Navigating Taxes: Convertible Debt and SAFEs Explained

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Tax Treatment of Convertible Debt and SAFEs

Written by Daniel Mayo, Partner at Withum

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.

Purchase

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.

Ownership

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...

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