Overview of convertible notes

While convertible notes (Convertible Notes) may in a lot of cases provide considerable benefits for the issuer they may also create a significant burdens.  This article attempts to explain what can be a complex financial instrument by examining some of the key features of Convertible Notes and some of the more common legal issues associated with their use.

What is a note?

A note (Note) is defined in Section 82L of the Income Tax Assessment Act 1936 (ITAA) of as ‘a note of instrument issued by a company that evidences, acknowledges, creates or relates to a loan to the company’.

What is a Convertible Note?

Section 82L of ITAA defines a convertible note (Convertible Note) as a note issued by a company that provides, whether in pursuance of or by virtue of a trust deed or otherwise:

• that the amount of the loan to the company that is evidenced, acknowledged or created by the note or to which the note relates:
  • whether with or without interest;
  • whether at the option of the holder or owner of the note or of some other person or not;
  • whether in whole or in part; or
  • whether exclusively or otherwise is to be or may be converted into shares in the capital of the company or of another company or is to be or may be redeemed, repaid or satisfied by:
    • the allotment or transfer of shares in the capital of the company or of some other company, whether to the holder or owner of the note or to some other person;
    • the acquisition of such shares, whether by the holder or owner or by some other person, otherwise than as mentioned in subparagraph (vi); or
    • application in or towards paying-up, in whole or in part, the balance unpaid on shares issued or to be issued by the company or by some other company, whether to the holder or owner or to some other person; or
• that the holder or owner of the note is to have, or may have, any right or option to have allotted or transferred to him or her or to some other person, or for him or her or some other person otherwise to acquire, shares in the capital of the company or of some other company.

A Convertible Note is therefore a written promise to repay a debt with interest, at a specified time, with the option to convert that debt to equity in a company. Convertible Notes are a quasi-equities as they include the elements of debt and equity.

What is the accounting treatment of a Convertible Note?

Division 3A of the Income Tax Assessment Act 1936 (Cth) deals with Convertible Notes. Section 82SA ITAA prescribes the rules to be complied with for the interest paid by the Issuer to be deductible as an expense. There are a number of prescriptive obligations in section 82SA, however some of the more notable ones include:

• the loan must have been after 1 January 1976; and
• the Convertible Note was issued before the expiration of 2 months after the loan was made; and
• the terms of issue of the Convertible Note include the option to the holder to convert the loan to shares in the company;
• the earliest point at which the option to convert may be exercised is a date not later than 2 years after the date of the offer;
• the rights of the holder of the Convertible Note with respect to the amount payable on redemption of the loan do not vary according to whether or not the holder exercises the option to convert
• the latest date on which the option to convert may be exercised is not later than the maturity date of the loan

Types of Convertible Notes Whilst there are many prescriptive obligations contained in ITAA which must be complied with for the interest component to be a deductible expense to the issuer, it is generally thought that Convertible notes can take two (2) primary forms:

• Secured; and
• Unsecured.

Although Convertible Notes are generally unsecured they can take security over real property by allowing for the creation of security interests which ware registrable on the Personal Property Securities Register. They may also be subject to various other agreements such as a facilities agreement and a shareholders agreement which would be enlivened should the loan element convert to equity in the issuer. Important features When drafting a Convertible Note Deed, particular care should be taken by the issuer to consider:

• the interest rate and whether the interest rate is fixed (a specific percentage) or floating (varies according to market rates);
• frequency of interest payments;
• whether the Notes are subordinate to other debt facilities of the issuer;
• voting rights of the note holders;
• how the company is to issue certificates to note holders;
• the term of maturity or redemption;
• the requirements of section Section 82SA of ITAA;
• how and when the note can be Converted into shares and what rights and obligations apply to those shares;
• at whose election the loan can be repaid or converted into shares and at what time;
• the strike price at which the notes can be converted to shares; and
• the terms and conditions which apply to the holder of the shares (usually the terms of a Shareholders’ Agreement is required to be agreed in advance);
• whether the issuance of the Note is contemplated by the Constitution of the Company; and
• whether the note is correctly classified and recorded in the accounts of the Company.

It is also important to consider the future growth plans for the company and whether the Convertible Note Deed poll provides for or in fact limits a potential sale or exist for the shareholders. In short will the issuance of the Note be a useful source of capital or, like an anchor, fix the company to a long term position which is difficult to resile from.

Benefits of Convertible Notes

Benefits to the Holder

The benefits for the holder of a Convertible Note will depend largely on the terms at which the Convertible Note is issued, however they may include:

• substantially higher interest rates than those presented as dividends paid to shareholders;
• ranking ahead of certain classes shareholders in the payment of interest by the company;
• the option to convert to shares in the future, may provide for the prospect of capital gain through the growth in the share price;
• secured Convertible Notes can have a higher priority over other creditors in the event of liquidation of the Company;
• acting as a safety net should the Company be unable to repay the debt (provided the holder has the right to elect to convert the debt to equity);
• the Convertible Note may be able to be secured by real or intellectual property owned by the Issuer or some other surety.

Benefits to the Issuer

The benefits to the issuer of a Convertible Note will depend on the terms of issue, but may include:

• the opportunity to negotiate the interest rate with potential Note holders;
• the ability to repay the debt instead of converting to equity and diluting the owners percentage of equity held;
• the ability to raise capital by way of loan initially and make a decision as to whether the loan is repaid or converted to shares can allow for a “wait and see” approach by the issuer.

Both unlisted and listed companies can issue Convertible Notes, however additional rules apply if the Company is listed on the ASX. Potential legal issues Many of the problems that arise with Convertible Notes relate to their hybrid nature. Whether Convertible Notes are considered ‘creatures of debt or equity’ can have profound tax implications as well as consequences in the event of insolvency. In the case of Perpetual Trustee Company Ltd v HIH Holdings (NZ) Ltd (in liquidation)^[1] investors in HIH were left unable to claim against the issuer of Convertible Notes on HIH’s insolvency. A Convertible Note Deed usually provides for redemption upon insolvency. In the case of HIH, the ability to redeem the notes was not considered their primary liability. Conversion required a two-step process whereby the notes would first be redeemed for their primary value and this amount would subsequently used to obtain shares. The notes may have been structured this way for taxation purposes; however, this meant the interests of holders were secondary to other creditors. The terms of issue of a Convertible Notes need to be carefully drafted to ensure that their issue clearly reflects what is negotiated between the issuer and the holder and that the various requirements contained in the ITAA are complied with.

Links and further references

Legislation

Income Tax Assessment Act 1997 (Cth)

Corporations Act 2001 (Cth)

Case law

Perpetual Trustee Company Ltd v HIH Holdings (NZ) Ltd (in liquidation) [2013] NSWCA 47

Macquarie Finance Limited v Commissioner of Taxation [2004] FCA 1170 (14 September 2004)

Other links

Australian Taxation Office, Convertible notes

ASX – Module 6 Convertible notes

ASIC Regulatory Guide 213 – Facilitating debt raising

Australian Taxation Office: Taxation Rulings

IT 2657 – Income Tax: deductibility of interest payable on convertible notes (24 October 1991)

IT 2427 – Income Tax: Convertible Notes – meaning of convertible note and note related instruments

IT2411 – Income Tax: Convertible Notes – meaning of convertible notes – perpetual floating rate note

Further information

If you need further information regarding Convertible Notes, please contact us for an obligation free and confidential discussion.

Disclaimer

This article contains general commentary only. You should not rely on the commentary as legal advice. Specific legal advice should be obtained to ascertain how the law applies to your particular circumstance.

[1] [2013] NSWCA 47.

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