Investment in Progress

Hotspot start-up financing: Income tax treatment of convertible loans

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In the early stages of start-ups, the question of financing plays a key role. Convertible loans take on the function of interim financing until the next financing round. The popularity of convertible loans is due, among other things, to the fact that they can be used to postpone some valuation issues, keep the cap-table „clean“ and are less complicated than capital increases.

Convertible loans often have a shorter term, are subordinated and with regard to interest final maturity is agreed during the term of the loan agreement in order to protect the company’s liquidity. In addition, a conversion obligation or a conversion right into a participation in the borrower (start-up) is provided in case of certain events as part of a future capital increase.

In order to make the conversion attractive, the conversion conditions generally provide for a „cap“ (= capped company valuation when the conversion right is exercised) or a „discount“ (= discount for company valuation when the conversion right is exercised) or a combination of both.

Tax aspects at lender level

In an unpublished answer to an inquiry the Austrian tax authorities assume that in the case of non-securitised convertible loans – in contrast to securitised convertible bonds – there is a taxable exchange at the time of conversion (loan claim against participation).

The tax authorities rely on the fact that securitised receivables and non-securitised receivables are subject to different tax consequences in case of private individuals. While income from securitised receivables is taxed at 27.5%, income from non-securitised receivables is subject to the progressive income tax rate.

In our opinion, however, there are many good reasons against the assumption of a taxable exchange:

  • analogous application of the Capital Measures Ordinance
  • exchange principle does not distinguish between securitised and non-securitised loans
  • conversion right arises from the convertible loan and is not separately tradable
  • conversion right is a unilateral right (by exercising the conversion right, the loan creditor does not effect an exchange but only the reassignment of his loan-related payment claim to a participation)
  • unobjective differentiation according to the type of shareholder, since the different tax consequences only apply to private individuals and not to (intermediate) corporations
  • difficulties in finding investors and thus impairing economically sensible measures
  • comparable legal situation in Germany, where the conversion of loans does not qualify as a taxable exchange

 

Tax aspects at start-up level

At the start-up level, a distinction must be made at the time of conversion between full recoverable and not (full) recoverable loan receivables. A waiver of a recoverable claim is seen as a contribution and therefore does not trigger any negative tax consequences.

If the convertible loan is granted in difficult times (which is usually the case with start-ups in the early seed phase), a receivable that is not (fully) recoverable could exist. In this case, a waiver of the claim would generally result in taxable operating income at the level of the start-up to the extent of the portion that is not recoverable, unless the loan does not qualify as hidden equity. However, since the loan receivable will regularly be classified as a recoverable receivable at the latest at the time of conversion – due to the injection of substantial equity funds in the course of a financing round – the conversion of the loan receivable should not result in any taxable business income in such cases.

Planned tax reform

In view of the planned tax reform, the legislator should not forget to create a correspondingly secure tax framework for start-ups in order to avoid locational disadvantages, as start-ups act as innovation drivers and thus have a positive effect on economic growth.

You can find further information about convertible loans and how they affect start-ups in our newly released article for the magazine swk (in German).

 

Authors:

Christoph Puchner, Managing Director and Tax Advisor & David Gloser, Partner, Chartered Accountant and Tax Advisor from ECOVIS Austria.