ATO ID 2002/1114: Convertible Notes - Return on a Debt Interest, Division 974, Income Tax Assessment Act 1997
Date of decision: 18 March 2002
Year of income: Other/Substituted Accounting Period 2004
Business line: Office Of the Chief Tax Counsel

Issue
Will an amount of accrued interest paid or credited to the benefit of a convertible note holder pursuant to one scheme be treated as a return on a debt interest as defined in Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997), if a subsequent scheme operates to recharacterise the convertible note from a debt interest to a non-share equity interest pursuant to that Division of the ITAA 1997?

Decision
Yes. The accrued interest paid or credited to the benefit of a convertible note holder before the subsequent scheme comes into existence will be treated as a return on a debt interest.

Facts
A convertible note to which Division 974 of the ITAA 1997 applies gives rise to a debt interest under that Division. The issuer is proposing: Under the first amendment, the interest obligation that had accrued daily on the convertible note according to the original terms of issue, from the 'Interest Payment Date' (as defined in the convertible note agreement) to the date that the first amendment comes into existence, will become due and payable at that time rather than on the next scheduled 'Interest Payment Date'. The return accrued will be paid or credited at the time the first amendment is accepted by the note holders. Where the return accrued is credited to the benefit of the note holders, the note holders will have an indefeasible entitlement to that accrued amount and may draw upon that amount at any time without contingency. The provisions of the first amendment, if accepted by the noteholders, will be implemented regardless of whether the second amendment is accepted.

Reasons for decision
Summary: An amount paid or credited for the benefit of the convertible note holders at the time the first amendment to the convertible note terms are accepted will be treated as a return on a debt interest as: Even though the return may be credited rather than physically paid, the convertible note holder will receive an indefeasible right to payment of the accrued interest obligation under the convertible note agreement. As a result, the obligation to pay the accrued interest on the convertible note will be treated as discharged and consequently treated as a return paid to the holder of the debt interest.

Legislative references: Income Tax Assessment Act 1997 division 974
Other references: Explanatory Memorandum: New Business Tax System (Debt and Equity) Act 2001
Subject references: Convertible notes Debt equity borderline