CFM55500 | Derivative contracts: issuers of convertible or share-linked securities: securities containing CFDs - example

Issuer of share-linked security

This example applies to periods of accounting beginning on or after 1 January 2005

Consider the example at CFM37650 from the point of view of the issuer, B Ltd. On 1 January 2007 B Ltd issues a 3 year security for £1million at 5 per cent interest, on terms that the redemption price exactly tracks the percentage change, over the 3 year term, in the value of the ordinary shares in its parent company X plc. At 1 January 2007 and 31 December 2009 respectively the X plc shares were worth £20 and £30 per share, representing an increase of 50 per cent. B Ltd must therefore pay the holder £1.5million to redeem the security.

Embedded derivative: accounting treatment

Assume B Ltd is required to account separately for the loan and the derivative. After taking into account its issue costs it attributes an initial fair value of, say, £48,000 to the contract for differences. It is required to recognise any subsequent changes in its fair value at each balance sheet date. Suppose it considered the fair value to be:

B Ltd will respectively bring in an accounting credit of £3,000, a debit of £355,000 and a debit of £100,000 for the 3 years to 31 December 2009, reflecting the amount by which its financial obligation under the derivative has decreased or increased.

Embedded derivative: tax treatment: CTA09/S656 to S658

Assuming the contract meets all the conditions for chargeable gains treatment at CFM55420, the normal income treatment of the derivative is disapplied by S639. All accounting debits and credits must therefore be removed from its corporation tax computations for each period including the last. B Ltd may compute a S658 chargeable gain, or allowable loss, but only in the period in which redemption occurs.

B Ltd’s allowable loss for the period to 31 December 2009 is the excess of the discharge amount £1.5million over the £1million issue proceeds. Its loss is therefore £500,000.

Suppose that instead of rising, the value of the X Plc shares fallen by 30 per cent over the life of the security, meaning that B Ltd only had to pay £700,000 to redeem the security. In that case B Ltd would have a S658 chargeable gain of £300,000.