ATO ID 2001/321: Convertible Note
Date of decision: 4 September 2001
Business line: Public Groups and International

Issue
Whether a proposal to amend the conversion ratio of a pre-qualifying convertible note issue contravenes section 82SA of the Income Tax Assessment Act 1936 (ITAA 1936)?

Decision
The proposal to amend the conversion ratio of a pre-qualifying convertible note issue does not pass all the tests detailed by subsection 82SA(1) of the ITAA 1936. Consequently subsection 82SA(2) of the ITAA 1936 would apply to deny interest deductions to the note issuer in respect of the note issue.

Facts
The issuer of a pre-qualifying convertible note is proposing to amend the notes' conversion formula, in order to provide an incentive for noteholders to exercise their option to convert earlier than they otherwise might. The issuer, by way of the proposed amendment to the conversion formula, is seeking to increase noteholders' entitlement to ordinary shares that will be allotted or transferred upon the exercise of each convertible note. Early conversion is available and at the option of the noteholder. The availability of cheaper funding from other sources has prompted the note issuer to propose to amend the note conversion formula. The decision to hold the convertible note to maturity or accept the issuer's proposal, and therefore exercise the option to convert early, rests with the noteholder.

Reasons for decision
Summary: An interest payment, or a payment in the nature of interest, made by an issuer under a convertible note that satisfies section 82SA of the ITAA 1936, will not be denied a deduction under section 8-1 Income Tax Assessment Act 1997 (ITAA 1997) through the operation of section 82R of the ITAA 1936. The proposed amendment to the terms of the note issue will not pass the tests detailed by subsection 82SA(1) of the ITAA 1936. Both subparagraphs 82SA(1)(d)(ii) and (xi) of the ITAA 1936 have application to the matter. Subparagraph 82SA(1)(d)(xi) of the ITAA 1936 contains the conversion price test, which determines the minimum amount payable by each noteholder for each share allotted or transferred on conversion. Sub-paragraph 82SA(1)(d)(ii) of the ITAA 1936 operates to ensure that the conversion price test is not circumvented. The proposed amendment of the conversion ratio of the convertible note effectively reduces the amount payable for each share on conversion and does not pass the tests contained in subparagraphs 82SA(1)(d) (ii) and (xi) of the ITAA 1936. By virtue of the failure of the tests in subparagraphs 82SA(1)(d)(ii) and (xi) of the ITAA 1936, subsection 82SA(2) of the ITAA 1936 will operate such that subsection 82SA(1) of the ITAA 1936 will be deemed to never have had effect to this convertible note. Consequently section 82R of the ITAA 1936 will apply in respect of the convertible note, and interest payments or payments in the nature of interest, including past and future payments, will be denied a deduction to the issuer. Subsection 170(10) of the ITAA 1936 authorises the reopening of assessments to give effect to subsection 82SA(2) of the ITAA 1936.

Legislative references: Income Tax Assessment Act 1936 section 82SA section 82R section 170
Related public rulings and determinations: IT 2204 | IT 2334 | IT 2427 | IT 2657 | IT 2653 | TD 92/160 | TD 94/49
Other references: Explanatory Memoranda relating to section 82SA of the ITAA 1936 Explanatory Memoranda relating to section 82S of the ITAA 1936
Subject references: Conversion of securities Convertible notes