Derivative contracts: issuers of convertible or share-linked securities: option lapses - example
Option on a non-standard convertible/exchangeable security lapses: 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 into its own ordinary shares. It is a ‘non-standard’ convertible because the terms permit the option, if exercised, to be cash settled. On 31 December 2009 the conversion shares are only worth £975,000. The holder abandons the option and X Ltd redeems for cash at par, £1million.
X Ltd is required to account separately for the loan and the embedded option. Using the principles outlined at CFM37650, suppose it attributed 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||£60,000|
|31 December 2008||£20,000|
|31 December 2009||£Nil|
For the 3 periods to 3 December 2009 X Ltd accordingly brings in:
- a debit of £10,000;
- a credit of £40,000; and
- a credit of £20,000
reflecting the amount by which its obligation has become greater or less.
The above debits and credits must be adjusted out in the corporation tax computations. This is because CTA09/S655 disapplies income treatment. Instead S655 computes a chargeable gain, but only for the terminal period to 31 December 2009.
The expiry of the option is treated for capital gains purposes as a disposal of an asset.
The gain is the amount by which the initial carrying value of the option, here £50,000 exceeds the amount paid to redeem the entire security (£1m) reduced by the fair value of the loan element (also £1million). This gives a chargeable gain of £50,000 (50,000 - [1,000,000 -1,000,000]). This might be thought of as X Ltd having received a £50,000 ‘windfall’ for granting an option that was never exercised. Overall, the company has an income loss of £50,000 on the host contract, and a capital gain of £50,000 on the option element.
It is not normally possible for the issuer to make an allowable loss under S655(1). If the terminal carrying value of the option were any positive amount, it would be ‘in the money’ and so not abandoned by the holder. Should the holder of a convertible who is connected with the issuer decline to exercise a valuable conversion option, the application of CTA09/S695 may need to be considered.