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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Derivative contracts: issuers of convertible or share-linked securities: securities containing equity instruments

Issuers of securities with embedded derivatives: equity instruments

Accounting and tax treatment for the issuer of a standard convertible

For the issuer of a standard (‘plain vanilla’) convertible, the embedded obligation to convert the debt into its own shares will generally be a ‘tax nothing’, giving rise to no taxable debits or credits under either an income or chargeable gains code. This mirrors the prescribed accounting, which does not recognise any change in the value of the obligation whether during the life of the security, or on conversion or expiry of the option. So for the issuer, the embedded instrument can generally be ignored for tax purposes.

It is a ‘tax nothing’ because for accounting purposes, the potential obligation to convert is not classified as a derivative contract at all. It is classified as an ‘equity instrument’, for which a different accounting treatment is prescribed. This reflects the fact that an obligation to issue own shares is not regarded as a financial liability, see CFM21250. Equally an ‘equity instrument’ does not rank as a ‘derivative contract’ for the purposes of CTA09/PART7. It is therefore not taxable or relievable under either an income or chargeable gains code.

CFM55520 provides an example of the normal accounting and tax treatment of the issuer of a standard convertible.

Exceptional case: ‘cash out’

There is one, relatively rare, exception to the ‘tax nothing’ rule. The issuer of a standard convertible security may ‘cash settle’ the conversion obligation. This may happen where issuing the full amount of shares would exceed the company’s authorised share capital, or where the terms of the security permit cash settlement in exceptional situations. If that happens, CTA09/S666 may allow the issuer to compute a one-off capital loss. That loss is equal to the excess, if any, of the amount paid to settle the option over its initial fair value. See the example at CFM55530.

CTA09/S666 applies to a company for an accounting period if each of the following conditions is met.

  • Condition A: The company is treated as a party to a relevant contract under S585(2) (loan relationships with embedded derivatives) because of a debtor relationship of the company (so it applies to issuers).
  • Condition B: The division mentioned in S585(1) in the case of the debtor relationship is between rights and liabilities under (a) a loan relationship, and (b) an equity instrument of the company.
  • Condition C: The relevant contract is treated as an option by S585(3) (contract treated as option, future or contract for differences). Here you ignore S580(2) and (3).
  • Condition D: The company pays an amount in the AP to the creditor in discharge of any obligations under the debtor relationship. So here the issuer gives the holder cash instead of shares. There is no requirement for all of the obligations to be discharged in this way - the condition will be satisfied if holders receive shares plus cash.
  • Condition E: at the time when the company became a party to the debtor relationship it was not carrying on a banking business or a business as a securities house, or if it was carrying on such a business, it did not become a party to the debtor relationship in the ordinary course of that business.
  • Condition F: The company must not be 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).

This should not be confused with a case where the terms of the security permit cash settlement instead of physical delivery of shares, and as a result the issuer accounts for the security as a financial liability plus an embedded option. Such a security would not be a ‘standard’ (‘plain vanilla’) convertible in the first place, but non-standard. For the tax treatment of the issuer of a ‘non-standard’ convertible under CTA09/S652 to S655, see CFM55420.

Allowable loss treated as accruing

Under S666, a ‘normal’ CG loss arises (rather than the annual CG treatment under S641), being the cash paid out less the fair value of the equity instrument.

The legislation states that where ‘A’ exceeds ‘B’, an allowable chargeable loss equal to the amount of the excess is treated as accruing to the company in the AP.

  • A = The amount paid under condition D reduced (but not below nil) by an amount equal to the fair value of the ‘host contract’ at the time that amount is paid.
  • B = The amount treated as the carrying value of the relevant contract under condition C at the time the company became a party to the debtor relationship under Condition A.

‘Host contract’ means the loan relationship to which the company is treated as a party under S415(2) (loan relationships with embedded derivatives) because of the debtor relationship.