CFM55420 - Derivative contracts: issuers of convertible or share-linked securities: non-standard convertibles

CTA09/S652-655

Issuers of securities with embedded derivatives: deemed options

For the issuer of either a ‘non-standard’ convertible or an exchangeable security the embedded obligation to convert or exchange is classified for accounting purposes as a derivative financial instrument - an option.

Under IAS 39 and IFRS 9 (and previously under FRS 26), the accounting standards will normally require the company to bifurcate the embedded option and measure it at its fair value, taking any movements through profit and loss account. Accounting debits and credits in respect of the embedded derivative may therefore arise in each accounting period.

Where the issuer accounts separately for the loan and option in this way:

  • CTA09/S585 requires the option to be dealt with under the derivative contract rules of CTA09/PT7.
  • Similarly, CTA09/S415 treats the company as party to a loan relationship whose liabilities consist only of those of the "host contract" from which the equity element has been separated.

Under the derivative contracts rules, credits and debits arising from an option are generally taxed or relieved as income. But this would create a significant mismatch in tax treatment between a company issuing such a security, and one issuing a bond with an attached warrant conferring similar rights.

The grantor of a ‘stand alone’ option that is settled in cash will have a capital loss or more rarely, a gain, under TCGA92/S144A(2). Similarly, if the option is settled by a transfer of shares, the premium received for the option forms part of the capital gains computation on the share disposal - TCGA92/S144(2). But TCGA92 does not recognise an embedded option as an asset separate from the security itself.

The purpose of CTA09/S653 to S655 is therefore to ensure that the issuer’s loss or profit from an option embedded within a security is brought into account as an allowable loss, or a chargeable gain, on a realisation basis - that is, in a manner comparable to TCGA92 treatment.

Non-bifurcated instruments

Note that bifurcation into a debt host and embedded derivative is not required under IAS 39 and IFRS 9 where the whole instrument is measured at fair value. Also, bifurcation is not permitted under FRS 102 unless the company chooses to apply the recognition and measurement requirements of IAS 39 or IFRS 9.

Where the instrument is not bifurcated then S652-S655 do not apply.

Conditions

S653 to S655 CFM55430 apply to a derivative contract of a company for an accounting period where all the following conditions, set out in S652, are met:

  • Condition A: the contract is a relevant contract to which the company is treated as a party under S585(2) (loan relationships with embedded derivatives) because of a debtor relationship of the company (so it applies to issuers).
  • Condition B: the contract is treated as an option by S585(3) (contract treated as option, future or contract for differences). Here S652(7) overrides S580(2) and (3), so it does not matter if the obligation must be settled in cash.
  • Condition C: the USM of the contract is shares. The meaning of shares is not restricted, so Condition C will apply even where the shares are redeemable preference shares or there is any ability at all to obtain cash (and therefore not an equity instrument for accounting purposes).
  • Condition D: at the time when the company became a 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 a party to the debtor relationship in the ordinary course of that business.
  • Condition E: The company must not be an authorised unit trust, an investment trust, an open-ended investment company or a venture capital trust (these are ‘excluded bodies’ as defined under CTA09/S706).

Note that the embedded option needs to be a derivative contract in order for the conditions at section 652 to be satisfied. For standard convertibles the conversion feature would be considered to be an equity instrument of the company, and as such would not meet the accounting conditions to be a derivative contract. See CFM55510+ for guidance on this.   

Treatment

Where the above conditions are met, the normal rules for bringing amounts into account as income (S573 and S574) do not apply to the relevant credits and debits. Instead, where the option is terminated (whether on its exercise, cashing-out or abandonment), the profit or loss accruing to the issuer in relation to the embedded option is taxed under the capital gains regime.

CFM55430 explains the treatment in more detail.

Historic position

For periods beginning on or after 1 January 2005 and ending before 16 March 2005, capital gains treatment was denied where the option was one to which any of FA02/SCH26/PARA6 to 8 applied. These paragraphs were repealed for accounting periods ending on or after 16 March 2005.