Tax Type
Corporation Income Tax
Individual Income Tax
Description
Qualified Equity and Subordinated Debt Investments Tax Credit
Topic
Basis of Tax
Credits
Date Issued
03-12-2002
March 12, 2002
Re: Ruling Request: Qualified Equity and Subordinated Debt Investments Tax Credit
Dear *****
This letter will reply to your request for clarification of the department's ruling concerning convertible instruments with regard to the Qualified Equity and Subordinated Debt Investments Tax Credit (the "Credit").
FACTS
The statute authorizing the Credit does not address convertible instruments. In keeping with the intent of the statute, the department has previously ruled that convertible instruments could qualify for the Credit under certain conditions. See Public Document ("P.D.") 01-153 (10/9/2001), copy attached.
You have raised an issue with the department's standard prohibiting otherwise qualified investments from having a forced conversion or call provision. You believe an issuer should be allowed to require a forced conversion of a qualified convertible subordinated debt instrument to qualified equity upon the occurrence of specified events, upon the expiration of the required three-year debt holding period.
In addition, you would like the department to reconsider the prohibition against any prepayment of debt principal by an issuer within three years of the date of issue. You aver the issuers should be allowed to make voluntary repayments of debt principal prior to the expiration of the required three-year debt holding period.
RULING
Convertible InstrumentsIn P.D. 01-153, the department set forth the following standards under which a convertible investment may qualify under the Credit:
1. the debt meets the definition of subordinated debt under Code of Virginia
§ 58.1-339.4(A),
2. the equity investment would meet the definition of equity under Code of Virginia
§ 58.1-339.4(A); and
3. the instrument does not include a call provision by which the issuer may force the conversion or retirement of the instrument.
The department's responsibilities under the Credit program are to enable individual taxpayers to earn and claim the Credit and administer the $5 million cap. To that end, the department developed the standards for allowing for the conversion of an investment in order to give individual taxpayers assurance that the holding period of such an investment could not be affected by the actions of an issuer.
You have indicated that many debt instruments issued by small businesses include provisions that trigger automatic conversion when certain events occur or allow the issuer an option to force conversion. However, you assert that these types of provisions are usually set to become effective after the three-year holding period required by the credit. You believe the departments standards as stated in P.D. 01-153 could be interpreted to disqualify instruments that have included an automatic or forced conversion provision even if such provision cannot be executed until after the end of the Credit holding period.
In the instant case, the department finds it appropriate to clarify its ruling in P.D. 01-153. The department's primary purpose in protecting the holding period is to prevent an individual taxpayer from being subject to the recapture provisions of the Credit or a longer holding period due to circumstances that are out of the taxpayer's control. The department's standards as set forth in P.D. 01-153 are, therefore, modified as:
1. the debt meets the definition of subordinated debt under Code of Virginia
§ 58.1-339.4(A),
2. the equity investment would meet the definition of equity under Code of Virginia
§ 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.
Repayment of Principal
With regard to the department's position on the repayment of principal, you assert that Code of Virginia § 58.1-339.4(A) does not permit a qualified debt instrument to require repayment of principal for the first three years after issuance, but does not prohibit an issuer from exercising a prepayment option if permitted by the instrument. As such, you suggest that an issuer should have the flexibility to prepay all or a portion of a qualified subordinated debt instrument.
Under the statute, a subordinated debt instrument will not qualify if it requires any repayment that would be considered principal within three years of issuance. The statute also sets forth the conditions under which an equity investment may be transferred before the expiration of the required holding period without triggering a recapture of the Credit. The department believes that these conditions express the intent of the General Assembly that qualified businesses benefit from these sources of capital for the duration of the required holding period and that these conditions would also apply to subordinated debt instruments. As such, the department would view any repayment of a qualified subordinated debt instrument within three years of issuance as a trigger for recapture of the Credit unless such repayment, retirement or replacement occurs as a result of the liquidation of a qualified business, the merger or acquisition of such business with or by an unrelated third party, or the death of the taxpayer.
For purposes of the holding period repayment restriction, repayment of principal would include any transaction the effect of which is to extinguish or to reduce outstanding subordinated debt, including, but not limited to:
1. Reacquisition, retirement, or cancellation of a qualified investment;
2. Refunding or refinancing by new issues of subordinated debt; or
3. Exchange of subordinated debt for common or preferred stock.
On January 23, 2002, the department, effective for tax years beginning on and after January 1, 2001, adopted final regulations (Title 23 of the Virginia Administrative Code ("VAC") 10-110-225 through 229), copy enclosed, for the Credit. These final regulations include the department's standards for convertible subordinated debt investments and the prepayment of principal of qualified subordinated debt. They were published in The Virginia Register of Regulations, Volume 18, Issue 11, on February 11, 2002.
I trust that this reply will address your concerns. If you have any questions regarding this ruling, you may call ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
Sincerely,
Danny M. Payne
Tax Commissioner
AR/37602
Rulings of the Tax Commissioner