Staying abreast of tax updates is becoming increasingly challenging due to the regular changes and extensions to Irish tax legislation and ever increasing number of Tax Appeals cases and decisions in Irish courts. We have highlighted and summarised a recent determination from the Tax Appeals Commission which may be of assistance to you when advising your clients:

70TACD2024 – Re: whether an instrument meets the definition of a “debt on security” for capital gains tax treatment

Overview

• This case centered on whether a Convertible Loan Agreement ("CLA") held by the appellant qualifies as a “debt on security” under Section 541 TCA 1997.
• The Appellant, along with his son, owned 100% of a company and over time provided substantial loans to the company through Convertible Loan Agreements.
• In 2018, the Appellant sold his shareholding and assigned the rights under the CLA to a third party for €21,350. The outstanding balance under the CLAs was €2,135,000 resulting in a claimed loss of €2,113,650.
• On disposal of the instrument, the appellant claimed a CGT loss which reduced his CGT liability. Revenue challenged this claim, on the basis that the instrument was not a “debt on security” under Section 541 TCA 1997 and therefore ineligible for loss relief against the Appellant’s CGT liability.
• A “debt on security” generally refers to a debt that is secured by some form of collateral or that has been issued in a form that gives it a security-like character, such as the potential for conversion to shares.

Revenue's Position

• Revenue argued that in this case, the instrument was not a “debt on security” as the potential for conversion into shares was "illusory" due to the company’s limited authorised share capital.
• Revenue’s position was that the CLA should be classified as a standard debt instrument rather than a “debt on security”. As such, this normal debt in the circumstances of the case would not come within the scope of CGT rules and the loss would not be an allowable capital loss under CGT rules.
• Additionally, they contended that the loss should not be allowed under Section 546A of TCA 1997, as they believe the arrangement was primarily designed to secure a tax advantage.

Appellant's Argument

• The Appellant contended that the CLA was a legitimate investment decision that provided security, flexibility, and the potential to convert the loan into equity.
• The loss incurred on the disposal of the CLA was a genuine commercial loss, and the Appellant sought to use it to offset gains from other investments.

Tax Appeal Commission Determination

• The TAC agreed with the interpretation of the Appellant determining that the CLA did indeed qualify as a "debt on security."
• The Commission emphasised the importance of the legal and commercial substance of the CLA over the form or theoretical possibilities (such as the ability to convert the debt into equity).
• The key issue was whether the CLA, as structured, genuinely functioned as a security-like instrument.
• The Commission focused on the inherent characteristics of the CLA as an instrument, rather than the practicalities or limitations of the company's authorised share capital.
• The key issue was whether the CLA, by its terms and design, constituted a "debt on security," not whether the conversion option was realistically feasible given the company’s share capital at the time.
• The Commission emphasised that the legal rights provided under the CLA, including the potential to convert the debt into equity, were sufficient to categorise the CLA as a "debt on security."
• The fact that the authorised share capital was insufficient for conversion did not negate the existence of those legal rights. The possibility of conversion, even if not immediately practical, was embedded in the agreement and was a key feature that contributed to its classification as a "debt on security."
• The Commission rejected the Revenue’s argument that Section 546A TCA 1997 applies in this circumstances, and ruled that it did not apply to the facts in this case. Section 546A generally deals with restrictions on the allowance of losses in circumstances where there is an arrangement or scheme designed to secure a tax advantage.

As summarised above, this case does highlight key considerations when implementing a “debt on security” type instrument into a transaction. The terms of the instrument, the underlying nature of the transaction and the commercial reality of the transaction should all be considered together and not in isolation.

Determining the correct tax treatment of complex financial instruments like Convertible Loan Agreements can be challenging and requires careful consideration of various factors. Given the complexities involved, seeking expert advice is essential to ensure optimal tax outcomes for your clients. The Omnipro tax and legal team has extensive experience in navigating these intricate areas of tax law. We can provide tailored guidance to help you make informed decisions. To discuss your specific circumstances, please book a convenient appointment with our team.

The contents of this article are meant as a guide only and are not a substitute for professional advice. The author/s accept no responsibility for any action taken, or refrained from, as a result of the material contained in this document. Specific advice should be obtained before acting or refraining from acting, in connection with the matters dealt with in this article.