Many companies – and almost all start-up companies – heavily rely on some form of financing to keep their businesses on track to meet goals and objectives. In fact, we have
seen a surge recently in the use of convertible debt instruments as a way to accomplish this, likely due to continued low interest rates (despite some recent inflation) and volatility within the market.
Convertible notes are a form
of unsecured debt that pays or accrues periodic interest – often at a lower rate than traditional debt – and provides for full repayment of principal at maturity. Standard convertible debt allows the debt holder the option to convert the
debt into equity shares of the issuer: this provides the holder with protection on their principal while keeping the potential for profit from the upside of the company’s performance.
The option to convert is generally made
upon maturity of the debt – or upon the occurrence of certain corporate events such as a change in control – at a predetermined conversion price designated in the terms of the debt agreement. Start-up companies often take advantage of
issuing convertible debt because it can favor companies with a low credit rating but high growth potential. Convertible debt also delays the need for a start-up to place an initial value on itself before it has been able to get off the ground. Mature
businesses, on the other hand, are issuing convertible debt to raise capital and hedge against dilution of shares due to conversion typically occurring at a higher share price and the possibility of cash settlement.1
the favorable aspects of convertible debt, borrowers need to be aware of rules that could limit the tax benefits of these instruments as well as the fact that the IRS closely scrutinizes debt instruments with significant equity features, often challenging
interest deductibility and the characterization as debt vs. equity. For instance, IRC Section 163(l) denies interest deductions (including Original Issue Discount) to corporate taxpayers who issue “disqualified debt instruments,” which
is defined as “any indebtedness of a corporation which is payable in equity of the issuer or a related party or equity held by the issuer (or any related party) in any other person.” “Payable in equity” means a substantial
amount of principal or interest is required to be paid in, or converted into, equity or can be paid in, or converted into, equity at the option of the debt instrument’s issuer (or a related party of the issuer), or the debt is part of an arrangement
that is reasonably expected to result in either the first or second option.
Section 163(l) also applies if debt is payable in equity at the option of the holder (i.e., the creditor) and there is substantial certainty the option will
be exercised. Thus, Section 163(l) would likely apply if the debt is payable in equity at the holder’s option and if the conversion price is substantially lower than stock value at the issuance date. However, if the conversion price is significantly
higher than the market price of the stock on the debt’s issuance date, Section 163(l) would likely not apply because the circumstances would imply it is not substantially certain that the holder will exercise the conversion option.2
Unfortunately, the terms “substantial amount,” “reasonably expected,” and “substantial certainty” are not defined, resulting in significant ambiguity for taxpayers. As a result, taxpayers must carefully
review the terms of convertible notes when assessing interest deductibility under Section 163(l).
In addition, IRC Section 279 allows the IRS to look at the issuer’s balance sheet and the acquisitive nature of the debt issuer
to determine interest deductibility. A company that issues convertible debt can find itself subject to Section 279 if the debt is considered “corporate acquisition indebtedness” and interest expense exceeds $5 million. Corporate acquisition
indebtedness exists to the extent the debt is subordinated; issued, directly or indirectly, to acquire another corporation or two-thirds of its operating assets; is convertible or has an option to convert/acquire shares of the issuing company; and
the issuing company has a debt-to-equity ratio exceeding 2:1 or has average earnings exceeding three times annual interest expense.
Determining the intent of the taxpayer in terms of whether the debt will be used directly or indirectly
for an acquisition is an important consideration when analyzing the potential impact of Section 279. However, for Section 279 to be met, the taxpayer must meet all four parts of the definition of corporate acquisition indebtedness above, so this gives
taxpayers room to exercise tax planning around the issuance.
There are a number of other rules that could limit interest deductibility, including debt/equity characterization under common law principles, the annual interest limitation under
Section 163(j) and Section 163(e)(5) (the Applicable High Yield Discount Obligation rules). However, a company’s capital financing decision is rarely determined through the lens of tax implications, and the issuance of convertible debt is an
example of financing that, while attractive, may have tax consequences.
The automatic deduction of interest paid on the issuance of convertible debt may not be a reliable assumption due to the above rules and IRS’s scrutiny
of debt instruments. A taxpayer may be aware of the potential impact of Section 163(l) upon issuance of a debt, but ambiguity remains around what constitutes a “substantial amount” of the issuance payable in equity or whether there is
“substantial certainty” the instrument will be converted to equity.
Section 279 may present more of a surprise to taxpayers if the issuer did not initially intend to use the debt for a direct or indirect acquisition, but
there is more flexibility to plan around this disallowance.
As interest rates creep higher, the attraction of debt financing may become less desirable from a business perspective and the value of interest deductions may increase.
This in turn may increase the importance of considering the impact of Section 163(l) and Section 279 before entering into a convertible debt agreement.
1 Maureen Farrell, “Convertible-Bond Sales Are Soaring in 2021—Often at 0% Interest,” The Wall Street Journal (May 28, 2021).
2 Revenue Ruling 2002-31, citing H.R. Rep. No. 105-220, at 524.
James P. Swanick, CPA, is managing director in Global Tax Management Inc.’s Wayne office and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.
Meredith Thornton, CPA, is a manager with Global Tax Management Inc. in Wayne. She can be reached at email@example.com.
Michael J. Tighe, CPA, is managing director in Global Tax Management Inc.’s Wayne office and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.