Loan relationships: 'hybrid' securities with embedded derivatives: first-time adoption of IAS 39 or FRS 26
Transitional adjustments on hybrid securities
A company that adopts IAS 39 or FRS 26 for the first time, and is party to a hybrid security - either as debtor or creditor - is likely to start to bifurcate the security. To take a much simplified example, a company that has subscribed £100 for a convertible security (with par value £100) might, in its first period of account to which FRS 26 applies, initially recognise the host contract as an asset valued at £80, and an embedded option valued at £30.
If no special rules applied, this would result in a loan relationships debit of £20 (because the ‘loan’ element has been revalued from £100 to £80), and a derivatives contract credit of £30 (because under CTA09/S585 a derivative contract is being recognised for the first time). Where the accounts show a prior period adjustment, these amounts would be brought into account under CTA09/S308 for loan relationships, and CTA09/S597 for derivative contracts. Where there is no prior period adjustment, CTA09/S315 and CTA09/S613 would nevertheless ensure they were brought into account - see CFM76010.
Even where the hybrid security is accounted for at fair value through profit and loss (FVPTL), there will be a transitional credit or debit where it has previously been carried at amortised cost.
The tax treatment on transition will depend on whether or not the securities in question are ‘existing assets’ - creditor relationships to which FA96/S92 or FA96/S93 applied immediately before the start of the company’s first accounting period beginning on or after 1 January 2005 - or ‘existing liabilities’, in other words debtor relationships to which FA96/S92A or FA96/S93 previously applied.
‘Existing assets’ and ‘existing liabilities’
A transitional tax treatment applies to hybrid securities that, in periods beginning before 1 January 2005, came within FA96/S92 or FA96/S92A (for convertibles) or FA96/S93 (for asset-linked securities). Details are at CFM37690 for holders, and CFM37700 - 37710 for issuers.
In broad terms, bifurcation is ignored and the previous tax treatment is continued. Consistent with this, loan relationships debits or credits arising on a change of accounting policy are - for the most part - not brought into account. The relevant statute is at regulation 11(4) of the Disregard Regulations (SI 2004/3256) for creditor relationships, and regulation 12(3) for debtor relationships.
Under regulation 11(4),
- for convertibles, the only transitional amounts to be brought into account will be those relating to interest or exchange gains and losses; and
- for asset-linked securities, only transitional amounts relating to interest are brought into account (since exchange differences will continue to form part of the capital gains computation on disposal).
Where the issuer is concerned, regulation 12(4) provides the following.
- For convertibles, transitional credits or debits are ignored except in so far as they relate to interest, exchange differences, or discounts, or to premiums or incidental costs (but only in so far as these amounts were not within FA96/S92A(3). But these amounts must be computed without regard to amounts given by an effective interest rate method. There is more about this at CFM37700.
- For asset-linked securities, transitional amounts are disregarded except in so far as they relate to interest (again, ascertained without reference to an effective interest rate method).
This special transitional treatment will apply to all ‘existing assets’ and ‘existing liabilities’ whether the company makes the transition to IFRS or new UK GAAP in 2005, or at a later date.
Hybrid securities that are not ‘existing assets’ or ‘existing liabilities’
Where the tax treatment outlined above does not apply, transitional credits and debits will be taxable, although 10-year spreading under the Change of Accounting Practice Regulations will apply in appropriate cases. The general guidance at CFM76000+ on changes of accounting policy will be relevant.
Hybrid securities will not be ‘existing assets’ or ‘existing liabilities’ in two main circumstances.
- The company may not adopt IAS 39 or FRS 26 in its first accounting period beginning on or after 1 January 2005, but makes the transition later. Normal transitional rules will apply to all hybrid securities to which the company has become party in periods beginning on or after 1 January 2005.
- Even where hybrid securities were held in a period to which the ‘old’ tax rules were applicable, they will not be existing assets or liabilities if they did not actually meet the conditions for FA96/S92, FA96/S92A or FA96/S93 to apply. An example is a convertible bond held by a company that fell outside of FA96/S92 because it was a relevant discounted security.