Convertible Notes and the debt/equity borderline

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?

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.

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.

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.