Convertible Notes - Non-Share Equity Interest, Division 974, Income Tax Assessment Act 1997

Will a convertible note that is characterised as a debt interest under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) be recharacterised as a non-share equity interest under that Division of the ITAA 1997, if a scheme of arrangement materially alters the terms of the convertible note to ensure that the convertible note holders convert their notes into equity of the issuer on their maturity?

Yes. At the time the scheme of arrangement is entered into, the resultant material change to the terms of the convertible note will result in the note no longer satisfying the debt test in Division 974 of the ITAA 1997.

The materially amended convertible note will give rise to an equity interest in accordance with subsection 974-70(1) of the ITAA 1997. That equity interest will be a non-share equity interest as defined in subsection 995-1(1) of the ITAA 1997.

The company has on issue a 5 year, 10 per cent convertible note. That convertible note is characterised as a debt interest for the purposes of Division 974 of the ITAA 1997. The company proposes to amend the terms of the convertible note through a scheme of arrangement. The scheme of arrangement will result in the holders of the convertible note agreeing, in consideration for the receipt of additional shares now, to accept shares in the issuer at the maturity of the convertible note rather than redeem their investment for cash. Under the scheme of arrangement the holders would continue to receive their regular coupon payments until maturity.

The proposed scheme of arrangement would be a material amendment to the terms of the convertible notes. A material change has the effect of treating the interest as coming into existence at the time the material change arises pursuant to the operation of paragraph 974-110(1)(c) of the ITAA 1997. The debt and equity tests are to be applied at that time to determine the character of the interest as a result of the material change.

Under subsection 974-70(1) of the ITAA 1997 an equity interest arises if, at the time the scheme comes into existence, it satisfies one of the items in the equity interest table in subsection 974-75(1) of the ITAA 1997 and is not a debt interest or part of a wider interest that gives rise to a debt interest. Subsection 974-75(2) further requires that a scheme giving rise to an equity interest in a company must be a financing arrangement (the latter term having the meaning given by section 974-130 of the ITAA 1997), in cases where the equity interest in the company is an interest other than that of a member or stockholder.

The amended convertible note would give rise to a scheme as defined in subsection 995-1(1) of the ITAA 1997.

The amended convertible note would be an interest that will convert into an equity interest in the company and as such, it would satisfy Equity Interest Item 4(b) of the table in subsection 974-75(1) of the ITAA 1997.

The amended convertible note would be a financing arrangement within the meaning of section 974-130 of the ITAA 1997 because the convertible note was entered into to raise finance for the company.

Accordingly, the proposed amended convertible note will, prima facie, give rise to an equity interest in the company. The equity interest will be prima facie be treated as a non-share equity interest as defined in subsection 995-1(1) of the ITAA 1997 as it is an equity interest that is not solely a share.

Although the proposed amended convertible note would fall within one of the items of the table of requirements of the equity test, if the interest also qualifies as a debt interest (or forms part of a larger interest that is characterised as a debt interest), paragraph 974-70(1)(b) of the ITAA 1997 prevents the interest from being classified as an equity interest. In such cases, the interest would be treated as a debt interest.

However, the convertible note under consideration does not give rise to a debt interest for the purposes of subsection 974-15(1) of the ITAA 1997, as it fails to satisfy the requirements of the debt test set out in subsection 974-20(1) of the ITAA 1997 after the material change. Specifically, the requirements of paragraph 974-20(1)(d) will not be met as it is not 'substantially more likely than not' that the value of the effectively non-contingent obligations (defined in section 995-1 to have the meaning given in section 974-135 of the ITAA 1997) to be provided by the issuer company in the future will be at least equal to the value of the financial benefit received by the company, that is the amount invested by the note holders.

The proposed amendment of the convertible note terms will result in the holders ultimately converting the investment into ordinary shares of the company. However, the conversion into an equity interest in the company does not constitute the provision of a financial benefit (subparagraphs 974-30(1)(a) and (b) of the ITAA 1997).

Whilst the company's obligations to make interest payments on the convertible notes give rise to effectively non-contingent obligations to provide financial benefits in the future, those amounts would not equal the financial benefit received by the issuer (the amount invested by the note holders).

As a result, the debt test in subsection 974-20(1) of the ITAA 1997 would not be satisfied and the interest would be characterised as a non-share equity interest at the time the conversion terms are materially altered.