In this quarter’s edition, we’ve already looked at convertible loan notes (CLNs) from the accounting point of view, but what about the tax implications? Head of Tax, Catherine Heyes explains.
When a non-derivative contract contains features that function the same way as a derivative, this is known as an ‘embedded derivative’. They can be accounted for separately from the host contract under IFRS 9. See our first article on CLNs. This can be known as bifurcation.
Loan relationships may contain embedded derivatives. Convertible and exchangeable securities are the most common ones. If a security can be converted into shares of the issuing company, or exchanged for shares in another company, it has the feature of both debt and equity. The tax implications depend on the accounting treatment.
Special rules
For debtor loan relationships which are bifurcated in a company’s accounts, special rules apply. Where an embedded derivative is treated as an equity instrument in the company’s accounts, the equity instrument is disregarded for tax purposes.
But tax relief can still be obtained for the discount recognised in respect of the host contract. It’s also possible for a company to obtain relief as a capital loss, where it redeems a convertible security at a premium.
Where the embedded derivative is treated as an option in a company’s accounts, profits or losses which the company recognises can, in certain circumstances, be disregarded.
Instead, the gain or loss arising on the embedded derivative is determined when the company ceases to be a party to the loan relationship. In the case of a convertible security where these provisions apply and conversion takes place, no non-trading credits or debits are recognised in respect of the embedded derivative.
What is the tax treatment for holders?
For companies required to bifurcate under an applicable accounting standard, the host contract is taxed as a loan relationship and the embedded derivative is taxed as if it were a derivative contract.
For companies that don’t need to bifurcate, the whole contract, including the embedded derivative, falls within the loan relationship rules. Where there are two or more embedded derivatives of different types, the position is more complicated.
In the financial statements, if an embedded derivative is separated from a loan relationship, the profits and losses arising on the embedded derivative are usually taxed as income.
In some exceptions, the embedded derivative is subject to tax as capital. In particular, for listed companies, these exceptions apply in two cases. Firstly, where it is treated as an option under s.585(3) CTA 2009 in respect of ordinary shares of a listed company. And, secondly, where it is treated as a contract for differences (under the same section of the Act) and is an exactly tracking contract, whose underlying subject matter is ordinary shares of a listed company.
Interest – don’t forget withholding tax
Often a CLN will include a provision to accrue interest to the noteholder. If the conversion includes any accrued interest being settled by issuing shares, this constitutes effective payment of the interest.
A UK tax resident company must withhold 20% on payments of interest unless it’s possible to reduce this. This means that when payment takes place through a share issue, a dry tax charge may arise for the paying company. Other countries also have withholding tax rules on payments of interest.
It’s important to be aware of wider situations related to the 20% withholding:
- No withholding is required on ‘short’ loans or on payments between UK companies that are UK tax resident, or those that have a UK permanent establishment through which they trade if resident overseas.
- Payments made to UK tax resident individuals will always be withheld at 20%.
- The 20% rate can be reduced or eliminated where the noteholder is resident in a country which has a suitable double taxation agreement with the UK.
- If the CLN is listed on a recognised stock exchange or admitted to a multilateral trading facility it will be exempt from withholding. This can be achieved, for example, by listing the debt on LSE or the AQSE Main Market. Note that AIM does not qualify for this purpose.
Sometimes a gross-up clause is included in a CLN agreement. This requires interest to be physically paid to the noteholder as if no withholding were applicable. This ensures that the noteholder receives an amount after taxes equivalent to what they would have done if no withholding was imposed.
It’s important to consider and discuss this scenario when entering into any agreements, in order to plan cash flow implications.
If you are looking at potential CLN arrangements, or have existing ones that you would like to discuss, please contact Catherine Heyes.
