In the early phase of start-ups, the question of financing plays an essential role. Convertible loans take on the function of interim financing until the next financing round. However, in the case of private individuals as lenders, there may also be fictitious profit taxation in certain cases.

 

Convertible loans
Convertible loans are becoming increasingly popular for financing start-ups. Convertible loans often have a rather short term, are subordinated and, with regard to the interest rate, a final maturity is agreed in order to preserve the liquidity of the company during the term of the loan agreement. In addition, a conversion obligation or a conversion right into a participation in the start-up is provided for upon the occurrence of certain events in the context of a future capital increase.

In the course of the conversion, the loan (including outstanding interest at final maturity) is converted into a participation. In order to make the conversion attractive, a „cap“ (= capped company valuation upon exercise of the conversion right) or „discount“ (= discount on the company valuation upon exercise of the conversion right) is usually provided for in the conversion conditions. In some cases, a cap is combined with a discount. Such economic incentives compensate for the higher risk of an unsecured investment in the early phase of the start-up and the fundamental lack of voting and minority rights of the investor.

Convertible loans are preferred for various reasons. For example, convertible loans can be granted as interim financing until the next financing round, whereby the period until the conversion date is often regarded as a „trial period“. Apart from this, convertible loans in the early phase of the start-up (early seed phase) can partly postpone valuation issues, as only the loan amount (investment) including interest and the conversion date have to be fixed. Furthermore, the cap table (shareholding ratios) remains „clean“ until the next financing round. Finally, convertible loans are generally less complicated under civil and company law than capital increases and can therefore be implemented more quickly.

 

How can a fictitious profit taxation occur?
According to the Austrian tax authorities, the exercise of the conversion right constitutes an exchange from a tax perspective (exchange of a loan claim for a participation). The following simplified example illustrates the idea of taxation according to the principle of exchange:

A private person grants a loan of € 100,000 as an investor to a start-up in the legal form of a GmbH. In this context a cap of € 10 million is agreed, so that the takeover price for the participation received as a result of the conversion is capped at a valuation of € 10 million. The convertible loan therefor corresponds to a participation of 1%.
The start-up develops positively, so that after ten months a new investor enters in the course of a financing round with a valuation of € 12 million. In the course of the financing round the convertible loan creditor converts his loan into a participation in the start-up. Due to the convertible loan agreement, the private individual receives a consideration in the form of a participation in the amount of € 120.000 (1% of € 12 million). Therefore, a profit of € 20,000 is achieved through the conversion (participation of € 120,000 less convertible loan of € 100,000).

The exchange taxation can lead to a tax payment without cash inflow at the time of conversion (so-called „dry income“). If the business idea of the start-up cannot be realised in subsequent periods and the start-up fails, a final loss of value from the participation in the start-up can only be offset against other income from capital assets in the same period, provided that this income is also subject to the special tax rate of 27.5% (e.g. capital gains or dividends from capital shares). If, however, there are no other capital assets or – for whatever reason – realisation of income from other capital assets does not make economic sense, the loss in value from the start-up participation is not taken into account for tax purposes.

A fictitious taxation of profits therefore occurs if, in a first step, a tax payment is made in the course of the conversion of the convertible loan and subsequently the participation in the start-up can only be realised at a loss without this loss also being utilised for tax purposes.

 

Structuring considerations in order to avoid a fictitious profit taxation
In this context, the preparatory transfer of the convertible loan to an existing or newly founded GmbH could be considered. At the level of a GmbH, losses can also be utilized in the form of a loss carried forward in subsequent periods (at least to the extent of 75% of the positive income), provided there is corresponding positive income. With such a structuring, however, it should be noted that a GmbH is also associated with certain structural costs (e.g. establishment, ongoing compliance) and apart from that, a later possible exit can be disadvantageous if the start-up develops in the opposite direction (e.g. taxation of the sale of the participation in the start-up at the level of the GmbH and additionally in the case of distribution of exit proceeds to the private individual).

Apart from that, one could also consider arguing that there is no exchange taxation for example based on the following considerations (in both cases, disclosure of the chosen argumentation to the tax office would be necessary):

• The value of the participation received in the start-up as a result of the conversion of the loan does not correspond to the value according to the financing round or, depending on the individual case, the value according to the financing round did not come about through market-conforming pricing (e.g. only one investor).
• It could also be argued that the conversion is not subject to exchange taxation for various reasons (e.g. conversion right has already been agreed from the beginning and is inseparably linked to the loan, German tax authorities do not see conversion as an exchange in a comparable legal situation, convertible loans and convertible bonds are economically identical transactions). For further details we refer to our article in a specialist journal, which can be found under the following link: https://www.ecovis.com/austria/wp-content/uploads/2021/04/Ertragsteuerliche-Behandlung-von-Wandeldarlehen_swk.pdf.

 

Conclusion
In certain constellations, convertible loans from private individuals can lead to a fictitious profit taxation. Possible strategies for avoiding taxation of such fictitious profits must be analysed on a case-by-case basis.

Against this background it is therefore still incomprehensible, that Austria – in contrast to Germany for example – has still not created better framework conditions for start-ups and convertible loans investments.

 

Authors:

Christoph Puchner, Managing Partner and Tax Advisor &
David Gloser, Managing Partner, Tax Advisor and Chartered Accountant from ECOVIS Austria, one of the leading tax consultants in Austria in the startup sector.