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  • Convertible notes

    A convertible note earns interest on the amount you pay to acquire the note until the note's expiry date. On expiry, you can either ask for the return of the money paid or convert the note to new shares or units.

    Convertible notes you acquire after 10 May 1989 are generally not subject to capital gains tax (CGT) if you sell or dispose of them before they are converted into shares. Instead, you include any gain you make on your tax return as ordinary income, and any loss as a deduction (see You and your shares).

    If the taxation of financial arrangements (TOFA) rules apply to you, gains and losses from your convertible notes may be taxed under the TOFA rules.

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    Conversion of notes to shares

    Shares acquired by the conversion of convertible notes on or after 20 September 1985 are subject to CGT when they are sold or disposed of as the shares are taken to be acquired when the conversion happens.

    You may have acquired the convertible note on or after 20 September 1985 and, as a traditional security or qualifying security, you have already included the gain you made on the conversion of the notes on your tax return as income (or as a deduction, if you made a loss). The way you calculate the cost base of the shares varies depending on whether the notes converted to shares before 1 July 2001 or on or after that date.

    If you have convertible notes that are traditional securities and were issued by a company after 14 May 2002:

    • any gains you make when these notes are converted or exchanged for ordinary shares in a company are not be ordinary income at the time of conversion or exchange, and any losses you make are not deductible
    • instead, any gains or losses you make on the later sale or disposal of the shares (incorporating any gain or loss that would have been made on the conversion or exchange of the notes) are   
      • subject to CGT if you are an ordinary investor, or
      • ordinary income (or deductible, in the case of a loss) if you are in the business of trading in shares and other securities.
       

    Conversion of notes to units

    If your convertible notes are traditional securities, the first element of the cost base and reduced cost base of the units includes:

    • the cost base of the convertible notes, plus
    • any amount paid on conversion, plus
    • any amount included in your assessable income on conversion.

    You disregard any capital gain or loss made on their conversion to units in the unit trust.

    Similarly, if the convertible notes are not traditional securities and were issued by the unit trust after 28 January 1988, the first element of the cost base and reduced cost base of the units includes:

    • the cost base of the convertible notes, plus
    • any amount paid on conversion, plus
    • any amount included in your assessable income on conversion.

    You disregard any capital gain or loss made on their conversion to units in the unit trust.

    Example: Converting notes to shares

    David bought 1,000 convertible notes in DCS Ltd on 1 July 1997 (that is, notes were issued before 15 May 2002) at a cost of $5 each. Each convertible note is convertible into one DCS Ltd share. On expiry of the notes on 1 July 2000, shares in the company were worth $7 each. David converted the notes to shares, which are subject to CGT. No further amount was payable on conversion. David sold the shares on 4 December 2017 for $10 each.

    The $2 ($7 minus $5) gain that David made on the conversion of each of the notes to shares was assessable as ordinary income at the time of conversion – that is, in 2000–01 income year. As such, David had no capital gain in that year.

    The $3 ($10 minus $7) gain David made on the sale of each of the shares is subject to CGT. The $7 cost base is the market value per share on the date the notes converted to shares. Because he sold the shares after 11.45am (by legal time in the ACT) on 21 September 1999, and owned them for at least 12 months, David can claim the CGT discount. He calculates his capital gain as follows:

    $3 per share × 1,000 shares =

    $3,000

    Less: CGT discount of 50% =

    $1,500

    Net capital gain =

    $1,500

    David includes the capital gain on his 2017–18 income tax return.

    End of example

    See also:

    Last modified: 29 Jun 2018QC 52231