EXPLANATORY NOTE

This clause amends the definition of "relevant discounted securities" to deal with a tax avoidance device which exploits a feature of the existing definition. The change will ensure that holders of discounted securities cannot escape an income charge on the discount by arranging an artificial option - which would never in practice be exercised - for the holder to redeem early at par. In future, the test for deepness of discount will be by reference to any occasion on which the security may be redeemed, except for redemptions triggered by a default which is unlikely to happen. This change will take effect from 15 February 1999, the date the change was announced.

Clause 60 is consequential on Clause 59. It deals with the case where a security which was not previously a qualifying corporate bond (QCB) becomes a QCB by virtue of Clause 59. The clause ensures that the appropriate capital gains tax treatment will follow, particularly where such a bond was previously acquired in exchange for other assets on a reorganisation.

The changes are being made to stop a tax avoidance scheme which exploited a weakness in the existing definition of relevant discounted securities.

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Subsections 1 and 2 change the definition of relevant discounted securities (RDS) in paragraph 3 Schedule 13 Finance Act 1996.

Subsection 1 inserts two new subparagraphs into paragraph 3 of Schedule 13 Finance Act 1996 to replace the existing subparagraphs (1) and (5), while subsection 2 repeals subparagraph (5).

The new definition in the revised paragraph 3(1) Schedule 13 considers every occasion on which a security might be redeemed and poses the question "If the security were to be redeemed on that occasion, would the amount payable involve a deep gain?" Whether a gain is deep or not depends on the difference between the redemption amount and the issue price and the time between the two.

This new rule is wider than the previous one. That considered only an amount payable on redemption, or, if there was the possibility of an earlier redemption at the option of the holder, the amount payable on the earliest such redemption.

The new paragraph 3(1A) allows an exception to the new rule that all possible redemptions are considered. The circumstance is where the holder has an option to redeem which arises only on a person’s default (for example the issuer may be unable to pay its debts as they arise which under the terms of a bond might trigger an event of default) and such a redemption is unlikely. This caters for bonds which may be issued at a small discount to par and which may be redeemed at par if a default event occurs at any time in their life.

Subsection 3 gives the general commencement date for the new section. It applies to any transfer of a security on or after 15 February 1999 (the date that the press release announcing the Government’s intention to legislate was issued).

Subsections 4 to 7 give the commencement date that applies to various provisions which use the main paragraph 3 definition of RDS. For the provisions which apply for corporation tax purposes the new definition applies for any accounting period of a company ending on or after 15 February but excludes any transfer or redemption of a security taking place before that date. Subsection 4 gives the commencement date for section 92 Finance Act 1996 (convertible securities held by companies) and subsection 5 for paragraphs 17 and 18 Schedule 9 FA 1996 (discounted securities issued to companies within a group, or by closely held companies)

Subsection 6 and 7 give the commencement date for capital gains tax provisions affected by the change in definition of RDS. The new definition applies to any disposal of an asset on or after 15 February, or in relation to a claim made on or after that day that a loan has become of negligible value.

Clause 60 deals with some capital gains consequences of the changes made by clause 59 to the definition of RDS.

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Discounted securities are those where the amount payable on redemption exceeds the issue price. They include zero coupon securities where no interest is paid, and other securities where some interest is paid but where some of the return to the holder comes through a discount or premium.

Generally under provisions enacted in 1984 and 1989 the profit represented by the discount on securities held by persons other than financial traders (such as banks) has been taxed only on redemption or transfer. When the loan relationship rules were enacted in 1996 the special rules for discounted securities applying to all holders were repealed. This is because under the new rules discount is always brought into account as it accrues year by year, and the old rules were inconsistent with this principle. But for holders other than companies, a new set of rules was introduced in Schedule 13 FA 1996. The securities within this regime are known as "relevant discounted securities" (RDS). Like the previous rules they generally charge the holder of discounted securities to tax only on redemption or transfer.

The new definition of RDS was not only used for taxing individuals and other non-corporate holders. It was also used in some of the loan relationship rules applying to companies. In particular it was used in the definition of convertible securities within section 92 FA 1996. This rule applies to holders of convertible securities and provides that any return on them other than interest is taxed under capital gains rules and so falls to be taxed only on disposal. But a security which is a RDS cannot be a convertible security within section 92.

Since 1996 schemes have been devised to exploit the section 92 rules by creating securities which are convertible within the meaning of section 92, which are discounted but which are not RDS within the meaning of paragraph 3 Schedule 13 FA 1996. The intended result is that the issuer will get relief for the accruing discount he suffers, while the holder is taxed on disposal and then only under the capital gains rules.

The possibility of having a discounted security which is not a RDS is realised by taking advantage of a weakness in the 1996 definition. The scheme involves issuing a security which does not pay an amount on redemption involving a deep gain, but gives the holder an option, as the earliest option available, to redeem at an amount not involving a deep gain. Because there are later, more beneficial redemption possibilities the holder is unlikely to exercise the first option, but its presence is sufficient to take the security outside the definition of RDS.

"Qualifying corporate bonds" (QCBs) are securities which are exempt from capital gains tax and corporation tax on chargeable gains. They generally include securities issued by companies which do not have unusual features, such as convertibility into shares.

Where a security which is not a QCB is exchanged for, or converted into, a security which is, any capital gain on the old security is calculated at the point of conversion etc. but is "frozen" and brought into charge only on disposal of the QCB. Where a non-QCB is exchanged etc. for another non-QCB the new asset takes on the cost of the old asset and the whole gain on the two assets is charged when the new asset is disposed of.