Convertibles and Exchangeables in an IAS World - Part Two
The tax treatment of issuers of convertibles and exchangeables is to some extent dependent upon the accounting treatment that the issuer adopts in its accounts. A convertible security will be bifurcated into a host contract and either an equity instrument or an embedded derivative. The conversion right would be treated as an equity instrument, broadly, where the security is convertible into a fixed number of shares and the issuer is not required to, and nor does it have an entitlement to, cash settle the conversion right (i.e. to make a payment to the holder equal to the then market value of the shares, as opposed to issuing shares). In other cases the conversion right will be treated as an embedded derivative. In the case of an exchangeable, the exchange right in all cases will be treated as being an embedded derivative.
On issue, the consideration received for the security will be split between the host contract and an equity instrument or embedded derivative. Any amount that is attributed to an equity instrument will not be revalued in the issuer’s accounts. The value of the equity conversion right will be determined by discounting the compound instrument (i.e. non-bifurcated security) by the interest rate which would have been payable had the security not contained an equity conversion feature. Once the initial carrying value of the host contract has been determined, the difference between this value and the issue price of the security is treated as being either an equity instrument or an embedded derivative, as the case may be. The difference between the deemed issue price of the host contract and the amount payable on redemption of the security is brought into account in the issuer’s accounts on an amortised cost basis over the life of the security and the issuer is able to obtain relief for this discount in computing its profits for the purposes of the loan relationships legislation.
Where a company first begins to prepare its accounts in accordance with IFRS or FRS 25 and FRS 26, the opening value of the host contract and the embedded derivative is determined on the basis that the security had been bifurcated at the time of its issue and had been accounted for from that time onwards on the same basis as is applied from the start of its first accounting period beginning on or after 1 January 2005. This thus means that the opening value of the host contract will reflect the discount that has been amortised to date, while the opening value of the embedded derivative (where relevant) will be its market value at the start of that accounting period.
Where an equity conversion right is treated as an equity instrument in the issuer’s accounts, this will be disregarded for tax purposes in all cases.1
Where the conversion or exchange right is treated as being a derivative financial instrument, as in the case of the holder, the embedded derivative is brought within the derivative contracts legislation2. Where certain conditions are satisfied, however, it is intended that any profits or losses arising on the embedded derivative, as reflected in the issuer’s accounts, will be ignored for the purposes of the derivative contracts legislation. These conditions are:
As drafted, paragraph 45J only prevents any profit or loss arising on the embedded derivative from being taken into account in computing a company’s non-trading debits and credits for the purposes of the derivative contracts legislation. It is assumed that this is a drafting error. Nevertheless, it is unlikely that a company that is not carrying on a financial trade will be considered to be a party to the embedded derivative for the purposes of its trade, given that the subject matter of the embedded derivative is shares (and in the case of a convertible, the company’s own shares).
Where the above conditions are satisfied and a company issued the convertible or exchangeable security before the start of its first accounting period beginning on or after 1 January 2005 it is intended that any gains or losses arising on the embedded derivative will be ignored for the purposes of the derivative contracts legislation and will not otherwise be brought into account for tax purposes.4
Where the above conditions are satisfied and a company issued the convertible or exchangeable security in an accounting period beginning on or after 1 January 2005, in certain cases the initial carrying value of the embedded derivative will be taken into account in computing the company’s chargeable gains or allowable losses for the purposes of corporation tax on chargeable gains. This is considered further in the following paragraphs.
Where an embedded option is exercised and as a result the issuer issues its own shares to the holder of the security, or is required to transfer shares in another company to that person, section 144(2) of the Taxation of Chargeable Gains Act 1992 applies5 such that the initial ‘grant’ of the embedded option and the issue or transfer of the shares are deemed to be a single transaction. Where the issuer issues its own shares the result is that the premium for the “grant” of the embedded option will be ignored for tax purposes (on the basis that the issue by a company of its own shares is not a chargeable transaction). In such cases the issuer, in its accounts, will treat itself as having ceased to be a party to the host contract at the value at which the host contract was carried at the date of conversion, such that no profit or loss will arise on the host contract as a result of the conversion.
Where the issuer transfers shares in another company the initial carrying value of the embedded option will be included in computing the chargeable gain or loss arising on the disposal of the shares in question.6
Where the conversion or exchange option is exercised and the issuer discharges its obligations in respect of the security by making a cash payment to the holder, it is intended that a chargeable gain or an allowable loss will arise equal to the initial carrying value of the embedded derivative less the amount by which the amount that the issuer paid to discharge its obligations under the security as a whole (i.e. ignoring the bifurcation) exceeded the issue price of the security.7 In effect, therefore, the chargeable gain arising in respect of the embedded derivative will be reduced (and can be converted into an allowable loss) by any premium paid to redeem the security.
Where the debtor loan relationship comes to an end without the option having been exercised, the holder is deemed to realise a chargeable gain equal to the initial carrying value of the embedded derivative irrespective of the amount paid to redeem or repurchase the security. This chargeable gain will arise in the accounting period in which the security is redeemed or repurchased.8
Where a convertible or exchangeable is repurchased early, in certain cases the issuer could be liable to tax on a chargeable gain which exceeds its income deduction on the host contract. For example, assume that a security was issued during a company’s first accounting period beginning on or after 1 January 2005 and that the security was bifurcated into a host contract of 80 and an embedded derivative of 20. After two years the security is repurchased by the company at 105. Assume also that 10 had been recognised up to the date of the redemption in respect of the host contract.
On the above facts the issuer would have obtained income relief on the host contract of 10 and would be liable to tax on a chargeable gain of 20. It would get no relief for the premium it paid to repurchase the security. What is needed to avoid this anomaly arising is to restrict the chargeable gain which arises in respect of the embedded derivative to an amount equal to the discount which has been recognised up to the date of the redemption or repurchase in respect of the host contract and to take into account any premium which is paid to redeem or repurchase the security whether or not the redemption occurs as a result of the exercise of an option.
Where a company prepares its accounts in accordance with IFRS or FRS 25 and FRS 26 and it redeems or repurchases a convertible or exchangeable security, an amount of the repurchase price equal to the then market value of the host contract will be allocated to the host contract and the balance of the consideration will be allocated to the equity instrument or embedded derivative. Any consideration that is allocated to the host contract will be taken into account in computing its profits or losses for the purposes of the loan relationships legislation. Any consideration that is allocated to an equity instrument will be disregarded for tax purposes. Any consideration that is allocated to an embedded derivative will also generally be ignored where the above conditions are satisfied.9 In other cases any payment that is allocated to the embedded derivative will be taken into account in computing the issuer’s profits or losses for the purposes of the derivative contracts legislation.
This provision can be contrasted with the treatment that applies for accounting periods which began before 1 January 2005. Where an issuer redeemed a convertible or exchangeable security at a premium in such an accounting period the premium would be taken into account in computing its loan relationship profits. If an issuer is considering redeeming or buying back convertible or exchangeable securities at a premium and it is not yet in the new regime then from a tax perspective it would be preferable to do this before it comes into the new regime so that is can obtain tax relief for the redemption premium.
As in the case of a holder, transitional provisions will apply for the purposes of the loan relationships legislation to pick up the difference between the value of the host contract under IAS 39 or FRS 26 as compared to its closing value under old UK GAAP where such difference has not been included as a prior year adjustment in the issuer’s accounts for its first accounting period beginning on or after 1 January 2005.10 This will produce a credit in most cases, as the carrying value of the host contract will typically be lower than the amount payable to redeem the security. This difference, however recognised, will be left out of account for a company’s first accounting period beginning on or after 1 January 2005, except to the extent that the issuer recognises a discount on the host contract in its accounts.11 The treatment that will apply for subsequent accounting periods is not clear. The author hopes that the transitional adjustment in subsequent accounting periods might reverse in line with the basis on which the issuer recognises discount on the host contract its accounts. Assuming that this treatment were adopted, the result is that, in effect, the issuer would be unable to obtain relief for any discount that it reflects in its accounts in respect of the host contract but at the same time it would not be liable to tax on any difference between the carrying value of the loan relationship under old UK GAAP and its opening value under IAS 39 or FRS 26.
As noted above, where certain conditions are satisfied any profits or losses arising on the embedded derivative will be disregarded for the purposes of the derivative contracts legislation.
Where a company is a party to an embedded derivative for the purposes of its trade, it is intended that any difference between the closing value of the derivative under old UK GAAP (generally nil) and the opening value of the embedded derivative under IAS 39 or FRS 26 would be brought into account for the purposes of the derivative contracts legislation.12 As mentioned above in the case of a holder it is doubtful that paragraph 50A of Schedule 26 to the Finance Act 2002, as drafted, achieves this effect as the issuer would not have been a party to the embedded derivative before the start of its first accounting period beginning on or after 1 January 2005. Whatever way in which the difference is brought into account for tax purposes, the intention is that the difference will be left out of account for the issuer’s first accounting period beginning on or after 1 January 2005 and currently would be taken into account in computing its taxable profits for its accounting period beginning on or after 1 January 2006.113
1 This is because although the equity instrument is treated as a “relevant contract” for the purposes of FA 2002, Sch. 26 by FA 1996, s.94A, it will not be a derivative financial instrument for the purposes of IAS 39 or FRS 26 and thus it will fail the accounting test and therefore will be excluded from the derivative contracts legislation: FA 2002, Sch. 26, para. 3(1)(a). Where a company prepares its accounts in accordance with IFRSs and thus IAS 39, or in accordance with FRS 26, in each case IAS 39 and FRS 26 respectively will be the successor standard to FRS 13 and thus whether or not a contract falls to treated as a derivative financial instrument has to be judged by reference to that accounting standard: FA 2002, Sch. 26, para. 3(4).
2 FA 2002, Sch. 26, para 5A.
3 FA 2002, Sch. 26, para. 45J(1)-(3).
4 FA 2002, Sch. 26, paras 1(2) and 45J(3), (4).
5 FA 2002, Sch. 26, para. 45J(3), (5).
6 FA 2002, Sch. 26, para. 45J(3), (5).
7 FA 2002, Sch. 26, para. 45J(3), (7), (8).
8 FA 2002, Sch. 26, para. 45J(3), (9).
9 On the basis that the issuer was a party to the convertible or exchangeable securities before the start of its first accounting period beginning on or after 1 January 2005 or, in other cases, because any premium paid to redeem convertible or exchangeable securities is not taken into account in computing the chargeable gain arising in respect of the embedded derivative unless the redemption arises as a result of the exercise of an option (see above).
10 FA 1996, Sch. 9, para. 19A. Where the difference is reflected in the issuer’s accounts as a prior year adjustment, this will be taken into account in computing its loan relationships profits under FA 1996, s.85B(1)(b).
11 The relevant regulations actually refer to the credit that is brought into account for that accounting period being equal to the debits (other than in respect of interest payable) that are recognised on the host contract in that accounting period: SI 2004/3271, regs 3, 4.
12 It is intended that where the difference is recognised as a prior year adjustment in the company’s accounts for its first accounting period beginning after 31 December 2004, the difference would be picked up in this way (FA 2002, Sch. 26, para 17B(1)(b)). In other cases the difference will be picked up under a specific transitional provision (FA 2002, Sch. 26, para 50A).
13 SI 2004/3271, reg. 3.