CFM55210 – Corporate Finance Manual – HMRC Internal Manual


Aspects of taxable gains from convertible and exchangeable securities – the holder’s perspective

Securities that can be converted into shares of the issuing company, or exchanged for shares of another company, have both debt and equity characteristics. Thus, it has always been considered appropriate to tax “debt-like” items, such as interest, under an income regime, while retaining the capital gains treatment for “debt-like” items. to actions”.

The tax treatment depends (and has changed accordingly) on the accounting treatment. For more details on the accounting treatment allowed by the different standards, see CFM55215.

Position under TCGA

In general, assignments of loan relationships are excluded from the TCGA92 rules. This is achieved by TCGA92/S117 (A1), which provides that a loan relationship asset (a creditor loan relationship) is a qualifying corporate bond (QCB). Capital gains on disposal of QCB are exempt per TCGA92/S115(1). (There is no corresponding provision for debtor loan relationships because the taxable gains arise from the disposal of assets – not liabilities).

Rules before 2005

For accounting periods beginning before January 1, 2005, FA96/S92 provided that qualifying convertible and exchangeable securities were not loan relationships for TCGA92 purposes. This had the effect of de-implementing TCGA92/S117(A1), with two major consequences. First, a disposition (or partial disposition) of the security gave rise to a taxable gain or allowable loss. Second, a conversion of the security into shares of the issuer (but not an exchange of shares of another company) fell under the provisions of TCGA92/S132 on conversions of securities (see CG55000+) and was therefore not treated as involving a surrender of the original security.

A security that carried the right to acquire shares, but did not satisfy one of the other conditions for FA96/S92 to apply, remained a normal lending relationship, and therefore a QCB. A conversion of security into shares fell under TCGA92/S116 and was treated as an assignment of the loan relationship (TCGA92/S116(9)).

Post-2005 rules: bifurcated instrumentsThe rules were changed with the introduction of IAS 39 and FRS 25 in 2005, which generally required bifurcation of convertible debt and other equity-linked debt held by a company.

Where under GAAP a loan is split into a host debt instrument and an embedded derivative, CTA09/S415 allows the host contract to be taxed as a separate loan relationship (CFM37600+), while CTA09/S585 introduces the option incorporated in the regime of derivative contracts. (CFM50420).

But it is important to remember that the “host contract” and the “embedded derivative” are accounting fictions and not real assets. The TCGA92, which concerns disposals of real assets, does not recognize such concepts: rather it deals with the convertible security as a whole. This raises the possibility of double counting of wins or losses. The provisions of Chapters 7 and 8 of CTA09/Part 7, insofar as they apply to holders of convertible or exchangeable securities, therefore do three main things:

  • they allow profits or losses resulting from the embedded stock option to be charged as capital gains or deductible losses, where appropriate,
  • they ensure that the conversion of a convertible security is not treated as a sale, and
  • they prevent profits or losses that have already been taken into account for loan relationships or derivative contracts from being taxed again under TCGA 92.

CFM55220/30 explains the tax treatment of convertible loans.

CFM55290 explains the tax treatment of equity-linked instruments.

Transitional provisions

However, these provisions do not apply to convertible or exchangeable securities held before January 1, 2005 and to which FA96/S92 previously applied. In general, the existing tax treatment of these securities is maintained (see CFM55240).

Processing of the hosting contract

Guidance on the treatment of host contract loan relationships, including the treatment of convertibles and equity-linked securities when the holder first adopts IAS 39 or FRS 26, can be found from CFM37680.

Post-2005 rules: non-bifurcated instruments

As explained in CFM55215, FRS 102 (where IAS 39 is not applied) and IFRS 9 do not allow companies to bifurcate a financial asset to separate an embedded derivative. Instead, the whole instrument will generally be measured at fair value through profit or loss. This treatment was also permitted, in certain circumstances, by IAS 39 and FRS 25.

In such cases, no special rule is needed to deal with the embedded derivative. Generally, the whole relationship with the creditor will be taxed as a lending relationship in accordance with the accounting treatment.

This is subject to any other legal derogations, for example the requirement that related company loan relationships should be treated as held on an amortized cost accounting basis for tax purposes.

CFM55250 explains the tax treatment of non-bifurcated instruments.


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