CFM82320 - Old rules: convertibles pre 2005: rules for issuing company

Accounting treatment

This guidance applies to periods of account beginning before 1 January 2005

Where the security was a true convertible, that is the debt would convert into shares of the issuing company, the accounting treatment followed FRS4 (now largely withdrawn following the implementation of IAS). No profit or loss would be shown on conversion. The adjustments to be made for tax purposes would therefore be restricted to any costs of issue that passed through the P&L.

Where

  • the security could be exchanged for shares in another company, and
  • it was clear that those shares would cost in excess of the amount payable on the debt

then the issuing company might have recognised this increased liability and accrue an amount. That recognition of a possible further liability might have passed through the P&L and would need to be adjusted for.

Tax effect of S92A: example

A Ltd issued a loan note for £500,000 on 1 January. The term of the loan was 2 years. The rights attached to the note allowed the holder to exchange the loan for 50,000 £1 shares in C Ltd. B Ltd subscribed for the loan note.

Shares in C Ltd rose in value so that at the end of Year 1 they were worth £15. On the loan redemption date the shares were worth £13. B Ltd therefore opted to exchange the debt for shares.

A Ltd did not own shares in C Ltd. It therefore had to buy the shares to be able to fulfil its obligations under the loan agreement. The shares cost £650,000 to buy.

A Ltd had a 31 December accounting period. Its accounts would initially record the debt at £500,000. At the end of Year 1 it would have to pay £750,000 for the shares. Because they were worth more than the loan, B Ltd was likely to exercise its right to exchange. A Ltd could, therefore, choose to recognise this increasing obligation in its accounts by accruing an additional £250,000.

At the end of Year 2 the value of the shares had fallen by £100,000 so that amount would be reversed - again through P&L. Any additional costs of acquiring the shares in B Ltd would be taken to P&L as a cost of redeeming the debt.

The legislation would have disallowed the debit in the P&L of £250,000 in Year 1, ignoring the credit of £100,000 and would disallow any further debits for costs of acquiring the shares in Year 2. There were certain exceptions for banking and similar businesses - see CFM82330.