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Convertible notes incorporate elements of both debt(1) and equity .(2) They possess the debt characteristics of payment of principal and interest and the equity characteristics embodied in the option to convert. This duality has led to their description by many writers as "hybrid" securities.(3) It has also led to controversy. This article examines some of the problems that arise from the dual nature of convertible notes and contrasts the different approaches that have been taken in Australia and the United States to these problems. First, the article analyses the term "convertible note': examines why companies issue convertible instruments and summarises some of the problems that have arisen in relation to convertible notes. Secondly, it provides an overview of Australian and United States legislation and case-law relating to the tax treatment of convertible notes, and concludes with a discussion of the relative merits of the different tax approaches adopted in each country and their possible impact on the financial sector.
The Oxford English Dictionary defines a "note" as "a written promise to pay a certain sum at a specified time".(4) The term "convertible" is defined as "capable of being 'converted' by exchange into property of another kind".(5) It follows from this that a convertible note is a written promise to pay a certain sum, at a specified time, which may be exchanged for property of another kind. Handbook of the Money and Capital Markets(6) adopts a similar definition:
"They [convertible notes] carry a call option, allowing the debenture holder to purchase some underlying asset, typically the common stock of the debenture issuer, where the exercise price of the option is the debenture itself."(7)
The limitation of these definitions is that problems may arise in relation to the distinction between convertible notes and secured loans. Specifically, the holder of a charge over some underlying asset has an "option" to take possession of that asset, subject to certain preconditions such as breach of loan covenants. How then is this to be distinguished from a convertible note? In this regard, a distinction might be: drawn between "purchase" and "possession" but this is hardly a satisfactory situation upon which to base a definition.
Another definition of "convertible notes" is as follows:
"debt instruments (bonds or debentures) or preferred stock...