Abstract
The New Business Tax System (Debt and Equity) Act established a set of criteria by which convertible securities could be classified as “debt-like” or “equity-like” for tax purposes. Using data on 256 convertible issues made in Australia between 2001 and 2012, we show that there is a strong relation between, on the one hand, a convertible’s ex ante classification determined at issuance using the tax criteria and, on the other hand, its ex post classification based on the conversion premium at maturity. We conclude that the criteria have been an efficient means of classifying convertibles. We also find an industry effect where debt-like convertibles are more likely to be associated with the resources, metals and mining firms, whilst equity-like are mainly issued by the finance sector. This finding is consistent with the solution to a finance-sequencing problem in the former case, and the impact of capital adequacy regulation in the latter.
Appendix A: Determination of debt-interests
Appendix A details the principal rules determining whether an interest is debt-like. The debt test is set out in Subdivision 974-B of the ITAA 1997. For a security to qualify as debt-like, both a scheme and a financing arrangement are necessary. A scheme is in line with Section 995–1 of the ITAA 1997 and refers to any arrangement, scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. A financing arrangement is specifically defined and generally relates to those arrangements entered into by the issuer to raise finance or to fund another scheme that is a financing arrangement. Furthermore, a financial benefit making up an economic transaction is required and the benefit must be independent of the firm’s economic performance, i. e. the payment of coupons must be made irrespective of the firm’s economic performance. Moreover, the maturity of debt-like securities must be less than ten years and redemption/conversion to common stock may be carried out by either the issuer or investor.
Appendix B: Determination of equity-interests
Appendix B sets out the main rules which determine whether an interest is equity-like. The equity test is set out in Subdivision 974-C of the ITAA 1997. A member or a stockholder is defined as an entity holding an interest in the company where the return to the holder of the interest depends on the economic performance of the company − this is clearly an equity-like convertible. Furthermore, if the issuer only retains discretion in regards to conversion, then another feature of the equity-like test tax provisions is satisfied. The security may also be issued in perpetuity. It is conceivable that a security could pass both tests of debt and equity. The rules stipulate that in such cases the security is deemed to be a debt interest.
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