CFM37680 - Loan relationships: 'hybrid' securities with embedded derivatives: bifurcation: first-time adoption of IAS 39 or FRS 26

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SI2004/3256/Regs 11, 12

This guidance is primarily relevant to companies that were party to loan relationships to which special rules in FA96/S92, 92A, or 93 applied in a period of account beginning before 1 January 2005 and which changed the basis of accounting, either in the first period of account beginning on or after 1 January 2005, or in a later period, so as to recognise an embedded derivative.

In these circumstances, the treatment previously applicable is effectively grandfathered by the Disregard Regulations (SI2004/3256) 11 or 12. Under FA96/S92, 92A or 93, certain amounts in respect of hybrid securities were treated as falling within chargeable gains rules, or fell outside the scope of taxation, rather than being brought into account under the loan relationships provisions.

The special tax treatment under Disregard Regulations 11 or 12 is not applicable to changes of accounting basis in other circumstances. The guidance below relates specifically to transitional adjustments. Guidance on the grandfathering rules is found at {CFM37690}+.

Transitional adjustments on hybrid securities

A company that adopted IAS 39 or FRS 26 for the first time, and was party to a hybrid security - either as debtor or creditor - was then likely to start to bifurcate the security. To take a much simplified example, a company that had subscribed £100 for a convertible security (with par value £100) might, in its first period of account to which FRS 26 applies, initially recognise the host contract as an asset valued at £80, and an embedded option valued at £30.

If no special rules applied, this would have resulted in a loan relationships debit of £20 (because the ‘loan’ element had been revalued from £100 to £80), and a derivatives contract credit of £30 (because under CTA09/S585 a derivative contract was being recognised for the first time). Where the accounts showed a prior period adjustment, these amounts would have been brought into account under CTA09/S308 for loan relationships, and CTA09/S597 for derivative contracts. Where there was no prior period adjustment, CTA09/S315 and CTA09/S613 would nevertheless have ensured they were brought into account - see CFM76010.

It should be noted that even the change in accounting basis had the effect that the hybrid security came to be accounted for at fair value, without bifurcation, having previously been carried at amortised cost, a transitional effect would have arisen.

Grandfathering and transitional rules - existing assets and liabilities

There are two types of adjustment provided for under Disregard Regulations 11 and 12, which apply only to what are referred to in this guidance as ‘existing assets’ and ‘existing liabilities’, that is securities to which FA96/S92, 92A or 93 applied in periods of account beginning before 1 January 2015.

The first type of adjustment provides for a transitional adjustment, leaving out of account amounts that might otherwise have been taken into account as a direct consequence of the change in accounting method. The amounts correspond to those that would be left out of account under the grandfathering rules. It is likely to be easier to understand the transitional rules if the guidance on the grandfathering rules is read first.

The practical effect is that normally no amounts will be brought into account as a direct result of transition because the effect of the grandfathering rules is to continue the existing basis of accounting for tax purposes.

The second type effectively grandfathers the previous treatment of such securities, so that they continue to be taxed as they were in periods of account beginning before 1 January 2015. Guidance on the grandfathering rules is found at CFM37690 to CFM36710.

Neither type of rule has any application to securities to which FA96/S92, 92A or 93 never applied, that is to say in cases where a company first became a party to the hybrid security in a period of account beginning on or after 1 January 2015.

Transitional rules where FRS26 of IAS 39 is first adopted in a company’s first period of account beginning on or after 1 January 2005

Specifically, under Disregard Regulation 11(4):

• for convertibles, the only transitional amounts to be brought into account will be those relating to interest or exchange gains and losses; and
• for asset-linked securities, only transitional amounts relating to interest are brought into account (since exchange differences will continue to form part of the capital gains computation on disposal).

Normally, the effect of this regulation is that any change in carrying value on transition, whether relating to the host debt, the embedded derivative or the entire instrument, would be disregarded for tax.

Where the issuer is concerned, regulation 12(4) provides the following.

• For convertibles, transitional credits or debits are ignored except in so far as they relate to interest, exchange differences, or discounts, or to premiums or incidental costs (but only in so far as these amounts were not within FA96/S92A(3)). But these amounts must be computed without regard to amounts given by an effective interest rate method. There is more about this at CFM37700.
• For asset-linked securities, transitional amounts are disregarded except in so far as they relate to interest (again, ascertained without reference to an effective interest rate method).

Normally, the effect of this is that any change in carrying value on transition, whether relating to the host debt, the embedded derivative or the entire instrument, would be disregarded for tax.

This special transitional treatment will apply to all ‘existing assets’ and ‘existing liabilities’ whether the company makes the transition to IFRS or new UK GAAP at the first opportunity, in its first period of account beginning on or after 2005, or at a later date. Even where the company did not adopt either IAS39 ot FRS26 at the first opportunity, continuing to apply old GAAP, the grandfathering rules would have preserved the pre-2005 tax treatment.

Hybrid securities that are not ‘existing assets’ or ‘existing liabilities’

Where the tax treatment outlined above does not apply, because the instruments had not been taxed in the past in accordance any of FA96/S92, 92A or 93, transitional credits and debits will be taxable, although 10-year spreading under the Change of Accounting Practice Regulations SI2004/3271 will apply in appropriate cases. The general guidance at CFM76000+ on changes of accounting policy will be relevant, but note that this guidance now relates to the current provisions and not to the position as it would have been back in 2005.