Tax Considerations Relating to Investments in Convertible Corporate Debt

Given the opportunity to invest in a business, at times an investor desires the potential upside of an equity investment while maintaining status as a creditor in the event the issuer is less successful.  One solution is a convertible note –a debt instrument that is convertible at the option of its holder into equity of its issuer.  For purposes of this discussion, a “convertible note” will be used to refer to a note that may be converted into stock of the issuer and that unless and until converted has conventional “debt” terms, including a specified principal amount payable on a fixed maturity date (in the absence of exercise of the conversion right), typical creditors’ rights and payment of periodic fixed interest either in cash or in kind.[1]  This discussion assumes a convertible note with a fixed interest rate issued by a corporation.[2]

The first thing that many investors want to know about a prospective investment in a convertible note is “will I be subject to tax as a result of a future conversion?”[3]  Since the investor normally will convert only at a time when the value of the stock is greater than the amount the investor paid for the convertible note, then any tax liability at the time of conversion would have to be taken into account in determining the attractiveness of the investment.  Under a longstanding IRS ruling published over fifty years ago, the conversion of a convertible note for stock of the note’s issuer does not result in realized gain or loss because it is not treated as a taxable exchange.  Therefore, even if the value of the stock into which the note is convertible is greater than the holder’s tax basis in the note, the conversion will not result in immediate recognition of gain for tax purposes.  The converting holder’s tax basis in the stock received on conversion, which will be used to determine any gain or loss on a future sale or other disposition of the stock, will be equal to the holder’s tax basis in the convertible note at the time of conversion (subject to possible future adjustments).

A common second question for an investor is “when will my holding period begin for stock that I receive on conversion of a convertible note?”  For most investors, a convertible note (and the stock received on exercise of the conversion right) would be treated as a capital asset.  Calculation of the investor’s holding period for stock held as a capital asset is important since an individual taxpayer’s gain from the sale or exchange of a capital asset with a holding period of more than one year is taxed at a preferential tax rate.[4]  If the holding period for the stock started at the time of conversion, then the holder would have to hold the stock for at least a year and a day after conversion before selling the stock in order to be eligible for the preferential tax rate on long-term capital gain.  In accordance with treating the conversion as a non-taxable event, the converting noteholder’s holding period for stock received on conversion will include the converting noteholder’s holding period for the note prior to conversion.  Therefore, a holder of a convertible note who has held the note for more than one year and immediately following the conversion sells the stock received on conversion would have a long-term holding period for the stock sold.

Another question often asked by investors is “how are interest payments on a
convertible note that I receive treated for tax purposes?  What about accrued interest that I do not actually receive?”  In general, an investor will be required to include interest payments in income, as ordinary income, during the time the investor holds the note prior to conversion, similar to interest payments on non-convertible debt instruments.[5]  In certain circumstances a holder of a convertible note may be required to include interest in income without receiving a corresponding cash payment.  For example, an investor that purchases a convertible note that was issued with “original issue discount” (or “OID”) for tax purposes would be required to include the OID in income as it accrues, even if the investor later converts and therefore never receives any cash in respect of the already-taxed OID.  In this circumstance, the amount of OID included in income by the investor prior to conversion would be added to the basis of the note, which as noted above is used to determine the basis of the stock received on conversion, and would reduce the amount of taxable gain on a future disposition of the stock.

Even in the case of stated interest that is paid periodically, a holder of a convertible note may be taxed on interest that has accrued since the most recent interest payment date but has not yet been paid at the time of conversion.  Whether the investor must include this accrued interest in income for tax purposes generally depends on the terms of the legal documents governing the convertible note.  If the contractual terms provide that upon conversion the interest accrued since the most recent payment of interest is forfeited, then the investor generally does not have to include that interest in income.  On the other hand, if the contractual terms provide that upon conversion the interest accrued since the most recent interest payment date is converted into stock, then the investor will have to include the amount of interest that accrued until the time of conversion in income for tax purposes despite the fact that it is never actually received.  In that circumstance, the accrued interest that was taxed but not received would be added to the basis of the stock received on conversion, and would reduce the amount of taxable gain on a future disposition of the stock.

This discussion addresses certain considerations relevant to investors in convertible notes, but does not address considerations for issuers of convertible notes, which will be addressed in a future article.  Please contact Seth Lebowitz with any tax-related questions at 212.573.8152 or slebowitz@sadis.com.