Convertible loan notes are increasingly a feature of the funding landscape, especially for early-stage companies. In addition, a number of the COVID-19 recovery support schemes also included funding through convertible loans. A convertible loan can provide much-needed finance for businesses but the accounting and resultant tax implications can be complex.

What is a convertible loan?

A convertible loan is an advance of a loan to a company which can be converted to equity (shares) in the future or may be repaid to the lender.

They will typically incur a lower rate of interest than mainstream debt because of the opportunity to participate in the growth in value in the company’s shares.

The key terms of a convertible loan will include:

• The interest rate;
• Any security arrangements;
• The circumstances in which the loan will be converted or repaid;
• The basis of the conversion to shares.

In addition, the loan note holders may also have certain rights akin to those that an equity investor might have.

When are they typically used?

Convertible loans are typically used by companies who are in need of funds to support their growth but are at a stage when they are unable to access mainstream debt facilities. They are therefore most commonly used when a company is still raising equity funds and the convertible loan provides additional cash runway to enable the company to raise the equity funds on the best possible terms.

UK resident individuals will typically want to benefit from tax relief on their investment via SEIS/EIS and a convertible loan should not be confused with an Advanced Subscription Agreement. An advanced subscription agreement can enable investors to invest funds before the shares are issued and can still enable tax relief to be claimed. A convertible loan cannot facilitate tax relief for the investor.

As a result, convertible loans are typically provided by individuals who cannot claim SEIS/EIS relief, corporate investors and government agencies such as Scottish Enterprise.

The complexities

Whilst convertible loans bring indisputable benefits to the business, the accounting treatment is not at all straightforward. There may be a temptation to record cash received as equity on the balance sheet as the loan may be converted into company shares in the future. This is, however, only possible if the number and price per share are fixed in the agreement, and there is no option to repay the loan in cash.

In other circumstances, such loans should be recognised as fully liability or both liability and equity (“compound instruments”), depending on the conversion terms. Further complications arise if the loan agreements introduce upper/lower limits to conversion price, discounts on conversion or early settlement features which provide exposure to risks and volatility unrelated to the loan. Depending on the accounting framework applied, such terms could indicate that the loan must be measured at fair value through profit and loss or, alternatively, that a separate financial instrument, an embedded derivative, should be recognised (unless it is “closely-related” when the company can elect to measure the whole instrument at a fair value).

Recording the loan at fair value through profit and loss in the financial statements results in additional volatility to the company’s income statement that cannot be fully explained by the contractual interest charged on the loan. This could affect key performance indicators of the business and alter the projected dividend payments. In addition, a valuation is required at each reporting date and the dates of drawing down and conversion/repayment of the loan which could increase the budgeted costs of the loan.

Tax treatment of these transactions should also be ascertained. The corporation tax relief for interest on convertible loan notes often does not follow the accounting entries or the flow of cash. The tax treatment can depend on a range of factors, such as the identity and residence of the note holders, the shareholder base of the issuing company, and the specific terms of the note. Where a conversion includes the settlement of accrued interest by the issue of shares to individuals, withholding tax obligations can effectively result in a “dry” tax charge for the issuing company, with income tax consequences to consider for the individual note holders. It is beneficial to understand the tax profile of a convertible loan note, both throughout its term and on conversion, from the outset.

It is therefore important to consider additional costs in relation to accounting for the convertible loans when making a decision on whether or not to issue such an instrument. Specialist advice should be sought to avoid possible errors in the financial statements and corporation tax returns of the company.

Get in touch

Our specialists can help you decide whether convertible loan notes are the right option for you and manage the resulting accounting and tax implications. If you would like to discuss this further, please don't hesitate to get in touch with Irina Cheburdanidze, Shaun Millican, or Suzanne Brownie.