CFM55250 - Holders of convertible or share-linked securities: convertibles where CTA09/S645 does not apply

What happens where CTA09/S645 conditions are not met

CTA09/S645 (CFM55220) will not apply if the holder of a convertible security does not adopt ‘bifurcation’ treatment in its accounts.

There are a number of reasons why this might not be the case.

• Perhaps the most likely reason is that the convertible is accounted for, under GAAP, at fair value through profit and loss. This may be because the company applies Section 12 of FRS102, or IFRS9. This treatments is also permitted where IAS 39 / FRS 26 applies, for example if it is economically the hedged item in a fair value hedge.
• Another possibility is that it is not bifurcated and the whole instrument is subject to amortised cost accounting, for instance if the company qualifies as a micro-entity and adopts FRS105.
• The same would apply in periods beginning before 1 January 2016, if the company had applied the FRSSE, Financial Reporting Standard for Smaller Entities.
• For periods beginning before 1 January 2016, it is possible that a company applied ‘Old UK GAAP’ (and has not elected under CTA09/S416 to be treated for tax purposes as though it had accounted separately for embedded options).

In such cases, no separate embedded option is recognised under CTA09/S585. Normal loan relationships rules apply to the security 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.

‘Bifurcation’ cases where CTA09/S645 does not apply

In some cases, the company may bifurcate the security in its accounts, but one or more of the remaining conditions in CTA09/S645 may not be met. For example, the company may be party to the security for trade purposes, or it may convert into shares that are neither qualifying ordinary shares nor mandatorily convertible preference shares.

The option embedded in the security will be subject to the derivative contracts rules, but credits or debits give rise to income profits or losses in the normal way. Here again, the security - viewed as a whole - is a QCB, so a disposal does not give rise to chargeable gains or allowable losses. Instead a disposal (including a conversion into shares) is treated as a simultaneous disposal of the host contract and the embedded option.

However, where the company is a financial trader, it is probable that the whole instrument will be accounted for at fair value through profit and loss - this would be the case under FRS102, or IFRS 9 and a choice available under IAS39. Even if bifurcated, both host debt and embedded derivative should also be accounted for at fair value through profit and loss. Either way the amounts recognised in the accounts as items of profit or loss would be brought into account in computing the profits of the financial trade.