ATO Interpretative Decision
ATO ID 2003/983
Income Tax
Characterisation of a 15 year convertible noteFOI status: may be released
Status of this decision: Decision Current
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Issue
Do the convertible notes issued by an entity give rise to a debt interest under Division 974 of the Income Tax Assessment Act 1997 (the ITAA 1997)?
Decision
Yes. The convertible notes issued by the Issuer to the Holder give rise to a debt interest since they satisfy the debt test in section 974-20 of the ITAA 1997.
Although the convertible notes also satisfy Item 4 in the table in subsection 974-75(1) of the ITAA 1997, the notes are prevented from being equity interests by virtue of paragraph 974-70(1)(b) of the ITAA 1997.
Facts
A company (Issuer) raises finance with the issue of 15 year convertible notes on 1 July 2001.
The notes are purchased by Holder for $9.00 each.
The notes have coupons of 7% pa that are paid annually on 1 July.
The obligation to pay the coupon is not subject to any contingency and cannot be deferred or waived in any circumstance.
Issuer may terminate the arrangement at any time after 1 July 2007. Upon redemption of the notes, whether early by Issuer or at maturity, Holder can choose to have the notes redeemed for $9.00 in cash, or converted into shares at a ratio of four shares in Issuer for each note.
Issuer's shares are currently trading at $1.75 per share.
Issuer's ordinary debt rate is 8% pa.
Reasons for Decision
For instruments issued on or after 1 July 2001, Division 974 of the ITAA 1997 provides rules that govern the classification of debt and equity interests for tax purposes.
Pursuant to subsection 974-70(1) of the ITAA 1997, in order to give rise to an equity interest, a scheme must satisfy the equity test in subsection 974-75(1) of the ITAA 1997 and the interest must not also be characterised as a debt interest under Subdivision 974-B.
Since the convertible notes may convert into an equity interest in the company they satisfy the basic test for an equity interest pursuant to Item 4 in the table in subsection 974-75(1) of Subdivision 974-C of the ITAA 1997.
In these circumstances to be considered an equity interest, the scheme must also be a 'financing arrangement' (subsection 974-75(2) of the ITAA 1997). The arrangement between Issuer and Holder in relation to the notes falls within the ambit of a 'scheme' which is defined very broadly in subsection 995-1(1) to include 'any arrangement'. Issuer issued the notes to raise finance, therefore the scheme is a financing arrangement under paragraph 974-130(1)(a) of Subdivision 974-F of the ITAA 1997.
To determine whether the interest is also characterised as a debt interest, it is necessary to examine the debt test contained in subsection 974-20(1) of Subdivision 974-B of the ITAA 1997. The debt test will be satisfied if:
- •
- the scheme is a financing arrangement for the entity (paragraph 974-20(1)(a))
- •
- Issuer receives a 'financial benefit' under the scheme (paragraph 974-20(1)(b))
- •
- Issuer has an 'effectively non-contingent obligation' to provide a financial benefit to Holder (paragraph 974-20(1)(c))
- •
- it is substantially more likely than not that the value of the benefit that Issuer provides to Holder will at least equal the value of the benefit that Issuer receives from Holder (paragraph 974-20(1)(d)), and
- •
- the value provided and the value received are not both nil (paragraph 974-20(1)(e)).
As discussed above, the scheme in this case constitutes a 'financing arrangement' (paragraph 974-20(1)(a) of the ITAA 1997).
Issuer receives a financial benefit under the scheme amounting to $9.00 for each convertible note purchased by Holder (paragraph 974-20(1)(b) of the ITAA 1997).
In return, Issuer has an obligation to pay the note holder an annual coupon of 7% of $9.00 on each note for the term of the note. The coupon payments are not subject to any contingency and cannot be deferred or waived in any circumstance. The company also has an obligation to repay the investment of $9.00 at maturity or earlier termination, provided that the note holder does not exercise its right to convert the note into shares. A right of this sort does not of itself make the obligation to repay the investment contingent (subsection 974-135(4) of the ITAA 1997). It is considered that in this case, Issuer has an effectively non-contingent obligation to repay the investment (paragraph 974-20(1)(c) of the ITAA 1997).
Under subsection 974-35(1) of the ITAA 1997, where the performance period for the arrangement exceeds 10 years the financial benefit is calculated in present value terms; otherwise the financial benefit is calculated in nominal terms. Further, when calculating the value of the financial benefit provided it is assumed that the interest arising from the scheme is held for the rest of its life (subsection 974-35(2) of Subdivision 974-B).
Once 6 years has passed, Issuer may redeem the notes at any time, however, it has no effectively non-contingent obligation to do so. In the absence of any such obligation, the existence of the option to terminate early is to be disregarded in determining the length of the life of the interest (subsection 974-40(2) of the ITAA 1997). Therefore, the note is taken to have a performance period of 15 years and the value of the benefit provided by Issuer is calculated in present value terms in accordance with the formula set out in subsection 974-50(4) of the ITAA 1997:
Financial Benefit Provided = Amount or value of financial benefit in nominal terms / [1 + Adjusted benchmark rate of return]n
where the adjusted benchmark rate of return is 75% of the ordinary debt rate of Issuer (section 974-145 of the ITAA 1997) that is, 75% x 8% = 6%.
n is the number of years in the period starting on the day on which the test interest is to be provided.
Therefore the financial benefit provided by Issuer
= ($9.00 x 7%)/(1 + 6%)1 + ($9.00 x 7%)/(1 + 6%)2 + ... + ($9.00 + [$9.00 x 7%])/(1 + 6%)15
= $9.87
As this is greater than the value of the financial benefit of $9.00 received by Issuer, it can be said that it is substantially more likely that not that the value of the benefit provided by Issuer is at least equal to the value of the benefit received by Issuer (paragraph 974-20(1)(d) of the ITAA 1997).
Neither the value provided, nor the value received, equal nil (paragraph 974-20(1)(e) of the ITAA 1997).
Therefore the convertible notes give rise to a debt interest.
In this case the interest meets the requirements of both the test for a debt interest and the basic test for an equity interest. However, since the debt test prevails over the equity test, the interest is a debt interest under Division 974 of the ITAA 1997.
Date of decision: 28 October 2003Year of income: Year ending 30 June 2004
Legislative References:
Income Tax Assessment Act 1997
section 974-20
section 974-35
subsection 974-40(2)
subsection 974-50(4)
subsection 974-70(1)
section 974-75
paragraph 974-130(1)(a)
subsection 974-135(4)
section 974-145
subsection 995-1(1)
Keywords
Convertible notes
Debt test
Equity test
Value of financial benefit/s
Debt equity borderline
ISSN: 1445-2782
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