CFM55510 – Corporate Finance Manual – HMRC Internal Manual

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CTA09/S665, 666

References to a standard convertible are instruments where the holder has the option to convert the loan instrument into a fixed number of common shares and without any cash settlement option.

Accounting treatment of the issuer of a standard convertible

A standard convertible will normally be a compound financial instrument in the hands of the issuer. The issuing company would therefore be required to separately recognize two components of the issue, a liability component and a residual equity component. See CFM21200 for more information on the recognition of ‘liabilities’ and ‘equity’ and the treatment of ‘compound financial instruments’.

Tax treatment of the issuer of a standard convertible

For the issuer of a standard (“plain vanilla”) convertible, the inherent obligation to convert debt into its own equity will generally be a “tax nil”, giving rise to no taxable debit or credit under an income or taxable gains code. This reflects prescribed accounting, which recognizes no change in the value of the bond, either during the life of the security, or upon conversion or expiration of the option. Thus, for the issuer, the embedded instrument can generally be ignored for tax purposes.

This is a “tax nil” because, for accounting purposes, the potential obligation to convert is not classified as a financial derivative instrument at all. It is classified as an “equity instrument”, for which a different accounting treatment is prescribed. This reflects the fact that an obligation to issue own shares is not considered a financial liability, see CFM21250. Similarly, an “equity instrument” is not considered a “derivative contract” for the purposes of CTA09/PT7. It is therefore not taxable or deductible under any taxable income or gains code.

Note that:

  • CTA09/S585 requires the option to be considered a relevant contract for the rules of derivative contracts (but it will not qualify to be a derivative contract).
  • CTA09/S415 treats the enterprise as a party to a loan relationship whose liabilities consist only of those of the “host contract” from which the equity element has been separated.

CFM55520 provides an example of the normal accounting and tax treatment of an issuer of a standard convertible.

Exceptional case: ‘cash out’

There is a relatively rare exception to the “no tax” rule. The issuer of a standard convertible security can “cash settle” the conversion obligation. This may occur when the issuance of the total amount of shares would exceed the authorized share capital of the company or when the terms of the security permit cash settlement in exceptional situations. If this happens, CTA09/S666 may allow the issuer to calculate a one-time loss. This loss is equal to the excess, if any, of the amount paid to settle the option over its initial fair value. See the example on CFM55530.

CTA09/S665 applies S666 to a company for an accounting period if each of the following conditions is met.

  • Condition A: The company is considered a party to a relevant contract under S585(2), (lending relationships with embedded derivatives) because of a debtor relationship of the company. (It follows that S666 can only apply to transmitters.)
  • Condition B: The division referred to in S585(1) in the case of the debtor relationship is between rights and obligations under (a) a loan relationship, and (b) an equity instrument of the company.
  • Condition C: The contract concerned is treated as an option by S585(3) (contract treated as an option, a futures contract or a contract for difference). Here you ignore S580(2) and (3).
  • Condition D: The company pays an amount in the PA to the creditor to discharge any obligation arising from the debtor relationship. So here the issuer gives the holder cash instead of shares. It is not necessary that all obligations be discharged in this way – the condition will be met if the holders receive shares plus cash.
  • Condition E: at the time when the company became a party to the debtor relationship, it did not exercise a banking activity or a securities firm activity, or if it exercised such an activity, it had not become a party to the relationship debtor in the normal course of this activity.
  • Condition F: The company must not be a permitted unit trust, investment trust, open-ended investment company or venture capital trust (these are “excluded organizations” within the meaning of CTA09 /S706).

This should not be confused with a case where the terms of the security permit cash settlement instead of physical delivery of the shares and therefore the issuer accounts for the security as a financial liability plus an embedded option. Such a security would not be a “standard” (“plain vanilla”) convertible in the first place, but a non-standard one. For the tax treatment of the issuer of a “non-standard” convertible under CTA09/S652 to S655, see CFM55420.

Qualifying loss treated as accumulating

Under S666, a “normal” CG loss arises (rather than the annual CG treatment under S641), equal to the cash paid less the fair value of the equity instrument.

The legislation states that when “A” exceeds “B”, an allowable taxable loss equal to the amount of the excess is considered to accrue to the company in the PA.

  • A = The amount paid under condition D reduced (but not below zero) by an amount equal to the fair value of the “host contract” at the time that amount is paid.
  • B = The amount treated as the book value of the relevant contract under condition C at the time the company became a party to the debtor relationship under condition A.

“Host Contract” means the Lending Relationship to which the Company is considered a party under S415(2) (Embedded Derivatives Lending Relationships) by virtue of the Obligor Relationship.

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