CFM37780 - Loan relationships: ‘hybrid’ securities: tax treatment where a convertible is not bifurcated

Many holders and issuers of convertible or exchangeable securities, or asset-linked securities, will account separately for the loan and the conversion / share-linked feature. However, the bifurcation of embedded derivatives will not always occur.

For periods of account beginning on or after 1 January 2015 bifurcation is expected to be less common. In particular, a company is not permitted to bifurcate an embedded derivative where:

  • It adopts FRS102 and accounts for the instrument in accordance with section 12 of FRS12 (and has not chosen to apply the recognition and measurement provisions of IAS39 or IFRS9). The instrument will be carried at fair value through profit or loss.
  • It adopts IFRS9 (including through the option under FRS102) in respect of a financial asset. The instrument will typically be carried at fair value through profit or loss.
  • It is a micro-entity and adopts FRS105 (it would be unusual for a micro-entity to hold such instruments). An amortised cost basis will apply under which interest and costs are allocated over the life of the instrument provision is made for impairment, where appropriate. A similar treatment also applied for companies which adopted Old UK GAAP and did not apply the requirements of FRS26.
  • The whole instrument is accounted for as fair value through profit or loss under IAS39 or IFRS9 (or previously FRS26). This could be the case with a bank or other financial trader which entered into the instrument for the purposes of a trade of dealing in securities. It could also be the case where the company designated the instrument as fair value through profit or loss, for example because it provides a natural hedge against another item.
  • Note that this does not affect the treatment of compound financial instruments which contain liability and equity components, which will typically be required to be split for accounting purposes.

For further details, see:

  • {CFM55215} for the accounting for the holder of hybrid financial instruments
  • {CFM55410} for the accounting for the issuer of hybrid financial instruments and compound financial instruments

Basic tax treatment

As set out in {CFM37660}, where a company treats an instrument for accounting purposes as split into a debt host and an embedded derivative or equity instrument, then the tax treatment will follow the accounting treatment under CTA09/S415 and S585.

However, S415/S585 will not apply where the instrument is not split for accounting purposes. The whole instrument falls within the loan relationship rules, with all profits gains and losses brought into account as income under CTA09/PT5 (or PT3 where held in the course of activities forming an integral part a financial trade).

As a result, where the hybrid financial instrument is accounted for at fair value through profit or loss then the fair value movements will typically be brought into account under the loan relationship rules.

Tax treatment - conversion into shares

Where a convertible security held by a company is bifurcated in a company’s financial statements into a host debt and embedded derivative (CTA09/S415, 585) and the conditions in CTA09/S645 are satisfied ({CFM55220}), a special tax treatment applies. This effectively applies chargeable gains treatment to the equity element - {CFM55230}. However, S645 will not apply if the holder of a convertible instrument does not adopt ‘bifurcation’ treatment in its accounts.

As noted above, where the holder does not bifurcate the instrument the normal loan relationships rules apply to the instrument as a whole. Nothing prevents it from being a qualifying corporate bond (QCB) for the purposes of TCGA92. This means that, on conversion into shares, there is a disposal of the security, and the shares are treated under TCGA92/S116(6) as acquired for the market value of the security immediately before the conversion.

Election under S416

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