Debt/Equity financing: unsecured notes that may be converted into preference shares

Does the issue of an unsecured note that provides for conversion to a preference share in the event of the issuer's default give rise to a debt interest?

Yes. The issue of an unsecured note that provides for conversion to a preference share in the event of the issuer's default satisfies both the equity test in subsection 974-75(1) of the Income Tax Assessment Act 1997 (ITAA 1997) and the debt test in section 974-20 of the ITAA 1997. However, the tiebreaker rule in paragraph 974-70(1)(b) of the ITAA 1997 applies so that the issue of the note gives rise to a debt interest.

An Australian resident company has raised capital by issuing unsecured notes (notes).

The notes are issued on the following terms: • Each note has a face value of $1.00 and was issued on subscription of an amount equal to that face value • The notes have a term of four years and are repayable in four equal instalments on each anniversary date of the issue • The company is liable to make interest payments on the portion of the notes that remains outstanding at any time, calculated at the rate of 10% per annum on the amortised face value outstanding • If an interest payment or principal repayment on the notes is not made in full within 30 days of the due date for the relevant payment, the interest rate on the notes will increase to 20% per annum from the date the payment became due and so long as the notes remain on issue. In addition, a right will arise in favour of noteholders to elect to convert their notes into non-redeemable preference shares at any time after the date the payment became due.

Division 974 of the ITAA 1997 classifies an interest in a company as a debt interest or an equity interest for tax purposes according to the economic substance of the rights and obligations of an arrangement rather than merely its legal form.

The debt test in section 974-20 of the ITAA 1997 is satisfied if all of the following five steps are satisfied:

Step 1: Is there a scheme?

Yes. The term 'scheme' is broadly defined in subsection 995-1(1) of the ITAA 1997. There is a scheme in the form of an arrangement or course of action to raise capital by issuing the notes.

Step 2: Is the scheme a financing arrangement?

Yes. The issue of the notes raises finance for the company and is therefore a financing arrangement as defined by section 974-130 of the ITAA 1997.

Step 3: Does the issuing entity receive a financial benefit under the arrangement?

Yes. The company receives a financial benefit from the issue of the notes by receipt of subscription money.

The concept of financial benefit is broadly defined in section 974-160 of the ITAA 1997.

Step 4: Does the issuing entity or a connected have an effectively non-contingent obligation to provide a financial benefit?

Yes.

The concept of an effectively non-contingent obligation (ENCO) is defined by section 974-135 of the ITAA 1997. There is an ENCO to provide a financial benefit if, having regard to the pricing, terms and conditions of the scheme there is in substance an ENCO to provide such a benefit (subsection 974-135(1) of the ITAA 1997).

The ENCO criterion applies to both the provision of financial benefits under the scheme and to the termination of the scheme (subsection 974-135(2) of the ITAA 1997).

The company does have an ENCO as it is obliged under the terms of the notes to: • pay interest on the portion of the notes that remains outstanding at any time, calculated at the rate of 10% per annum on the amortised face value outstanding; and • repay the principal in annual instalments over the term of the notes.

Step 5: Is it substantially more likely than not that the financial benefit to be provided will be at least equal to or exceed the financial benefit received?

Yes.

If there is an ENCO, the fifth step of the debt test requires that it be substantially more likely than not that the financial benefit provided to the noteholders will be at least equal to the value of the financial benefit the company received.

The value of the financial benefit is calculated in nominal terms if the performance period for the interest must end 10 years or less after the interest is issued (subparagraph 974-35(1)(a)(i) of the ITAA 1997).

The period within which the taxpayer's ENCO is to be satisfied is four years. The nominal value of the financial benefit, being the repayment of principal plus the interest payments, to be provided by the company will at least equal the amount subscribed on issue of the notes.

As the entire debt test requirements are satisfied in relation to the issue of the notes it gives rise to a debt interest.

In determining what an equity interest is, the rules contain a table in section 974-75 of the ITAA 1997 that lists interests in a company that, as a general rule, are equity interests.

As noteholders can elect to convert their notes into preference shares if an interest payment or principal repayment on the notes is not made by the time the payment becomes due the notes are an interest that satisfy item four in the equity interests table in subsection 974-75(1) of the ITAA 1997.

The notes are a convertible interest as defined by section 974-165 of the ITAA 1997 because they can be converted into preference shares of the company if the company defaults on the interest payments payable on the notes.

In such situations, that is, where an interest satisfies both the debt and the equity tests (hybrid interest), the tiebreaker rule in paragraph 974-70(1)(b) of the ITAA 1997 applies, resulting in the interest being a debt interest.