CFM55520 - Derivative contracts: issuers of convertible or share-linked securities: equity instruments - example

Example of the tax treatment of a standard convertible security by the issuer applying to periods of account beginning on or after 1 January 2005

On 1 January 2007 X Ltd issues a 3-year security paying 4 per cent interest. The terms are that it will redeem for cash at par £1million or, at the holder’s option, convert into 100,000 of X Ltd’s ordinary £10 shares. X Ltd’s issue costs are £20,000.

X Ltd bifurcates the security at issue, attributing initial fair values of, say, £950,000 to the loan and £50,000 to the equity instrument. It must also split issue costs in the same ratio, allocating £19,000 to the loan and £1,000 to the equity instrument. The initial fair value of the loan obligation is therefore £931,000, representing a discount of £69,000 on its face value £1million. The initial fair value of the equity instrument is £49,000. These total £980,000 (£931,000 + £49,000) being X Ltd’s net proceeds of issue after its £20,000 issue costs.

Because X Ltd uses ‘split’ accounting this is followed for tax purposes (CTA09/S585). It is treated as a party to both a debtor loan relationship, and a separate equity instrument. The host loan relationship is taxed as a normal debtor loan relationship (CFM37680).

The implied discount of £69,000 is amortised to profit and loss account over the term of the convertible. This means that X Ltd can claim loan relationship debits for its ‘notional finance cost’ - the value of the conversion right attached to the security - as well as for the actual interest coupons that it pays. This represents a change from the tax treatment applying in periods of account beginning before 1 January 2005.

Tax treatment of the equity instrument

The required accounting for an equity instrument is to credit its initial fair value (here £49,000) to ‘equity’ in the balance sheet. It is not subsequently re-valued, so no accounting debits or credits arise. On conversion the carrying value of the security, here £1m, would be transferred from the loan account and credited to equity. The £49,000 carrying value of the equity instrument would remain in equity (although it may then be transferred to another part of equity).

The tax treatment is the same whether or not the holder exercises the option, as follows.

Holder exercises the conversion option

If on the option exercise date the value of X Ltd’s shares was £12 per ordinary £10 share, the holder would opt to convert. X Ltd would issue 100,000 of its ordinary shares, then worth £1.2million.

The initial £49,000 fair value of the conversion obligation was credited to equity in X Ltd’s accounts, and not subsequently re-measured. On conversion it remains in equity. An equity instrument is not a ‘derivative contract’ for the purposes of CTA09/PART7, so no profits or losses arise under either an income or chargeable gains code.

Option expires unexercised

Had X Ltd’s share value in the above example been less than £10 per share, the holder would have chosen to redeem for cash at par £1million.

On redeeming for cash X Ltd will derecognise the carrying value of the loan, £1million (if there were any difference between the carrying value and the redemption value, this would be recognised as a profit or loss when the loan element is derecognised). The accounts carrying value of the equity instrument remains at £49,000 throughout, with no profit or loss recognised for accounting or tax purposes.