CFM55440 - Derivative contracts: issuers of convertible or share-linked securities: non-standard convertibles: options exercised and shares delivered - examples
Option on a non-standard convertible/exchangeable security is exercised and shares are delivered:
These examples apply to periods of account beginning on or after 1 January 2005.
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.
Example 1
On 1 January 2017 X Ltd issues a 3 year security exchangeable for ordinary shares in its parent company, Y plc. On 31 December 2019 the exchange shares are worth £1.2m, and the holder opts to exchange. X Ltd duly purchases the Y Plc shares for £1.2m and delivers them to the holder. Its associated costs of purchase are £5,000.
Assume X Ltd applied IAS 39 or IFRS 9 and, as a result, is required to account separately for the loan and the embedded option. Using the principles outlined at CFM37650, it attributes an initial value to the option of, say, £50,000. X Ltd is required to recognise subsequent changes in its fair value through profit and loss. Assume it considered its fair value to be:
| Date | Fair value |
|---|---|
| 1 January 2017 | £50,000 (as above) |
| 31 December 2017 | £40,000 |
| 31 December 2018 | £130,000 |
| 31 December 2019 | £200,000 |
In its accounts for the 3 periods to 31 December 2019 X Ltd accordingly brings in the following amounts:
- a credit of £10,000;
- a debit of £90,000; and
- a debit of £70,000
reflecting the amount by which its obligation has become less or greater.
The above debits and credits must all be adjusted out in the corporation tax computations. This is because CTA09/S653 disapplies normal ‘income’ treatment and instead computes a one-off chargeable gain or allowable loss, but only for the terminal period to 31 December 2019.
For the period to 31 December 2019, X Ltd is treated for the purposes of TCGA1992/S144(2) as having originally granted the option for consideration equal to its tax-adjusted carrying value, here £50,000. S653 then compares this ‘consideration’ with the issuer’s costs, if any, of fulfilling the option - here £205,000 (including the associated purchase costs). Because X Ltd’s costs exceed the deemed consideration, it has an allowable loss of £155,000.
Example 2
The facts are the same as in Example 1, except that the exchange shares were only worth £1,030,000. The holder would still opt to exchange. However, this time X Ltd would make a S653 chargeable gain. Its TCGA1992/S144 (2) proceeds of granting the option would be the same, £50,000. However, its costs of fulfilling it would only be £35,000 producing a gain of £15,000.
Example 3
The facts are the same as in Example 1, except that instead of being exchangeable, the security is convertible into preference shares in X Ltd. This makes the security a ‘non-standard’ convertible, and X Ltd accounts for its obligation to issue shares as an embedded option. At the option exercise date the relevant shares are worth £1.2million. The holder opts to convert, and X Ltd duly issues its own preference shares worth £1.2million.
As in Examples 1 and 2, the accounting debits and credits arising from the option must be adjusted out in X Ltd’s tax computations. For the terminal period to 31 December 2019, S653 applies to treat the grant of the embedded option as part of the wider transaction for the purposes of TCGA92/S144(2). However, the transaction in this case is simply an issue of shares: there is no disposal for the purposes of TCGA92. Thus the share issue has no tax consequences - there is no difference in this respect from the case where the issuer accounts for its obligation to issue shares as an equity component (CFM55290).
Although in this case there is no disposal for the purposes of TCGA92, CTA09/S653(1)(b) nevertheless defines the share issue to be a ‘relevant disposal’. This means that a share issue cannot be treated as the making of a payment, and the company cannot claim a loss, or be taxed on a gain, as a result.