My earlier blog post, here examined some of the United States income tax consequences that could occur when a taxpayer mistakenly classifies an advance to a foreign corporation as a “loan” but that the Internal Revenue Service (IRS) treats as a stockholding interest (“equity”) in the corporation. Two follow up posts, here and here examined the factors used by the courts in making a debt-equity determination.
Today’s post will look at several important US tax issues for the US investor who purchases a “convertible” promissory note from a non-US corporation. The area of convertible debt is a highly complex topic which I have tried to greatly simplify today. My post barely scratches the surface and should serve as a head’s up to US taxpayers planning on investing in foreign start-ups by purchasing convertible notes. Look before you leap and get the proper tax advice.
Typical Features of the Convertible Note
It is rather common for many startup companies to use convertible promissory notes to raise capital from investors. Seed investors often invest in a startup using such notes which are typically structured as short-term debt. Investors can be repaid with shares (equity) in the issuing company rather than principal and interest. Investors are very tempted by such a structure because it provides good risk protection while simultaneously granting the investor a share in the appreciation of the company as it grows and its stock increases in value.
Typically a convertible note will have traditional debt terms including a fixed maturity date and a fixed interest rate. It will require the investor to pay for the note in an amount that is equal to the principal amount of the note. The convertible note usually will not require payment of any principal or interest until the note matures.
The interest rate will generally be lower than comparable nonconvertible debt because the investor will have a call option on the issuer’s stock, since the note will provide an option to the investor for repayment in the form of shares in the company. Essentially, the investor trades a portion of investment yield in exchange for getting this conversion feature.
The note will generally contain terms providing a discount rate the investor will receive on shares when the note matures. The discount rate compensates the investor for the risk involved in investing in an unknown startup. For example, if the discount term is 25%, shares that are sold to later investors at $1 per share, can be purchased by the seed investor at 75 cents per share.
The US tax ramifications of convertible notes are often not considered by the investor. Since the company is a non-US corporation, it may not have any US tax issues to consider (e.g., deduction of interest expense) and US investors will not be informed by the company about US tax risks.
Is a “Convertible” Promissory Note Treated as “Debt” or “Equity” for US Income Tax Purposes?
Given the attributes outlined above, a convertible note has features of both “debt” and “equity”. The issue of its characterization for US tax purposes cannot be ignored since characterization will govern the tax consequences to the US holder/investor. One must consider the various factors set out in my earlier blog posts in making a debt/equity determination. Assuming the note does not run afoul of a “debt” classification based on those factors, as a general matter, a convertible note with the features described above will be treated as “debt” until the time it is converted into shares of the company. The US tax rules do not bifurcate the convertible debt instrument into the 2 distinct components of a debt instrument and an equity instrument.
Assuming the instrument is “debt” until converted, the investor should have a full understanding of the consequences of this investment. He must be prepared before the time of the conversion to understand whether he will be holding shares in a “controlled foreign corporation” (CFC) or “passive foreign investment company” (PFIC). An overview of the US tax ramifications of these classifications was set out in my earlier post.
When Does the Investor Have Interest Income with a Convertible Note?
As mentioned, in the more common case, interest on a convertible note is not payable to the investor until the note matures. For tax purposes, however, the note will probably be treated as having “original issue discount” (OID). OID is taxed in a special way, and it often comes as an unwelcome surprise to the investor. With OID, the investor is required to take the interest into taxable income over the term of the note, even though payment of the interest is deferred until the maturity date of the note. This is the case even if the investor is a cash-basis taxpayer. (See IRC Sections 1272 and 1273).
The investor’s tax basis in the convertible note is increased by the interest income taken into account by the investor over the term of the note. This assures that no additional interest income is taxed to the investor when the accrued interest is eventually paid upon the note’s maturity.
Rarely, a convertible note will require regular interest payments (e.g., every 6 months or annually). If the interest payments are timely made, an investor on the cash-basis method of accounting will recognize interest income when the interest is paid.
I will just add here that purchasing a note that does not bear interest will not solve the problem. First, as discussed in my earlier post, it will impact the debt-equity classification issue. Furthermore, under special rules the IRS may impute interest using the so-called “Applicable Federal Rate“; it may also argue that the investor has in fact purchased a discounted note and must report OID.
What are the US Tax Consequences to the Investor Upon “Conversion” of the Note to Equity?
The conversion of convertible debt into stock is not a taxable event to the investor, even if the value of the shares received on conversion is greater than the principal amount of the note. The tax rules view this conversion as a transformation of ownership and not a taxable disposition. However, if shares of stock are received in payment of accrued interest that the investor has not already included in income, then the receipt of shares in lieu of accrued interest will be taxable. The investor will take what is called a carryover basis in the shares equal to the principal amount of the note (plus the amount of any accrued interest that has been previously included in the investor’s income and taxed). The holding period in the stock will also be “carried over” so as to include the period of the investor’s ownership of the note. For example, if the investor held the convertible debt for 365 days before converting the note to company stock, the investor’s holding period in the stock after the conversion will include that 365 day period of ownership.
Posted April 7, 2022
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