CFM37700 - Loan relationships: 'hybrid' securities with embedded derivatives: pre 1 January 2005 convertible securities - issuers

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Former FA96/S92A, 93; SI2014/3256 Reg 12

This section of guidance describes the historic (pre-2005) tax treatment of holders of certain hybrid instruments, and the grandfathering rules that continue this treatment for companies that are a party to instruments that had previously been subject to these rules.

Convertible securities issued in periods beginning before 1 January 2005

For issuers of a convertible security, interest and exchange gains and losses in respect of the security were allowable under loan relationships rules, relief for the costs of issuing the security was restricted by FA96/S92A, and other gains and losses were tax nothings. As for holders (CFM37690), the previous tax treatment is broadly continued for issuers of convertible securities where the liability straddles the start of the company’s first accounting period beginning on or after 1 January 2005.

Regulation 12 of the Disregard Regulations (SI 2004/3256) applies for loan relationships purposes. It has effect for any debtor relationship where

  • FA96/S92A applied immediately before the start of the company’s first accounting period beginning on or after 1 January 2005, but
  • the company did not enter into the debtor relationship in the ordinary course of a banking or security dealing business.

Where these conditions are met, regulation 12 applies both where the company accounts for the security as a financial liability and an equity element or an embedded derivative (so that CTA09/S415 applies), and where it does not bifurcate.

Where the company does not bifurcate, debits are allowable in respect of the debtor relationship to the extent that they would not have been disallowed under FA96/S92A(3). This means that interest and exchange losses are allowable (and exchange gains are taxable), but debits connected with the acquisition or issue of shares are not allowed. Thus the tax treatment formerly given by S92A simply continues.

Where the company does bifurcate, amounts to be brought into account in relation to the host contract are restricted to:

  • debits in respect of interest
  • exchange gains or losses, and
  • credits and debits in respect of discounts, premiums, fees and expenses, to the extent that these would not have been prohibited by S92A(3).

Amounts to be taxed or relieved are to be determined without regard to amounts given by the effective interest rate method. In particular, debits for the ‘implied finance cost’ - the accretion of the liability up to its face value - are not allowed in the transitional case.

Guidance on the tax treatment of the equity component or embedded derivative is at CFM55540.

Adjustment in respect of periods ended before 11 April 2007

This section of guidance applies to an adjustment that fell to be calculated in respect of a change to the law in 2007. This continued to be of relevance on later periods, because the adjustment fell to be spread over a ten-year period.

Before the amendment of the Disregard Regulations by SI 2007/948, which came into force on 11 April 2007, regulation 12(2)(a) referred merely to debits to the extent that they are within S92A(3). This means that issuers may have had ‘excessive’ debits on transitional securities in accounting periods ended before 11 April 2007. A consequential adjustment was made to the transitional amount recognised under the Change of Accounting Practice Regulations, SI2004/3271, regulations 4(1A) and (1B).

The adjustment was calculated by taking the difference between the amount actually allowed in any accounting period ending on or after 27 December 2006 and before 11 April 2007, and the amount that would have been allowable had the amendment to regulation 12(2)(a) of the Disregard Regulations, made by SI2007/948, been in force for this period. The disregard of transitional credits imposed by regulation 12(3) is then restricted by this amount - see the example below.

Example

A company, which accounts to 31 March, issued convertible securities (maturing in 2010) before 31 March 2005. The company was not a bank or a dealer in securities. On 1 April 2005, it adopted IAS for the first time, accounting for the securities as a compound financial instrument (financial liability plus equity component). On transition, a loan relationships credit of £500,000 would - but for regulation 12(3) of the Disregard Regulations - have fallen to be brought into account under FA96/SCH9/PARA19A (which became CTA09 S315-319).

In its accounting period ended 31 March 2006, the company - using an effective interest rate method - debits £150,000 in respect of the financial liability component. None of this debit is a ‘share-related’ amount within FA96/S92A(3), so on the formulation of regulation 12(2) applying at the time, the entire debit is allowable. But had the amendment made by SI 2007/948 been in force, to exclude the ‘implied finance cost’, only (say) £90,000 would have been allowable.

Thus for the accounting period ended 31 March 2007, an adjustment of £60,000 (£150,000 - £90,000) is computed under regulation 4(1B) of the Change of Accounting Practice Regulations. This restricts the credit that is disregarded under regulation 12(3) of the Disregard Regulations. Suppose it is agreed that, save for this restriction, £450,000 of £500,000 transitional credit would be thus disregarded. The £60,000 adjustment made reduces the disregarded amount to £390,000. So the amount which is a ‘prescribed credit’ for the Change of Accounting Practice Regulations is £110,000 (£500,000 - £390,000). This is spread over 10 years, starting in year ended 31 March 2007, under regulation 3A.

If, in this example, the amount otherwise falling to be disregarded under regulation 12(3) of the Disregard Regulations was only £50,000, the restriction would reduce the ‘disregarded amount’ to nil. The full transitional credit of £500,000 would be taxable under the Change of Accounting Practice Regulations.

Banks and dealers in securities

Regulation 12 of the Disregard Regulations did not apply where a company had entered into the debtor loan relationship in the ordinary course of a business of banking or dealing in securities. ‘Ordinary course of banking business’ should be interpreted in accordance with Statement of Practice 4/96, so that if a bank issues convertible securities as part of its Tier 1, 2 or 3 capital, they will not have fallen with FA96/S92A(4) prior to 1 January 2005 and will not be within the exclusion from regulation 12.