What creates an equity element in a financial instrument? Is an important question to answer before we discuss with the mathmatics behind seperation of equity element from a financial instrument. See my previous blogs regarding this issue here: What creates an equity element in a financial instrument?
Position of Financial Reporting Standards
Is the Issuer's classification of Liability and Equity Components relevant to the holder?
The distinction between equity and liability is not relevant for holders of such instruments since compound instruments represent either an asset or liability in the holder’s hands. However, provisions of IAS 39 relating to embedded derivatives are applicable and consistent with the requirements in IAS 32 for separating out the various components of a hybrid instrument, where such instrument contains an embedded derivative. Essentially these provisions provide that the embedded derivative should be separated out where it is not closely related to the host contract (and an equity and debt component are not considered to be closely related).
Classification with Liability or Equity
The fundamental principle of IAS 32 is that an instrument should be classified as either a liability or an equity instrument according to its substance, not its legal form. The enterprise must make the decision at the time the instrument is initially recognised. The classification is not subsequently changed based on changed circumstances. The key distinguishing feature is that a financial liability involves a contractual obligation either to deliver cash or another financial asset, or to issue another financial instrument, under terms that are potentially unfavourable to the issuer. An instrument that does not give rise to such a contractual obligation is an equity instrument. [IAS 32.18]
To illustrate, if an enterprise issues preference (preferred) shares that pay a fixed rate of dividend and that have a mandatory redemption feature at a future date, the substance is that they are a contractual obligation and, therefore, should be recognised as a liability. In contrast, normal preference shares do not have a fixed maturity, and the issuer does not have a contractual obligation to make any payment. Therefore, they are equity.
Some financial instruments – sometimes called compound instruments – have both a liability and an equity element. In that case, IAS 32 requires that the component parts be split, with each part accounted for and presented separately according to its substance. To illustrate, a convertible bond contains two components. One is a financial liability, namely the issuer’s contractual obligation to pay cash, and the other is an equity instrument, namely the holder’s option to convert into common shares. This split is made at the time the instrument is issued and is not subsequently revised as a result of a change in interest rates, share price, or other event that changes the likelihood that the conversion option will be exercised. [IAS 32.23]
Interest, dividends, gains, and losses relating to an instrument classified as a liability should be reported in the income statement. This means that dividend payments on preferred shares classified as liabilities are treated as expenses. On the other hand, distributions to holders of a financial instrument classified as equity should be charged directly against equity, not against earnings. [IAS 32.30]
Comparision with US GAAP
There is currently no equivalent concept under US GAAP that provides for the split presentation of the debt and equity components of compound instruments, either from the issuer’s or the holder’s perspective. Although FASB 133, paragraph 61, regards mandatorily redeemable preferred stock as more akin to debt whereas cumulative participating perpetual preferred shares are more akin to equity instruments, it only requires separation in the case of hybrid contracts that contain embedded derivatives. The SEC requires presentation of redeemable preferred share instruments on the balance sheet under a ‘mezzanine’ section (between debt and equity). These provisions do not, however, require the debt and equity components to be separated and accounted for individually.
The Theory behind splitting the components of compound instruments
AS 32.28 offers two potential approaches that might be followed in separating and valuing the components of a compound financial instrument on initial recognition.
An enterprise issues 2,000 convertible bonds at the start of Year 1. The bonds have a three-year term, and are issued at par with a face value of £1,000 per bond, giving total proceeds of £2 million. Interest is payable annually in arrears at a nominal annual interest rate of 6%. Each bond is convertible, at the holder’s discretion, at any time up to maturity into 250 common shares. When the bonds are issued, the prevailing market interest rate for similar debt without conversion options is 9%. At the issue date, the market price of one common share is £3. The dividends expected over the three-year term of the underlying shares amount to £0.14 per share at the end of each year. The risk-free annual interest rate for a three-year term is 5%.
Approach One: Residual Valuation of Equity Component
Under this approach, the liability component is valued first, and the difference between the proceeds of the bond issue and the fair value of the liability is assigned to the equity component. Note that from the holder’s perspective, since the conversion option is not considered to be closely related to the debt host, the embedded derivative is separated from the host contract and measured at fair value as illustrated in the second approach below rather than the first approach. Under this approach, the fair value of the embedded derivative is determined, and the difference between the proceeds of the bond issue and the fair value of the embedded derivative may be allocated to the remaining component – which is a financial asset (call option) in the holder’s hands. The present value of the liability component is calculated using a discount rate of nine percent, the market interest rate for similar bonds having no conversion rights, as shown.
Principal: £ 2,000,000
Present value of the principal payable at the end of three years: £ 1,544,367 (A)
Present value of the interest – £120,000 payable annually in arrears for three years: 303,755 (B)
Total liability component: 1,848,122 (C=A+B)
Residual equity component: 151,878 (D=E-C)
Proceeds of the bond issue: £ 2,000,000 (E)
Approach Three: Seperate Valuation of Each Component and Allocation on Pro-Rata Basis
Option pricing models may be used to determine the fair value of the embedded conversion option directly rather than by deduction as illustrated above. Financial institutions often use option-pricing models for pricing day-to-day transactions. There are a number of models available and each has a number of variants. This example has been determined using values that have been obtained from a version of the Black-Scholes model. Pricing the bond conversion option as a call option (assuming a volatility of 30%), results in a fair value of £0.289366 per conversion right. The valuation of the conversion options therefore can be calculated as: £0.289366 per share x 250 shares per bond x 2,000 bonds = £144,683
Fair value of liability component (determined in approach 1 above): £ 1,848,122 (A)
Fair value of equity component (determined above): 144,683 (B)
Total fair value (equity + liability components): 1,992,805 (C=A+B)
Proceeds of the bond issue: 2,000,000 (D)
Difference to be pro-rated between the components based on their relative values: £ 7,195 (E=D-C)
As illustrated in the above table, the aggregated fair values of the debt and equity components of the compound instrument do not equal the £2,000,000 proceeds from the issuance of the convertible bonds. The small difference is therefore prorated over the fair values of the two components to produce a fair value for the liability of £1,854,794 and a fair value for the option of £145,206. [IAS 32, Appendix, paragraph A24]
Recognition of Dividend as Interest Expesne
Under IAS 32, the measurement and recognition of interest and dividends associated with compound instruments follows the classification of the underlying component. Historically, dividends have only been recognised once declared, even where there is an economic obligation on the company to pay them at regular intervals (for example with cumulative preferred stock). Where an instrument (or component of an instrument) obligates the issuer to provide a return to holders in the form of dividends, the fair value of that obligation is classified under IAS 32 as a financial liability. The right to dividends is, in substance, interest and, therefore, should be accrued between payment dates rather than only recognised once declared.
Position of Income Tax Act, 2058 Nepal
Who is a shareholder?
The question as old as time. Who is a Shareholder?
As per Income Tax Act 2058,
Section 2(Ka.Ya): Shareholder means a person who is a beneficiary of a company.
Section 2(Ka.La): Beneficiary means a person who has an interest as specified in Section 2(Ma) in an entity.
Section 2(Ma): Interest in an entity means a right, including a contingent right, to participate in the income or capital of an entity.
So this means in the context of the Income Tax Act 2058, any holder of the financial instrument which gives the holder to participate in the income or capital of an entity.
No much else is described in Income Tax Act 2058. It gives a short description on how these rights are characterized in different forms of entities. Interest in an entity in context of the following entities means the followings:
● Partnership: Right to participate in the profit, Right to ownership against the asset in the partnership
● Company: The return of the investment made by the shareholder in the company, Right to receive in liquidation of the company in normal or contingent terms
● Retirement Fund: The investment made by the beneficiary or the return of investments to the beneficiary
● Trust: Interest of the beneficiary
● Foreign Permanent Establishment: The interest of the owner
Do Preference Shareholders have right to participate in the income of an entity?
Well, what is “right to participate in the income of an entity”? Simply because Preference Shareholders receive the income from the after tax reserve of the company, does this amount to the right to participate in the income of an entity? As per IFRS, No. This depends more on the substance of the instrument. IAS 32 establishes principles for distinguishing between liabilities and equity. The substance of the contractual terms of a financial instrument governs its classification, rather than its legal form. More on that concept of IFRS here. What creates an equity element in a financial instrument?
Do the Preference Shareholders have the right to participate in the capital of an entity?
Same concept as above follows here too. This is because that some form of preference shares may be classified as debt component based on its subtance for financial purpose. More on that concept of IFRS here. What creates an equity element in a financial instrument?
What is the meaning of contingent right to participate in the capital of an entity?
Well this is a confusing one. This probably means that when a financial instrument has the right to be settled in shares based on the contingent event. However as per IFRS, when such contingent event is in the control of the issuer i.e. entity then no equity element aries. Also, when such contingent event is the control of the holder i.e. the holder of the instrument then equity element will arise. This does mean that the term “contingent” is intended to encompass the equity element of the Financial Liabilities with option to convert into fixed number of Equity Shares where as per IFRS present value of Principal is recognized as Liability and present value of the Option is recognized as Equity. In the same tune, the term “continget” also intends to encompass the quity element of Puttable Financial Liabilities that meets all the characteristics of Equity Shares.
The term “contingent shares” refers to shares issued to one or more shareholders provided that certain conditions are met. They are conceptually similar to instruments such as stock options, warrants, or convertible preferred shares. Contingent shares are shares that vest subject to specified conditions. They are often used to incentivize management and employees to work in the interests of shareholders. Although they can be dilutive to existing shareholders, they might still create positive shareholder value on a net basis. As per IFRS, when such contingent event is in the control of the issuer i.e. entity then no equity element aries. Also, when such contingent event is the control of the holder i.e. the holder of the instrument then equity element will arise.
Position around the World
Position of Commonwealth of Symmetrica
THE COMMONWEALTH OF SYMMETRICA is a sample tax code for a hypothetical Commonwealth of Symmetrica, for use as reference material to provide assistance in the preparation of legislative acts and the application of laws. The IMF and Dr. Peter Harris were assisting in the drafting of income tax laws for a number of common-law-based countries. In particular, the “Equitable Republic” sample (still in progress), which is of a similar nature, formed the starting point from which the Symmetrica sample was developed. Nevertheless, the Symmetrica sample developed in a very different direction from the Equitable Republic sample, warranting their separate consideration.
What does THE COMMONWEALTH OF SYMMETRICA speak in this context?
“partner” means a person who is a beneficiary of a partnership;
“shareholder” means a person who is a beneficiary of a company;
“beneficiary” in relation to an entity means any person who owns an interest in an entity;
“interest” in an entity means a right, including a contingent right and whether of a legal or equitable nature, to participate in any income or contributed capital of the entity;
“debt claim”– (a) means a right of one person to receive a payment or repayment from another person; (b) includes a deposit with a financial institution, account receivable, note, bill of exchange, or bond and, in accordance with section 67, rights under an annuity, finance lease, or instalment sale; and (c) excludes an interest in an entity;
Well, looking at the provisions of THE COMMONWEALTH OF SYMMETRICA, it can be said that the “interest” in an entity is intended to include the actual equity instrument of financial instrument rather than what the instrument may exist in its legal sense. However, countries do not adopt holistic approaches to the issues considered in this subheading. Indeed, the issues considered here demonstrate the difficulty in adopting a substance approach to debt / equity distinction.
So, I am not able to conclude anything other than to provide some general background and isolated examples. Sorry !
Practice around the world
In Germany, preference shares are treated as shares for tax purpoes. One reason may be that German corporate law regulates the issue of preference shares to a greater extent than in most common law jurisdictions. German corporate law permits the exclusion of voting rights on preferred stock and a preferential right to dividends, subject to certain floors and ceilings or fixed terms. However, if preferential dividend is not paid, corporate law activates certain inalienable rights including voting rights.
Under US case law, preference shares might be characterized as debt. This depends on weighing up the characteristics of the investment. At one extreme, preference shares that participate in profits are likely to give “an invunerable equity status”. As more debt-like features are introduced, there is greater risk of the instrument being classified as debt.
In UK, redeemable preference shares that are designed to yield an interest like return are, subject to conditions, treated as creditor loan relationships for tax purposes. These rules cover only quasi-loan that are treated as a financial liability rather than equity for accounting purposes, and the generation of tax advantage must be one of the main purposes of the investment.
The Australian debt / equity rules do not directly re-characterize preference shares of any type as debt. However, dividends paid on shares that meet the debt test are provided with a difference tax treatment from dividends paid on other types of shares. It can result in dividend on ten-year or less redeemable preference shares being taxes in a manner that is consistent with the tax treatment of interest on debt.
Is it fair? What is the Conclusion?
There could be three conclusions here:
1. The one is Absurd Conclusion: Ordinary Shares + Preference Shares + Contingent Right in Shares = Shareholder
Unlike in IFRS, for tax purposes, all kinds of shares do have the right to participate in the income or capital of the entity and such right also includes contingent right which gives rise to equity element in instuements like Puttable Financial Liabilities and Financial Liabilities with option to convert into variable number of Equity Shares. This conclusion is absolutely stupid.
2. The next one is Inconsistent Conclusion: Ordinary Shares + Preference Shares = Shareholder
Currently, this seems to the conclusion of the legal practices, tax practices, court and tax authorities. But as discussed above this would be inconsistent with the definition of the “interest” in an entity that clearly includes the contingent rights (e.g. those of convertible debts, income participating debts, quasi-loan arrangements through preference shares etc.) as having “interest” in an entity. Refer to the Everest Bank Limited v. Inland Revenue Department case, which concludes with this isolated and inconsistent conclusion.
3. The last one is Best Conclusion: Go with the interpretation of IFRS
What creates an equity element in a financial instrument?
Financial Instruments that may contain Equity Element
Cash Obligation for Principal?
Cash Obligation for Servicing Cost?
Settlement in Equity causes Intrinsic Loss in Equity?
Equity / Liability?
Redeemable Preference Shares
Redeemable Preference Shares
PV of Principal as Liability
Irredeemable Preference Shares
Principal as Equity (b/f)
Irredeemable Preference Shares
Puttable Financial Liabilities that meets all the characteristics of Equity Shares
Financial Liabilities with option to convert into fixed number of Equity Shares
PV of Principal as Liability
Financial Liabilities with option to convert into variable number of Equity Shares
Other Financial Liabilities
Puttable Instrument: A financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder. A puttable Financial Liability means a financial liability where there will not be cash obligation for principal and servicing cost more preferable than what an ordinary shareholders has.