Optional Convertible Notes with Discretionary Interest Payments
This determination relates to the issue of optional convertible notes issued by the Issuer to Holders who are owned and controlled by the same persons as the Issuer’s shareholders. The Issuer (at their sole discretion) can elect to pay interest quarterly (and if no interest is paid it does not accumulate). The exercise of the option to convert into shares is held by the Holders, and if exercised would result in no change in the ownership/voting interests in the Issuer. The determination specifies whether any amount is solely attributable to an excepted financial arrangement.
This determination may be cited as Special Determination S61: Optional Convertible Notes with Discretionary Interest Payments.
1. Explanation (which does not form part of the determination)
- This determination relates to optional convertible notes (Convertible Notes) issued by the Issuer to the Holders. The Holders are different legal entities to the shareholders of the Issuer. However, they are ultimately owned and controlled by the same persons. This determination only applies to the Issuer as the Note Holders are not New Zealand residents and do not have a fixed establishment in New Zealand for the purposes of ss EW 9 and EW 10.
- Under the Convertible Notes, the Holders have loaned funds to the Issuer. The Issuer, at their sole discretion, can elect to pay interest to the Holders on a quarterly basis. If no interest is paid, it does not accumulate. The interest rate is set at 250bp over the bank bill rate. No fees are payable by either the Issuer or the Holders in relation to the Convertible Notes. The Holders have the option to convert the Notes to an equivalent value of shares in the Issuer at any point during the term of the facility, but cannot demand repayment in cash until the facility maturity date. The exercise of the option to convert the debt to equity would result in no change in the ownership/voting interests in the Issuer.
- A share or an option to acquire a share is an excepted financial arrangement under s EW 5(13). The Convertible Notes are a financial arrangement that include an excepted financial arrangement. In accordance with s EW 6(2), an amount that is solely attributable to an excepted financial arrangement under ss EW 5(2) to EW 5(16) is not taken into account under the financial arrangements rules.
- Determination G22A: Optional Convertible Notes Denominated in New Zealand Dollars (Determination G22A) prescribes the method under the financial arrangement rules for calculating income, expenditure and the base price adjustment in relation to optional convertible notes that are denominated in New Zealand Dollars. Determination G22A does not apply to the Convertible Notes as the date and amount of all payments is not known by the first balance date. This determination applies the method and the principle from Determination G22A to the Convertible Notes.
- If the Holders exercised the option and the result would be no change in the ownership of the issuer (either beneficially, voting or market value interests), no value is attributed to the Convertible Note’s equity component. Therefore, all consideration paid or received under the Convertible Notes is attributed to the debt component.
- As interest is discretionary, no amounts are taken into account under the financial arrangements rules, as the amount and timing of payment is not known at the first balance date. However, in the income year in which such payments are made, the amounts will be accounted for by applying Determination G25: Variations in the Terms of a Financial Arrangement.
This determination is made under ss 90AC(1)(bb) and 90AC(1)(h) of the Tax Administration Act 1994.
3. Scope of determination
- This determination applies to the Convertible Notes issued by the Issuer to Holders on 26 February 2019.
- The terms of the Convertible Notes are as follows:
- The Convertible Notes will have a face value of NZ$1.00.
- The payment of any interest is discretionary and non-cumulative. The interest rate will be 250bp over the bank bill rate. The Issuer’s decision on whether to pay interest is made on a quarterly basis. Any interest will not be capitalised.
- The Principal is required to be repaid by the Final Repayment Date, which is 9 years and 360 days from the date of issue.
- At any point prior to the Final Repayment Date, any of the Holders may elect to convert their Convertible Notes into ordinary shares in the Issuer (subject to a 90% agreement of the Holders). No Holder can act independently, a unanimous conversion will occur so that there is no change in the ownership of the Issuer.
- The number of shares to be issued upon a conversion event will be based on the market value of the Issuer at the time of conversion.
- The right of conversion is solely held by the Holders i.e. the Issuer has no power to convert.
- The Issuer has the right to early repay a portion or all of the Convertible Notes by giving 5 days notice.
- No fees are payable by the Issuer or the Holders in relation to the Convertible Notes.
- The Convertible Notes are a financial arrangement (as defined in s EW 3).
- A share or an option to acquire a share is an excepted financial arrangement (s EW 5(13)). The Convertible Notes are therefore a financial arrangement that includes an excepted financial arrangement.
- Under s EW 6(2), an amount that is solely attributable to an excepted financial arrangement under ss EW 5(2) to EW 5(16) is not taken into account under the financial arrangements rules. Any amount that is not solely attributable to an excepted financial arrangement is required to be taken into account under the financial arrangements rules and spread in accordance with those rules.
- Under s EW 14(3) an amount that is allocated to an income year under a spreading method will either be expenditure incurred or income derived by the person. Any discretionary interest payments made will be expenditure incurred by the Issuer.
- Determination G22A sets out a method for calculating and allocating income and expenditure for the purposes of the financial arrangement rules. In accordance with the principle in Determination G22A, none of the consideration provided or received under the Convertible Notes is attributed to the equity component of the Notes, and all consideration paid or received is attributed to the debt component. This is because:
- The parties to the Convertible Note at the date of issue are beneficially owned and ultimately controlled by the same person; and
- There would be no change to either the voting interests or the market value interests in the Issuer if the option to convert was exercised by the Holders.
- The Issuer’s discretion to elect to pay interest on a quarterly basis results in the dates and amounts of interest payments not being known by the first balance date following issue of the Convertible Notes.
- Using the principle and method in Determination G22A, there will be no amounts to spread under the financial arrangement (as the subscription price for the Convertible Notes is equal to the repayment price and there are no known interest payments). In an income year in which any interest is paid, Determination G25: Variations in the Terms of a Financial Arrangement should be applied to account for those payments.
In this determination, unless the context otherwise requires:
- All legislative references in this determination are to the Income Tax Act 2007, unless otherwise stated.
- Convertible Notes means the unsecured subordinated notes, in a denomination of $1.00 issued by the Issuer to the Holders.
- The Convertible Notes have both a debt and equity component. The equity component (being the conversion option) is an excepted financial arrangement.
- The amount of consideration received by the Issuer that is solely attributable to the equity component of the Convertible Note is nil.
- Any early redemption of a Convertible Note for its $1 face value will be attributed to the debt component of the note.
- As the issue price and redemption price of the Convertible Notes are the same, there will be no amounts of expenditure or interest to be spread in accordance with the financial arrangements rules.
- Any interest payments made will not be solely attributable to an excepted financial arrangement. Under s EW 14(3) any discretionary interest payments will be expenditure incurred by the Issuer.
- In the event that interest is paid, the amount of consideration paid by the Issuer must be varied using Determination G25: Variations in the terms of a financial arrangement.
This example illustrates the application of the method set out in this determination.
On 1 April 2019, 1,000 $1 Optional Convertible Notes are issued to the Holders for a 9 year and 360 days term. The notes can be converted to shares at any time.
No interest will accrue as the interest payments are at the discretion of the Issuer. On the date of issue, as a conversion event will not trigger a change in the beneficial or ultimate owner of the Issuer, no value will be allocated to the equity component of the convertible note.
However in the 2023 income year, the Issuer exercises its discretion to pay interest for two quarters. The market interest rate is set as per the facility agreement (but for the purposes of this example we will use 5%).
The annual sum of the expenditure incurred under the financial arrangement applying the principles in Determination G25 for the period 31 March 2020 to 2024 is:
|31 March 2020||Nil|
|31 March 2021||Nil|
|31 March 2022||Nil|
|31 March 2023||$25 (being the year in which cash interest is paid)|
|31 March 2024||Nil|
This Determination is signed by me on the 6th day of March 2019.
Director, Taxpayer Rulings