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A convertible note is another type of investment you can make in a company or unit trust. A convertible note earns interest on the amount you pay to acquire the note until the note's expiry date. On expiry of the note, you can either ask for the return of the money paid or convert that amount to acquire new shares or units.
Where the cost base of the new shares or units includes the cost of the convertible note, indexation is available from when the liability to pay for the note arose.
Convertible notes acquired after 10 May 1989 are not subject to capital gains tax. Instead, any profit made on sale or conversion of the note to shares or units - the difference between the cost of the note and the sale price or the value of the shares or units received - is included in and taxed as ordinary income. For future capital gains purposes, the cost of any shares or units received will be their market value when you acquired them.
Convertible notes acquired before 11 May 1989 may be subject to capital gains tax and the rules on how they are treated are described below.
Conversion of notes to shares If you convert a convertible note acquired from a company before 20 September 1985 and do not make any further payment to the company on the conversion, the shares you received are treated as if you acquired them before 20 September 1985. Therefore, any capital gain or capital loss is disregarded.
In all other cases, the shares acquired by the conversion of a convertible note on or after 20 September 1985 may be subject to capital gains tax. The cost base of the shares received as a result of the conversion will include any amount payable on the conversion plus:
- if you acquired the convertible note on or after 20 September 1985, the cost of acquiring the note
- if you acquired the convertible note before 20 September 1985 and make a payment on the conversion, the market value of the convertible note at the time of its conversion.
Converting notes to shares
David bought 1,000 convertible notes in DCS Ltd for $5 each on 1 July 1983. Their expiry date was 1 July 1988, at which time shares in DCS Ltd were worth $10 each.
He decided to convert the notes to shares and no extra payment to the company was required upon conversion. The shares are treated as having been acquired when the tax notes were acquired - 1 July 1983. Any capital gain or capital loss made on the shares is disregarded.
David bought another 1,000 convertible notes in DCS Ltd on 1 July 1986. These notes also cost $5 each. On expiry of the notes on 1 July 1999, shares in the company were worth $7 each. David also converted those notes to shares, which are subject to capital gains tax.
As no further amount is payable on conversion of the notes, the cost base of the shares is the $5 originally paid for the note. If David chooses indexation he may index the $5 from 1 July 1986 when David became liable to pay the cost of the notes.
Last modified: 18 Sep 2009QC 18323