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CTA09/S665, 666

References to a standard convertible are to instruments where the holder has the option to convert the loan instrument into a fixed number of ordinary shares and without any cash-settlement options.

Accounting treatment for the issuer of a standard convertible

A standard convertible will normal be a compound financial instrument in the hands of the issuer. The issuer company would therefore be required to account for two components of the issue separately, a liability component and a residual equity component. See CFM21200 for further guidance on the accounting for 鈥榣iability鈥� and 鈥榚quity鈥� and the treatment of 鈥榗ompound financial instruments鈥�.

Tax treatment for the issuer of a standard convertible

For the issuer of a standard (鈥榩lain vanilla鈥�) convertible, the embedded obligation to convert the debt into its own shares will generally be a 鈥榯ax nothing鈥�, 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 鈥榯ax nothing鈥� because for accounting purposes, the potential obligation to convert is not classified as a derivative financial instrument at all. It is classified as an 鈥榚quity instrument鈥�, 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 鈥榚quity instrument鈥� does not rank as a 鈥榙erivative contract鈥� for the purposes of CTA09/PT7. It is therefore not taxable or relievable under either an income or chargeable gains code.

Note that:

• CTA09/S585 requires the option to be regarded as a relevant contract for the derivative contract rules (but it will not meet the conditions to be a derivative contract).
• CTA09/S415 treats the company as party to a loan relationship whose liabilities consist only of those of the 鈥渉ost contract鈥� from which the equity element has been separated.

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

Exceptional case: 鈥榗ash out鈥�

There is one, relatively rare, exception to the 鈥榯ax nothing鈥� rule. The issuer of a standard convertible security may 鈥榗ash settle鈥� the conversion obligation. This may happen where issuing the full amount of shares would exceed the company鈥檚 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/S665 applies S666 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. (It follows that S666 can only 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 鈥榚xcluded bodies鈥� 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 鈥榮tandard鈥� (鈥榩lain vanilla鈥�) convertible in the first place, but non-standard. For the tax treatment of the issuer of a 鈥榥on-standard鈥� convertible under CTA09/S652 to S655, see CFM55420.

Allowable loss treated as accruing

Under S666, a 鈥榥ormal鈥� 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 鈥楢鈥� exceeds 鈥楤鈥�, 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 鈥榟ost contract鈥� 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.

鈥楬ost contract鈥� 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.