CFM55260 | Holders of convertible or share-linked securities: embedded derivatives which are options: example

This example applies to periods of account beginning on or after 1 January 2005. It concerns a case where a company bifurcates a loan asset under IAS 39 or FRS 26. Bifurcation is not permitted for financial assets under FRS 102 (unless IAS 39 is applied) or IFRS 9. For further details of the accounting permutations see CFM52215.

Example of chargeable gains treatment for holder of an embedded option

Abacus Ltd accounts to 31 December. On 1 January 2006 it subscribes for a 3 year security issued by X plc at par £1million, carrying interest at 5 per cent. It redeems for cash of £1million or, at the option of Abacus, is convertible into 10,000 ordinary £10 shares in X plc. On 31 December 2008 X plc’s shares are worth £110 per share. Abacus therefore exercises the conversion option and acquires 10,000 X plc shares worth £1,100,000. Its commercial profit from the option is therefore £100,000 (£1,100,000 less £1,000,000).

Abacus accounts separately for the loan and the option. For convenience, assume it ascribed an initial fair value to the option of £50,000. (IAS39 requires Abacus to fair value the derivative element of the hybrid instrument - the loan element is the residual amount of £950,000.)

Accounting and tax treatment of the loan element

Abacus will treat the loan as acquired for £950,000, a discount of £50,000 to its face value £1million. It accrues credits for the discount over the 3 year term. These credits are taxable under the loan relationship rules in addition to the interest receivable.

Accounting for the embedded option

For accounting purposes Abacus must recognise any changes in the option’s fair value at each balance sheet date. Assume the company considered the fair value to be:

Accordingly, in its accounts for the 3 periods to 31 December 2008, Abacus respectively brings in a credit of £61,000, a debit of £7,000, and a debit of £4,000.

Taxing the embedded option: CTA09/PART7/CHAPTER 7

The above credits and debits are taxable under the derivative contracts rules at CTA09/PART7. If the conditions for chargeable gains treatment are met, see CFM55220, the usual income treatment does not apply, and Abacus has a corresponding chargeable gain, or allowable loss, in each relevant accounting period.

Over the 3 year period Abacus has been taxed on net chargeable gains of £50,000 (£61,000 - 7,000 - 4,000). This represents the difference between its £100,000 commercial profit from the option and its £50,000 initial value on bifurcation. The remaining £50,000 of the overall £100,000 profit has been taxed as income under loan relationships, in respect of the notional issue discount.

Carry back of allowable losses

Abacus may be able to carry back the allowable losses for the periods to 31 December 2007 and 2008, see CFM55040.