ATO ID 2002/1115: Convertible Notes - Non deductible distribution, Section 26-26, Income Tax Assessment Act 1997
Date of decision: 18 March 2002
Year of income: Other/Substituted Accounting Period 2004
Business line: Public Groups and International

Issue
Will distributions paid on a convertible note that is a non-share equity interest be treated as non-deductible distributions pursuant to section 26-26 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
A company issuer that distributes money to the holder of a non-share equity interest as a result of the holder being a holder of that non-share equity interest, will be treated as having made a non-share distribution as defined in section 974-115 of the ITAA 1997, to the holder of that interest. Paragraph 26-26(1)(a) of the ITAA 1997 would operate to deny a deduction in respect of those non-share distributions.

Facts
A company that issues convertible notes which Division 974 of the ITAA 1997 characterises as a debt interest is proposing to enter into a scheme of arrangement in respect of those notes. If the note holders and shareholders accept the scheme of arrangement, it will ensure that the note holders will convert their notes on maturity into shares of the issuer rather than seek a return of the face value of the notes. Under the scheme of arrangement, the 'interest payments' on the convertible note will continue until maturity of the convertible note. All payments made under the convertible note from the date the scheme of arrangement is entered into will represent payment obligations accrued by the company over the period that the convertible note is a non-share equity interest.

Reasons for decision
Summary: The amounts paid by the company to the note holders whilst the convertible note is a non-share equity interest will be non-share distributions as defined in section 974-115 of the ITAA 1997. Those amounts paid will give rise to non-share distributions as the distributions represent amounts of money distributed to the holder of a non-share equity interest as non-share equity interest holders. By virtue of the operation of paragraph 26-26(1)(a) of the ITAA 1997, those non-share distributions would not be deductible to the company.

Legislative references: Income Tax Assessment Act 1997 section 974-115 paragraph 26-26(1)(a)
Other references: Explanatory Memorandum: New Business Tax System (Debt and Equity) Act 2001
Subject references: Convertible Notes Debt equity borderline