Loan relationships: 'hybrid' securities with embedded derivatives: pre 1 January 2005 convertible securities - issuers
Convertible securities issued or acquired 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, it 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 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.
Periods ended before 11 April 2007
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 corresponding adjustment is made to the transitional amount recognised under the Change of Accounting Practice Regulations.
The adjustment is 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.
A company, which accounts to 31 March, issued convertible securities (maturing in 2010) before 31 March 2005. The company is 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 - fall to be brought into account under FA96/SCH9/PARA19A.
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 does not apply where a company has 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.