Holders of convertible or share-linked securities: share-linked securities
Holders of share linked securities: embedded derivatives which are exactly tracking contracts for differences
Share-linked securities are those where the final redemption amount depends in some way on the value of a specific share or basket of shares, or a share index (CFM11110). Where a company accounts under IAS 39 or FRS 26, the equity derivative embedded in the security may be recognised separately, and treated as a relevant contract under CTA09/S585 (CFM50420). Unlike convertible securities, the holder’s rights can only be settled by the payment of cash - there is no question of shares being acquired. So the embedded derivative will always be, in tax terms, a contract for differences (see CFM50380).
Chargeable gains treatment is appropriate where holding the security exposes to the same risks and rewards as actually holding the relevant shares. This happens where the embedded derivative exactly tracks the value of the relevant shares or share index. The conditions for chargeable gains treatment are in CTA09/S648.
As with CTA09/S645 (see CFM55220), where S648 applies, the annual CG charge under S641 applies and the asset representing the creditor relationship is not a QCB for chargeable gains purposes. This ensures that debits and credits taxed as chargeable gains or allowable losses under S641 are not exempt gains.
CTA09/S648 applies where all the following conditions are met:
- Condition A: There is a derivative contract which is a relevant contract to which a company is treated as a party under CTA09/S585(2) (CFM50420) because of a creditor relationship of the company.
- Condition B: The derivative contract is treated as a CFD by S585(3).
- Condition C: The derivative contract is an ‘exactly tracking contract’ (defined under S649(2)) - see below. This means it must match the change in value of the underlying asset. Condition D: The USM of the contract is ‘qualifying ordinary shares’ (defined under S649(4) - CFM55220) listed on a recognised stock exchange.
- Condition E: The contract must not be held for trading purposes.
- Condition F: The company is not an authorised unit trust, an investment trust, an open-ended investment company or a venture capital trust (these are ‘excluded bodies’ as defined under CTA09/S706).
Exactly tracking contract
The derivative contract is an ‘exactly tracking contract’ if:
D = R% x C, where D is the amount received on redemption, R% is the percentage change in the underlying assets or index, C is the original cost of the security.
If it is not an exactly tracking CFD, for example if there is any element of a capital protection under the terms of the security, it will be within the normal CTA09/PART7 rules and debits and credits will be brought into account as income. Unlike FA96/S93, which applied to asset-linked securities in periods beginning before 1 January 2005, there is no provision for a ‘floor’ of 10% or less of the face value to be disregarded. There is an example at CFM55300.
The test is applied over the ‘relevant period’, which is the entire period from issue of the security to when it is redeemed. The contract may however provide for the linked shares to be valued at dates which slightly pre- date the issue and redemption dates - a process known as ‘lagging’. This will not prevent the contract being regarded as ‘exactly tracking’ provided any such variation is relatively small, and is solely for the purposes of giving effect to valuations. This is a practical rule which recognises that certain assets do not have daily published prices. Thus without some ‘lagging’ it might not be possible to redeem the security on the maturity date.
Interaction with TCGA 1992
S672 deals with the CG consequences from disposal of a share-linked security within S648, either by redemption or onward sale. It is similar to how S670 applies for S645 (CFM55230). S672 prevents double counting where a share linked security is disposed of, by deducting previously-allowed losses from, or adding previously-taxed profits to, the base cost for CG purposes of the security. See CFM55310 for an example.
As with convertible securities, where a share-linked security satisfies the condition of CTA09/S648, and the company became party to the security in a period of account beginning before 1 January 2005, the previous tax treatment under FA96/S93 is essentially continued.
Where the embedded derivative is concerned, CTA09/SCH2/PARA86 provides that no amounts are to be brought in under the derivative contracts rules. The security is not treated as a qualifying corporate bond and hence is not treated as exempt from chargeable gains.
Under regulation 11 of the Disregard Regulations, only interest and exchange differences are brought into account under loan relationships (see CFM37690). A just and reasonable apportionment is to be made in respect of interest received or accruing under the security (but not exchange gains or losses), to exclude such amounts from consideration received on disposal for chargeable gains purposes.