Did two-year convertible notes or the stock received on conversion qualify for Virginia's equity and subordinated-debt investment credit?

Subject

Ruling on convertible notes if qualified investments for purposes of Credit; equity would not qualify when the notes are converted.

Plain-English summary

Virginia ruled that neither the two-year convertible notes nor the common stock issued on conversion qualified for the investment credit. The proposed instrument failed both the holding-period and direct-cash-investment requirements described in the ruling.

A convertible investment could qualify only if the debt met the statutory subordinated-debt definition, the eventual equity met the equity definition, and the issuer could not compel conversion before the required holding period ended.

Here, the notes were payable or mandatorily convertible within two years. The credit rules required no conversion, retirement, or repayment during the first three years, so the notes failed.

The later stock also did not qualify independently. The investors' cash purchased the convertible notes; cash was not directly invested in qualifying equity when conversion occurred. Virginia strictly construed the credit against the taxpayer.

What this means for you

• Review maturity, redemption, and mandatory-conversion dates against the full statutory holding period.
• A later conversion into stock does not necessarily create a new qualifying cash equity investment.
• Tax-credit eligibility depends on the exact instrument and transaction sequence.

Common questions

Why did the notes fail? They had to convert or be repaid within two years, shorter than the required three-year holding period.

Why did the stock fail? The original cash bought notes, not equity directly.

Citations and references

• Va. Code § 58.1-339.4(A).
• P.D. 02-34 (March 12, 2002).
• Howell's Motor Freight, Inc. v. Virginia Department of Taxation, Roanoke Circuit Court Law No. 82-0846 (October 27, 1983).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 08-11

Original ruling text

January 11, 2008

Re: Ruling Request: Individual Income Tax

Dear *:

This letter will reply to your request for a ruling on behalf of your client, * (the "Taxpayer"), concerning the Qualified Equity and Subordinated Debt Investments Tax Credit (the "Credit").

FACTS

The Taxpayer plans to issue a subordinated debt that will be convertible into equity of the corporation. The convertible notes would be due and payable within two years after issuance. They also stipulate a mandatory conversion to equity when certain investment targets are met. The equity would be converted to common stock.

The Taxpayer requests a ruling as to whether the convertible notes would be qualified investments for purposes of the Credit, and if not, whether the equity would qualify when the notes are converted.

RULING

In Public Document 02-34 (3/12/2002), the Department set forth the standards under which a convertible investment may qualify under the Credit. A convertible instrument will qualify if:

1. The debt meets the definition of subordinated debt under Va. Code § 58.1-339.4 A;

2. The equity investment would meet the definition of equity under Va. Code

§ 58.1-339.4 A; and

3. The instrument does not include a provision by which the issuer may compel the conversion before the end of the required holding period.

A convertible subordinated debt instrument would not be subject to the recapture provisions of the Credit so long as no portion of the subordinated debt is converted, retired or repaid during the first three years after being issued. In this case, the notes are required to be either converted or redeemed within two years of the date of issuance. Accordingly, the convertible notes would not: qualify for the Credit.

In the alternative, the Taxpayer asks whether the equity would qualify for the Credit at the time of conversion of the notes. A credit against a state income tax is, in effect, an exemption from an already determined income tax liability. Credits, deductions or exemptions allowed in the computation of an income tax are privileges accorded as a matter of legislative grace and not as a matter of taxpayer rights. By reason of their character as legislative grants, statutes relating to deductions allowable in computing income and credits allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell's Motor Freight, Inc., et al. v. Virginia Department of Taxation , Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/83).

Under Va. Code § 58.1-339.4, a "qualified investment" is a "cash investment in a qualified business in the form of equity or subordinated debt." In this case, the Taxpayer's investors are making cash investment in a convertible note. Because cash was not directly invested in a qualified equity or subordinated debt, the Taxpayer's investors would not be considered to have made a qualified investment. Accordingly, the equity resulting from the conversion of notes would not qualify for the credit.

This ruling is based on the facts provided as summarized above. Any change in facts or the introduction of new facts may lead to a different result.

The Code of Virginia section and public document cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this ruling, you may contact * of the Appeals and Rulings Unit at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

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