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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Holders of convertible or share-linked securities: tax consequences where CTA09/S645 applies

Tax treatment for holders of bifurcated convertibles

Where a security meets the conditions of CTA09/S645, there are three consequences.

  • Credits or debits on the embedded option are brought into account as chargeable gains or allowable losses under CTA09/S641 (CFM55030).
  • The security is treated for CT purposes as not being a qualifying corporate bond (QCB), by virtue of CTA09/S645(7). This means that chargeable gains or losses arising under CTA09/S641 on the option component, or gains or losses arising on a disposal of the security, are not exempted under TCGA92/S115. It also means that if there is a conversion of the security into shares, to which TCGA92/S132 applies, the convertible and the shares into which it converts are treated as a single asset (TCGA92/S127): TCGA92/S116 will not apply.
  • CTA09/S670 applies to ensure that profits or losses are taxed once and only once.

Effect of CTA09/S670

Although the heading to CTA09/S670 refers to the embedded option being exercised, the section in fact applies to any disposal of the right to acquire shares. It will therefore apply both where

  • the security is converted into, or exchanged for, shares; or
  • there is a disposal of the security as a whole, either because it has been sold to another person or because it has been redeemed for cash. Cash redemption includes both the case where the holder chooses not to exercise the conversion option, and the security redeems at par, and the case where the conversion option is exercised but is cash-settled - in other words, the issuer pays the cash value of the conversion shares.

Conversion into shares

Where the security converts into shares, and TCGA92/S127 treats the shares as comprising the same asset as the original security, there will not be a chargeable occasion until the company disposes of some or all of the conversion shares. At this point, the rule in CTA09/S670(5) applies in order to eliminate from the capital gains computation those amounts that have already been taxed.

This is achieved by increasing the acquisition cost allowable under TCGA92/S38(1)(a) by the amount of any net profit that has been taxed, or restricting it by the amount of any net loss that has been relieved. If the restriction exceeds the acquisition cost, the excess is added to the disposal consideration.

The net loss, and net profit, are defined in terms of three variables - G, L and CV. G is the amount of chargeable gains accruing to the company under CTA09/S641, both in the accounting period of the disposal and in previous periods. Similarly, L is amount of allowable losses accruing under CTA09/S641. Where only some of the conversion shares are disposed of, G and L are the gains or losses referable on a just and reasonable apportionment to those shares.

CV is the amount by which the carrying value of the host contract at the date when the option is exercised exceeds its value when the company first acquires the convertible (or when it first starts to bifurcate). In other words, it is the amount that has been taxed under loan relationships.

Thus a net profit has already been taxed on the convertible if the sum of G and CV is greater than L. There will have been a net loss if L is greater than the sum of G and CV.

There is an example at CFM55270.

Disposal of security

CTA09/S670(3) applies to any event treated as a disposal of the security, including an exchange of the security for shares in a company other than the issuing company. The capital gains computation is modified in exactly the same way as described above. If the sum of G and CV exceeds L, the acquisition cost is increased by the excess. If L exceeds the sum of G and CV, the acquisition cost is reduced by the amount of the excess. If the net loss exceeds the acquisition cost, the extra amount is added to the disposal consideration.

There are examples at CFM55280.