Convertible Notes

Does subsection 82SA(2) of the Income Tax Assessment Act 1936 (ITAA 1936) apply if the terms of convertible notes are materially amended subsequent to the application of the New Business Tax System (Debt and Equity) Act 2001 ['Debt and Equity Amendments'] to the convertible notes?

No. Division 3A of the ITAA 1936 has a very limited application from the time that the Debt and Equity Amendments apply to a convertible note. Where those amendments apply, any subsequent material alteration to the convertible notes will not result in subsection 82SA(2) of the ITAA 1936 operating to deny prior year interest deductions.

The taxpayer issued convertible notes before 1 July 2001. After the passage of the Debt and Equity Amendments, the taxpayer elected under subitem 118(6)(b) of those amendments to have those provisions apply to transactions in respect of the convertible notes that take place on or after 1 July 2001. The first transaction after the election was a payment of interest on the convertible notes.

Subsequent to the election, the operation of the Debt and Equity Amendments [ie, Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)] characterised the interest as a debt interest.

The taxpayer had proposed that, subsequent to the election taking effect and subject to noteholders' and shareholders' consent, a material change would be made to the terms of the convertible notes so that they would convert into shares of the taxpayer on their maturity.

Both future and previously allowed interest payments on the convertible notes would not be deductible if subsection 82SA(2) of the ITAA 1936 were to apply as a consequence of the proposed alteration to the terms of the convertible notes.

Section 82LA was introduced into the ITAA 1936 by the Debt and Equity Amendments. It provides that Division 3A of Part III of the ITAA 1936 [provisions dealing with convertible notes] will only apply for the purposes of certain Controlled Foreign Companies provisions and for the purposes of defining a convertible note. However, this limitation on the operation of Division 3A of the ITAA 1936 is imposed by the application of the Debt and Equity Amendments, and thus only applies to convertible notes which are subject to the Debt and Equity Amendments.

Where a convertible note was issued before 1 July 2001, subitem 118(6)(b) of the Debt and Equity Amendments allows the issuer to elect subject to the provisions of Item 118 of those amendments to have the amendments apply to transactions on or after 1 July 2001 that take place in relation to that interest. If a valid election is properly made pursuant to subitem 118(10) of the Debt and Equity Amendments, Division 3A of the ITAA 1936 will have limited application from the first transaction associated with that interest.

In the present case, the proposed material amendment to the terms of the convertible notes would occur after the first transaction under the convertible notes (ie, the interest payment on the convertible notes). For the purposes of the Debt and Equity Amendments, paragraph 118(13)(a) defines a transaction as including the making of a return. The payment of interest on the convertible notes would constitute the making of a return. Accordingly, the convertible notes would be subject to the Debt and Equity Amendments at the time of the proposed material alteration, and section 82 LA of the ITAA 1936 would apply. Thus, subsection 82SA(2) of Division 3A of Part III of the ITAA 1936 could not apply.