ATO Interpretative Decision
ATO ID 2003/327
Income Tax
Convertible Notes and the debt/equity borderlineFOI status: may be released
This ATOID provides you with the following level of protection:
If you reasonably apply this decision in good faith to your own circumstances (which are not materially different from those described in the decision), and the decision is later found to be incorrect you will not be liable to pay any penalty or interest. However, you will be required to pay any underpaid tax (or repay any over-claimed credit, grant or benefit), provided the time limits under the law allow it. If you do intend to apply this decision to your own circumstances, you will need to ensure that the relevant provisions referred to in the decision have not been amended or repealed. You may wish to obtain further advice from the Tax Office or from a professional adviser.
Issue
In the absence of subsection 974-15(2) of the Income Tax Assessment Act 1997 (ITAA 1997) applying, will a convertible debenture that pays interest at the discretion of the issuer and which may convert into an equity interest but has no effectively non-contingent obligations to provide a financial benefit to the holder, or a connected entity of the holder, be characterised as an equity interest under section 974-70 of the ITAA 1997?
Decision
Yes. In the absence of subsection 974-15(2) of the ITAA 1997 applying, a convertible debenture that pays interest at the discretion of the issuer and which may convert into an equity interest but has no effectively non-contingent obligations to provide a financial benefit to the holder, or a connected entity of the holder, will be characterised as an equity interest under section 974-70 of the ITAA 1997.
Facts
A trust subscribes for convertible debentures issued by X Corporation.
Interest payments will only be made on the convertible debenture where a committee of X Corporation has declared interest to be payable. The convertible debenture will convert into a preference share in X Corporation upon the occurrence of a Conversion Event as defined in the Convertible Debenture Deed.
The interest is not treated as giving rise to a debt interest in a company under subsection 974-15(2) of the ITAA 1997.
Reasons for Decision
The issue of the convertible debenture by X Corporation is a scheme as defined in section 995-1 of the ITAA 1997.
The scheme is a financing arrangement of either X Corporation or a connected entity of X Corporation as the funds raised by the issue of the convertible debenture are used by Y, a division of X Corporation, in its business operations.
The convertible debenture will be an equity interest under subsection 974-75(1) of the ITAA 1997 for any or all of the following reasons:
a) returns are at the discretion of the issuer. This is an equity interest as per Item 3 in the table in subsection 974-75 (1) of the ITAA 1997; and
b) the convertible debentures are an interest that may or will convert into a share. This is an equity interest as per Item 4 in the table in subsection 974-75 (1) of the ITAA 1997.
The convertible debenture will not pass the debt test as the issuer does not have an effectively non-contingent obligation to provide a financial benefit to the holders as:
a) interest will only be paid where a committee has declared interest be payable;
b) X Corporation does not have an effectively non-contingent obligation to redeem the convertible debenture. The obligation to redeem is contingent on the occurrence of an event, condition or situation;
c) the only obligation on X Corporation upon the occurrence of a Conversion Event, is to convert the convertible debenture into a share. Subsection 974-30(1) of the ITAA 1997 provides that the issue of an equity interest in the entity or a connected entity of the entity, or an amount that is to be applied in respect the issue of an equity interest in the entity or a connected entity of the entity, does not constitute the provision of a financial benefit; and
d) the pricing terms and conditions of the share to which the convertible debenture will or may convert are not such that the payment of interest on the convertible debenture would become in substance an effectively non-contingent obligation.
Date of decision: 30 April 2003Year of income: Year ended 30 June 2003
Legislative References:
Income Tax Assessment Act 1997
subsection 974-15(2)
subsection 974-30(1)
subsection 974-75(1)
section 995-1
Keywords
Convertible notes
Debt equity borderline
Debt test
Effectively non-contingent obligation
ISSN: 1445-2782
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