»Ê¹ÚÌåÓýapp

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. »Ê¹ÚÌåÓýapp 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. »Ê¹ÚÌåÓýapp initial fair value of the loan obligation is therefore £931,000, representing a discount of £69,000 on its face value £1million. »Ê¹ÚÌåÓýapp initial fair value of the equity instrument is £49,000. »Ê¹ÚÌåÓýappse 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 ‘splitâ€� 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. »Ê¹ÚÌåÓýapp host loan relationship is taxed as a normal debtor loan relationship (CFM37680).

»Ê¹ÚÌåÓýapp 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 costâ€� - 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

»Ê¹ÚÌåÓýapp required accounting for an equity instrument is to credit its initial fair value (here £49,000) to ‘equityâ€� 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. »Ê¹ÚÌåÓýapp £49,000 carrying value of the equity instrument would remain in equity (although it may then be transferred to another part of equity).

»Ê¹ÚÌåÓýapp 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.

»Ê¹ÚÌåÓýapp 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 contractâ€� 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). »Ê¹ÚÌåÓýapp accounts carrying value of the equity instrument remains at £49,000 throughout, with no profit or loss recognised for accounting or tax purposes.