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HMRC internal manual

Corporate Finance Manual

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Derivative contracts: holders of convertible or share-linked securities: convertible securities: introduction

Chargeable gains aspects of convertible and exchangeable securities - the holder’s perspective

Securities that may be converted into shares of the issuing company, or exchanged for shares in some other company, have features both of debt and equity. So it has always been seen as appropriate to tax the ‘debt-like’ features, such as interest, within an income regime, while retaining capital gains treatment for ‘share-linked’ aspects.

In general, disposals of loan relationships are excluded from the TCGA92 rules. This is achieved by TCGA92/S117(A1), which provides that a loan relationships asset (a creditor loan relationship) is a qualifying corporate bond (QCB). Gains on disposals of QCBs are exempted by TCGA92/S115(1). (There is no corresponding provision for debtor loan relationships because chargeable gains arise on disposal of assets - not on liabilities).

For periods of account beginning before 1 January 2005, FA96/S92 provided that convertible and exchangeable securities meeting the qualifying conditions were not loan relationships for TCGA92 purposes. This had the effect of disapplying TCGA92/S117(A1), with two major consequences. First, a disposal (or part-disposal) of the security gave rise to a chargeable gain or allowable loss. Second, a conversion of the security into shares of the issuer (but not an exchange for shares in some other company) came within the provisions at TCGA92/S132 on conversions of securities (see CG55000+) and was therefore not treated as involving a disposal of the original security.

A security that carried rights to acquire shares, but failed one of the other conditions for FA96/S92 to apply, remained a normal loan relationship, and therefore a QCB. A conversion of the security into shares fell within TCGA92/S116, and was treated as a disposal of the loan relationship (TCGA92/S116(9)).

From 1 January 2005, a company holding a convertible or exchangeable security, which has adopted IAS 39 or FRS 26, may account separately for the embedded equity option - the right to acquire shares - and the loan component, or host contract. Details of the accounting are at CFM25000 onwards. Where this treatment (sometimes referred to as ‘bifurcation’) is adopted, CTA09/S415 allows the host contract to be taxed as a separate loan relationship (CFM37600+), while CTA09/S585 brings the embedded option into the derivative contracts regime (CFM50420).

But it is important to remember that ‘host contract’ and ‘embedded derivative’ are accounting fictions, not real assets. TCGA92, which is concerned with disposals of real assets, does not recognise such concepts: instead, it deals with the convertible security as a whole. This raises the possibility of double-counting of gains or losses. The provisions of Chapters 7 and 8 of CTA09/Part 7, in so far as they apply to the holders of convertible or exchangeable securities, therefore do three main things:

  • they allow profits or losses arising from the embedded equity option to be charged as capital gains or allowable losses, in appropriate cases,
  • they ensure that conversion of a convertible security is not treated as a disposal, and
  • they prevent profits or losses that have already been taken into account for loan relationships or derivative contracts purposes from being taxed again under TCGA 92.

These provisions do not, however, apply to convertible or exchangeable securities that were held before 1 January 2005, and to which FA96/S92 previously applied. Broadly speaking, the existing tax treatment of these securities is continued (see CFM55240).

Guidance on the loan relationships treatment of the host contract, including treatment of convertibles and share-linked securities where the holder adopts IAS 39 or FRS 26 for the first time, is at CFM37680 onwards.