Convertible debt is attractive for pre-and post-valuation start-up companies and others looking to conserve cash and to avoid dilution of their capital structure in the short term.
It is a hybrid instrument consisting of a combination of nonconvertible debt and an out-of-the-money call option (usually American style) on a fixed amount of the issuer’s stock. Because of the embedded call option, convertible debt typically is priced at a yield to maturity that is lower than nonconvertible debt with comparable terms.
From the investor’s standpoint, the investment thesis is fairly straightforward – the investor accepts a reduced rate of interest on the debt in exchange for the call option on the issuer’s stock. For example, if an issuer can issue traditional nonconvertible debt at a yield to maturity of 10% per year, then let’s assume it can issue convertible debt with otherwise comparable terms at a yield to maturity of 7% per year. In this case, the holder has traded 3% of yield in exchange for its receipt of the conversion feature. Ideally, the value of the conversion feature is equal to the present value of the 3% yield over the life of the debt. Often times, however, convertible debt is priced “theoretically cheap,” meaning that its issue price is less than the value of the sum of its components.
For legal purposes, convertible debt is issued as one integrated security, unlike an investment unit that consists of separate or separable components. The federal income tax rules generally respect the integrated nature of convertible debt and do not bifurcate it into its constituent parts, even though such an approach would conform the tax treatment to the underlying economics. There are circumstances where convertible debt can be treated as equity rather than as debt, such as where the embedded call option is deep-in-the-money at issuance and there is a very high probability that the debt will convert into stock, but such treatment is the exception rather than the rule and we assume debt treatment for the remainder of this discussion.
Tax Treatment of Convertible Debt
Below is a summary of federal income tax consequences relating to the ownership and issuance of convertible debt. It is general in nature and exceptions abound, so please consult your tax advisor for advice in regard to your particular situation.
The purchase of convertible debt is not a taxable event to the holder unless he transfers appreciated or depreciated property in exchange for the debt. Similarly, the issuer’s receipt of proceeds from issuing convertible debt is not a taxable event.
The holder and issuer of convertible debt are subject to the normal interest inclusion/deduction rules that apply to stated interest payments on debt. Even though the conversion feature itself does not create original issue discount (OID), there can still be OID if a convertible debt is issued with more than a de minimis amount of discount, or if the stated interest on the debt is not qualified stated interest, meaning that it is not fixed-rate, stated interest that is unconditionally payable in cash or property (other than debt of the issuer) at least annually during the entire term of the debt.
A holder that purchases convertible debt at a premium generally would be subject to the bond premium amortization rules, which generally add the premium to the holder’s basis in the convertible debt unless an election is made to amortize it and to reduce the holder’s current interest inclusions by the amortized portion. In calculating the amount of bond premium, the value of the conversion feature is excluded.
Sale or Other Disposition
A holder generally realizes capital gain or loss on the sale or other disposition of convertible debt, assuming it is held as a capital asset. The amount of gain or loss is equal to the difference between the fair market value of the proceeds received and the holder’s basis in the convertible debt as adjusted to reflect any accrued but unpaid interest as of the exchange date. There are exceptions where ordinary income would be recognized instead of capital gain, such as when there is an accrued market discount on the debt at the time of the disposition.
The conversion of convertible debt into stock is not a taxable event to the holder because the tax law views it as a transformation of ownership rather than as a disposition. The holder is not taxed on the conversion, even if the value of the stock received on the conversion exceeds the principal amount of the debt; however, any stock received in payment of accrued interest that has not already been included in income will be taxable. He also takes a carryover basis (plus the amount of any accrued interest recognized under the preceding sentence) and holding period in the stock. So if the holder held the convertible debt for 360 days before the conversion, then his holding in the stock after the conversion includes such a period of ownership.
The conversion has no tax consequences to the issuer, except that it stops paying interest, and taking interest deductions if it is not subject to section 163(l). Note that the legislative history to section 163(l) states that “it is not expected that the provision will affect debt with a conversion feature where the conversion price is significantly higher than the market price of the stock on the issue date of the debt.”
Lapse of Conversion Right (or Issuer’s Repurchase Right)
The expiration of a conversion/repurchase right is not a taxable event to the holder or to the issuer because such rights are not treated as items of separate property for federal income tax purposes.
Repurchase Before Maturity
If the issuer repurchases its convertible debt before maturity for an amount in excess of the debt’s adjusted issue price, then the issuer can deduct the repurchase premium as additional interest expense, subject to limitation or disallowance under section 249. The policy underlying this limitation is that the cost of the repurchase should not be deductible to the extent it is attributable to appreciation on the embedded option, which is capital in nature.
If the issuer repurchases its convertible debt for an amount less than its adjusted issue price, then the issuer should recognize cancellation of indebtedness income, unless one of many exceptions apply.
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SAFEs, or simple agreements for future equity, were introduced by Y Combinator in late 2013 as a replacement for convertible debt. They are a popular way for early-stage start-ups to raise capital and are often preferred over convertible debt because they bear no interest, have no maturity date, and convert into equity only if certain predetermined criteria are met.
In a typical SAFE, the investor provides funding to the issuer in exchange for the right to acquire equity in the future upon the occurrence of a triggering event, such as the completion of a priced round of equity financing, sale of the company, or dissolution. It is fully prepaid and the investor has no funding obligation beyond the purchase price paid for the SAFE. The SAFE terminates after it converts to equity.
SAFEs are intended to be simple, flexible agreements that provide little room for negotiation beyond the valuation cap, or the maximum valuation at which the SAFE will convert into equity. The future equity price is not specified in the SAFE agreement and it provides no exercise or maturity dates; rather, these items are determined in the future when there is a triggering event – either an Equity Financing, Liquidity Event, or Dissolution Event. If there is a Liquidity Event (e.g., change of control or IPO) before conversion, then an investor receives the greater of (i) the purchase price for the SAFE or (ii) the as-converted proceeds he would have been entitled to receive in the Liquidity Event. If there is a Dissolution Event before conversion, then an investor receives back the purchase price for the SAFE. In both cases, the investor’s claim is junior to creditors and outstanding indebtedness and has the same priority as non-participating preferred stock. In sum, SAFEs provide investors with equity upside and none of the downside protections of debt.
The tax treatment of SAFEs is unclear and there is no IRS guidance squarely on point. The general approach to taxing new derivatives like SAFEs is to try and assign them to various categories of transactions for which there are established rules. These categories are commonly referred to as “cubbyholes.” New financial transactions often do not fit neatly into any one cubbyhole and this creates uncertainty regarding the tax treatment.
SAFEs do not fit precisely into any cubbyhole. Despite their resemblance to convertible debt, they should not be treated as debt because they lack a repayment obligation, interest payments, creditors’ rights, and a maturity date, among other things. SAFEs also lack many of the rights traditionally associated with equity, such as dividend rights and the right to vote on corporate matters, but they can be treated as equity if upon issuance they are substantially certain to be converted into equity.
Putting aside equity treatment, the two remaining cubbyholes into which SAFEs could fit are options and forward contracts. In exchange for the payment of a premium, options provide the holder the right but not the obligation to purchase property at a fixed price within a limited period of time. In contrast, SAFEs do not contain a premium, a fixed strike price, or a maturity date. They are fully prepaid and do not contain optionality. For these reasons, option treatment is not a good fit. The remaining cubbyhole is forward contracts, and more particularly variable prepaid forward contracts.
In a forward contract, one party obligates itself to purchase from the other party a fixed amount of property at a fixed price on a fixed future date. In legal terms, it is a bilateral executory contract. The forward buyer is betting that the price of the underlying property will increase and the forward seller is betting that it will fall. Forward contracts can be prepaid – where the purchase price is paid upon execution of the forward contract, or postpaid – where the purchase price is paid upon settlement of the forward contract. They also can be physically settled in property, or cash-settled with an amount of money equal to the difference between the contract price and the value of the property when the contract expires. If the number of shares to be purchased under a forward contract is variable (e.g., it depends on the future price of the underlying property), then the contract is referred to as a variable forward contract. Variable prepaid forward contracts are fairly common in the market and typically are used in monetization transactions involving low-basis stock.
Forward contracts are afforded open transaction treatment for tax purposes. There are no tax consequences to the parties upon execution of the contract, and the seller takes any amount received under the contract into account upon settlement of the contract. The fact that some or all of the purchase price has been prepaid under a forward contract does not alter its general tax treatment. In 2003, the IRS issued a published ruling confirming the open transaction tax treatment of variable prepaid forward contracts.
SAFEs are economically similar to variable prepaid forward contracts. The investor pays an amount of money upfront to the issuer and has the right to acquire a variable amount of equity in the future. No additional amount of money is required to be paid by the investor under a SAFE. Although the number of shares to be acquired and the purchase date are not specified in a SAFE, there is a formula to determine these items and this should not disqualify SAFEs from treatment as variable prepaid forward contracts.
Assuming the treatment of SAFEs as variable prepaid forward contracts, the acquisition of a SAFE, and the issuer’s receipt of money at inception, should not be taxable events to either party. The subsequent issuance of shares in satisfaction of the SAFE also is not a taxable event, though, in the case of physical settlement, the investor’s basis in the stock received equals the amount he paid to acquire the SAFE. The investor’s holding period starts anew, which is important because holding period is one of the key factors determining eligibility for the gain exclusion in section 1202, relating to qualified small business stock and for determining a taxpayer’s entitlement to long-term capital gain treatment.
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