Does an investment in a certified Qualified Emerging Technology Company made in the form of convertible debt qualify for New York's QETC tax credit, and if so, in which tax year is the credit claimed?

Plain-English summary

An accounting firm, Salmin, Celona, Wehrle & Flaherty, asked the Department to interpret "qualified investment" for purposes of the Qualified Emerging Technology Company (QETC) credit under Tax Law § 606(r). Investors in start-up companies frequently fund them with convertible debt: the investor makes a loan (takes a note) from the company, expecting the note to convert into capital stock within a year or two, typically once a later financing round makes the stock's value easier to determine. Accrued interest, along with the principal invested, is often folded into the stock received on conversion. The petitioner asked whether this kind of convertible-debt investment counts as a qualified investment in a certified QETC and, if so, whether the credit is claimed in the year the note is taken or the year it converts.

The Department explained that a "qualified investment" under § 606(r)(1)(C) means "the contribution of property to a corporation in exchange for original issue capital stock or other ownership interest." Because the investor doesn't receive stock at the time the note is issued, the question was whether the loan itself already amounts to a contribution of property in exchange for an ownership interest. The Department said no on both counts: a convertible-debt investment is essentially an interim loan, subject to conditions that may or may not be satisfied, and it's possible the capital will simply be returned and the note cancelled rather than converted. That contingency makes it hard to call the transaction a "contribution of property." Nor does holding a debt note give the investor an "ownership interest" - the start-up hasn't ceded any control over its business, there's been no change in dominion over its operations, and the note holder has no right to dispose of corporate property, citing Martin v. Commissioner and Key Homes Inc. v. Commissioner of Internal Revenue as examples of established ownership indicia.

Because neither element of a qualified investment exists at the time the note is issued, the investor isn't entitled to the QETC credit then. The credit becomes available only if and when the note actually converts into original issue capital stock - at that point the investor has both contributed property and received an ownership interest. The Department concluded that the qualified investment is made in the year of conversion, not the year the note was given, and that the amount of the qualified investment includes any interest that has accrued on the note by the time of conversion.

What this means for you

Investors funding QETCs with convertible notes

If you invest in a certified QETC using convertible debt rather than a direct stock purchase, you cannot claim the Tax Law § 606(r) QETC credit in the year you make the loan. The credit is only available in the tax year the note actually converts into original issue capital stock. If the note is never converted - for example, if it's repaid and cancelled instead - no qualified investment under § 606(r)(1)(C) is ever made.

Calculating the credit once conversion happens

When the note does convert, the qualified investment isn't limited to the principal you originally advanced. Any accrued interest on the note that is also converted into capital stock at that time is included in the qualified investment amount for purposes of computing the credit.

Common questions

Q: I made a convertible-debt investment in a QETC last year but the note hasn't converted yet. Can I claim the credit this year?
A: No. Until the note converts to original issue capital stock, you haven't made a "contribution of property" in exchange for an "ownership interest," so no qualified investment has occurred yet under Tax Law § 606(r)(1)(C).

Q: Why doesn't a loan to the company count as a contribution of property?
A: Because a convertible-debt transaction is contingent - depending on future events, the capital might be returned to the investor and the note cancelled rather than converted, so the Department would not characterize the initial loan as a completed contribution of property.

Q: Why doesn't holding the note give the investor an ownership interest?
A: A note holder is a creditor, not an owner. The company hasn't ceded control of its business, there's no change in dominion over its operations, and the note holder has no right to dispose of the corporation's property - the traditional indicia of ownership are absent.

Q: When my note converts, does only the original principal count toward the credit?
A: No. The qualified investment includes accrued interest on the note that is converted into capital stock at the time of conversion, in addition to the principal.

Citations and references

• Tax Law § 606(r) - credit against the tax imposed by Article 22 for qualified investments in a Qualified Emerging Technology Company
• Tax Law § 606(r)(1)(C) - defines "qualified investment" as the contribution of property to a corporation in exchange for original issue capital stock or other ownership interest
• Martin v. Commissioner, 56 T.C. 1255 (1971) - cited for indicia of corporate ownership
• Key Homes Inc. v. Commissioner of Internal Revenue, 30 T.C. 109 (1958) - cited for indicia of corporate ownership

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_2009.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a09_1i.pdf

Original ruling text

New York State Department of Taxation and Finance

TSB-A-09(1)I
Income Tax
February 5, 2009

Office of Counsel
Advisory Opinion Unit
STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I080603A

A petition dated May 30, 2008 requests an interpretation of the term “qualified investment” for
purposes of Section 606(r)(1)(C) of the Tax Law. Specifically, petitioner asks whether an investment in a
certified Qualified Emerging Technology Company (QETC) in the form of convertible debt constitutes a
qualified investment for purposes of the QETC tax credit available pursuant to section 606(r) of the Tax Law
and, if so, whether the credit may be claimed in the tax year in which the note is taken or the tax year in
which the note is converted.
Facts
Petitioner has advised that investments in start-up companies are frequently made in the form of
convertible debt, wherein a note is taken by an investor from the company with the expectation that the note
will convert into capital stock within a year or two of the initial investment. These conversions are typically
structured so that the conversion will occur during a period of financing for the company where the market
value of the stock is more readily ascertainable. Accrued interest, along with the principal amount invested,
is often converted into capital stock.
Analysis
Section 606(r) of the Tax Law provides that a taxpayer will be allowed a credit against the tax
imposed by Article 22 for certain qualified investments made in a QETC. A qualified investment is defined
as “the contribution of property to a corporation in exchange for original issue capital stock or other
ownership interest.” (Tax Law section 606(r)(1)(C)). Since the investor does not receive the stock at the
time of the investment, the issue is whether the investment represents a contribution of property in exchange
for an ownership interest in the corporation within the meaning of section 606(r)(1)(C).
The role of the investor in the convertible security transaction is essentially that of an interim lender.
The investor loans the money to the corporation in exchange for the promise of a stock transfer at some
future date. The first issue is whether or not the loan of capital constitutes a “contribution of property” for
purposes of section 606(r)(1)(C)). By its very nature, a convertible securities transaction is one in which
conditions may or may not be met if and/or when the note is converted to stock. It is thus possible that the
capital will be returned to the investor and the note cancelled upon the occurrence or non-occurrence of
certain events. Under those circumstances, it would be difficult for us to characterize this particular
transaction (i.e. the loaning of money in exchange for a note and the promise of future events) as a
contribution of property for purposes of section 606.

TSB-A-09(1)I
Income Tax
February 5, 2009

-2-

Nor does the holder of a note evidencing a debt obligation incurred by a corporation have an
ownership interest in that corporation. Although the statute does not define “ownership interest” for
purposes of this credit, there are well-established indicia of ownership in the law. In this case, the start-up
company has not given up any of its rights to control its business, there has been no substantial change in the
dominion and control over its operations, and the note holder has no right to dispose of any property of the
corporation. (See, e.g., Martin v. Commissioner, 56 T.C.1255 (1971), Key Homes Inc. v. Comm’r of
Internal Revenue, 30 T.C. 109 (1958)).
Therefore, if the investor has neither made a contribution of property nor has acquired an
ownership interest in the corporation at the time the initial investment in the QETC is made, he is not
entitled to the QETC credit at that time. However, if and when the note is converted to original issue
capital stock, the investor is entitled to the QETC credit at that time.
Conclusion
For purposes of the QETC credit, a qualified investment is made in a QETC in the year that a note is
converted to capital stock, not in the year the note is given. The amount of the qualified investment will
include accrued interest on the note at the time of the conversion.

DATED: February 5, 2009

NOTE:

/S/
Jonathan Pessen
Director of Advisory Opinions
Office of Counsel

An Advisory Opinion is issued at the request of a person or entity. It is limited to the
facts set forth therein and is binding on the Department only with respect to the person
or entity to whom it is issued and only if the person or entity fully and accurately
describes all relevant facts. An Advisory Opinion is based on the law, regulations, and
Department policies in effect as of the date the Opinion is issued or for the specific
time period at issue in the Opinion.