• Convertible interests

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    Convertible notes

    A convertible note (which is one type of convertible interest) 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.

    Convertible notes you acquired after 10 May 1989 will generally not be subject to CGT if you sold or disposed of them before they were converted into shares. Instead, you include any gain you make on your tax return as ordinary income and any loss you make is included as a deduction.

    For more information, see You and your shares 2006.

    If you have sold or disposed of a convertible note that you acquired before 11 May 1989, phone the Business Infoline on 13 28 66. When you phone, make sure you know the date you acquired the convertible note as this may affect the tax treatment.

    Conversion of notes to shares

    The tax treatment that applies when your convertible notes are converted to shares depends on when you acquired the convertible notes, the type of convertible note, when the conversion occurred and when the convertible note was issued.

    Shares acquired by the conversion of a convertible note on or after 20 September 1985 will be 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 note 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. Table 1 below provides a summary.

    Convertible notes issued after 14 May 2002

    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 will not be ordinary income at the time of conversion or exchange, and any losses you make will not be 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) will be:
      • 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.
       

     

    Table 1: Treatment of convertible notes acquired after 10 May 1989

    Convertible note

    Converted before 1 July 2001

    Converted on or after 1 July 2001

    The note is a traditional security* that was issued before 15 May 2002.

    You include gain on conversion as income (or loss on conversion is deducted).

    Cost base of shares includes their market value at the date the convertible notes were converted.

    You include gain on conversion as income (or loss on conversion is deducted).

    Cost base of shares includes cost base of the convertible note, any amount paid on conversion and any amount included in your assessable income on conversion.

    The note is a traditional security* that was issued after 14 May 2002.

     

    You disregard gain (or loss) on conversion.

    Cost base of shares includes cost base of the convertible note and any amount paid on conversion.

    The note is a qualifying security**.

    You include accrued gains as income and include any gain on conversion as income (or deduct any loss on conversion).

    Cost base of shares includes amounts paid to acquire the note and any amount paid on conversion.

    You include accrued gains as income and include any gain on conversion as income (or deduct any loss on conversion).

    Cost base of shares includes cost base of the convertible note, any amount paid on conversion and any amount included in your assessable income on conversion.

    *A traditional security is one that is not issued at a discount of more than 1.5%, does not bear deferred interest and is not capital indexed. It may be, for example, a bond, a deposit with a financial institution, or a secured or unsecured loan.

    **A qualifying security is one that has a deferred income element - that is, it is issued under terms such that the investor's return on investment (other than periodic) will be greater than 1.5% per annum.

    If you are an individual who is an ordinary investor, this change means you will be able to get the benefit of the CGT discount if you own the shares for more than 12 months. The table above sets out how you calculate the cost base.

    Conversion of notes to units

    Convertible notes - converted before 1 July 2001

    If the convertible note is a traditional security, the first element of the cost base and reduced cost base of the units is their market value at the time of conversion. You disregard any capital gain or capital loss made on their conversion to units in the unit trust.

    If the convertible note is not a traditional security and was issued by the unit trust after 28 January 1988, the first element of the cost base and reduced cost base of the units includes both the cost of the convertible note and any further amount payable on the conversion. You disregard any capital gain or capital loss made on their conversion to units in the unit trust.

    Convertible notes - converted after 1 July 2001

    If the convertible note is a traditional security the first element of the cost base and reduced cost base of the units includes:

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

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

    Similarly, if the convertible note is not a traditional security and was 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 note, plus
    • any amount paid on conversion, plus
    • any amount included in your assessable income on conversion.

    You disregard any capital gain or capital 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 that were issued before 15 May 2002). The notes cost $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 of the notes. David sold the shares on 4 December 2005 for $10 each.

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

    The $3 ($10 - $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. David calculates his capital gain as follows:

    $3 per share x 1,000 shares =

    $3,000

    less CGT discount of 50%

    $1,500

    Net capital gain

    $1,500

    David includes the capital gain on his 2006 tax return.

    Last modified: 06 Oct 2009QC 18504