Derivative contracts: issuers of convertible or share-linked securities: option exercised and cash-settled - examples
Option on a non-standard convertible/exchangeable security is exercised but cash settled: example applying to periods of account beginning on or after 1 January 2005
On 1 January 2007 X Ltd issues a 3 year security convertible, at the holder’s option, into X Ltd’s own ordinary shares. The terms permit the option, if exercised, to be settled for the cash value of the shares instead of by physical delivery. On 31 December 2009 the conversion shares are worth £1.2million, and the holder opts to convert. Instead of issuing shares X Ltd cash settles for £1.2million. Of this, £1million is amount required to redeem the underlying loan liability; the remaining £200,000 is the amount required to fulfil the option.
Assume X Ltd accounts separately for the loan and the option. Using the principles outlined at CFM37650, suppose it attributes an initial fair value of £50,000 to the option. It is required to recognise subsequent changes in its fair value through profit and loss. Assume it considers its fair value to be:
|1 January 2007||£50,000 (as above)|
|31 December 2007||£40,000|
|31 December 2008||£130,000|
|31 December 2009||£200,000|
For the 3 periods to 31 December 2009 X Ltd accordingly brings in:
- a credit of £10,000;
- a debit of £90,000; and
- a debit of £70,000
reflecting the amount by which its obligation has become less or greater.
The above debits and credit must be adjusted out in the corporation tax computations. This is because CTA09/S654 disapplies income treatment. Instead S654 computes a terminal chargeable gain, or allowable loss, but only for the terminal period to 31 December 2009.
In terms of S654(2)
- amount CV is the initial carrying value of the option, £50,000
- amount X is £200,000, being
the total amount paid out by the issuer to fulfil its obligations under the security (£1.2 million), less
the fair value of the loan relationship element of the security (£1 million).
X exceeds CV by £150,000, so X Ltd has an allowable loss of £150,000.
If the convertible was issued for £1 million, X Ltd will initially have shown the loan relationship as a liability of £950,000. In the period to maturity, it will have accrued the liability up to £1 million, and will therefore have had allowable loan relationship debits of £50,000. Thus of the ‘extra’ £200,000 paid by the company over and above the £1 million redemption amount, £50,000 is relieved as income and £150,000 as a capital loss.
X Ltd could only make a S654(2) chargeable gain, as opposed to a loss, where the value of the conversion shares had been at least £1m (otherwise the option would not be exercised) but less than £1,050,000.
The facts are as above, except that 60 per cent of the holders of the convertible elect to take cash settlement, and 40 per cent decide to take shares. X Ltd, therefore, pays out £720,000 to those bond-holders wanting cash. To those requiring shares, it issues its own shares which have a market value of £480,000.
The security should be treated as two separate debtor loan relationships, with S653 applying to one part of it, and S654 to the other. The amounts assigned to the embedded option, and to the host contract, on initial recognition should be apportioned rateably.
Looking at the 60% of the security that is cash-settled, CV will be £30,000 (60 per cent x £50,000) and X will be £120,000 (60 per cent x £200,000). So X Ltd will have a capital loss of £90,000.
The issue of the shares is a ‘relevant disposal’ under S653, so S654 will not apply to the 40 per cent of the security settled in this way. The share issue has no tax consequences.
X Ltd will still get relief for the loan relationship debits of £50,000 shown in its accounts - the implied cost of financing.