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16 April, 1999
RE: Taxation treatment of Debt/Equity Hybrids
Please find enclosed a copy of my research paper recently published in the Journal of Multinational Financial Management Vol. 8 (1998), co-authored by Dr. Edward Watts and Dr. Sue Wright, dealing with the issue of whether convertible notes should be treated as debt or equity, or whether a system of "bifurcation" is more appropriate. The principles applied in the study are also applicable to other types of debt/equity hybrids.
The paper may offer a threefold contribution to the debate relating to how hybrids should be treated for taxation purposes. The following provides a one-paragraph summary of each point.
Firstly, the paper is strongly critical of the present taxation regime that applies to convertible notes under S82SA of the Income Tax Assessment Act (1936). In particular, the severe restrictions placed on tax deductibility for interest payments relating to such instruments seems antiquated given that the system of imputation taxation on dividend income limits severely the taxation advantage that could be gained by using equity-like convertible notes as a substitute for ordinary equity financing. An exception to this rule may be the case of foreign investors who are not eligible for imputation credits. In such cases there may be a taxation benefit available to companies that pay interest on debt/equity hybrids instead of dividends on equity capital, as interest payments are tax deductible for the Australian company whereas dividends are not. The foreign investor will presumably face full tax on either source of income in his or her home country.
Secondly, the paper provides empirical evidence regarding the nature of convertible notes. The paper supports the Kim (1990) theory that convertible notes can be relatively more debt-like or more equity-like dependent upon the conversion terms of the issue. This theory contradicts the Stein (1992) hypothesis that convertible notes are simply " backdoor equity." Support for the Kim theory, in turn provides support for the finding that the current tax treatment of convertible notes is overly restrictive, since convertible notes that are debt-like when assessed according to their conversion terms have their interest payments disallowed as tax deductions due to other criteria. Mourell and Willoughby (1993) highlight the inequity of these restrictive criteria, in that they do not allow Australian firms to raise finance on equal terms to their overseas competitors, and suggest that these restrictions may be a contributor to Australias foreign indebtedness as firms are forced to borrow overseas to avoid Australias restrictive tax regime.
Thirdly, the paper offers a tool that could assist in either categorisation of convertible notes into those that are debt-like and those that are equity-like, or could assist in the process of "bifurcation." Expected time to at-the-money is a measure of the length of time that is likely to pass before the convertible note is exchanged for ordinary shares of the issuer. It is this variable that is essential to determining whether a convertible note is relatively more debt-like or more equity-like. If a convertible note is issued with conversion terms such that it is unlikely to be converted to equity during its lifetime it is difficult to consider the instrument to be anything other than particularly debt-like. On the other hand, when a convertible note is issued with conversion terms that ensure conversion to equity soon after issuance, the instrument should be considered to be very similar to an equity security.
The copy of my paper included with this letter develops the above points more fully. I hope you find the results of our research of assistance to the review.