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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Old rules: disposal of a convertible security pre 2005: bringing foreign exchange differences into account example


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

Gurling plc is the parent company of a biotechnology group. Its accounting date is 31 December. In 2000, it took a minority stake in a joint venture to develop new strains of genetically modified cereals. The joint venture company, Wheatgene Inc, is incorporated in the USA. As well as issuing shares to the joint venturers, it issued securities convertible at the holder’s option into further shares of the company. This was so that, should the company become thinly capitalised, it would be relatively easy for the joint venturers to convert debt financing to equity.

Gurling plc held 7.5% of shares in Wheatgene Inc, and 7.5% of the convertible notes. Its total investment amounted to $12 million. It financed the investment through the issue of US dollar denominated commercial paper to a corresponding amount. Exchange differences on the investment and the liability were accounted for by the cover method. The convertible securities fulfilled all the conditions to come within FA96/S92.

On 1 October 2005, Gurling plc acquired a further interest in Wheatgene Inc. Subsequently, it holds 57.5% of the shares and 57.5% of the convertible securities, so that it controls the company. Thus for loan relationship purposes it is connected with Wheatgene Inc. and so by virtue of FA96/S92(1F), it ceases to be a S92 security and becomes a loan relationship.

FA96/S92(7) deems the convertible securities to be disposed of and re-acquired at market value. The chargeable gain or allowable loss that arises is held over until the convertible is disposed of.

Wheatgene Inc redeems the convertible securities in 2007.

Suppose that the following exchange gains and losses on the convertible have been taken to reserves each year:

Year ended 31 December 2000 Gain £12,400
Year ended 31 December 2001 Gain £115,800
Year ended 31 December 2002 Loss £347,500
Year ended 31 December 2003 Loss £211,900
Year ended 31 December 2004 Gain £84,000
1 January to 30 September 2005 Gain £265,200

Corresponding losses and gains are taken to reserves in respect of that portion of the borrowing that matches the convertible securities.

Calculation of the gain or loss on the deemed disposal of the asset

Were the convertible securities not matched, exchange gains and losses arising year ended 31 December 2003 and succeeding periods would have been brought into account for loan relationship purposes by virtue of S92(2). But because the convertible is matched, S84A(3) ensures that nothing is brought into account. No adjustment to the disposal consideration needs to be made under S92(5A). The overall exchange difference accruing up to 1 October 2005 is taken into account in the capital gains computation.

The deferred chargeable gain or allowable loss calculated is brought into account in the year ended 31 December 2007, when the securities are disposed of. From 1 October 2005, the convertible security is an ordinary loan relationship that is no longer within S92. If exchange gains and losses have continued to be taken to reserves, they will be brought back into account under Regulation 13 when the final disposal occurs.

Exchange gains or losses on the matching liability

In accounting periods beginning before 1 October 2002, a net exchange loss of £219,300 arose on the matched liability. This is brought into account as an allowable loss of £219,300 for the year ended 31 December 2005, in accordance with Regulation 4(1).

For accounting periods beginning after 1 October 2002, we look at what exchange gains and losses would have been brought into account on the asset had it not been for S84A(3), and use this as a measure of the adjustment to be made for the liability. A net loss of £137,300 arises on the asset between 1 January 2003 and 30 September 2005. Regulation 6(3)(b) brings into account a loan relationships credit of £137,500 for the year ended 31 December 2005.

Gains or losses on the matched liability arising between 1 October 2005 and the final disposal of the convertibles in 2007 will be brought into account as loan relationship debits or credits in the year to 31 December 2007, under Regulation 6(1)(a)