CFM55430 - Derivative contracts: issuers of convertible or share-linked securities: non-standard convertibles: tax treatment of deemed options

CTA09/S653-655

The provisions of S653-655 apply in the context of non-standard convertibles where the conversion option is bifurcated as an embedded derivative under IAS 39, IFRS 9 (or, previously, under FRS 26). See CFM55420 for details of the relevant conditions. These rules do not apply to issuers of standard convertibles, because in applying these accounting standards, the conversion right would give rise to an equity component, rather than an embedded derivative.

Option exercised and shares issued or delivered

The rules at S653 apply where, on the holder exercising the conversion/exchange option, the issuer duly issues its own (or delivers another company’s) shares. The issuer is treated for the purposes of TCGA92/S144 (2) as having granted the option for a consideration equal to its tax-adjusted carrying value. The approach of S144 (2) is to treat the grant of a share option as part of the wider transaction.

For an exchangeable security, the wider transaction is the company’s acquisition of shares to fulfil its obligations, followed by the disposal of those shares to the holder. On that basis S653(2) and (3) computes a chargeable gain, or allowable loss, by comparing the issuer’s consideration for granting the option with its eventual costs of fulfilling the option. Where the company issues its own shares, the wider transaction is the share issue. In terms of TCGA92/S144(2), the option binds the grantor neither to buy nor to sell anything: there is no chargeable disposal. Thus there are no capital gains consequences for the issuer.

CTA09/S653(2) and (3) additionally provides that TCGA92/S17(1) does not apply. This prevents the ‘consideration’ being treated as any different amount from its tax-adjusted carrying value as might otherwise have been required by TCGA92/SS144ZB to 144ZD.

See CFM55440 for examples.

Option exercised but cash settled

The rules at S654 apply where, on the holder exercising the option, the issuer fulfils its obligation by paying the holder the cash equivalent of the conversion or exchange shares, as permitted under the original terms of issue of the security.

The issuer is treated as making a chargeable gain or allowable loss in the terminal period. The gain or loss is found by comparing amounts CV and X. If CV is greater than X, there is a chargeable gain; if X exceeds CV, an allowable loss.

CV is the tax-adjusted carrying value of the option in the usual case where the company paying the cash equivalent was also the issuer. In a case where the paying company became a party to the security by novation after issue, CV is the tax-adjusted carrying value of the option at the time it became a party.

X is the amount paid by the debtor in fulfilment of the obligations under the entire security (that is, the loan element plus the embedded derivative) reduced (but not below nil) by the fair value of the host contract (that is, the loan element) at the date on which the option is exercised. This amounts to the amount the issuer pays to fulfil the option obligation.

For periods ending on or before 30 December 2006 X was defined simply as the part of the total amount paid in fulfilment of the obligations under the entire security that relates to the option element, but the effect was the same.

See example at CFM55450.

Option lapses unexercised

The rules at S655 apply where the holder does not exercise the option, and takes cash redemption; the issuer is treated as making a chargeable gain. The gain is found by comparing the amounts CV and Y.

CV has the same meaning as in S654. So it is the deemed disposal consideration and is the tax-adjusted carrying value of the option in the usual case where the company paying the cash equivalent was also the issuer. In a case where the paying company became a party to the security by novation after issue, CV is the tax-adjusted carrying value of the option at the time it became party.

Y is the deemed acquisition cost and is the amount paid by the company by way of cash redemption of the entire security (that is, the loan element plus the embedded derivative) reduced (but not below nil) by the fair value of the host contract (that is, the loan element) at that time.

In the unusual case where the issuing company ceases to be a party to the security (for example by novation) at a time when the option is unexercised, Y is the consideration given by the company ceasing to be party to the original relationship reduced (but not below nil) by the fair value of the host loan relationship contract at that time.

For periods ending on or before 30 December 2006, the comparison was simply between the carrying value of the option at the terminal event and its initial carrying value.

See example at CFM55460.