profits brought into account:

Pre Sch 10 0

Post Sch 10 45 (CG)

1b. On the assumption that the asset is redeemed in accordance with terms at 100 (because option out of the money), there will be -

A transitional loan relationships amount (disregarded) Dr 20 [100 – 80]

A transitional derivative contract amount (disregarded) 30 [30 – 0]

Section 92(7) gain 0

Gain on redemption 0

Total non interest profits brought into account:

Pre Sch 10 0

Post Sch 10 0

Example 2a & 2b

Assume

convertible security within section 92 issued at 100
it pays 3% interest (AI)
on 31 December 2004 carrying value is 110 (MTM)
on 1 January 2005 it is bifurcated to 80 host contract, 30 embedded option
from 1 January 2005 effective interest rate on host contract is 5%

On the assumption that the asset goes to conversion and loan relationship exchanged for shares with value of £145, there will be -

A transitional loan relationships amount (disregarded) Dr 30 [110 – 80]

A transitional derivative contract amount (disregarded) Cr 30 [30 – 0]

Section 92(7) gain 10

Gain on conversion 35*

Total non actual interest profits brought into account:

Pre Sch 10 0

Post Sch 10 45 (CG)

On the assumption that the asset is redeemed in accordance with terms at 100 (because option out of the money), there will be -

A transitional loan relationships amount (disregarded) Dr 30 [100 – 80]

A transitional derivative contract amount (disregarded) Cr 30 [30 – 0]

Section 92(7) gain 10

Gain on redemption -10

Total non interest profits brought into account:

Pre Sch 10 0

Post Sch 10 0

*Application of TCGA 1992 on conversion in a new period

On conversion into shares of the issuer, section 132 TCGA will apply (as no QCB is involved on either side (paragraph 45FA(2)(b)), section 116 does not apply). Section 127 deems the shares to have been acquired when the "original shares" were acquired, i.e. when the deemed section 92(7) disposal took place, for a consideration equal to the "relevant consideration".

If the shares acquired in the conversion are immediately sold, the gain on sale will be calculated thus (assuming -

Sale of shares 145

MV on 31 12 2004 (EEP) 110

EEP Accounting value of host contract 80

Redemption amount 100

EEP Accounting value of embedded option 30

A where MTM used in earlier periods – see Example 2a

Gain 145 – 110 = 35

plus s 92(7) gain = 10

B where accruals used in earlier periods – see Example 1a

Gain 145 – 100 = 45

plus s 92(7) gain = 0

In the case where the conversion is into shares of another company (exchangeable), section 132 TCGA cannot apply. For TCGA purposes there is a disposal consisting of an exchange of an asset which is not a QCB for shares. All other things being equal the disposal value of the exchangeable asset is equal to the market value of the shares acquired. The base cost of the exchangeable is the section 92(7) relevant consideration. The section 92(7) held over gain is triggered on conversion.

New periods – exception for maturity in 2005

Where the loan relationship matures in 2005 (whether as a result of conversion or otherwise), regulation 4(3) and (4)(a) of the CofAP regulations applies to require the transitional loan relationships and derivative contracts credits and debits to be brought into account.

3. Asset-linked securities to which section 93 FA 1996 does NOT apply immediately before transition which are bifurcated (or electively treated as bifurcated) in the first new period.

This covers those securities which were held for the purposes of a trade (other than life assurance), or failed the other conditions in section 93, particularly because there was a floor or cap in the arrangements.

Assets held on transition – transitional adjustments

The accounting value of the security at the end of the company’s final earlier period will either be its market value (where an authorised MTM basis is used) or, in an accruals basis case, a value which recognises accrual towards the value of the reference assets, subject to any provision for bad or doubtful debts.

It is unlikely that the tax adjusted accounting value will differ, unless paragraph 6(3) Schedule 9 FA 1996 applies (no bad debt debit for transaction between connected person).

It is unlikely that the tax adjusted accounting value for the purposes of paragraph 19A Schedule 9 FA 1996 will differ, unless

section 87(2) (accruals basis to be used for tax in connected party cases) forced accruals accounting for tax purposes in a case where market to market was, or fair value is, used for accounting purposes
or paragraph 6(3) Schedule 9 FA 1996 applies (no bad debt debit for transaction between connected person).

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing (tax adjusted) accounting value and the tax adjusted accounting value of the host contract. This may result in a debit representing the difference between that value and the host contract value.

In cases where paragraph 19A or paragraph 50A do not apply (i.e. where the change is from old UK GAAP to FRS 26, or to IAS 39 where the option not to restate comparatives under IAS for earlier period is taken (IFRS 1 paragraph 36A), section 85B FA 1996 and paragraph 17B Schedule 26 FA 2002 will apply to give the same outcome.
In a case where the old carrying value is equal to the aggregate new carrying values (i.e. where in old periods MTM or accretion to share value was used and followed for tax), the transitional adjustment for Chapter 2 and for Schedule 26 will be equal and opposite.

In the perhaps unlikely case where the old carrying value was not equal to the aggregate new carrying values (i.e. where in old periods cost was used and followed for tax), the transitional adjustment for Chapter 2 and for Schedule 26 will not be equal and opposite (in general the Schedule 26 transitional will be a credit greater than the Chapter 2 debit: but where the option is out of the money there will be no Schedule 26 credit or debit).

Post-transition new periods – assets held on transition: general rule

Example 1a & 1b

Assume

asset-linked security outside section 93 issued at 100 redeemable at value set by reference to FTSE.
it pays 3% interest (AI)
on 31 December 2004 carrying value is 110 (MTM or accretion to share value)
on 1 January 2005 it is bifurcated to 80 host contract, 30 embedded option
from 1 January 2005 effective interest rate on host contract is 5%

On the assumption that the asset is redeemed for £145, there will be -

A transitional loan relationships amount (spread 10 yrs 2006+) Dr 30 [110 – 80]

A transitional derivative contract amount (spread 10 yrs 2006+) Cr 30 [30 – 0]

Post FA 2004 period loan relationships credits Cr 20.

Post FA 2004 periods derivative contract credit Cr 15 [(145– 100) - 30]

Total non actual interest profits brought into account:

Pre Sch 10 10

Post Sch 10 35

On the assumption that the asset is redeemed in accordance with terms at 100 (because FTSE lower than at opening and there is a floor), there will be -

A transitional loan relationships amount (spread 10 yrs 2006+) Dr 30 [100 – 80]

A transitional derivative contract amount (spread 10 yrs 2006+) Cr 20

Post FA 2004 period loan relationships credits Cr 20

Post FA 2004 periods derivative contract credit/debit Dr 30

Total non actual interest profits brought into account:

Pre Sch 10 10

Post Sch 10 -10

New periods – exception for maturity in 2005

Where the loan relationship matures in 2005 (whether as a result of conversion or otherwise), regulation 4(3) and (4)(a) of the CofAP regulations applies to require the loan relationship and derivative contracts transitional credits and debits to be brought into account.

4. Asset-linked securities to which section 93 FA 1996 DOES apply immediately before transition which are bifurcated (or electively treated as bifurcated) in the first new period

Deemed disposal on transition

Where a security within this part (a former section 93 security) is held at the start of the first new period, paragraph 11(2) Schedule 10 FA 2004 has effect. This means that section 93B FA 1996 (deemed disposal and re-acquisition) has effect: the company is deemed for the purposes of TCGA to have disposed of the asset (the loan relationship) for the "relevant consideration", and immediately reacquired it. But by section 93B(3), section 116 TCGA is treated as applying for the purposes of the TCGA 1992. Thus a non-QCB is treated as exchanged for a loan relationship which is treated as a QCB by virtue of section 117(A1). A gain (or loss) calculated by reference to the relevant consideration is deferred until a disposal of the deemed QCB which is not a no gain/no loss disposal – section 116(10). But the market value used to determine the would-be gain or loss is whatever is the accounting value of the asset using the "relevant accounting method".

There is a question as to whether the accounting value on the date of deemed disposal (e.g. 31st December 2004) or deemed reacquisition (e.g. 1st January 2004) is used, and if the latter whether the value is that of the host contract only or the entire (actual) loan relationship. Section 93B(4) says in terms that it is the method used on disposal. Section 93B(6) seems to contradict that by requiring that the relevant consideration be determined by using the accounting method on reacquisition.

However section 93B(6) is difficult to make work in this case. It assumes that the reacquisition will be part way through an accounting period ("that part of the accounting period"), and so makes the natural assumption that the same accounting method will be used on disposal and reacquisition as they will fall within the same accounting period. . Secondly, "accounting method" is not a term used in Chapter 2 for new periods (except in the heading to two sections (87 and 88A) and in parenthetical references to one of those sections). No part of the operative text of Chapter 2 uses the term. As a result, the Revenue view is that the relevant consideration is determined by reference to the use of an authorised accruals basis or authorised mark to market basis as the case may be at the end of the final earlier period. Given paragraph 1(1A) Schedule 11 FA 1996, it is likely that most holders of asset-linked securities within section 93 will be companies which use a mark to market basis.

Transitional adjustments

It is unlikely that the tax adjusted accounting value for the purposes of paragraph 19A Schedule 9 FA 1996 will differ, unless

section 87(2) (accruals basis to be used for tax in connected party cases) forced accruals accounting for tax purposes in a case where market to market was, or fair value is, used for accounting purposes
or paragraph 6(3) Schedule 9 FA 1996 applies (no bad debt debit for transaction between connected person).

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing (tax adjusted) accounting value and the tax adjusted accounting value of the host contract. This adjustment falls within the amounts prescribed by regulation 11 of the Disregard regulations and so does not come into account for tax purposes

Post transition new periods – assets held on transition: general rule

Regulation 11 of the Disregard regulations has the effect that the only credits that will be brought into account for loan relationships will be credits in respect of actual interest accruing rather than the full amount accruing under the effective interest method.

In relation to the derivative contract element, paragraph 45FA Schedule 26 FA 2002 prevents any charge arising under Schedule 26. Paragraph 45FA also provides that the total asset is not treated as a QCB. Thus there will be a disposal on sale or redemption for which the base cost is the re-acquisition value under section 93B as applied by paragraph 11(2) Schedule 10 FA 2004. The section 93B gain will also be triggered.

This will ensure that on disposal or redemption, the same credits and debits and the same chargeable gains will have been given as would have been given had Chapter 2 as it stood before FA 2004 continued to apply.

Example 1a & 1b

Assume

asset-linked security within section 93 issued at 100, redemption value by reference to FTSE
it pays 3% interest (AI)
on 31 December 2004 carrying value is 110 (MTM)
on 1 January 2005 it is bifurcated to 80 host contract, 30 embedded option
from 1 January 2005 effective interest rate on host contract is 5%

On the assumption that the asset is redeemed at £145, there will be -

A transitional loan relationships amount (disregarded) Dr 30 [110 – 80]

A transitional derivative contract amount (disregarded) Cr 30 [30 – 0]

Gain on redemption 35

Section 93B gain 10

Total non actual interest profits brought into account:

Pre Sch 10 0

Post Sch 10 45 (CG)

On the assumption that the asset is redeemed at 85, there will be -

A transitional loan relationships amount (disregarded) Dr 30 [100 – 80]

A transitional derivative contract amount (disregarded) Cr 30 [30 – 0]

Gain on redemption -25

Section 93B gain 10

Total non actual interest profits brought into account:

Pre Sch 10 0

Post Sch 10 -15

New periods – exception for maturity in 2005

Where the loan relationship matures in 2005, regulation 4(3) and (4)(a) of the CofAP regulations applies to require the transitional loan relationships and derivative contracts credits and debits to be brought into account.

The debtor (issuer)

5. Convertible securities where IAS 32/FRS 25 treats the embedded derivative as an equity component (standard convertible) and which are former section 92A securities

Transition

The accounting value of the security at the end of the company’s final earlier period will be its carrying value found in accordance with FRS 4.

The accounting value of the security at the beginning of the company’s first new period will be that of the host contract accounted for on the basis of amortised cost, while the derivative will be accounted for at its dis(embedded) fair value on issue of the security.

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing accounting value and the accounting value of the host contract. This will usually result in a credit representing the discount in the host contract. This adjustment falls within the amounts prescribed by regulation 12 of the Disregard regulations and so does not come into account for tax purposes

Paragraph 50A Schedule 26 FA 2002 does not apply to the (dis)embedded derivative contract, because it does not fall within Part 2 Schedule 26.

In cases where paragraph 19A does not apply (i.e. where the change is from old UK GAAP to FRS 26, or to IAS 39 where the option not to restate comparatives under IAS for earlier period is taken (IFRS 1 paragraph 36A), section 85B FA 1996 will apply to give the same outcome.

Post transition new periods – liabilities owed on transition: general rule

Regulation 12 of the Disregard regulations has the effect that existing pre-IAS treatment is continued until the company ceases to be a party to the loan relationship. In other words the only debits that will be brought into account for Chapter 2 purposes will be debits in respect of actual interest accruing rather than all amounts accruing under the effective interest method, together with credits and debits for exchange gains and losses and credits and debits in respect of discounts, premiums, fees and other incidental costs to the extent that these amounts are not within section 92A(3) of the Finance Act 1996.

New periods – exception for maturity in 2005

Where the loan relationship matures in 2005, regulation 4(3) of the CofAP regulations applies to require the transitional loan relationships credit to be brought into account, where it will be set against any debit arising in 2005.

Examples

Assume

security convertible into issuer’s ord shares issued at 100 redeemable at 100
it pays 3% interest (AI)
on 31 December 2004 carrying value is 100 FRS4
on 1 January 2005 it is bifurcated to 80 host contract, 30 embedded equity component
from 1 January 2005 effective interest rate on host contract is 5%

1a. On the assumption that the asset goes to conversion and the loan relationship exchanged for shares with value of £145 there will be -

A transitional loan relationships amount (disregarded) Cr 20 [100 - 80]

No transitional derivative contract amount 0

Post FA 2004 period loan relationships credits (disregarded) Dr 20 [80 - 100]

Post FA 2004 periods derivative contract credits 0

Total non interest profits brought into account:

Pre Sch 10 0

Post Sch 10 0

1b. On the assumption that the asset is redeemed in accordance with terms at 100 (because option out of the money), there will be -

A transitional loan relationships amount (disregarded) Cr 20 [100 - 80]

No transitional derivative contract amount 0

Post FA 2004 period loan relationships credits (disregarded) Dr 20 [80 – 100]

No post FA 2004 periods derivative contract credit/debits 0

Total non actual interest profits brought into account:

Pre Sch 10 0

Post Sch 10 0

6. Convertible securities where IAS 32/FRS 25 treats the embedded derivative as a derivative (exchangeable or non-standard convertible) and which are former section 92A securities

Tax issues – transition

The accounting value of the security at the end of the company’s final earlier period will be its carrying value found in accordance with FRS 4.

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing accounting value and the opening accounting value of the host contract. This may result in a credit representing the discount in the host contract. This adjustment falls within the amounts prescribed by regulation 12 of the Disregard regulations and so does not come into account for tax purposes

Paragraph 50A Schedule 26 FA 2002 applies to the (dis)embedded derivative contract. There is an accounting value of that contract at the opening of the first new period equal to the fair value of the derivative element, and an accounting value of nil at the end of the final earlier period. This adjustment is disregarded entirely by regulation 3C(2)(a) of the CofAP regulations and so does not come into account for tax purposes

Post transition new periods – liabilities owed on transition: general rule

In order to maintain the previous tax treatment of section 92A securities, regulation 12 of the Disregard regulations ensures that existing pre-IAS treatment is continued until the company ceases to be a party to the loan relationship. In other words the only debits that will be brought into account for Chapter 2 purposes will be debits in respect of actual interest accruing rather than the full amount accruing under the effective interest method, together with credits and debits for exchange gains and losses and credits and debits in respect of discounts, premiums, fees and other incidental costs to the extent that these amounts are not within section 92A(3) of the Finance Act 1996.

Paragraph 45J(3) provides that no amounts in relation to the derivative contract element, including any transitional adjustment, are brought into account. Paragraph 45J(4) is amended by SI 2005/2082 to create an allowable loss but only in a case where paragraph 45J(7) applies (cash out). Paragraph 45J does not apply where at the time when the company became party to the debtor relationship -

it was not carrying on a banking business or a business as a securities house, or if it was carrying on such a business, it did not become party to the debtor relationship in the ordinary course of that business,
the company is not a body falling within paragraph 45C(3) (authorised unit trusts etc).

Examples

Assume

security convertible into parent’s ord shares issued at 100 redeemable at 100
it pays 3% interest (AI)
on 31 December 2004 carrying value is 100 FRS4
on 1 January 2005 it is bifurcated to 80 host contract, 30 embedded equity component
from 1 January 2005 effective interest rate on host contract is 5%

1a. On the assumption that the asset goes to conversion and the loan relationship exchanged for shares with value of £145 there will be -

A transitional loan relationships amount (disregarded) Cr 20 [100 - 80]

A transitional derivative contract amount (disregarded) Dr 30 [0 - 30]

Post FA 2004 periods Sch 26 amounts 0

Total non actual interest losses brought into account:

Pre Sch 10 0

Post Sch 10 0

1b. On the assumption that the asset is cashed out for £145 there will be -

A transitional loan relationships amount (disregarded) Cr 20 [100 - 80]

A transitional derivative contract amount (disregarded) Dr 30 [0 - 30]

Post FA 2004 periods Sch 26 amounts 0

Total non actual interest losses brought into account:

Pre Sch 10 0

Post Sch 10 -45 (CG loss)

1c. On the assumption that the asset is redeemed in accordance with terms at 100 (because option out of the money), there will be -

A transitional loan relationships amount (disregarded) Cr 20 [100 - 80]

A transitional derivative contract amount (disregarded) Dr 30 [0 - 30]

Post FA 2004 Schedule 26 losses 0

Total non interest profits brought into account:

Pre Sch 10 0

Post Sch 10 0

7. Asset-linked securities to which section 93 applies immediately before transition.

Tax issues – transition

The accounting value of the security at the end of the company’s final earlier period will be its carrying value found in accordance with FRS 4 - this will usually take the movement in the value of the reference assets or index into account.

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing accounting value and the opening accounting value of the host contract. This may result in a credit representing the excess of the cumulative value movements in the reference asset or index and the issue price. This adjustment falls within the amounts prescribed by regulation 12 of the Disregard regulations and so does not come into account for tax purposes.

Paragraph 50A Schedule 26 FA 2002 applies to the (dis)embedded derivative contract. There is an accounting value of that contract at the opening of the first new period equal to the fair value of the derivative element, and an accounting value of nil at the end of the final earlier period. This adjustment is deferred by regulation 3A of the CofAP regulations to 2006 and is brought into account over 10 years. .

Post transition new periods – liabilities owed on transition: general rule

Regulation 12 of the Disregard regulations applies so that existing pre-IAS treatment is continued until the company ceases to be a party to the loan relationship. In other words the only debits that will be brought into account for loan relationships will be debits in respect of actual interest accruing together with exchange gains and losses.
In relation to the derivative contract element Schedule 26 applies. Paragraph 45K does not apply – paragraph 45K(1)(e).

8. Asset-linked securities to which section 93 does NOT apply immediately before transition which are bifurcated (or electively treated as bifurcated) in the first new period.

Tax issues – transition

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing accounting value and the opening accounting value of the host contract. This may result in a credit representing the excess of the cumulative value movements in the reference asset or index and the issue price. This adjustment falls within the CofAP regulations, and is be deferred to 2006, but see below in relation to the treatment of deferred transitional adjustments.

Paragraph 50A Schedule 26 FA 2002 applies to the (dis)embedded derivative contract. There is an accounting value of that contract at the opening of the first new period equal to the fair value of the derivative element, and an accounting value of nil at the end of the final earlier period. This adjustment is disregarded by the CofAP regulations and is deferred to 2006, but see below in relation to the treatment of deferred transitional adjustments.

Regulation 3A of the CofAP regulations provides that both adjustments will be brought into account over a 10 year period beginning in 2006 unless the creditor loan relationship comes to an end in 2005 (see below).

Post transition new periods – liabilities owed on transition: general rule

Chapter 2 Part 4 FA 1996 and Schedule 26 FA 2002 will apply in full in relation to credits and debits on the entire loan relationship arising after transition.

New periods – exception for maturity in 2005

Where the loan relationship matures in 2005, regulation 4(3) and (4)(a) of the CofAP regulations applies to require the transitional loan relationship credits and derivative contract credits or debits to be brought into account, where they will be set against any debit arising in 2005.

9 Derivative contracts embedded in host contracts which are not treated as loan relationships to which paragraph 45M does not apply – election cases.

Paragraph 45L applies to contracts where a derivative contract is embedded in a contract which is not a loan relationship and the embedded derivative is bifurcated. Thus it does not apply where the company accounts for the contract as at fair value through profit or loss.

Transitional adjustments

Where paragraph 45L would apply but for an election under paragraph 45L(2A) to follow bifurcation being made, by definition the pre-IAS contract is not a loan relationship and is not subject to the provisions of paragraph 19A Schedule 9 FA 1996. If there is a change in the accounting value of a contract before and after entry to IAS 39/FRS 26, an adjustment may arise under

Chapter 13A Schedule 29 FA 2002 (intangibles)
Schedule 22 FA 2002 as a result of section 64(3) FA 2002 (as substituted by section 81 FA 2005).

There is in general no deferral or spreading of Chapter 13A transitional adjustments, nor of Schedule 22 adjustments unless paragraph 6 Schedule 22 applies

Paragraph 50A Schedule 26 FA 2002 applies to the (dis)embedded derivative contract. There is an accounting value of that contract at the opening of the first new period equal to the fair value of the derivative element, and an accounting value of nil at the end of the final earlier period. The adjustment is deferred to 2006 and will be brought into account over a 10 year period beginning in 2006 by virtue of regulation 3A of the CofAP regulations.

In cases where paragraph 50A does not apply (i.e. where the change is from old UK GAAP to FRS 26, or to IAS 39 where the option not to restate comparatives under IAS for earlier period is taken (IFRS 1 paragraph 36A), paragraph 17B Schedule 26 FA 2002 will apply to give the same outcome.

Post transition new periods – contracts held on transition: general rule

The general rule will be that profits and losses on the host contract will arise in accordance with GAAP generally (section 42 FA 1998 or section 25 ITTOIA 2005) while credits and debits on the embedded derivative will be brought into account in accordance with Schedule 26 FA 2002.

10 Derivative contracts embedded in host contracts which are not treated as loan relationships – non election cases to which paragraph 45M does not apply.

Transitional adjustments

Where paragraph 45L applies and the election in paragraph 45L(2A) Schedule 26 to follow bifurcation is not possible or is not made so that a transitional adjustment will arise in respect of the change of accounting basis in relation to the derivative element, regulation 3C(b) of the CofAP regulations ensures that this transitional adjustment is never brought into account.

Post transition new periods – contracts held on transition: general rule

The general rule is that profits and losses on the embedded derivative contract are not brought into account under Schedule 26 – paragraph 45L(1B)(a) and profits and losses on the host contract will arise in accordance with GAAP (section 42 FA 1998 or section 25 ITTOIA 2005) as it applies to an underlying contract where an embedded derivative is closely related to the contract. More particularly

If the total contract is not itself a derivative contract, profits and losses are brought into account for the purposes of the Corporation Tax Acts as if the contract was not accounted for as bifurcated and was not one in relation to which a fair value basis of accounting is used – paragraph 45L(2). Thus one resorts to the accounting that would be given to a contract in which the derivative embedded in it is closely related to the host contract. Where the derivative contract is a currency contract, then exchange gains and losses are found for tax purposes on the basis of a comparison of the accounting value of the contract on a non-bifurcated basis.
If the total contract is a derivative contract, for example a forward supply of gas or a prepaid equity future, profits and losses are computed for the purposes of Schedule 26 as if that contract were not one to which section 94A FA 1996 and paragraph 2(3) Schedule 26 applied (so as to allow bifurcation) and was not one in relation to which a fair value basis of accounting is used. Thus one resorts to an amortised cost basis of accounting for the instrument as a whole.

11 Derivative contracts embedded in host contracts which are not treated as loan relationships –paragraph 45M cases

Paragraph 45M applies to contracts where a derivative contract whose USM is shares is embedded in a contract which is not a loan relationship but which is treated for accounting purposes as, or as forming part of, a financial asset, and the embedded derivative is bifurcated. Thus it does not apply where the company accounts for the contract as at fair value through profit or loss.

Where paragraph 45M applies, paragraph 45L does not. The typical contact to which this paragraph applies is a prepaid equity forward of the type used by life assurance companies (see HSBC Life Assurance Ltd v Stubbs SpC 36A and HMRC’s Life Assurance Manual Chapter 4D.36A)

Transitional adjustments

Contracts to which paragraph 45M applies were most likely treated as derivative contracts falling within paragraph 7 (or possibly 6 or 8) Schedule 26 at transition. Such contracts would usually have been accounted for on a mark to market basis before 2005 and will be accounted for on a fair value basis after.

But if a contract of this type does change its accounting basis at transition, the adjustment is deferred to 2006 and will be brought into account over a 10 year period beginning in 2006 by virtue of regulation 3A of the CofAP regulations

Post transition new periods – contracts held on transition: general rule

The general rule is that profits and losses on the embedded derivative contract are not brought into account under Schedule 26, but only under the rules in TCGA 1992 – paragraph 45M(2)(b). The host contract is treated as a loan relationship – paragraph 45M(2)(a).

The cases below cover the situation where bifurcation does not apply post-transition

1A. Convertible securities to which section 92 FA 1996 does NOT apply immediately before transition which are not bifurcated (or electively treated as bifurcated)

This covers those securities which were held for the purposes of a trade (other than life assurance), or failed the other conditions in section 92 and which are accounted for in the first new period at fair value through profit or loss or which continue to be accounted for on old UK GAAP. Here "convertible" includes "exchangeable" (i.e. the right is to acquire shares in a company other than the issuer of the hybrid security)

Assets held on transition – Transitional adjustments

The accounting value of the security at the beginning of the company’s first new period will either be its fair value (if it is a FVPL security) or if the contract is accounted for on the basis of fair value (if available-for-sale) or amortised cost, its carrying value under that basis.

It is unlikely that the tax adjusted accounting value for the purposes of paragraph 19A Schedule 9 FA 1996 will differ, unless

section 87(2) (accruals basis to be used for tax in connected party cases) forced accruals accounting for tax purposes in a case where market to market was, or fair value is, used for accounting purposes
or paragraph 6(3) Schedule 9 FA 1996 applies (no bad debt debit for transaction between connected person).

Regulation 3A of the CofAP regulations provides that any adjustment will be brought into account over a 10 year period beginning in 2006 unless the creditor loan relationship comes to an end in 2005 (see below).

Post transition new periods – assets held on transition: general rule

The general rule will be that credits and debits given in accordance with the accounting treatment in new accounting periods will be brought into account in accordance with Chapter 2 only.

Application of TCGA 1992 on conversion in a new period

New periods – exception for maturity in 2005

Where the loan relationship matures in 2005 (whether as a result of conversion or otherwise), regulation 4(3) of the CofAP regulations applies to require the transitional loan relationships credits and debits to be brought into account.

2A. Convertible securities to which section 92 FA 1996 does apply immediately before transition which are NOT bifurcated (or electively treated as bifurcated) in the first new period..

This covers those securities which were previously within section 92 and which are accounted for in the first new period at fair value through profit or loss or which continue to be accounted for on old UK GAAP. Here "convertible" includes "exchangeable" (i.e. the right is to acquire shares in a company other than the issuer of the hybrid security)

Deemed disposal before transition

See the discussion on Case 4 (bifurcation)

Transitional adjustments

The "old" tax adjusted accounting value will be the issue price, adjusted only for exchange gains and losses.
The accounting value of the security at the beginning of the company’s first new period will either be its fair value (if it is a FVPL security) or if the contract is be accounted for on the basis of fair value if AFS or amortised cost, its carrying value under that basis.

It is unlikely that the tax adjusted accounting value for the purposes of paragraph 19A Schedule 9 FA 1996 will differ, unless

section 87(2) (accruals basis to be used for tax in connected party cases) forced accruals accounting for tax purposes in a case where market to market was, or fair value is, used for accounting purposes
or paragraph 6(3) Schedule 9 FA 1996 applies (no bad debt debit for transaction between connected person) and
the security is one grandfathered by section 73 FA 2002.

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing (tax adjusted) accounting value and the tax adjusted accounting value of the host contract. This will give a difference only in the unlikely event that the case changes from MtM to amortised cost or vice versa. This adjustment falls within the amounts prescribed by regulation 11 of the Disregard regulations and so does not come into account for tax purposes.

Post transition new periods – assets held on transition: general rule

In order to maintain the previous tax treatment of section 92 securities, regulation 11(3) of the Disregard regulations (SI 2004/3256 as amended by SI 2005/2012) has the effect that existing pre-IAS treatment is continued until the company ceases to be a party to the loan relationship. In other words the only credits that will be brought into account for loan relationships will be credits in respect of actual interest accruing rather than the full amount accruing under the effective interest method, together with exchange gains and losses.

Where the security is one to which section 87(2) applies, that subsection will, in an earlier period, have required the security, if marked to market, to be accruals accounted (with no possibility of a deduction for a decrease in value of the option element). In post-transition new periods this will continue. And the loan relationship will be subject to tax using an amortised cost basis as if the embedded derivative were closely related.

*Application of TCGA 1992 on conversion in a new period

Where a company uses fair value through profit and loss because it holds the asset as an integral part of a trade, TCGA is not an issue.

In any other case, on conversion into shares of the issuer, section 132 TCGA will not apply (as the "original shares" are a QCB) and section 116 applies. loan relationships credits and debits will follow the accounts, and the base cost for TCGA will be the market value of the asset representing the loan relationship (section 116(6) TCGA). Section 116(8A) does not apply.

Any section 92(7) held over gain is triggered on conversion.

New periods – exception for maturity in 2005

3A. Asset-linked securities to which section 93 FA 1996 does NOT apply immediately before transition which are NOT bifurcated (or electively treated as bifurcated) in the first new period.

This covers those securities which were held for the purposes of a trade (other than life assurance), or failed the other conditions in section 93 and which are accounted for in the first new period at fair value through profit or loss or which continue to be accounted for on old UK GAAP. .

Assets held on transition – transitional adjustments

It is unlikely that the tax adjusted accounting value will differ, unless paragraph 6(3) Schedule 9 FA 1996 applies (no bad debt debit for transaction between connected person).

It is unlikely that the tax adjusted accounting value for the purposes of paragraph 19A Schedule 9 FA 1996 will differ, unless

section 87(2) (accruals basis to be used for tax in connected party cases) forced accruals accounting for tax purposes in a case where market to market was, or fair value is, used for accounting purposes
or paragraph 6(3) Schedule 9 FA 1996 applies (no bad debt debit for transaction between connected person).

Post-transition new periods – assets held on transition: general rule

The general rule will be that credits and debits given in accordance with the accounting treatment in new accounting periods will be brought into account in accordance with Chapter 2 only.

New periods – exception for maturity in 2005

Where the loan relationship matures in 2005 (whether as a result of conversion or otherwise), regulation 4(3) of the CofAP regulations applies to require the loan relationships transitional credits and debits to be brought into account.

4A. Asset-linked securities to which section 93 FA 1996 DOES apply immediately before transition which are NOT bifurcated (or electively treated as bifurcated) in the first new period.

This covers those securities which were previously within section 93 and which are accounted for in the first new period at fair value through profit or loss or which continue to be accounted for on old UK GAAP.

Deemed disposal before transition

See the discussion on Case 4 (bifurcation)

Transitional adjustments

The "old" tax adjusted accounting value will be the issue price, adjusted only for exchange gains and losses.

The accounting value of the security at the beginning of the company’s first new period will either be its fair value (if it is a FVPL security) or if the contract is accounted for on the basis of fair value if AFS or amortised cost its carrying value under that basis.

It is unlikely that the tax adjusted accounting value for the purposes of paragraph 19A Schedule 9 FA 1996 will differ, unless

section 87(2) (accruals basis to be used for tax in connected party cases) forced accruals accounting for tax purposes in a case where market to market was, or fair value is, used for accounting purposes
or paragraph 6(3) Schedule 9 FA 1996 applies (no bad debt debit for transaction between connected person).

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing (tax adjusted) accounting value and the tax adjusted accounting value of the host contract. This will give a difference only in the unlikely event that the case changes from MtM to amortised cost or vice versa This adjustment falls within the amounts prescribed by regulation 11 of the Disregard regulations and so does not come into account for tax purposes.

Post transition new periods – assets held on transition: general rule

Regulation 11(3) of the Disregard regulations (SI 2004/3256 as amended by SI 2005/2012) has the effect that the only credits that will be brought into account for loan relationships will be credits in respect of actual interest accruing rather than the full amount accruing under the effective interest method, together with exchange gains and losses.
Where the security is one to which section 87(2) applies, that subsection will, in an earlier period, have required the security, if marked to market, to be accruals accounted (with no possibility of a deduction for a decrease in value of the option element). In post-transition new periods this will continue. And the loan relationship will be subject to tax using an amortised cost basis as if the embedded derivative were closely related.

New periods – exception for maturity in 2005

The debtor (issuer)

5A. Securities where neither IAS 32 nor FRS 25 apply and which are former section 92A securities

Transition

The accounting value of the security at the end of the company’s final earlier period will be its carrying value found in accordance with FRS 4.

The accounting value of the security at the beginning of the company’s first new period will also be that found in accordance with FRS 4. Thus there will be no relevant difference.

Post transition new periods – assets held on transition: general rule

Chapter 2 Part 4 FA 1996 applies in full.

6A. Securities within IAS 32 or FRS 25 which are not bifurcated and which are former section 92A securities

This covers those securities which were previously within section 92A and which are accounted for in the first new period at fair value through profit or loss. This will include only "exchangeables" (i.e. the right in the holder is to acquire shares in a company other than of the issuer) or those convertibles where the shares to be acquired are not part of equity (e.g. redeemable preference shares)

Tax issues – transition

The accounting value of the security at the end of the company’s final earlier period will be its carrying value found in accordance with FRS 4.

The accounting value of the security at the beginning of the company’s first new period will be the fair value at that date.

It is unlikely that the tax adjusted accounting value for the purposes of paragraph 19A Schedule 9 FA 1996 will differ, unless section 87(2) (accruals basis to be used for tax in connected party cases) forced accruals accounting for tax purposes in a case where market to market was, and fair value is, used for accounting purposes
Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing accounting value and the opening accounting value of the contract.

Regulation 3A of the CofAP regulations provides that any adjustment will be brought into account over a 10 year period beginning in 2006 unless the debtor loan relationship comes to an end in 2005. Where the loan relationship matures in 2005, regulation 4(3) of the CofAP regulations applies to require the transitional amounts to be brought into account.

Post transition new periods – assets held on transition: general rule

Chapter 2 Part 4 FA 1996 applies in full

7A. Asset-linked securities where neither IAS 32 nor FRS 25 apply and which are NOT former section 93 securities

Tax issues – transition

Post transition new periods – assets held on transition: general rule

Chapter 2 Part 4 FA 1996 applies in full.

7B. Asset-linked securities where IAS 32 or FRS 25 applies which are not bifurcated and which are NOT former section 93 securities.

This covers those securities which are accounted for in the first new period at fair value through profit or loss.

Tax issues – transition

The accounting value of the security at the beginning of the company’s first new period will be its fair value at that date.

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing accounting value and the opening accounting value of the contract.

Post transition new periods – assets held on transition: general rule

Chapter 2 Part 4 FA 1996 applies in full.

8A. Asset-linked securities where neither IAS 32 nor FRS 25 applies and which are former section 93 securities.

Tax issues – transition

The accounting value of the security at the beginning of the company’s first new period will also be its carrying value found in accordance with FRS 4 - this will usually take the movement in the value of the reference assets or index into account. Thus there will be no relevant difference. It is unlikely that the tax adjusted accounting value for the purposes of paragraph 19A Schedule 9 FA 1996 will differ, unless section 87(2) (accruals basis to be used for tax in connected party cases) forced accruals accounting for tax purposes in a case where market to market was, or fair value is, used for accounting purposes

Post transition new periods – assets held on transition: general rule

Chapter 2 Part 4 FA 1996 applies in full.

8B. Asset-linked securities where IAS 32 or FRS 25 applies but there is no bifurcation and which are former section 93 securities.

This covers those securities which are accounted for in the first new period at fair value through profit or loss.

Tax issues – transition

The accounting value of the security at the beginning of the company’s first new period will be its fair value at that date.

Paragraph 19A Schedule 9 FA 1996 applies to any difference between the closing accounting value and the opening accounting value of the contract.

Post transition new periods – assets held on transition: general rule

Chapter 2 Part 4 FA 1996 applies in full.

Transitional adjustments where the later period is later than the first new period

All the material above covers only the case where the transition takes place between a company’s last old period and its first new period. There will be many cases where a company does not adopt IAS 39 or FRS 26 until a period later than for the first new period.

Existing assets and liabilities (those held or owed at end of last old period)

So far as applies to assets and liabilities existing at the end of the last old period, one difference between what happens on such an event and those described above is that where an asset was within section 92 or 93 in its last old period, the deemed disposals given by paragraph 9 and 11 Schedule 10 FA 2004 will have applied even if there was no change of accounting basis to show bifurcation and no election to follow bifurcation.

If bifurcation is not followed in the first new period, a subsequent change will either be from following a pure loan relationships charge to coming within the scope of section 94A (whether following paragraphs 45D and 45F or not), or from a deemed bifurcation to an actual bifurcation.

The latter will not involve any transitional adjustments. The former can give rise to transitional adjustments for Chapter 2 Part 4 FA 1996 which will fall to be spread over 10 years under regulation 3A CofAPR (irrespective of when the new period begins).

No change of this sort triggers the section 92 or 93 frozen gain.

In other cases a transitional adjustment may arise which will fall to be spread over 10 years under regulation 3A CofAPR (irrespective of when the new period begins).

New assets and liabilities (those coming to be held or owed after end of last old period)

So far as applies to assets and liabilities coming to be held or owed after the end of the last old period, there will be a change of accounting or tax basis if the company used old UK GAAP to start with and then adopts IAS 39 or FRS 26 from a later period.

The differences between this event and the descriptions for the "transition" are that

There can be no frozen gains within section 92(7) or 93B FA 1996
Paragraphs 45D, 45F, 45J (in full), 45JA and 45K may apply for the periods after the change.
Transitional adjustments will be deferred, where relevant, for the 10 years starting from the period of change if later than 2006.
The rules in regulation 4(3) and (4) of the CofAP regulations will not apply, unless the change takes place before the end of 2005, subject to a proposed amendment to those paragraphs to generalise them.