CFM37670 - Loan relationships: ‘hybrid’ securities with embedded derivatives: bifurcation: taxing the loan element

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CTA09/S415

Taxing the separate loan element

Where in accordance with generally accepted accounting practice a company accounts separately for the loan and the embedded derivative or equity instrument, CTA09/S415 mirrors that treatment for tax. The loan element is treated as a loan relationship in its own right, and taxed fully under the loan relationships rules.

In the example at CFM37650, the holder of a convertible security divided the £1m purchase price as between:

• £947,513 paid to acquire the ‘host’ loan, and
• £52,487 paid for the embedded derivative.

Accounting treatment of the loan relationship

The company treats the ‘host’ as a simple loan, acquired at a discount of £52,487 to its £1million face value. It will accrue credits for the discount over the life of the security. The discount plus the 5 per cent interest receivable produce the overall effect of a return on lending of 7 per cent, which is likely to be equal to what would have been required had the conversion option not been included. Similarly if the issuer/borrower uses separate accounting, it will accrue debits for the discount over the life of the security. As explained at CFM37650 the amount the issuer treats as ‘discount’ may not exactly match that in the accounts of the corresponding creditor.

Tax treatment of the loan relationship

Because the above treatment accords with generally accepted accountancy practice, CTA09/S307 brings the corresponding credits and debits into account for tax. For the holder, the discount credits are taxable loan relationships credits. For the issuer, if it uses separate accounting, the corresponding debits are relievable as loan relationships debits. These credits and debits are brought into account in addition to any interest payable under the terms of the security.

Changes in value of conversion/ exchange shares or linked assets

It should be noted that the accounts carrying value of the ‘host’ loan is unaffected by any periodic changes in the value of the shares into which it may convert or exchange, or in the value of the linked assets. Where the company is required to recognise such changes, it will do so by periodically revaluing the embedded derivative. The resulting credits or debits would be taxable separately under the derivative contracts tax rules in CTA09/PT7 - see CFM55200+ for holders, and CFM55400+ for issuers. Thus apart from the accruing discount and any changes in prevailing interest rates, the only factors potentially affecting the value of the loan relationship will be impairment losses, or the reversal of such losses.

Companies which do not bifurcate an embedded derivative

Not all companies will bifurcate an embedded derivative, and will instead account for the whole instrument as a single item - typically the whole instrument will be measured at fair value.

In such cases S415 and S585 do not apply. See CFMXXX for guidance on the treatment of hybrid debt where the company does not bifurcate.

Note, however, that in certain limited cases a company can make an election for the instrument to be treated as being bifurcated - see CFM37720.