CFM55410 - Derivative contracts: issuers of convertible or share-linked securities: introduction

The issuer’s perspective and the relevant accounting issues

This section of guidance covers three different cases in which a company has issued securities that are either convertible into shares or are otherwise linked to the value of shares.

A number of different accounting treatments apply and there have been changes, over time, in the applicable accounting standards. The accounting treatment is not always straightforward. In particular, in some cases such an instrument will treated as having two components: a debt liability and an equity component, which are accounted for separately. In others the instrument may be treated as a financial liability with an embedded derivative whose underlying subject matter is shares.

The guidance covers three broad classes of equity-linked debt:

  • ‘standard’ convertibles (see CFM55510+),
  • ‘non-standard’ convertibles (see CFM55420+), and
  • share-linked debt securities (see CFM55470+).

(1) Issuers of ‘standard’ convertibles

A company may issue a ‘standard’ convertible - if a holder exercises the conversion option, the issuer’s outstanding obligations are satisfied by the issue of a fixed number of ordinary shares in the issuing company. Sometimes conversion is only possible on maturity of the debt, in other cases the bond may be converted at other times. The conversion feature will be considered to be part of the company’s equity for accounting purposes where it is an exchange into a fixed number of ordinary shares.

In this situation the instrument would be regarded as being a compound instrument having both liability and equity components. One component is host debt. The other is, in effect, a call option granted to the holder to acquire a fixed number of shares in exchange for releasing the issuer from its outstanding obligations under the debt.

Where an issuer has a compound instrument, they will typically be required to split the instrument into two components, one being a liability component (representing the debt element of the instrument) and the other being an equity component (representing the conversion feature). Note that because the conversion feature is considered to be an equity instrument it cannot be considered to be an embedded derivative.

The equity component is accounted for in the same way as an equity instrument, defined as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. See CFM21250 for more about the accounting.

Note that the accounting requirements are the same under IFRS (under IAS 32), Old UK GAAP (under FRS 25), FRS 102 (under section 22.13) and FRS 105 (under section 17.11).

Applying the normal rules under CTA09/PT7, the equity component is treated as a relevant contract under CTA09/S585 (CFM50420), but it will not be a derivative contract because it does not satisfy any of the ‘accounting conditions’ in CTA09/S579 (CFM50210). It is a ‘tax nothing’. The issue of shares in satisfaction of the company’s obligations under the security has no tax consequences.

This is not quite the end of the story, however, since - exceptionally - a company may be forced to settle all or part of its obligation in cash. CTA09/S666 allows the company to recognise an allowable loss in this circumstance.

The relevant guidance is found at CFM55510+.

(2) Issuers of ‘non-standard’ convertibles

Certain other convertibles (referred to in this guidance as ‘non-standard’) are accounted for as a host contract and an embedded derivative. This will be the case where the issuer must, or may, satisfy its obligations other than by issuing its own shares - for example, where the security converts into shares other than those in the issuing company (sometimes referred to as an ‘exchangeable security’), or where a convertible can (or must) be settled in by a cash payment (typically representing the value of the shares into which the security would otherwise convert).

The accounting treatment of such instruments will differ from that of ‘standard’ convertible debt instruments. The fundamental difference between such instruments and ‘standard’ convertible debt is that the issuer may be required to pay cash or transfer other financial assets (such as shares in another company). Thus, in essence, the entire instrument has the quality of a liability, and not of equity in the company.

Depending on the accounting standard applied the company may or may not have to treat the equity-linked element as an embedded derivative.

Under both IFRS9 and IAS39, the equity-linked element would normally be treated as an embedded derivative and be required to be bifurcated (split) from the host liability. The embedded derivative would be measured at fair value, leaving it possible that the debt liability is accounted for on an amortised cost basis. Note, however, bifurcation is not required where the whole instrument is measured at fair value.

The position under superseded UK standard FRS 26 was the same as that under IAS 39.

Under FRS102, however, the entire instrument would be considered to be a non-basic financial instrument. So the entire instrument would fall to be accounted for at fair value in accordance with section 12 and disclosed at fair value. Note, however, that the fair value of an instrument cannot be less than the amount payable on demand, discounted from the first date that the amount could be required to be paid.

However, FRS102 does allow the company to choose to apply the recognition and measurement requirements of either IAS39 or IFRS9 to all of its financial instruments, which would allow separation of an embedded derivative as explained above.

Where the company bifurcates the instrument into a debt host and an embedded derivative, the effect of CTA09/S585 is to treat the issuing company as party to an (embedded) option. This deemed option may be exercised by the holder - and may result in the issuer either issuing its own shares, or transferring shares, or making a cash payment - or it may be allowed to lapse if the holder chooses instead to redeem the security for its par value. CTA09/S652 - 655 provide the tax rules for each of these cases.

The relevant guidance is found at CFM55420+.

(3) Share-liked debt securities

The issuer of a share-linked security will account for it in a similar manner to a non-standard convertible:

  • Under IAS 39 and IFRS 9 (and previously under FRS 26) it would normally be treated as a hybrid financial instrument and bifurcated into a financial liability plus an embedded derivative.
  • Alternatively, it may be that the whole instrument is measured at fair value (either as an option under IAS 39 or IFRS 9, or under FRS 102 where the company does not take the option to apply the requirements of IAS 39 or IFRS 9).

The difference between such an instrument and a ‘non-standard’ convertible is that the embedded derivative, in this case, is regarded under CTA09/PT7 as a contract for differences (CFD), rather than an option. Where the CFD exactly tracks the underlying shares, profits or losses on the CFD are brought into account as chargeable gains or allowable losses by CTA09/S658.

The relevant guidance is found at CFM55470+.

Historic position and transitional rules

In each of the three cases above, there are special rules for securities issued in an accounting period beginning before 1 January 2005 - see CFM55540.

Tax treatment of the host debt element, where bifurcation applies

This part of the guidance does not deal with the treatment of the host contract under loan relationships - see CFM37600+.

Taxation of the holder of such securities

The accounting treatment of the holder may differ to that of the holder. So in particular, FRS102 and IFRS9 will typically require the whole instrument as a financial asset to be measured at fair value (they do not permit bifurcation in respect of a financial asset).

This part of the guidance does not deal with the tax position of a company holding such securities:

  • The treatment of the holder under the loan relationship rules is covered at CFM37600+.
  • The treatment of the holder under the derivative contact rules (where an embedded derivative bifurcated) is covered at CFM55200+.