Convertibles and Exchangeables in an IAS World - Part One
For accounting periods beginning on or after 1 January 2005, companies which prepare consolidated accounts and which have securities that are admitted to trading on a regulated market of any EU member state are required to prepare their consolidated accounts in accordance with international financial reporting standards (IFRS). Such companies may also prepare their individual accounts in accordance with IFRS. Other companies are also permitted to prepare their individual or consolidated accounts in accordance with IFRS.
At the same time, a company that has securities that are admitted to trading on a regulated market of any EU member state and which prepares its accounts in accordance with UK generally accepted accounting practice (UK GAAP) is required to prepare its accounts in accordance with FRS 23 to FRS 26. FRS 25 incorporates the provisions of IAS 32 into UK GAAP while FRS 26 incorporates the provisions of IAS 39 (except the derecognition provisions which apply to previously recognised financial assets and liabilities). This article considers the tax and accounting treatment that applies where a company prepares its accounts in accordance with IFRS or FRS 25 and 26. It first considers the position of a holder and then considers the tax treatment of an issuer.
The tax treatment which applies to a holder depends in part on the accounting treatment which it applies in its accounts. Where a holder accounts for a convertible or an exchangeable as a financial asset at fair value through profit and loss, with profit or loss being taken to its income statement (the IFRS equivalent of a profit and loss account) where it prepares its accounts in accordance with IFRS, or its profit and loss account where it prepares its accounts in accordance with UK GAAP, it will not be required to separate the security into a host contract and an embedded derivative. A company may also adopt such accounting treatment where it is not holding a convertible or an exchangeable as a trading asset. Where a company adopts this accounting treatment its accounting treatment will generally be followed for tax purposes with the result that any gains or losses arising on the convertible or exchangeable security, as recognised in its income statement or profit and loss account, will be taken into account in computing its loan relationship profits.
Where a holder does not account for a convertible or an exchangeable at fair value through profit and loss it will be required to bifurcate the convertible or exchangeable into a host contract, which will be dealt with under the loan relationships legislation, and an embedded derivative which will be dealt with under the derivative contracts legislation.1 Where a company is a party to the host contract otherwise than for the purposes of its trade2, the holder is not an authorised unit trust, investment trust, open-ended investment company, or a venture capital trust and the security carries rights of conversion or exchange into certain ordinary shares or mandatory convertible preference shares (these are shares which have to be converted into ordinary shares within 24 hours of the time at which they are issued) and certain other conditions are satisfied, any profits or losses arising on the embedded derivative will be treated as chargeable gains or allowable losses for the purposes of corporation tax on chargeable gains, on the basis on which such profits or losses are recognised in the holder’s accounts in accordance with IFRS or UK GAAP.3 In such cases, the host contract is not treated as a qualifying corporate bond and thus will be a chargeable asset for the purposes of corporation tax on chargeable gains.4 At the same time, the holder will be liable to tax under the loan relationships legislation on the difference between the initial carrying value of the host contract and the amount payable on redemption as this discount is amortised in its accounts over the life of the host contract.5 This discount will in all cases be treated as being an income profit.
For example, assume a company acquires a convertible security on issue for £1000, and if conversion does not take place the security will be redeemed for £1000. In its accounts, the company records the initial carrying value of the host contract at £900 with £100 being treated as the initial carrying value of the embedded derivative. In this case, the holder will be liable to tax on the ‘discount’ of £100 (being the difference between the initial carrying value of the host contract and the amount payable on redemption) under the loan relationships legislation on the basis on which it is recognised in its accounts. Were the holder to hold the security until redemption, any profits or losses arising on the embedded option were treated as chargeable gains or allowable losses, and the option were to expire unexercised, over the life of the option it would have suffered a capital loss of £100 which, unless it has chargeable gains against which the loss can be relieved, is of little value.
Where for an accounting period a holder of a convertible or exchangeable security is connected with the issuer for the purposes of section 87 of the Finance Act 19966 any profits or losses arising on the embedded derivative will not be eligible to be treated as chargeable gains or allowable losses. Further, the holder will be denied relief for any loss arising on the embedded derivative in that accounting period, even if this loss does not exceed any cumulative net profits that have been included in computing the taxable profits arising on the embedded derivative in earlier accounting periods.7
Where a company is a party to an exchangeable or convertible for the purposes of its trade, as mentioned above, it would generally account for the security at fair value through profit and loss and thus would not bifurcate the security. In such cases the shares that it acquires would normally be deemed to have been acquired at the market value of the loan relationship as at the date of conversion or exchange under general principles. Generally any profits or losses arising on the shares would be included in computing the holder’s Schedule D Case I trading profits on the basis on which such profits or losses are recognised in its accounts.
Where a company holds a convertible or exchangeable security otherwise than for the purposes of its trade, the security is bifurcated into a host contract and an embedded derivative in its accounts and profits or losses arising in respect of the embedded derivative are treated as chargeable gains or allowable losses, there is no provision to prevent double counting of chargeable gains and allowable losses which have arisen on the embedded derivative. One clear case where such double counting would arise would be where a convertible security is converted into shares. In such cases under section 132 of the Taxation of Chargeable Gains Act 1992 the holder would be deemed to have acquired the shares for a consideration equal to the price which it paid to acquire the non-bifurcated security. There is currently no provision for the gain or loss arising on the disposal of the shares to be adjusted for any chargeable gain or allowable loss which has been brought into account in respect of the embedded derivative. The same double counting issue can arise even where section 132 does not apply. It is to be hoped that the Inland Revenue can be persuaded to introduce suitable provisions to prevent such double counting. If not this is likely to prove an issue for life insurance companies, being the companies who are most likely to hold convertible and exchangeable securities for investment as opposed to trading purposes.
Transitional Provisions – Loan Relationships
Where a company was a party to a convertible or an exchangeable otherwise than for the purposes of its trade in an accounting period beginning before 1 January 2005 and certain conditions were satisfied, any gain or loss arising on the disposal of the convertible (excluding any exchange movements and accrued interest) was treated as giving rise to a chargeable gain or an allowable loss for the purposes of corporation tax on chargeable gains.8 Where a convertible or exchangeable security was so treated, special transitional provisions apply. Under these provisions, the holder is deemed to have disposed of the security immediately before the start of its first accounting period beginning on or after 1 January 2005 for an amount equal to the value at which the security would have been carried in its accounts at that time had it always accounted for the security using the accounting method used in the following accounting period.9 Typically, such a holder would account for a convertible or exchangeable security as an available for sale asset and such assets have to be carried at fair value. In this case, any growth in value of the security over its acquisition cost up to the start of the holder’s first accounting period beginning on or after 1 January 2005 would be treated as giving rise to a chargeable gain, which will be brought into account for tax purposes when the holder disposes of the security.
A mismatch could arise, however, where the holder accounts for the security under IAS 39 or FRS 26 as a held to maturity asset. In this case, it would account for the security on an amortised cost basis. The result of this is that any increase in the market value of the security over its acquisition cost would not necessarily be treated as a chargeable gain or an allowable loss, particularly where there was little difference between the carrying value of the security under “old” UK GAAP (i.e. excluding FRS 25 and FRS 26) as compared to its value under IAS 39 or FRS 26 using an amortised cost basis.
The same issue could arise where the holder is not required to adopt IFRS or FRS 26 from the start of its first accounting period beginning on or after 1 January 2005. In such cases, the carrying value of the security at the start of its first accounting period beginning on or after 1 January 2005 would be the value at which the security was carried in its accounts immediately before that time, which typically would be the acquisition cost of the security. Further, there is no interaction between this transitional provision and the transitional provisions which apply for the purposes of the derivative contracts legislation and thus double counting could arise in respect of any held over gain.
Additional transitional provisions apply in all cases to pick up the difference between the opening value of the host contract at the start of the holder’s first accounting period beginning on or after 1 January 2005, and the carrying value of the security at the end of the previous accounting period, to the extent that these have not already been reflected in the holder’s accounts for that period as a prior year adjustment.10
Originally it was proposed that any difference, whether reflected as a prior year adjustment or under the specific transitional provision, would generally be brought into account in determining the holder’s taxable profits for its first accounting period beginning on or after 1 January 2005. Provision was introduced by regulation, however, in December 2004 to provide that any difference, however recognised, would not be taken into account in computing a holder’s taxable profits for its first accounting period beginning on or after 1 January 2005 and instead would be taken into account in computing a company’s loan relationship profits for its first accounting period beginning on or after 1 January 2005. There is an exception to this rule which applies in the case of bifurcated securities such as exchangeables and convertibles and in such cases where a transitional loss arises (as would typically be the case where a creditor loan relationship is bifurcated), an amount of the transitional loss will be brought into account in computing the holder’s taxable profits for its first accounting period beginning on or after 1 January 2005 equal to the credits (apart from interest receivable) which are recognised in respect of the host contract in that accounting period.11 In effect, this should result in the amount of the transitional loss which is brought into account for that accounting period being equal to the discount which is recognised on the host contract in that accounting period.
The derivative contract legislation contains transitional provisions which apply where there is a difference between the closing value of a derivative contract at the end of a company’s last accounting period beginning before 1 January 2005 and the start of its first accounting period beginning on or after that date and this difference is not reflected as a prior year adjustment in the holder’s accounts for its first accounting period beginning on or after 1 January 2005.12 It is doubtful that paragraph 50A as currently drafted would apply to an embedded derivative given that the embedded derivative would not have “existed” before the start of a company’s first accounting period beginning on or after 1 January 2005. Even if such transitional provisions are capable of applying, any difference will be disregarded in computing a company’s derivative contracts profits for its first accounting period beginning on or after 1 January 2005 and instead will be taken into account in computing its taxable profits for its first accounting period beginning on or after 1 January 2006 unless provision is made to the contrary. The same applies where this difference is included as a prior year adjustment in the company’s accounts.13 Where any profits or losses arising on an embedded derivative are treated as chargeable gains or allowable losses (see above) any transitional adjustment will be similarly treated.
Assuming that this transitional provision is capable of applying it would appear that, where a holder acquired a security after the date of its original issue, the amount of the transitional gain on which it is assessed to tax could exceed its actual gain in respect of the embedded derivative to the start of its first accounting period beginning on or after 1 January 2005. This is because, as drafted, the transitional adjustment would bring in a gain equal to the carrying value of the embedded derivative at the start of that accounting period, as opposed to the actual gain that has arisen in respect of the embedded derivative in the period that the company had been a party to the creditor loan relationship (for example where it had paid a premium to acquire the loan relationship, such premium being attributable to the conversion or exchange option embedded in the security). A similar problem could arise where the company acquired a security at a premium and the value of the security fell before the start of its first accounting period beginning on or after 1 January 2005. Here, in addition to the transitional gain issue, the gain on which it is assessed to tax under the new regime would be greater than its economic gain.
Also, there is currently nothing to prevent double counting of any transitional gain or loss which arises in respect of an embedded derivative to the extent that such gain or loss has been taken into account in determining the held over capital gain or loss which arises on a convertible security which fell within section 92 of the Finance Act 1996.
The second part of this article – to be published soon on gtnews – will cover the tax treatment of issuers.
1 FA 1996, s.94A. Normally a derivative contract whose underlying subject matter consists of shares is excluded from the derivative contracts legislation. This exclusion is disapplied where a derivative is bifurcated from a loan relationship: FA 2002, Sch. 26, para 5A.
2 There is an exception to this rule where a company is an insurance company or is carrying on a mutual trade. In such cases this restriction does not apply: FA 2002, Sch. 26, para. 45D(2)(a), (3).
3 FA 2002, Sch. 26, paras 45A, 45D, 45E. The other conditions which have to be satisfied are closely modelled on FA 1996, s.92, which applied to certain convertible securities for accounting periods which began before 1 January 2005. Where such conditions are satisfied and the holder satisfies the requirements for substantial shareholding relief any profits or losses arising on the embedded derivative are disregarded for tax purposes: FA 2002, Sch. 26, para. 45A(6).
4 FA 2002, Sch. 26, para. 45D(8).
5 FA 1996, s.94A.
6 The two companies will be connected for an accounting period for the purposes of this section where at any time during that accounting period either one company controls the other or both companies are under the control of the same third person.
7 FA 2002, Sch. 26, paras 45E(5), 48A.
8 FA 1996, s.92.
9 FA 2004, Sch. 10, para. 9.
10 FA 1996, Sch. 9, para. 19A. Where the difference is reflected in the company’s accounts for its first accounting period beginning on or after 1 January 2005 as a prior year adjustment, this will be included in computing its taxable profits for the purposes of the loan relationships legislation under FA 1996, s.85B(1)(b).
11 SI 2004/3271, regs 3, 4(1), (2), (6).
12 FA 2002, Sch. 26, para. 50A. Where this difference is taken into account as a prior year adjustment it will be included in computing the holder’s derivative contracts legislation profits under FA 2002, Sch. 26, para. 17B(1)(b).
13 SI 2004, 3271 regs 3, 4(1).