A convertible note (which is one type of convertible interest) is another type of investment you can make in a company or unit trust. A convertible note earns interest on the amount you pay to acquire the note until the note’s expiry date. On expiry of the note, you can either ask for the return of the money paid or convert that amount to acquire new shares or units.
Convertible notes you acquired after 10 May 1989 will generally not be subject to CGT if you sold or disposed of them before they were converted into shares. Instead, you include any gain you make on your tax return as ordinary income and any loss you make is included as a deduction.
If the TOFA rules apply to you, gains and losses from your convertible notes may be brought to account under those TOFA rules. For more information about the TOFA rules, see Guide to the taxation of financial arrangements (TOFA) rules
For more information, see You and your shares 2013.
Conversion of notes to shares
The tax treatment that applies when your convertible notes are converted to shares depends on when you acquired the convertible notes, the type of convertible note, when the conversion occurred and when the convertible note was issued.
Shares acquired by the conversion of convertible notes on or after 20 September 1985 will be subject to CGT when they are sold or disposed of as the shares are taken to be acquired when the conversion happens.
You may have acquired the convertible notes on or after 20 September 1985 and, as a traditional security or qualifying security, you have already included the gain you made on the conversion of the notes on your tax return as income (or as a deduction if you made a loss). The way you calculate the cost base of the shares varies depending on whether the notes converted to shares before 1 July 2001 or on or after that date. Table 4 below provides a summary.
Convertible notes issued after 14 May 2002
If your convertible notes are traditional securities and were issued by a company after 14 May 2002:
- any gains you make when these notes are converted or exchanged for ordinary shares in a company will not be ordinary income at the time of conversion or exchange, and any losses you make will not be deductible
- instead, any gains or losses you make on the later sale or disposal of the shares (incorporating any gain or loss that would have been made on the conversion or exchange of the notes) will be
- subject to CGT if you are an ordinary investor, or
- ordinary income (or deductible, in the case of a loss) if you are in the business of trading in shares and other securities.
If you are an individual who is an ordinary investor, this means you will be able to get the benefit of the CGT discount if you own the shares for more than 12 months. Table 4 below sets out how you calculate the cost base.
Table 4: Treatment of convertible notes acquired after 10 May 1989, converted to shares
| Convertible note | Converted before 1 July 2001 | Converted on or after 1 July 2001 |
|---|---|---|
The note is a traditional security* that was issued before 15 May 2002. |
You include gain on conversion as income (or loss on conversion is deducted). Cost base of shares includes their market value at the date the convertible notes were converted. |
You include gain on conversion as income (or loss on conversion is deducted). Cost base of shares includes cost base of the convertible note, any amount paid on conversion and any amount included in your assessable income on conversion. |
The note is a traditional security* that was issued after 14 May 2002. |
Not applicable |
You disregard gain (or loss) on conversion. Cost base of shares includes cost base of the convertible note and any amount paid on conversion. |
The note is a qualifying security**. |
You include accrued gains as income and include any gain on conversion as income (or deduct any loss on conversion). Cost base of shares includes amounts paid to acquire the note and any amount paid on conversion. |
You include accrued gains as income and include any gain on conversion as income (or deduct any loss on conversion). Cost base of shares includes cost base of the convertible note, any amount paid on conversion and any amount included in your assessable income on conversion. |
*A traditional security is one that is not issued at a discount of more than 1.5%, does not bear deferred interest and is not capital indexed. It may be, for example, a bond, a deposit with a financial institution, or a secured or unsecured loan.
**A qualifying security is one that has a deferred income element, that is, it is issued under terms such that the investor’s return on investment (other than periodic interest) will be greater than 1.5% per annum.
Conversion of notes to units
Convertible notes, converted before 1 July 2001
If your convertible notes are traditional securities, the first element of the cost base and reduced cost base of the units is their market value at the time of conversion. You disregard any capital gain or capital loss made on their conversion to units in the unit trust.
If your convertible notes are not traditional securities and were issued by the unit trust after 28 January 1988, the first element of the cost base and reduced cost base of the units includes both the cost of the convertible notes and any further amount payable on their conversion. You disregard any capital gain or capital loss made on their conversion to units in the unit trust.
Convertible notes, converted after 1 July 2001
If your convertible notes are traditional securities the first element of the cost base and reduced cost base of the units includes:
- the cost base of the convertible notes plus
- any amount paid on conversion plus
- any amount included in your assessable income on conversion.
You disregard any capital gain or capital loss made on their conversion to units in the unit trust.
Similarly, if the convertible notes are not traditional securities and were issued by the unit trust after 28 January 1988, the first element of the cost base and reduced cost base of the units includes:
- the cost base of the convertible notes plus
- any amount paid on conversion plus
- any amount included in your assessable income on conversion.
You disregard any capital gain or capital loss made on their conversion to units in the unit trust.
Example 41: Converting notes to shares
David bought 1,000 convertible notes in DCS Ltd on 1 July 1997 (that is, notes that were issued before 15 May 2002). The notes cost $5 each. Each convertible note is convertible into one DCS Ltd share. On expiry of the notes on 1 July 2000, shares in the company were worth $7 each. David converted the notes to shares, which are subject to CGT. No further amount was payable on conversion of the notes. David sold the shares on 4 December 2012 for $10 each.
The $2 ($7 – $5) gain David made on the conversion of each of the notes to shares was assessable to David as ordinary income at the time of conversion, that is, in the 2000–01 income year. As such, David has no capital gain in that year.
The $3 ($10 – $7) gain David made on the sale of each of the shares is subject to CGT. The $7 cost base is the market value per share on the date the notes converted to shares. Because he sold the shares after 11.45am (by legal time in the ACT) on 21 September 1999 and owned them for at least 12 months, David can claim the CGT discount. David calculates his capital gain as follows:
$3 per share x 1,000 shares = |
$3,000 |
less CGT discount of 50% |
$1,500 |
Net capital gain |
$1,500 |
David includes the capital gain on his 2013 tax return.
End of example