Convertible notes have recently become popularized by early-stage startups as an effective vehicle to raise capital from both a speed and cost perspective, compared to other traditional methods. These terms of the convertible notes are often spelled out in a document containing as few as two to three pages. Unlike traditional financing arrangements, the payments of principal and interest on a convertible note can be deferred until maturity. Furthermore, the entire amount of accrued interest is often payable in additional equity, and not necessarily in cash. While the ability to preserve cash is usually critical to early-stage startups, there is a significant downside to this benefit under the current tax law. Enter Internal Revenue Code (IRC) Section 163(l).
IRC 163(l) operates to disallow the deduction for interest paid or accrued on a “disqualified debt instrument,” the indebtedness of a corporation that is payable in equity of the issuer. In layman’s terms, this means that if the issuer of debt (the corporation) decided at the time of the note’s maturity to pay the debt (a portion of which is interest) through the issuance of new equity, the deduction for the amount of interest paid may be disallowed under this rule.
Since most convertible notes contain a provision allowing the conversion of principal and interest to equity doesn’t that mean that all convertible notes are disqualified debt instruments? When it comes to the tax rules, the answer to most questions is dependent on facts and circumstances.
The general rules of IRC Section 163(l) provide that if an issuer of the debt has an option to convert the debt into equity, then the tax deduction for any interest paid with equity would be disallowed. On the other hand, if the holder of the debt has the option to convert both principal and accrued interest to equity, the interest expense deduction may not be disallowed. For the rule under IRC Section 163(l) to apply, it must be proven that there was “substantially certain” that the option to exercise the conversion to equity was inevitable. If substantial certainty is proven, then the disallowance of the interest expense deduction would be the result. To illustrate this point, if the language of the note provides the noteholder has an option to receive equity or cash to settle the debt, then there would appear to be uncertainty surrounding the ultimate payment of the note. It should be a reasonable conclusion, in this case, that the issuer and noteholder treated this debt in good faith, thus the rules of 163(l) would not apply.
To illustrate a situation where IRC Section 163(l) would apply, consider these facts:
A corporation issues $100,000 of debt via a convertible note. After one-year the accrued interest and principal totals $105,000. The issuer opts to convert the note to equity and also pay the accrued interest in the form of additional equity.
What are the tax consequences to the issuer and holder?
- The issuing corporation will issue equity to the holder equal to $105,000, and they will not be able to deduct the accrued interest paid.
- As the holder received equity worth $5,000 as payment of the interest they were owed, they will receive a Form 1099-OID for the $5,000. Even though not paid in cash, this interest is still taxable and is often referred to as “phantom income” since no cash was received. The $5,000 would add to the holder’s basis in the equity received for a total of $105,000.
While this trap for the unwary results in the loss of a tax deduction, whether or not it negates the other positive aspects of using convertible notes as a fundraising vehicle depends on numerous facts and circumstances. We strongly encourage you to consult with your W&G advisor to help analyze your situation and plan for any tax consequences surrounding such an issuance.
