Debt deduction: interest paid on convertible notes

Are periodic payments made by the company on convertible notes a debt deduction within the meaning of subsection 820-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. The payments made by the company constitute a debt deduction as they are a cost incurred that satisfies: • subparagraph 820-40(1)(a)(i) [interest, an amount in the nature of interest, or any other amount that is calculated by reference to the time value of money], and • paragraph 820-40(1)(b) [apart from Division 820, the cost is deductible for the year of income] of the ITAA 1997.

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

The notes were 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

The issue of the notes gives rise to a debt interest under Division 974 of the ITAA 1997.

The capital raised by the notes is applied by the company in the refinancing of funds employed in the company's business.

A debt deduction is defined by subsection 995-1(1) of the ITAA 1997 as having the meaning given by section 820-40 of the ITAA 1997.

Under section 820-40 of the ITAA 1997 a debt deduction of an entity for an income year includes a cost incurred that is: • interest • an amount in the nature of interest, or • any other amount that is calculated by reference to the time value of money

and which would be, apart from the operation of Division 820 of the ITAA 1997, deductible for the year of income.

There is not a general definition of 'interest' in the ITAA 1997. In considering its ordinary meaning, interest was described by Rowlatt J in Bennett v. Ogston (HM Inspector of Taxes) (1930) 15 TC 374 at 379 as being 'payment by time for the use of money'.

The payments made by the company are compensation for the delay in repayment of the consideration for the acquisition of the preference shares and as such are considered to be interest payments.

Apart from Division 820 of the ITAA 1997 (about Thin Capitalisation) the payment of interest on funds employed in the business of the company, or in the refinancing of such funds, would be deductible under section 8-1 of the ITAA 1997.

For these reasons, the periodic payments made by the company on convertible notes are a debt deduction within the meaning of subsection 820-40(1) of the ITAA 1997.