Convertible notes are frequently used by startups to raise capital. One of the reasons companies use convertible notes to raise capital (rather than sell stock directly) is it is possible to raise money through the issuance of a convertible note without setting a valuation on the company. Instead, that valuation question is suspended or avoided until a later date (typically, when more money is invested; this subsequent fund raise is usually defined in the convertible note as a “qualifying financing”). On a qualifying financing, when the subsequent money is raised and the valuation is set, the convertible notes then convert into stock at the valuation set in the qualifying financing or at a discount to that valuation.
What happens for tax purposes when the notes convert into stock?
When convertible debt converts into stock, one of the key questions an investor will have is–is the conversion taxable?
Revenue Ruling 72-265, quoted below, is helpful in answering this question, and so we quote it below in full. You should always consult with your tax advisor as to the tax consequences of any particular transaction. We also have a comprehensive article about convertible debt and the tax implications.
Rev. Rul. 72-265, 1972-1 CB 222
No gain is realized upon the exchange of a convertible debenture for stock of the obligor corporation and the basis of the debenture becomes the basis of the stock, except where the Code specifically requires recognition of gain or loss; Mim. 3156 and G.C.M. 18436 superseded.
Advice has been requested concerning the Federal income tax consequences to the owner of a corporate debenture of his exercise of the right, provided for in the debenture, to surrender it and to receive in exchange common stock of the corporation.
A purchased on the open market in 1967 for 500x dollars a debenture of Y corporation with a principal amount of 500x dollars. The terms of the offering of this issue of debentures in 1965 had included a provision that, at any time before January 1, 1970, the holder of any debenture could surrender all or part (in multiples of 100x dollars of principal amount) of his holdings of this issue of debentures and would receive 20 shares of Y common stock for each 100x dollars of principal amount of the debentures surrendered. In 1969 A exercised the right to surrender the debenture and received therefor 100 shares of Y common stock with a total fair market value of 1000x dollars.
Section 1001(a) of the Internal Revenue Code of 1954 provides that the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis for determining gain and the loss shall be the excess of the adjusted basis for determining loss over the amount realized.
The conclusion that no gain or loss is realized upon the conversion of a corporate debenture into stock of the obligor corporation was initially stated in Article 1563 of Treasury Regulations 45 (1920 edition) under the Revenue Act of 1918. This rule remains applicable except where provisions of the Code specifically require that gain be recognized. See Revenue Ruling 72-264, page 131, this bulletin. No gain is therefore realized by A upon his exercise of the right to surrender the debenture for common stock. Similarly, the unadjusted basis of the 100 shares of Y common stock is 500x dollars, the cost of the debenture. The conversion of a debenture into stock of a different corporation, however, is a taxable event. See Revenue Ruling 69-135, C.B. 1969-1, 198.
Mim. 3156, C.B. II-2, 24(1923) and G.C.M. 18436, C.B. 1937-1, 101, are superseded since the position set forth therein is restated under current statute and regulations in this Revenue Ruling.