Finance and Treasury blog: Tax treatment of a group company which holds the convertible debt of another group company as an asset and accounts at fair value through profit and loss

Earlier this year, with my colleagues in the PwC Finance and Treasury Network, I spent some time discussing how a UK company which holds convertible debt issued by a related company (as defined by FA 1996 s87) should account, if it is preparing its accounts under IFRS or UK GAAP with FRS 26.

Assume that the debt is convertible into ordinary shares (equity) of the issuing company. Also, to avoid complications, assume that FA 1996 s87 is not overridden by the exemptions in s88 such as s88(2) for bond dealers or s88(3) for life assurance companies.

In most cases, I would expect such an asset to fall into the category of “loans and receivables” and to be accounted for at amortised cost. Accordingly, as there is an embedded derivative which is not closely related (being an option to convert into equity) the investing company would be required to bifurcate the loan asset. The conversion option being a derivative would be accounted for at fair value with differences taken to profit and loss (assuming it is not a hedging instrument) while the host contract, being the loan after splitting out the embedded option, would be accounted for at amortised cost.

However, what happens if instead the investing company accounts for its convertible loan asset at fair value through profit and loss? Such accounting is permitted under IFRS by exercising the fair value option upon initial recognition, in view of the existence of the embedded derivative. In this case, the entire instrument is marked to market, with no bifurcation of the embedded derivative.

Such fair value accounting is precluded for tax purposes by s87. As the convertible loan is between connected companies s87 requires the loan relationship to be taxed on the basis of amortised cost accounting. There seemed to be two ways this section could be applied:

(1) Apply amortised cost accounting to the whole instrument, given that the embedded option is not accounted for separately in the accounts.

(2) Even though the actual accounts of the company do not bifurcate the loan, assume for the tax computations that the loan has been bifurcated with only the host contract being accounted for under amortised cost accounting. This leaves open the issue of how the tax return should then treat the embedded derivative after bifurcation. FA 2002 sch 26 does not contain any equivalent of s87 imposing an accounting treatment, and as the company’s own accounting policy for derivatives under IFRS is to always carry them at fair value, one assumes this would be followed by the tax computations.

We concluded that, on balance, alternative (1) appeared more consistent with the language of the tax legislation in s87.

Alternative (2) appears to require too much deeming. As the company has in its actual accounting simply carried the whole loan asset at fair value, all that one needs to do to give effect to s87 is to prepare tax computations as if the whole loan asset was being carried at amortised cost. There is no reason to go further and say that, if the company was deemed to carry the loan asset at amortised cost, then it would also be deemed to bifurcate it as IFRS would then require.

As far as I can tell, the point is not addressed in the HM Revenue & Customs Inspectors’ Manuals. However, I understand that HMRC share the view that (1) above is the better reading of the legislation.