Achieving Long-Term Capital Gains Treatment for Convertible Note Repayment Premiums

Today, many venture capital investors holding convertible notes of a start-up company may face an acquisition event of the startup company instead of a follow-on financing by the startup company. The convertible notes usually provide that investors can choose to be paid the original principle amount plus the repayment premiums, or convert notes into a pre-existing equity security at an attractive valuation in the event of acquisition. However, there is a tax risk that these convertible notes may be characterized as a “contingent payment debt instrument” (CPDI) as defined in Treas. Reg. Sec. 1.1275-4. One of the unfavorable tax consequence of this characterization is that certain payments on CPDI are taxed as ordinary income instead of capital gain even if the note has been held for more than one year.

Investors can avoid this characterization and achieve long-term capital gain treatment for repayment premiums on their convertible notes by employing one of the following arrangements:

  • A termination payment provision in the warrant coverage (or a token warrant if the notes employed conversion discount instead of warrant coverage) that obligates the start-up company to pay the warrant holder, upon termination of the warrant in the event of acquisition, an amount equal to what otherwise would have been a repayment premium under the corresponding convertible note. The termination payment will be taxed as long-term capital gain, if the investor held the warrant for more than one year.
  • An agreement with the start-up company to convert the notes prior to the acquisition into a newly-authorized series of preferred stock that entitle the holder to a liquidation preference equal to what otherwise would have been the repayment of the original principle amount plus the repayment premium. The acquisition proceeds received in respect to the newly authorized preferred stocks will be taxed as long-term capital gain, if the investor held the note for more than one year.

In sum, an investor may achieve a favorable tax treatment for convertible note repayment premiums by recasting repayment premiums into warrant termination payments or liquidation preference to newly authorized preferred stocks.

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Roger Royse

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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